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Subordination Agreements and the Hybrid Debt Rules: the Latest

28 November 2016

By David Warneke, Head of Technical Tax, BDO SA

The Draft Taxation Laws Amendment Bill of 2016 proposed a notable reprieve for companies with subordinated debt that are experiencing financial difficulty.

In terms of current legislation, interest incurred on subordinated debt is reclassified as a dividend in specie in the hands of both the borrower and lender. This reclassification leads to financial hardship for borrowers as generally companies that are in financial difficulty have subordination agreements. The reclassification of interest to a dividend in specie denies the borrower an income tax deduction for the interest, which may exacerbate the financial distress of the borrower.

To alleviate this hardship, the Draft Bill proposed that a portion of the interest incurred on subordinated debt would escape reclassification to a ‘dividend in specie’. The portion that the company was legally able to declare as a distribution in terms of the solvency and liquidity test (per the Companies Act of 2008) would be reclassified. The balance of the interest, namely the amount that the company would not be able to legally declare as a distribution in terms of the solvency and liquidity test, would not be reclassified. The proposal would only have applied to amounts owed between companies that were within the same South African ‘group’ as defined for income tax purposes.

The final version of the Bill alters the reclassification test. The proposal is now wider than in the Draft Bill as reclassification may potentially even be avoided on debts that are not owing between companies that are within the same South African ‘group’ as defined for income tax purposes. To escape reclassification, an auditor registered in terms of the Auditing Profession Act of 2005 must certify that the payment by the debtor of an amount owed in terms of the debt instrument has been or is to be deferred by reason of the market value of the assets of the company being less than the amount of the liabilities of the company.

It is likely that the proposal will be enacted in this form and if so, it would take effect for years of assessment commencing on or after 1 January 2016.

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