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  • Double Non-taxation and Hybrid Debt Instruments: What you Should know

Double Non-taxation and Hybrid Debt Instruments: What you Should know

20 June 2016

By Esther van Schalkwyk, Senior Tax Consultant at BDO SA

In the 2016 Budget, it was proposed to address double non-taxation that arises where the issuer of a hybrid debt instrument is not a South African resident taxpayer, effective 24 February 2016. Debt instruments with equity features are commonly referred to as hybrid debt instruments. To qualify for an interest deduction, companies often issue debt instruments as opposed to equity instruments as dividend payments are not deductible against taxable income. Instruments that are equity in substance but disguised as debt, are likely to be caught by the anti-avoidance rules contained in the Income Tax Act (the Act). These provisions effectively reclassify interest on “hybrid debt instruments” and “hybrid interest” as dividends in specie in the hands of the issuer and the holder of the instrument. These dividends in specie are deemed to be declared and paid by the issuer, and accrued to the holder, on the last day of the issuer’s year of assessment. The issuer of the instrument is denied an interest deduction against taxable income. Government recognised that the anti-avoidance provisions that apply to hybrid debt instruments do not effectively deny interest deductions to issuers that are not South African resident taxpayers in their countries of residence. This results in a double non-taxation or mismatch between the two countries as the holder is deemed to receive an exempt dividend in specie whereas the foreign issuer cannot be prevented from claiming an interest deduction.

SARS’ Binding Private Ruling 225 (BPR 225) (issued on 1 March 2016) illustrates an unintended favourable outcome for the taxpayer using certain hybrid debt instruments. In BPR 225, a foreign company applicant, proposed to issue secured and unsecured interest-bearing notes that would be listed on the JSE’s interest rate market. The applicant’s obligation to make payments in respect of the notes was conditional on the market value of the applicant’s assets being equal to or exceeding its liabilities. In terms of the Act, a “hybrid debt instrument” includes, among others, an instrument in respect of which a company owes an amount in terms of an arrangement where the obligation to pay an amount in respect of that instrument is conditional on the solvency of the issuer. SARS accordingly ruled that the notes constitute “instruments” (an interest-bearing arrangement or debt) and “hybrid debt instruments”. Application of the Act favoured the South African companies holding the notes, who were deemed to have received exempt dividends in specie that were not even subject to dividends tax. In BPR 225 SARS ruled that dividends tax will not be payable in respect of the payments that were deemed to be dividends in specie. This is likely based on the definition of “dividend” for purposes of dividends tax in the context of dividends paid by a foreign company, which excludes foreign dividends consisting of distributions in specie.

In light of the 2016 Budget, it is anticipated that the Act will be amended to exclude the unintended consequences illustrated above where the issuer of a hybrid debt instrument is not a South African resident taxpayer. Hybrid debt instruments issued by foreign companies may be excluded from the application of the reclassification rules.