The concept of contributed tax capital (CTC) was introduced into the Income Tax Act, No 58 of 1962 (Act) with effect from 1 January 2011.
The relevance of the concept of CTC is that it is one of the main exclusions from the definition of a dividend. A dividend is defined as any amount transferred or applied by a company that is a resident for the benefit of any person in respect of a share but does not include any amount transferred/applied that “results in a reduction of contributed tax capital of the company”. A distribution by a resident company to its shareholders, which results in a reduction of CTC will thus not constitute a dividend.
If no election is made by the directors of the company (or persons with comparable authority) that a distribution results in a reduction of CTC, the distribution will by default constitute a dividend (unless one of the other exclusions is applicable).
On 14 January 2022, President Cyril Ramaphosa assented to the Taxation Laws Amendment Bill, B22 of 2021 (TLAB), which introduced a host of amendments to the Income Tax Act 58 of 1962 (ITA). One such amendment is that, with effect from 1 January 2023, the definition of ‘contributed tax capital’ (CTC) in section 1 of the ITA will be amended.
Where preference shares are redeemed, different tax consequences would apply if the amount paid on redemption constitutes a ‘return of capital or a ‘dividend’ for the purposes of the ITA.
Where the holder of the preference shares is not exempt from dividends tax, it is favourable from a tax point of view if the redemption of preference shares takes the form of a ‘return of capital’ rather than a ‘dividend’.
The redemption of preference shares is a ‘disposal’ for capital gains tax purposes and what accrues as a result of that disposal is the redemption price. For the purposes of capital gains tax (as regulated in the 8th schedule of the ITA), the ‘proceeds’ from the disposal of the preference shares will be equal to the redemption price, and the redemption price is usually equal to the issue price of the preference shares. In paragraph 35(3) of the 8th schedule of the ITA, any portion of the proceeds that is included in the gross income of the taxpayer is disregarded in determining the ‘proceeds’.
Dividends, in terms of paragraph (k) of the definition of ‘gross income’ in section 1 of the ITA, are included in ‘gross income’ and are therefore disregarded from the proceeds for the purposes of capital gains tax. The ‘base cost’ of the preference shares is also usually equal to the issue price. As such, if the holder of the preference share(s) originally subscribed for the preference shares and if the whole redemption price reduces CTC, there should be no tax consequences flowing from the redemption for purposes of the ITA. This is because the holder’s ‘proceeds’ from the disposal will be equal to the ‘base cost’ and there will be no capital gain or capital loss on the ‘disposal’. If, however, the whole or any portion of the redemption price constitutes a ‘dividend’ and the holder is not exempt from dividends tax, the redemption will be a dividend and (unless an exclusion applies) subject to dividends tax in terms of the ITA.
Where the redemption of preference shares takes the form of a return of CTC, it may result in a better tax position for the holder of the preference shares.
The ITA, however, regulates what CTC constitutes and also how the return of CTC is to be facilitated.
Prior to the TLAB, the return of CTC:
• had to be pursuant to the board of directors of the company having resolved (i) to return CTC and (ii) the amount of CTC that was to be returned; and
• had to be proportional to the holders of the specific class of shares on a per share basis.
The TLAB introduces an additional requirement which provides that it cannot constitute a return of CTC “unless ALL holders of shares in that class participate in the transfer in the same manner and are allocated an amount of contributed tax capital based on their proportional shareholding within that class of shares”.
The TLAB now also requires that:
(i) ALL of the shareholders of that class of shares must participate in the return of CTC; and
(ii) that ALL of the shareholders of that share must be allocated an amount of the return of CTC based on their proportionate shareholding.
It would then not be possible to effect a transfer of contributed tax capital (and thus a return of capital) if just some shareholders participate and not all.
In the 2022 Budget Speech, it was indicated that the National Treasury will further consider the impact of the proposed amendments and review the matter during the 2022 legislative cycle. Maybe the proposed amendments will not come into effect on 1 January 2023 in their current form; only time will tell.