If a community were to promote the chief rat catcher to, say, the post of mayor, it should not be surprised if the town council were to devote increasing resources to rat catching. Unrestrained, the new mayor might end up deploying all council resources to the worthy aim of catching rats.
Restaurants might be closed down because that is where rats congregate. Sewers would be stopped up because rats like sewers. Perhaps the libraries would be compelled to stock only those books that dealt with rat catching in its various aspects. The rat population would undoubtedly decrease. But it would be a poor sort of town that dedicated all its resources to rat catching. The trouble is that all a rat catcher can see is rats.
I am discussing the latest draft Taxation Laws Amendment Bill, issued on June 2 by the Treasury. This bill and its 129-page explanatory memorandum show in a clear light the dangers of allowing the rat catchers to get too powerful.
The new bill proposes a vast array of measures that will have a massive impact not only on the rats who seek to avoid paying the taxes they should be paying, but every honest participant in the economy.
Directors at property loan stock companies, hitherto unsuspected of membership to the rodent fraternity, as well as at dividend unit trusts and private equity funds, are just three of the groups that will be reaching for their lawyers.
In particular, I want to draw attention to a single paragraph in the 129 pages – it doesn’t even merit a heading of its own – which will effectively abolish the redeemable preference share, and in doing so dramatically curb investment flows into the real economy. (The section is so hard to find that I give the reference here: paragraph four of page 83 of the explanatory memorandum on the draft Taxation Laws Amendment Bill 2011. In the bill itself, it’s at page 35, Section 20 (1) (b).)
The redeemable preference share is one of the great unsung glories of the financial system. Invented in Britain in the 19th century, its contribution since then to the financing of the longest and fastest period of economic growth the world has seen can scarcely be grasped. I would place it behind only the joint stock company among the great innovations in economic history.
What the redeemable preference does is fill the gap between pure equity (ordinary shares) and debt (or loans). For the investor, redeemable preference shares have four main advantages:
n They have “preference” over the ordinary shares, and have prior call over the company’s cash flow. In short, risk is lower.
n There is a definite date for redemption (“redeemable”). Ordinary shareholders have to wait.
n If the company cannot pay dividends in the early years, these can be rolled up, compounded and paid later (“cumulative”).
n Many preference shares are “participating”, that is, a defined share of the profits accrues to them.
For a company, issuing a preference share is often more attractive than pure equity, because preference shareholders have no votes. Control remains with the owners. Another plus is that the return is limited to the dividend plus a defined share of the profits.
A chief advantage of preference shares over debt is that unpaid interest is taxable. The lender must pay tax on accrued interest even if he has received nothing. Obviously lenders prefer not to pay tax in cash that they have not yet received. This is not the case with preference share dividends.
New companies and expanding companies find preference share finance a flexible and convenient financing tool, which is often attractive to investors as well. Black economic empowerment (BEE), for example, would be almost impossible without preference shares. I can think of few BEE transactions that have not involved these shares.
Preference shares form part of the toolkit for the financing of new investment: equity, preference shares, debt. Each has its own risk and return characteristics and the ability to select from these tools in different proportions are significant in promoting investment into companies. Flexibility here means a generally lower cost of capital.
Now it is proposed that, from April 1 next year, all dividends from preference shares redeemable within ten years will be taxed as income. This will raise the tax burden – in a typical case where capital gains tax and secondary tax on companies are levied – from today’s 24 percent to 44 percent for companies, and to 54 percent for trusts and individuals. It amounts to double taxation and is obviously intended to exterminate redeemable preference shares.
Why exterminate these flexible and useful instruments, which in the normal course result in zero tax leakage? The Treasury has time only to make the casual remark that “given the ease in (sic) which taxpayers are circumventing the three year rule, it is proposed that the three year rule be extended to ten years”. This is a typical case where all you can see is rats.
The Treasury allows one exclusion. A preference share will be exempt from double taxation if it may be redeemed only after 10 years (the current rule is three years). Unfortunately few investors are willing to wait ten years – five and seven years are the most common term for redeemable preference shares. And a 10-year wait creates potentially large inefficiencies.
A right to apply for exemption has been granted to anyone who has concocted a “pre-existing” clever tax-avoidance scheme by means of a third-party guarantee. Affected parties may apply to the SA Revenue Service for exemption. This discretionary power flies in the face of the principles of good governance, equitable treatment, and not least the rule of law.
It will be a sad day indeed when Parliament allows the tax officials to decide who should and who should not pay tax. It was a sad day when the tax officials felt free to publish such an outrageous proposal.
Should we be surprised that this major and far-reaching tax measure should receive no more than a single paragraph in the explanatory memorandum, and is not mentioned at all in the media statement?
Either the Treasury is clueless about the role of redeemable preference shares in the financing of investment, or it is only too well aware, and wishes to push this through without public notice.
It has certainly erred in allowing exemptions only for the questionable third-party backed schemes but not the normal, plain vanilla preference share.
The new measure may well be dropped when the consequences are brought home to our rodent operatives, but unfortunately the mere announcement causes uncertainty, and investors hate uncertainty. A capital-raising programme with which I am familiar – now at a delicate phase – will probably fail as a result of the uncertainty caused by this irresponsible proposal.
Ironically, the fiscus will get less tax revenue now, than if we had been permitted to proceed – an own goal which will be repeated in many other instances.
But if passed into law, I can tell you this: the new measure will have an immediate and disastrous chilling effect on investment flows into the real economy. Job creation – rightly the key government objective – will be severely prejudiced.
BEE will wilt. Starting new small companies and expanding existing ones will be gravely affected.
The rats will probably leave the sinking ship, but that will be a cold comfort to those of us who perforce remain aboard. I say this to our rat catchers: catch rats, but do not meddle with a financing tool that has stood the test of time.
Gordon Young, who is an investment adviser to Ditikeni Empowerment Group, is writing in his private capacity. Young, who was the founder of the Community Growth Fund, has been involved in structuring BEE transactions since 1992.