The recently released Draft Taxation Laws Amendment Bill of 2022, which is open for public comment to 29 August, proposes important amendments to the definition of contributed tax capital (“CTC”). CTC is a tax concept akin to the old company law concept of share capital and share premium. If an amount is received by or accrues to a company in exchange for shares issued by the company, such amount is added to the CTC attributable to the class of shares that was issued. If the company makes a distribution to shareholders, its directors may resolve that the distribution, or a part of the distribution, constitutes a return of CTC. In such a case there is a subtraction of the return of CTC from the balance of CTC attributable to the relevant class of shares. To the extent that the distribution is not resolved to be a return of CTC, it will constitute a dividend.
To a shareholder receiving a distribution from a company, there are important differences between whether what is received is a return of CTC or a dividend. If it is a dividend, the dividend will not give rise to capital gains tax but dividends tax may be payable. There are various types of shareholders who are not subject to dividends tax, most notably, South African resident companies. On the other hand, if the distribution is a return of CTC, the amount received usually has capital gains tax consequences for the shareholder but not dividends tax consequences. However, there are various situations in which shareholders are not subject to capital gains tax in relation to shares in South African resident companies, most notably, if the shareholder is a non-resident (with some exceptions) or an entity that is entirely exempt from income tax. Depending on the nature of a company’s shareholders and the availability of CTC for distribution, the definition of CTC does not prohibit a company from resolving, based on the tax consequences of the decision for its shareholders, whether a distribution will constitute a return of CTC or a dividend.
Although each class of shares has its own separate balance of attributable CTC, within each class the definition of CTC does not envisage a “tracing” of CTC contributed by particular shareholders. In other words, CTC that is contributed by one shareholder in a class may be distributed to another shareholder in the same class. However, there is a pro-rata limit to the amount of CTC that may be distributed to any shareholder in a distribution, which is calculated as the total CTC in the relevant class immediately before the distribution multiplied by the percentage of shares of that class held by the shareholder. If the company makes multiple distributions of CTC, this limit is reset for each distribution. Given the tax play between dividends tax and capital gains tax, these principles can lead to situations that are perceived by National Treasury to constitute tax avoidance, as illustrated by the following example.
Say a company has one class of shares and that it has one shareholder (“shareholder A”), a South African resident company that is a member of an international group of companies. Say shareholder A subscribed for its 100 shares by contributing R100 to the company. Therefore, the CTC of the company is R100. If shareholder A were to sell 50 of its 100 shares to a non-resident member of its group (“shareholder B”), shareholder A would hold 50 shares and shareholder B would hold 50 shares. The CTC of the company would remain at R100, since a total of R100 would have been contributed to the company by its shareholders.
If the company wished to distribute R60 of accounting profits to its shareholders, in terms of the Companies Act it must do so pro-rata to the shareholders’ shareholding. In other words, R30 must be distributed to shareholder A and R30 to shareholder B. It would suit shareholder B to receive CTC rather than a dividend because as a non-resident shareholder, shareholder B would generally not be subject to capital gains tax in relation to the shares in the company but would potentially be subject to dividends tax were the distribution to constitute a dividend rather than CTC. In terms of the definition of CTC, since there is R100 of CTC available and each shareholder holds 50 per cent of the shares, up to R50 of any distribution may constitute a return of CTC to each shareholder.
Therefore, the company may resolve that the distribution of R30 to shareholder B be made entirely from CTC but that the distribution of R30 to shareholder A be entirely a dividend, which dividend would be exempt from dividends tax in the hands of shareholder A since it is a South African resident company. Therefore, although shareholder B did not contribute any of the company’s CTC, shareholder B would be able to enjoy the benefit of CTC that was contributed by shareholder A and would not pay dividends tax on the distribution. After the distribution, the company would have R70 of CTC remaining and up to 50 per cent, or R35, of any distribution may constitute a return of CTC to each shareholder. If the company were to distribute a further R60 of accounting profits, it could therefore once again resolve that the full distribution of R30 to shareholder B be made entirely from CTC but that the distribution of R30 to shareholder A be a dividend. Thus, not only would shareholder B have received distributions without suffering dividends tax, due to the “re-setting” of the pro-rata amount of CTC available after each distribution, shareholder B could receive more than its original pro-rata share of CTC of R50.
It is therefore the fact that CTC contributed by a shareholder may be “returned” to another shareholder coupled with the ability of the company to resolve whether distributions constitute a return of CTC or a dividend that give rise to the anti-avoidance concerns.
The above treatment also applies to targeted buy-backs of shares by companies, excluding general buy-backs by SA-listed companies. When a company buys back its shares from a particular shareholder, the amount paid by the company for the shares may be resolved to either constitute a dividend or a return of CTC. The one or other classification of the amount may suit the shareholder from a tax perspective. However, in the case of a share buy-back, only the shareholder whose shares are bought back will receive the distribution.
To address its concerns, as part of the 2021 income tax amendments National Treasury proposed that changes be made to the definition of CTC. These changes would have had the effect that all proceeds arising in any scenario in which non-pro rata distributions of CTC were made to shareholders, including in targeted share buy-back scenarios, would have had to constitute a dividend and that no portion thereof would have been able to constitute a return of CTC. However, this would clearly have been inequitable in various situations. If, for example, a shareholder who is a natural person contributed CTC to a company in exchange for the issue of shares and was seeking to have the shares held in the company bought back for an amount of proceeds that were the same as the amount contributed, it would be inequitable if the CTC contributed could not be returned to the shareholder. If the proceeds from the buy-back were not a return of CTC, they would constitute a dividend which would attract dividends tax. However, if the proceeds were a return of CTC, the shareholder would be in the (correct) tax-neutral position, by having a gain of zero on the acquisition and disposal of shares and no dividends tax.
As a result of submissions made by SAICA’s National Tax Committee to the Parliamentary Standing Committee on Finance in November 2021, the effective date of the above proposal was postponed by one year from 1 January 2022 to 1 January 2023, to allow more time for National Treasury to deliberate with stakeholders on the amendments.
Following a public consultation session earlier this year, revised wording of the amendment appears in the Draft Taxation Laws Amendment Bill of 2022. Although the wording is not altogether clear, it seems that companies will, as before, still be able to allocate unequal amounts of CTC between shareholders in a distribution, provided that in all other distributions of CTC made within 91 days prior to or after the date of the non-pro rata CTC distribution, CTC is allocated on a pro-rata basis to all shareholders within the relevant class of shares. Failure to comply with this requirement will result in distributions made during this running period having to be accounted for entirely as dividends, which may result in retrospective reclassifications of distributions as dividends together with associated dividends tax implications. If the proposed amendment is passed, it will come into effect from 1 January 2023.
It appears that the ‘prior to or after’ requirement above should have been a ‘prior to and after’ requirement to achieve the intended result. In other words, a given distribution is meant to be tested against all other distributions made within the 91-day period prior to the given distribution and all other distributions made within the 91-day period after the given distribution.
Effectively, the 91-day periods against which the distribution is tested will allow companies to make both a half-yearly and final distribution each year, allocating CTC unequally between shareholders, provided that any other distributions of CTC during the year are made on a pro-rata basis. Usually, except in the case of distributions on preference shares and targeted buy-backs, distributions by companies are not made more than once every six months. Therefore, if the amendment is passed in its current form, I doubt whether it will prove acceptable to National Treasury in the longer term. BDO will submit comments on the above amendment as part of our annual submission to National Treasury and SARS on the Draft Bills.
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