On the other hand, where a company declares a dividend, the dividend may be exempt from normal tax in the hands of the shareholder recipient, however, the company will not be able to deduct the amount as an expense. Further, the dividend may be subject to dividends tax (unless – among other things – the shareholder is a company), which burden is borne by the beneficial owner, i.e. the person entitled to the benefit of the dividend attaching to a share.

The South African Revenue Service (SARS) recently issued Binding Private Ruling 398, dated 17 November 2023 (BPR 398) which provides a great opportunity to refresh one’s memory of the anti-avoidance provisions contemplated in section 8E and 8EA of the Income Tax Act 58 of 1962 (Act).

Facts of BPR 398

The applicant in BPR 398 was a resident company that wholly owned a resident property holding company (PropCo) which, in turn, owned land situated in South Africa.

In terms of the ruling, the applicant and another resident company (DevelopCo) intended to incorporate a joint venture for the purposes of developing the land owned by PropCo and “unlock[ing] the inherent value of the land”.

It is noted in the ruling that given the uncertainty around the ability to “unlock the inherent value of the land”, a third-party buyer would be unwilling to pay for the speculative value of the land.

As such, it was proposed that:

• PropCo would issue preference shares to the applicant as a capitalisation share issue which would give the applicant a preferential right equal to the speculative value of the land; and
• the applicant would, thereafter, dispose of 51% of the ordinary shares in PropCo to DevelopCo.

The preference shares to be issued to the applicant by PropCo would incorporate, inter alia, the following terms:

• the preference shares would rank in priority with respect to distributions by PropCo and the repayment of shareholder loans;
• each preference share would be or may be redeemable, as the case may be:
  • on a scheduled redemption date (which will be five years after the original date of issue); or
  • at the voluntary and sole discretion of the board of PropCo; or
  • if a trigger event, illegality event or a sanction event arises; and
• if a trigger event occurs, a dividend rate of 7% would be applied to any outstanding payments in respect of the preference shares.

The rationale for issuing the preference shares was to protect the applicant against divestiture of control in the shareholding of PropCo. In this context, the preference shares intended to enable the applicant to have a preferential claim which would be secured by the land, enabling it to have direct access to the land as security in the event that the joint venture was not successful, and the preference shares could not be redeemed.

The ruling further notes that on redemption, the preference shares would be redeemed out of profits and not out of capital.

Ruling issued by SARS

Based on the above facts SARS’ ruling noted, amongst other things, that:

• The preference share dividends and/or redemption amounts received by or accrued to the applicant would constitute "dividends", as defined in section 1(1) of the Act.
• The preference shares would not constitute “hybrid equity instruments" as defined in section 8E(1). As such, the dividends would not be deemed to be income under section 8E(2) of the Act.
• The preference shares would not constitute “third-party backed shares” as defined in section 8EA(1) of the Act either, and any dividends declared would not be deemed to be income under section 8EA(2) of the Act.
• As soon as the applicant became entitled to compel PropCo to redeem the preference shares within three years of the date of issue, the preference shares would constitute "hybrid equity instruments" as contemplated in section 8E(1)(a)(ii) of the Act.

SARS also made some interesting rulings regarding the interpretation and application of paragraph 43A of the Eighth Schedule to the Act which pertains to the so-called “anti-dividend stripping rules”, however, we have not (for the sake of brevity) addressed these issues in this note although they do warrant further analysis.

Recap on applicable provisions

Section 8E and 8EA of the Act are anti-avoidance provisions aimed at share-financing transactions (usually preference shares) that disguise otherwise taxable interest as tax-exempt dividend income.

In terms of section 8E(2) of the Act, a taxpayer who receives or to whom dividends or foreign dividends accrue, during any year of assessment in respect of a share or equity instrument, will be deemed to have received or accrued an amount of income to the extent that the share or equity instrument constitutes a “hybrid equity instrument” at any time during the year of assessment. The practical effect of this provision is that since the amount is deemed to be income, the basic dividend exemption in section 10(1)(i) of the Act will not be available.

The trigger for the applicability of section 8E is the presence of a “hybrid equity instrument”.

