Debt restructuring and relief within the business environment have been undertaken since time immemorial. Given the current economic climate, such debt restructuring and relief has increased and thus received concomitant increased attention from the relevant tax and finance authorities.
In assessment years that commenced before 1 January 2013, the reduction of debt was generally subject to either income, capital gains or donations tax. The purpose of the relevant provisions at the time was, among other things, to ensure that relieving a debtor of the obligation to pay any portion of an amount owing would result in such debtor being subject to tax in its hands. In addition, the provisions aimed to achieve tax symmetry so that while creditors would be able to claim losses, debtors would also be taxed on the corresponding gains.
For assessment years commencing on or after 1 January 2013, the relevant rules governing this area of tax law were subjected to a significant overhaul. The new rules, contained in Section 19 of the Income Tax Act (58/1962) and Paragraph 12A of the Eighth Schedule to the act, were designed to introduce a new uniform system to provide relief to persons in financial distress that were unable to pay their debts. The amendments were necessary on the basis that the pre-existing provisions may have effectively undermined the economic benefit of the debt relief for debtors given the potential tax imposed on them.
In 2017 further significant changes were made to the debt relief rules to, among other things:
- introduce definitive rules dealing with the tax treatment of the conversion of debt into equity; and
- ensure that the relevant rules applied in all instances where a debt is settled by a debtor and the creditor receives inadequate consideration for the debt claim (ie, in order to address certain abuses pursuant to the artificial repayment of debt).
Of particular significance was the replacement of the trigger to apply the relevant provisions pursuant to a reduction of debt with two new concepts: a debt benefit and concession or compromise. In addition, the amendments provided for the exclusion of interest from the application of the debt relief rules and for debt-to-equity conversions to be limited to arrangements between companies forming part of the same group.
As is often the case when introducing new tax legislation designed to deal with specific tax avoidance arrangements, various concerns were raised about the unintended consequences that could result from the application of the recent tax amendments. The latest round of proposed tax amendments thus attempts to address the following concerns discussed in the explanatory memorandum on the draft Taxation Laws Amendment Bill:
- The inclusion of any changes in the terms or conditions of a debt as a concession or compromise could have the unintended consequence of affecting legitimate transactions. For example, a lender bank often requires related party debt to be subordinated, which would unintentionally trigger the debt relief. It has been argued that the inclusion of a change in the terms and conditions of a debt as a concession or compromise is a blunt instrument aimed at targeting a narrow group of taxpayers and should thus be removed.
- The inclusion of a substitution of an obligation in respect of a debt adversely affects arrangements that result in no loss to the fiscus (eg, the use of bridging loans) and should thus be removed.
- Determining the amount of a debt benefit by comparing the face value of a debt prior to a concession or compromise with the market value thereafter is cumbersome for each and every event and should thus be removed.
Proposal 1: definition of ‘concession or compromise’ The first proposal is that a more comprehensive definition of ‘concession or compromise’ should be included. The intention is for the new definition to limit the application of the rules to realisation events (eg, a cancellation, waiver, redemption, acquisition or conversion of debt to equity) and to ensure that any change in the terms and conditions of a debt will not trigger the rules unless such changes result in an actual realisation event.
Proposal 2: definition of ‘interest-bearing debt’ The intention has always been to exclude equity loans that are non-interest bearing from the ambit of the debt relief rules and therefore only interest-bearing debt that is converted to equity will fall within the ambit of the rules. The proposal therefore envisages including a definition of ‘interest-bearing debt’, in respect of which, interest will take on its meaning as already defined in Section 24J of the Income Tax Act. Any debt substituted for a interest-bearing debt will also fall within the ambit of the rules.
Proposal 3: definition of ‘debt benefit’ It is proposed that the definition of ‘debt benefit’ be amended in order to clarify when the new debt reduction provisions will be triggered. In summary, ‘debt benefit’ will include the following scenarios:
- In the case of a cancellation, waiver or remittance, the debt benefit will apply to the amount cancelled, waived or remitted.
- In the case of a redemption of a debt or merger by reason of the debtor acquiring the claim in respect of the debt, the debt benefit will apply to the amount by which the face value of the claim exceeds the market value of the debt after such redemption or merger.
- In respect of conversions of debt into equity where the subscriber holds no shares in the debtor prior to the arrangement, the debt benefit will apply to the amount by which the face value of the claim prior to the conversion exceeds the market value of the shares held or acquired by reason or as a result of that conversion.
- In respect of conversions of debt into equity where the subscriber holds a direct or indirect interest in the debtor prior to the arrangement, the debt benefit will apply to the amount by which the face value of the claim prior to the conversion exceeds the amount by which the market value of the shares held by the creditor or that other company after the conversion exceeds the market value of the shares held by that person in that company prior to that conversion.
Proposal 4: multiple layers of shareholdings It is proposed that definitions of ‘direct interest’ and ‘indirect interest’ should be inserted in order to eliminate double counting, which currently allows taxpayers to reduce their debt benefit by multiple increases of multiple layers of shareholdings in the debtor company.
Proposal 5: introduction of definition of ‘market value’ It is proposed that a definition of ‘market value’ will also be introduced under the debt relief rules. The key issue is not that the proposal fails to clarify the meaning of the words ‘market value’; rather, the purpose of the definition is to provide clarity regarding the timing of determining the market value of shares acquired in respect of a debt-to-share conversion.
Further proposal: closing loophole in debt relief rules In addition to the specific proposed amendments above, the National Treasury has identified two further loopholes in the legislation which require attention. The debt relief rules provide for ordering rules that give preference to the application of other provisions of the Income Tax Act, before the application of the debt relief rules. In particular, these ordering rules broadly apply in the case of, among other things, estate duty and donations and employees’ tax. The rationale is thus to avoid double taxation in respect of the same economic event.
However, it has come to the National Treasury’s attention that there may, in certain instances, be double non-taxation, which was not the legislature’s original intention. The proposals in this regard are twofold:
- The donations tax exclusion under the debt relief rules should be amended to provide that the exclusion will be available only where donations tax is actually payable on a donation arising from a debt relief arrangement.
- Amendments should be made in the debt relief rules to provide that where a concession or compromise arises after a capital or allowance asset has been disposed of, this will give rise to tax consequences.
The tax laws pursuant to debt restructuring and relief form a complex web of technical rules and while the additional proposed amendments will hopefully clear up some of the concerns recently raised, taxpayers would be well advised to keep their fingers on the pulse by studying the final proposed amendments and seeking professional advice when considering any debt restructuring arrangements so as to avoid any unintended consequences.
For further information on this topic please contact Jerome Brink at Cliffe Dekker Hofmeyr by telephone (+27 115 621 000) or email (firstname.lastname@example.org). The Cliffe Dekker Hofmeyr website can be accessed at www.cliffedekkerhofmeyr.com.