South Africa: Do Preference Shares Qualify as Debt for Purposes of the Thin Capitalisation Rules?

by
Lourika Goodburn, KPMG Services (Proprietary) Limited, South Africa

Thin capitalisation rules are a specific anti-avoidance provision very closely related to the transfer pricing rules, in that they are designed to combat the extraction of excessive pre-tax profits from South Africa.

Thin capitalisation arises when a nonresident investor “capitalises” a connected party with loans that are disproportionately large to the equity portion of the capitalisation. The tax avoidance intended to be prevented is that the investor would be paid amounts of interest which would under the current South African domestic law be exempt from tax while the resident recipient of the loans would be claiming a deduction for the interest paid to the investor, provided this interest expenditure meets the South African deduction criteria. This would result in a loss to the South African fisc.

Thin capitalisation rules apply to a loan from any shareholder holding 25% or more of the shares of the South African company. Any amount of interest or finance charges that is considered excessive by the Commissioner for the South African Revenue Service will be disallowed as a tax deduction in the South African company’s hands. The tax implications can be onerous, since the disallowed interest is also deemed to be a dividend and subject to Secondary Tax on Companies at a rate of 10%.

In terms of the South African Revenue Service’s Practice Note 2, the Commissioner generally accepts a maximum debt to equity ratio of 3:1.

What Constitutes Fixed Capital?

Since the thin capitalisation rules call for a comparison between the quantum of financial assistance provided by the foreign investor and the resident company’s equity (fixed capital), the components comprising the latter become integral to the identification of thin capitalization contraventions. Consequently, in determining the amount of equity, the following items are to be taken into account:

• Share capital
• Share premium
• Accumulated profits of a capital and revenue nature
• Permanent owners’ capital (excluding any financial assistance) in circumstances when there is no share capital
• Any losses resulting from the revaluation of assets

Practice Note 2 states that in determining whether or not the resident company is thinly capitalised, only the pro rata share of the amount of fixed capital is taken into account. Accordingly, a company may be thinly capitalized when it has received interest-bearing financial assistance from an investor, which has no attributable fixed capital but who is nevertheless a connected person in relation to the investee. Such a situation often arises in a multinational group context involving a centralised treasury company, which provides interest-bearing loan funding to a South African tax-resident subsidiary of the treasury company’s parent, but which has no interest in the equity in the South African tax-resident subsidiary.

What Constitutes Debt?

Practice Note 2 specifically states that only interest-bearing financial assistance is to be taken into account in calculating the amount of excessive interest. Practice Note 2 explains that:

On a literal interpretation of section 31 the concept of financial assistance would include not only interest-bearing financial assistance, but also interest-free financial assistance. As the purpose of section 31(3) is in essence to enable the Commissioner for Inland Revenue to determine an acceptable debt/equity ratio in order to disallow a deduction in respect of interest relating to the excessive portion of loan capital, the application of section 31(3) will be limited to interest-bearing financial assistance.

Paragraph 1.2 of the introduction of Practice Note 2 states that the concept of financial assistance will only include interest-bearing financial assistance for thin capitalisation adjustment purposes, despite section 31(3) being broad enough to include interest-free financial assistance. Interest-free financial assistance will not be added to permanent owners’ capital (fixed capital). Rather, it will simply be ignored for the purposes of the thin capitalisation calculation (the debt-to-equity ratio adjustment). However, for purposes of calculating the excessive interest, the interest-free loan is taken into account on a weighted average basis. Consequently, this operates for the benefit of the taxpayer because it has the result of bringing down the overall effective rate of interest.

How Are Preference Shares Treated?

Preference shares are present in most entities annual financial statements. The question now arises as to whether or not preference shares qualify as equity or as debt when calculating whether or not the entity is thinly capitalised.

Both section 31(3) and Practice Note 2 are silent regarding the treatment of preference shares.

From a company law point of view, preference shares represent share capital of a company and are not regarded as debt. Further, the South African Revenue Service has confirmed that it will treat preference shares as forming part of the equity of a company. Consequently, the value of preference shares would be included in determining the fixed capital component of the thin capitalization calculation.

How Is Convertible Debt Treated?

Convertible debt (i.e., loans that may be converted to equity) will be treated as debt until such time that they are converted to equity.

For more information, contact a tax professional with KPMG in South Africa:

Lourika Goodburn, +27 (0) 11 647 7631, lourika.goodburn@kpmg.co.za