Introduction
On 29 June 2012, National Treasury published the proposed draft Taxation Laws Amendments Bill 2012 (TLAB) containing significant amendments to the current Income Tax Act, 58 of 1962 (the ITA).
With the benefit of reflection since the first, but certainly not the last, draft of the TLAB was issued, we discuss below two of the more complicated concepts introduced by the TLAB. Not only are they complicated in themselves but, as we illustrate below, they have far reaching ramifications.
We alert you to two fundamental principles in the ITA that are being amended -
- the tax principles and implications relating to debt; and
- the alignment of various tax principles and implications with accounting principles set out in the International Financial Reporting Standards (IFRS).
The following amendments have been proposed in the TLAB with respect to debt:
- a definition in section 1; debt means “any amount owing by or to a person”;
- extensive amendments to section 8F regarding hybrid debt instruments and the introduction of a new section 8FA deeming hybrid interest to be a dividend;
- section 10(1)(h) relating to the exemption of interest income accruing to any person who is not a resident;
- a proposed section 23L relating to the suspension of deductions for any intellectual property and debt;
- interest withholding tax applicable to foreign debt;
- a complete overhaul of the provisions, from a revenue and capital perspective, with respect to the reduction or cancellation of debt;
- a proposed section 24BB dealing with transactions where assets are acquired as consideration for debt issued; and
- the deductibility of interest in terms of certain debt issued in order to acquire an equity share.
Four amendments relate to aligning the tax rules of certain instruments with their accounting treatment in terms of IFRS:
- the introduction of the definition of IFRS in section 1 of the ITA;
- for exchange items, the tax implications of foreign exchange differences arising where the parties to an exchange item form part of the same group for financial reporting purposes under IFRS;
- the insertion of a new section 24JB dealing with fair value taxation in respect of certain financial instruments; and
- the insertion of a new section 29B introducing mark-to-market of taxation for long-term insurers.
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Debt
Definition of Debt
The introduction of a definition of debt may result in unintended consequences in various sections of the ITA where the definition and previous judicial interpretations of the term do not align, as we explain below.
Hybrid Debt
The current section 8F of the ITA deals with the tax implications of a hybrid debt instrument defined in that section. Its does not allow any deduction on any amount paid or payable by an issuer in terms of a hybrid debt instrument.
Under the proposed amendments a new definition of “hybrid debt” has been introduced. The new definition seeks to procure that an instrument with certain characteristics is equity and not debt, this will affect the deductibility of expenditure relating to the instrument, in that expenditure linked to equity, as opposed to debt, is usually not deductible.
At present, section 8F of the ITA deems the interest in relation to a hybrid debt instrument not to be deductible. It is proposed in terms of the amendments in the TLAB, that instead of deeming interest to not be deductible, it is proposed to deem the payment or receipt in terms of hybrid debt to be with respect to a share other than an equity share. The implication of this change results in payment or receipts with respect to hybrid debt to have dividend receipt and withholding tax on dividend implication instead of non-deductibility.
The new section 8FA deems hybrid interest to be a dividend. To this end, “hybrid interest” is defined as any interest paid by the issuer if:
- the interest is not determined with reference to the time value of money; or
- the obligation to make payment is conditional upon the solvency and liquidity of the issuer; or
- there is security attached to the instrument which results in the issuer being entitled to make payment of interest in the form of shares.
Because hybrid interest is deemed to be a dividend paid by the issuer, it constitutes a distribution of an asset in specie and is not treated as interest for the purposes of section 24J.
Suspension of deduction
A new section 23L will suspend the deduction of interest expenditure to the extent that it does not constitute income received by or accrued to any other person and is not paid and has not become payable during that year of assessment.
Where the deduction of the interest expenditure has been suspended, the amount may be carried forward and deducted in a succeeding year of assessment when the amount has been actually paid or becomes payable.
Reduction or cancelling of debt
Paragraph 12(5) of the Eighth Schedule to the ITA provides for the treatment of a benefit arising from the waiver of a debt. There was uncertainty about the order of its interaction with section 24(m), recoupment of expenses, and section 20, assessed losses. This uncertainty has been resolved with the introduction of a new section 19, which spells out the order in which the benefits of a waiver are to be dealt with.
Firstly, it must be determined whether the waiver (now referred to as a reduction or cancellation, and further in this article as a benefit) has any donations tax, estate duty or fringe benefits tax implications. If so, and to that extent, the benefit has no further tax effect.
