Is your loan a disguised equity instrument?

FREEPIK

FREEPIK

Published Jul 22, 2020

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By Willem Oberholzer

Obtaining funding is an essential aspect of running a business. Loans are among the avenues businesses have at their disposal for raising funds to provide the operating and working capital vital to their subsistence and recovery.

At the same time, businesses should be aware of the anti-avoidance and “substance-over-form” provisions that govern debt financing. When concluding loan agreements, the following question should be asked: Is the debt a disguised equity instrument?

Section 8F and section 8FA of the Income Tax Act are designed to ensure that hybrid debt instruments are treated as equity instruments, as hybrid debt instruments are essentially equity instruments in their underlying nature.

A hybrid debt instrument is when:

* A company has debt instruments convertible or exchangeable for shares, unless the market value of the shares is equal to the amount owed in terms of the instrument at the time of conversion or exchange.

* A subordination agreement is entered into in which the obligation to pay an amount so owed on a date, or dates, falling within that year of assessment has been deferred by reason of that obligation being conditional upon the market value of the assets of that company not being less than the amount of the liabilities of that company.

* A company owes the amount to a connected person in relation to that company and is not obliged to redeem the instrument, excluding any instrument payable on demand, within 30 years from the date of issue of that instrument.

In a nutshell, hybrid interest in relation to any debt means:

* Any interest where the amount of that interest is not determined with reference to a specified rate of interest or the time value of money.

* If the rate of interest has been raised by reason of an increase in the profits of the company, so much of the amount of interest as has been determined with reference to the raised rate of interest as exceeds the amount of interest that would have been determined to the lowest rate of interest in terms of that instrument during the current year of assessment and the previous five years of assessment.

Interest will not be deductible but will be deemed to be dividend income included in gross income.

The interest received by the lender will be deemed to be a distribution in specie received. The interest paid by the borrower will be deemed to be a distribution in specie received.

Therefore, in the case of the taxable income of the lender and the borrower, the interest will be included in their gross income as dividend income, and no interest will be deductible for the borrower.

Section 64FA of the Income Tax Act stipulates that where a dividend consists of an asset in specie, the dividend shall not be exempt, unless a declaration and written undertaking for exemption is approved by the SA Revenue Service.

A disallowed exemption means the borrower will effectively be taxed at 28 percent on the value of the interest deemed to be a dividend and receive no relief - the deemed dividend will be taxable and the interest on the loan will not be deductible.

In this time of Covid-19, funding is indispensable to businesses. However, careful consideration should be given to the method of financing used, as the tax implications may become burdensome for the taxpayer.

Willem Oberholzer CA (SA) is the chief executive of Probity Advisory.

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