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The South African Registrar of Banks has issued regulations in terms of s90 of the Banks Act which allow banks to raise a specified form of hybrid debt capital which will rank as primary share capital, also known as Tier 1 Capital. Other corporates may issue similar instruments ("Notes"). The salient features of such Notes can vary but some terms that may be common are the following-
- the Notes have no fixed maturity date but may be redeemed by the company that issued the Notes on, say, the seventh anniversary of the date of issue of the Notes ("optional redemption date");
- the Notes must be redeemed in cash and cannot be converted into shares or be redeemed by issuing shares to the noteholders;
- on liquidation of the issuer company ("the issuer" or "the company")capital and outstanding interest (if any) on the Notes must be repaid to noteholders;
- noteholders may not attend and vote at meetings of the company;
- the Notes bear interest at a fixed rate until the optional redemption date. Thereafter the interest rate is increased;
- the issuer has the right to elect not to pay interest on the Notes subject thereto that the election not to pay must be made prior to the interest payment date. If it is not made timeously, interest must be paid to noteholders. The issuer of the Notes may only pay dividends to its shareholders if the interest on the Notes has been paid;
- the issuer may issue ordinary shares for cash and utilise the proceeds to pay the interest on the Notes;
- in the event of winding-up of the issuer, the Notes rank pari passu with any preference shares, ahead of ordinary shares and junior to all classes of debt.
Since the Notes may not be converted or exchanged for shares and may not be redeemed within 3 years from the date of issue, the Notes will not constitute 'hybrid debt instruments' for purposes of s 8F of the Income Tax Act.
The question is therefore whether these hybrid instruments constitute debt or equity and if the financing costs in respect thereof are tax deductible. If the instrument in question is a debt instrument, the issuer will normally qualify for a tax deduction in terms of s24J of the Income Tax Act, but if the said section does not apply, the issuer can qualify in terms of 11(a) of the Income Tax Act in respect of interest paid or incurred by it on the instruments and the noteholders will be taxable on interest accrued to or received by them in terms of the definition of gross income. If the instrument constitutes equity, the amounts which will be paid by the issuer to the noteholders will be dividends. The issuer will not qualify for a tax deduction and secondary tax on companies or dividends tax will be payable in respect of dividends declared.
One can draw the following comparison between debt and equity-
- a shareholder has a say in the affairs of a company but a creditor of a company may not attend and vote at meetings of a company;
- the return on a shareholder's investment is uncertain as dividends are only declared out of the profits of the company. A creditor's return on his investment is much more certain as he would be entitled to receive interest irrespective of the profitability of the company;
- security which entitles its holder to a return on capital which is variable and linked to the profitability of the issuing company displays a feature indicative of equity;
- a company is not obliged to repay capital raised by equity, whereas loan capital is repayable on the maturity date of the loan or on demand;
- an investment in equity gives the investor an exposure to substantial upside, whereas a creditor is only entitled to repayment of the amount advanced; and
- a creditor takes preference over the members of the company in respect of any distribution on liquidation of the company; and
- a right to participate in surplus assets on a winding-up is more consistent with equity.
The main reasons for there being a risk that the Notes may not qualify as debt instruments are that-
- the debt has no fixed maturity date;
- there is not a absolute legal obligation on the issuer to pay interest on the Notes on the interest payment date; and
- the Notes rank junior to all other creditors of the company but senior to ordinary shares.
The question is whether these factors alone could result in the Notes being regarded as equity instruments for tax purposes. If one considers the approach by other international jurisdictions, it appears that all the circumstances and facts surrounding the issuance of instruments must be considered and no particular fact is conclusive in making the determination of whether the instruments should be classified as debt or equity.
By following the above approach, it appears that the Notes contain many attributes that are commonly treated as supporting debt characterization for income tax purpose and therefore, in substance, they should constitute a debt instrument. For example:
- The holders of the Notes may not attend and vote at meetings of the issuer.
- The issuer will be obliged to pay interest if it does not notify noteholders that it had elected not to pay interest. In the case of equity a company is not obliged to declare dividends.
- Interest will be payable irrespective of the profitability of the issuer. In the case of equity, dividends may only be declared from distributable profits.
- In practice the issuer will pay interest on the Notes since it will not get investors if it does not pay interest and it may not pay dividends to shareholders unless interest has been paid on the Notes.
- The issuer may utilise the proceeds from the issue of ordinary shares to pay interest on the Notes. In terms of the common law dividend rules, a company may only pay dividend from profits available for distribution and may not utilise share capital raised by the issuing of new shares to pay dividends to existing shareholders.
- Interest will be payable at prescribed rates and will not be calculated by reference to profits, as in the case of dividends.
- The issuer will be obliged to repay the capital to the noteholders on winding-up. A company is not obliged to repay capital raised by equity.
- Noteholders will also not participate in surplus assets on the winding-up of the company and are only entitled to capital and outstanding interest on the liquidation of the company
- An investment in equity gives the shareholder an exposure to substantial upside, whereas noteholders will only be entitled to repayment of their capital and interest which accrue to them on redemption of the Notes.
- Although the claims of holders of the Notes are subordinated to the rights of general creditors, they will on insolvency of the issuer have the status of creditors and are entitled to priority over the claims of ordinary shareholders.
- As a consequence of the increase in the interest rate on the optional redemption date, there is an "economic compulsion" on the part of the issuer to redeem the Notes on the optional redemption date.
The Notes constitute debt instruments for purposes of the Income Tax Act. Each case must however be considered on its own facts. The terms and conditions and the circumstances surrounding the issuance of a specific instrument will determine whether it can be characterized as a debt instrument.
Interest on the Notes will however not constitute 'interest' which is tax deductible in terms of s24J of the Income Tax Act due to the fact that interest is only payable if the issuer does not elect not to pay interest and the rate of compound interest per accrual period, as contemplated in s 24J, will therefore be zero.
Subject thereto that funds raised through the issue of such Notes will be used in the production of the issuer's income, the finance charges will be tax deductible in terms of s 11(a) read with s 23 of the Income Tax Act. The finance charges will only be incurred by the issuer when it is actually paid by or if the issuer becomes unconditionally obliged to pay it because it did not exercise its election not to pay interest timeously.
susan nieuwoudt – senior associate
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