If and to the extent not, it must be treated in terms of the ordinary revenue rules to the extent that it was used to fund deductible expenditure or allowances (see (3) below for more detail).
If and to the extent that the benefit falls outside both these groups, it must be taken into account under the capital gains rules.
In applying the benefit with respect to debt relating to revenue assets, a three-tier system has been proposed:
- firstly, the benefit will reduce the cost price of trading stock. However, this cost price reduction will apply only to the extent to which the borrowed funds were used to acquire trading stock still held by the debtor and only to the extent that the trading stock has not already been written down;
- secondly, if the amount cannot be traced to trading stock so held, the excess reduction of cancellation will be applied against the balance of any assessed loss that the debtor may have; and
- lastly, if the benefit falls outside the cost price of the trading stock and balance of assessed loss reduction rules, any residue will be viewed as giving rise to ordinary revenue as a recoupment.
The capital portion of the benefit is subject to a two-tier system:
- it will firstly reduce the base costs of the capital assets to which it relates; and
- if and to the extent that it cannot be traced to an asset so held, the excess will be applied against any assessed capital losses that the debtor may have.
Assets acquired as consideration for the issue of debt
A new section 24BB proposes that where assets are acquired as consideration for the repayment of debt, and the market value of the assets immediately after the acquisition exceeds the amount of the debt, the excess is treated as a reduction of the base cost, if the asset is capital in nature, or as a reduction in the cost price, if the asset is trading stock.
Where the debt owing by that company after its issue exceeds the market value of the asset after the acquisition, the excess amount must be apportioned between the assets to which it refers., as base cost or as cost price.
Acquisition of assets in exchange for debt
A new section 40CA proposes to deem that where a company acquires any assets in exchange for debt issued by it, the company must be deemed to have actually incurred an amount of expenditure in respect of the acquisition of the assets equal to the amount of that debt.
Debt funding for the acquisition of equity
A new section 24O proposes to deal with a scenario where a company acquires an equity share in another company and as a result that company becomes a controlling group company in relation to the other company. Any interest incurred by the acquiring company in respect of an instrument issued by it solely for the purpose of directly financing the acquisition of the equity share in the other company must be deemed to have been so incurred in the production of income of that company and therefore allowed as a deduction.
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IFRS
Definition of IFRS
The introduction of the definition of IFRS promises to add a new dimension to the task of interpreting the ITA. IFRS has a history of regular, significant and complex changes. According to the proposed amendment, these will now filter through to the ITA and tax practitioners will have to remain abreast of them. This is not a proper way of legislating.
Fair value taxation in respect of financial instrument
With the development and complexity of financial institutions and products, it has become of paramount importance to the National Treasury to ensure that the appropriate tax rules are in place to deal with these.
As a step in this direction it is proposed that financial institutions fair-value various financial instruments in terms of the principles of IFRS and that those financial instruments be taxed accordingly. In order to simplify compliance and enforcement, regulated banks and authorised members of the JSE that operate under IFRS will be required to determine taxable income in respect of certain financial instruments in accordance with the mark-to-market regime required by IFRS. This will annually trigger either revenue or a loss for these financial instruments in the hands of the holder, owing to the changes in the fair value of those specific financial instruments.
These provisions apply only to instruments that, in terms of IFRS, comprise financial assets or liabilities classified as “held for trading” or “designated upon initial recognition as at fair value through the statement of profit or loss and other comprehensive income”. This language, so alien to tax ears, is a perfect example of the difficulties that await tax practitioners and taxpayers in meshing IFRS and tax.
Mark-to-market taxation of long-term policyholder funds
There are two reasons for the proposed amendments, namely:
- realised versus unrealised insurer tax allocation by insurers; and
- the recent capital gains tax increase.
Insurers, as trustees of policyholder investments achieve allocation of tax by applying a continued mark-to-market approach in respect of investment gains and losses.
This principle has become outmoded for financial institutions, including insurers, and the proposal is that a deemed disposal and re-acquisition approach be applied to all policyholder fund assets that mimic mark-to-market taxation.
This approach will apply on an annual basis when allocating income tax among policyholders. The impact is a deemed sale and re-purchase of all policyholder interests at the close of each policyholder fund’s year of assessment.
A wholly revised deduction formula has been proposed for selling, administration and indirect expenses to allow for the amended mark-to-market taxation of policyholder funds.
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