Double Non-taxation of Hybrid Debt Instruments Issued by Non-residents
27 September 2016
By Esther van Schalkwyk, Senior Tax Consultant at BDO South Africa
National Treasury indicated its intention to address double non-taxation, if an issuer of a hybrid debt instrument is not a South African resident taxpayer, with effect from 24 February 2016.
Debt instruments containing equity features are commonly referred to as hybrid debt instruments. The anti-avoidance rules contained in the Income Tax Act reclassify interest on “hybrid debt instruments” and “hybrid interest” as dividends in specie in the hands of the issuer and the holder of an instrument. As a result, the issuer of the hybrid debt instrument is denied an interest deduction against its taxable income and is usually subject to dividends tax. The holder, on the other hand, is deemed to receive an exempt dividend instead of an interest payment.
As explained in the 2016 Budget, the South African government cannot effectively deny interest deductions to foreign issuers of hybrid debt instruments 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 and the foreign issuer may claim an interest deduction. Many countries work together to address the exploitation of tax mismatches between jurisdictions, known as Base Erosion and Profit Shifting (BEPS).
The 2016 Draft Taxation Laws Amendment Bill indicated that the Income Tax Act would be amended to exclude the unintended consequences where the issuer of a hybrid debt instrument is not a South African resident taxpayer. The proposed amendments include limiting the definition of an “instrument” as a basic requirement for the application of the interest reclassification rules, based on the identity of the issuer of the instrument.
Treasury proposed that the definition of an instrument, which is currently “any form of interest-bearing arrangement or debt” be limited to any form of interest-bearing arrangement or debt that is issued by:
- a company that is a resident;
- a non-resident company where that interest is attributable to a permanent establishment of that company in South Africa; or
- a controlled foreign company if that interest must be taken into account in determining that company’s net income as contemplated in section 9D.
The interest reclassification rules should then only apply to situations where the South African government can effectively deny an interest deduction to the issuer of an instrument. If enacted, the proposed amendment will to some extent apply retrospectively. Any interest incurred / accrued on or after 24 February 2016 in respect of instruments issued by non-residents may no longer be subject to reclassification in terms of the Income Tax Act, notwithstanding that that same instrument may during previous years of assessment have given rise to the reclassification of interest under the Income Tax Act. In the absence of the interest reclassification rules applying, the interest payments may give rise to taxable income in the hands of the holder as such payments will no longer be reclassified as exempt dividends in specie.
Taxpayers that are parties to hybrid debt instruments that were issued by non-residents should therefore consider the impact of the proposed amendments on their tax affairs.
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