The term “hybrid equity instrument” is defined in section 8E(1) and can be divided into five categories. However, for purposes of this article we only include two (out of five) of the subparagraphs of the definition that are contemplated in section 8E(1) of the Act.

In this context, section 8E(1) defines a “hybrid equity instrument” as:

“(a) any share, other than an equity share, if:

• the issuer of that share is obliged to redeem that share or to distribute an amount constituting a return of the issue price of that share (in whole or in part); or
• the holder of that share may exercise an option in terms of which the issuer must redeem that share or to distribute an amount constituting a return of the issue price of that share (in whole or in part, within a period of three years from the date of issue of that share …

(c) any preference share if that share is:

• secured by a financial instrument;
• subject to an arrangement in terms of which a financial instrument may not be disposed of, unless that share was issued for a qualifying purpose.”

Section 8EA, on the other hand, is triggered by the existence of a “third-party backed share”. Similar to section 8E, any dividends or foreign dividends received or accrued in respect of a share or equity instrument will be deemed to be income in the hands of the recipient to the extent that the share or equity instrument constitutes a “third-party backed share”.

Section 8EA(1) defines a “third-party backed share” as:

“[A]ny preference share or equity instrument in respect of which an enforceable right is exercisable by the holder of the preference share or equity instrument as a result of any amount of specified dividend, foreign dividend, return of capital or foreign return of capital attributable to that share or equity instrument not being received by or accruing to any person entitled thereto.”

The mischief that is sought to be eliminated by section 8EA is a situation where, instead of granting a loan, the lender acquires shares and stands to receive tax-free dividends – as opposed to interest – from the borrower. The objective is therefore to eliminate special purpose vehicles and other third-party guarantee mechanisms that allow the holder of preference shares to rely on guarantees from third parties, thereby avoiding the risk inherent in the issue of the preference shares itself. In essence, the concept of a “third-party backed share” is a preference share guaranteed or endorsed by a third party with regard to the specified dividend yield or return attached to it.

The difference between section 8E and 8EA is that the focus in 8E is on the instrument itself, whereas in 8EA it is on the dividend yield.

Comments

It is noted that in terms of the facts of BPR 398, the preference shares are subject to a scheduled redemption date of five years after the original date of issue. However, the facts also signal the possibility of redemption prior to the lapse of the five years – i.e. if the board of PropCo so decides or if a trigger event, illegality event or a sanction event arises. It is therefore no surprise that SARS ruled, in the first instance, that the preference shares do not constitute “hybrid equity instruments”.

However, and more importantly, the ruling does note that “as soon as the applicant becomes entitled to compel PropCo to redeem the preference shares within three years of the date of issue, the preference shares will constitute hybrid equity instruments as contemplated in section 8E(1)(a)(ii).”

This ruling is important because it confirms that even though there is no upfront obligation on the issuer (i.e. PropCo) in the first three years to redeem the preference shares (and concomitantly no right for the holder (i.e. the applicant) to redeem the preference shares within the first three years, if certain events arise and the applicant becomes entitled to compel redemption, then the instrument becomes a “hybrid equity instrument”. All dividends then declared in that year of assessment will be recharacterised as income.

Furthermore, even though there is a type of security provided for the preference share holder in the facts in this ruling, SARS implied that the preference shares would not fall within subparagraph (c) of the definition of “hybrid equity instrument”. This means that, in SARS’ view, the security provided would not, among others things, be considered a “financial instrument” or a “financial arrangement in terms of which a financial instrument may not be disposed of”.

Additionally, SARS implied that the security mechanism would not result in the preference shares becoming “third-party backed shares”. In this context, the security rights held by the applicant were importantly exercisable against the issuer of the preference shares itself and not a “third-party”.

This ruling also highlights the importance of reviewing the nature of a preference share or equity instrument on a regular basis as both sections 8E and 8EA will apply if the share or equity instrument constitutes a “hybrid equity instrument” or “third-party backed share”, as the case may be, at any time during the year of assessment. These provisions are complex technical anti-avoidance sections with many nuances and one could unwittingly fall within these sections (with dire consequences – especially for the issuer) if a taxpayer does not seek professional tax advice prior to entering into the arrangement.