By Emil Brincker, Cliffe Dekker Hofmeyr Inc., South Africa
South Africa’s National Treasury on 10 June released draft legislation designed to further strengthen the recently introduced anti-dividend stripping rules. The new draft is part of the first batch of legislation proposed for inclusion in the Taxation Laws Amendment Bill, 2019.
The draft unfortunately appears to miss its target of shutting down the targeted dividend stripping abuse. As such, substantial amendments to these provisions can therefore be expected.
South Africa’s anti-dividend stripping rules
South Africa’s anti-dividend stripping rules essentially re-characterise dividends as taxable income if a company receives extraordinary dividends within 18 months before or as part of the disposal of the shares.
During South Africa’s February Budget Review, the government announced that these anti-dividend stripping rules would be further refined to target a scenario where a target company distributes a substantial dividend to its current company shareholder and subsequently issues shares to a third party.
It was suggested that, as a result of this transaction, the value of the current company shareholder’s holding in the shares of the target company would be diluted in circumstances where these shares are not immediately disposed of.
The Explanatory Memorandum to the draft legislation explains further that new rules would target transactions where a substantial dividend distribution is made by the target company to the shareholder company combined with the issuance by the target company of shares to a third party or third parties.
The ultimate result is a dilution of the shareholder company’s effective interest in the shares of the target company that does not involve a disposal of those shares by the shareholder company. It was indicated that these amendments are to have effect from the date of announcement, being 20 February.
Earnings stripping target?
The newly released draft legislation seems to address a different type of transaction, however.
National Treasury states it is targeting a situation where a shareholder company holds shares in another company (the target company) and the target company issues new shares to a third party. In such case, the market value of the shares held by the shareholder company in the target company is reduced by reason of the new share issue and the shareholder company is deemed to have disposed of a percentage of those shares immediately after the new shares were issued for an amount that is equal to the percentage by which the market value of those shares was reduced by reason of the new shares issued by the target company.
Thus, it appears that the draft legislation may not necessarily have targeted the relevant potential abusive transaction.
The real concern should be a scenario where a dividend is declared by the target company and paid to the shareholder company in circumstances where the market value of those shares reduces substantially. A new shareholder would thereafter subscribe for shares in the target company at minimal value (which is still market-related), given the fact that the market value of those shares would be negligible at that point in time.
There is thus only a reduction in the effective interest of the shareholder company as opposed to a dilution by the shareholder company in circumstances where new shares are issued at discounted prices. Whereas the existing shareholder’s effective interest is reduced in percentage holding terms pursuant to the subscription of shares by the new shareholder, the value of such interest remains constant in Rand terms.
The reduction in value would have occurred pursuant to the declaration of the dividend and not pursuant to the issue of the new shares.
By way of example, if one assumes that the value of the target company is 100, which is represented by one share in issue, the target company will declare a dividend of, say, 99 to the existing shareholder, reducing the market value of the one share from 100 to 1. The target company would then issue 99 shares to the new shareholder at 1 per share. The proceeds from the share subscription are used to discharge the dividend obligations of the target company. At the same time, however, the existing shareholder’s effective interest is reduced from 100% to 1%. The existing shareholder will not dispose of the one share for 18 months on the basis that such effective interest is negligible in the circumstances.
It is also noted that the proposed provisions also do not take cognisance of rights issues, capitalisation shares, or shares issued in terms of a share incentive scheme.
–Emil Brincker is a partner with Cliffe Dekker Hofmeyr, Inc.
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