This site uses cookies to provide you with a more responsive and personalised service. By using this site you agree to our use of cookies. Please read our PRIVACY POLICY for more information on the cookies we use and how to delete or block them.
  • Subordination Agreements Excluded from Constituting Hybrid Debt Instruments

Subordination Agreements Excluded from Constituting Hybrid Debt Instruments

26 February 2016

By Jennily Viljoen, Tax Trainee at BDO

Section 8F of the Income Tax Act (No. 58 of 1962) (“Act”) is an anti-avoidance provision aimed at debt having equity features. In a nutshell, its effect is to recharacterise the return on so-called “hybrid debt instruments” (interest) to a return on equity (dividends) resulting in the interest incurred by the payor on a hybrid debt instrument not to qualify for a tax deduction. The payor would furthermore be liable for, and would have to withhold dividends tax from, the interest recharacterised to a dividend if the person to whom the interest is paid is not a person who is exempt from dividends tax.

Paragraph (b) of the definition of “hybrid debt instrument” in section 8F(1) of the Act determines that a loan would constitute a hybrid debt instrument if “… the obligation to pay an amount in respect of that instrument is conditional upon the market value of the assets of that company not being less than the market value of the liabilities of that company …”

As can be seen from the above definition, should a creditor be required to subordinate its loan with a company in favour of other creditors, such subordinated loan may be classified as a “hybrid debt instrument” according to paragraph (b) of the definition.

The effect of a subordinated loan was described in Ex Parte: De Villiers and Another NNO: In Re Carbon Developments (Pty) Ltd (In Liquidation) from 24 to 29 by Goldstone JA as follows: “The essence of a subordination agreement, generally speaking, is that the enforceability of a debt, by agreement with the creditor to whom it is owed, is made dependent upon the solvency of the creditor and the prior payment of its debts to other creditors.

Subordination agreements may take many forms. They may be bilateral i.e. between the debtor and the creditor. They may be multilateral and include other creditors as parties. They may be in the form of a stipulation alteri, i.e. for the benefit of other and future creditors and open to acceptance by them. The subordination agreement may be a term of the loan or it may be a collateral agreement entered into some time after the making of the loan.

Save possibly in exceptional cases, the terms of a subordination agreement will have the following legal effect: the debt comes into existence or continues to exist (as the case may be), but its enforceability is made subject to the fulfilment of a condition. Usually the condition is that the debt may be enforced by the creditor only if and when the value of the debtor’s assets exceeds his liabilities, excluding the subordinated debt.

As can be seen from Goldstone JA’s remarks above the terms associated with a subordinated loan are different to the terms associated with a loan that is not subordinated. In a typical lending arrangement, the loan capital is repayable by the debtor to the creditor at a foreseeable future date or dates, with interest representing the return on investment for the creditor. Under a subordinated loan, the debt becomes enforceable only once the value of the debtor’s assets exceeds its liabilities. It is therefore arguable that such features classify a subordinated debt closer to equity than to debt, as the creditor cannot claim repayment until the company’s assets fairly valued exceed its liabilities fairly valued.

The tax consequences associated with subordinated loans that qualify as hybrid debt instruments place increased pressure on companies that may already be in financial distress. In this regard, Minister of Finance Pravin Gordhan announced in the Budget Speech 2016 that subordinated loans should be excluded from constituting “hybrid debt instruments”. This announcement has the effect that the interest incurred on such loans may qualify for tax deductions should the other interest deduction limitation provisions of the Act so allow. The potential liability of the payer company of interest for dividends tax would furthermore also fall away with this proposal. The Budget Speech 2016 was silent on the implementation date of this proposal.