By Erich Bell, Senior Tax Consultant at BDO
Despite wide speculation about potential increases in the maximum marginal tax rate for individuals and the introduction of a new wealth tax, the honourable Minister of Finance, Pravin Gordhan, delivered a budget speech on 24 February 2016 that could be described by most South African citizens as pretty mundane. For the ordinary South African citizen, the main highlights from the Budget Speech 2016 would be the introduction of a tax on sugar-sweetened beverages from 1 April 2017, and the increase of the inclusion rates for Capital Gains Tax (“CGT”) purposes for all taxpayers.
However, from an adviser’s point of view, the Budget Speech 2016 contained a lot more proposals that require careful dissection – especially from a corporate tax point of view. One such proposal, contained on page 161 of Annexure C to the National Budget Review, is the review of the tax implications associated with share buybacks to curtail tax avoidance schemes involving share buybacks aimed at preventing the imposition of CGT.
The arsenal of any corporate tax adviser worth his or her salt includes a share buyback. This is due to the fact that a share buyback between two companies tax resident of South Africa and the reissue of shares afterwards could virtually be done without paying any taxes, with the exception of Securities Transfer Tax (“STT”), which would have to be paid by the company repurchasing its own shares at a mere 0.25% . Furthermore, shares constitute “financial services” for Value-Added Tax (“VAT”) purposes and are therefore exempt from VAT.
The income tax consequences associated with share buybacks are all attributable to the definition of a “dividend” in section 1(1) of the Income Tax Act (No. 58 of 1962) (“Act”) and the tax treatment associated with the receipt of a dividend by the shareholder. This is explained in further detail below.
The definition of a “dividend” means “… any amount transferred or applied by a company that is a resident for the benefit or on behalf of any person in respect of any share in that company …” The definition goes on to determine that any amount applied as consideration by a company for a share buyback would specifically be included in the definition of a “dividend” . Therefore, any amount applied by a company as consideration to the shareholder for the share buyback would be classified as a “dividend” for income tax purposes.
The company buying back its own shares would therefore be obligated to withhold dividends tax at 15% from the consideration, unless an exemption from dividends tax applies. One of the most common exemptions from dividends tax finds application in the case where a resident company pays a dividend to another resident company. Therefore, if the share buyback takes place between two resident companies, the company buying back its own shares would not pay any dividends tax on the consideration payable to its shareholder as part of the share buyback. It would, however, be liable for STT at 0.25% as indicated above.
The company receiving the dividend would have to include the dividend in its gross income due to paragraph (k) of the definition of “gross income” in section 1(1), which requires a person to include dividends received in their gross income. Irrespective of this gross income inclusion, the dividend would qualify in full for an exemption in terms of section 10(1)(k)(i) of the Act, as it was paid by a company that is tax resident of South Africa to another company that is tax resident of South Africa. If it was paid by a foreign company, the dividend would be partially exempt. If the shareholder held the shares as capital assets, it would have to calculate CGT on the disposal of the shares in terms of the share buyback as CGT must be calculated on the disposal of any asset which includes a sale of shares.
A capital gain would arise if the proceeds from an asset exceed the base cost thereof. Similarly, a capital loss would arise where the base cost of an asset disposed of exceeds the proceeds received by the seller for the disposal. The base cost of an asset, in broad terms, represents the expenditure incurred by the owner in acquiring an asset. The proceeds, in turn, represent the amount received by or accrued to the seller for the disposal of an asset (i.e. the consideration). Proceeds, however, exclude any amount already included in the seller’s gross income to prevent double taxation from taking place (i.e. if a seller is required to include the consideration in gross income through a specific inclusion and then again to take the same consideration into account as proceeds in calculating CGT on the disposal of the asset). In this regard, because a dividend is specifically included in gross income, even though it may be completely exempt thereafter, it must be excluded from proceeds for CGT purposes.
The fact that a dividend is excluded from proceeds from CGT purposes has the effect that a shareholder would have proceeds of Rnil for CGT purposes if a share buyback takes place and no contributed tax capital is distributed to the shareholder as consideration for the share buyback by the company buying back its own shares. The shareholder would accordingly suffer a capital loss. In the event of share buybacks taking place between two resident companies, such a capital loss would typically have to be disregarded to a certain extent.
A company does not pay any tax on the issue of shares to a shareholder. Therefore, if a share buyback is followed by fresh issue of new shares to a third party, no taxes other than STT at 0.25% become payable. This effect must be compared to the outright sale of shares by a shareholder to a third party, which would attract both CGT and STT. Therefore, by making use of the share buyback mechanism described above, the taxes associated with an outright sale by a shareholder to a third party could be circumvented.
Consider the two examples below:
Example 1: Share buyback followed by a fresh issue of new shares to a third party
Company A, Company B and Company C each own 33.33% of the issued share capital of Company Z. Company B wants to sell its entire interest in Company Z, valued at R100, to Mr A, an unconnected person. Company B has, however, rather than conducting an outright direct sale between itself and Mr A, requested Company Z to buy back its entire 33.33% shareholding for the agreed purchase price of R100 and to, thereafter, issue the same shares to Mr A for R100. Suppose that the shares held by Company B in Company Z collectively have a base cost of R40 for Company B, that Company Z did not apply any contributed tax capital as part of the consideration , that all of the above parties are tax resident of South Africa, and that all shares are unlisted. The tax implications would be as follows:
Company B would have to include the full consideration in its gross income, as it would constitute a dividend. The full proceeds would then be exempt from normal tax. Company B would have a capital loss of R60 that would have to be disregarded. No tax would therefore be payable by Company B if the share buyback option is pursued.
Company Z would be deemed to have paid a dividend to Company B equal to the consideration for the share buyback. No dividends tax would have to be withheld from the dividend as it is exempt from dividends tax because it is paid to a company that is tax resident of South Africa. Company Z would, however, have to pay STT at 0.25% on the share buyback. The issue of new shares to Mr A in exchange for the R100 would not attract any CGT as the issue of shares does not constitute a “disposal” for CGT purposes. Such a share issue would also not be subject to STT. The R100 received by Company Z from Mr A would form part of Company Z’s contributed tax capital.
Mr A would receive the shares at a base cost of R100, representing the amount he paid to Company Z to acquire the shares. He would not be liable for STT on the issue of the shares.
Suppose the facts are exactly the same as under example 1, with the exception that Company B sells its shares in Company Z directly to Mr A for R100 rather than through the share buyback mechanism involving Company Z. The tax implications would then be the following:
Company B would suffer a capital gain of R60 (R100 - R40) on the disposal of the shares to Mr A.
Company Z would not be affected by this transaction.
Mr A would be deemed to have acquired the shares at a base cost of R100 for CGT purposes. He would also be liable for STT at 0.25% on the R100 consideration paid for the shares (assuming that the consideration is equal to or higher than the market value of the shares). The STT would be allowed to be added to the base cost of the shares in Company Z for Mr A.
Share buybacks under the microscope
As of 16 March 2015, companies are required to report to SARS all share buybacks for which the consideration exceeds R10 million which are followed by a subsequent fresh issue of new shares within 12 months. Information that must be reported includes a detailed description of all the steps followed in the transaction(s), the tax benefits received by all parties, the agreements and company resolutions passed to give effect to the transaction(s), and the identification of the parties to the transaction(s). This information allows SARS to carefully investigate the transactions to determine whether they constitute tax avoidance schemes that cause the fiscus to leak taxes. It would seem that the information collected by SARS has placed share buybacks under Treasury’s microscope, with the honourable Minister of Finance announcing a review of the tax implications associated with share buyback schemes in the Budget Speech 2016.
Treasury will most likely only show its hand as to the proposed changes to the tax implications associated with share buybacks during the 2016 legislative round, which would lead to the publication of the 2016 Taxation Laws Amendment Bill in June 2016. At this point in time it is therefore impractical to speculate whether the applicable provisions would be completely overhauled or whether Treasury would merely impose a specific anti-avoidance provision aimed at curtailing share buybacks followed by a fresh issue of new shares as described above. Taxpayers considering implementing transactions which consist of a share buyback step are therefore advised to keep a close eye on the Taxation Laws Amendment Bill of 2016.