Hybrid Equity Interest on Third-Party Shares

Source: BINDING CLASS RULING: BCR 081 dated 08 September 2022 from SARS

ACT : INCOME TAX ACT 58 OF 1962, SECTIONS 8E AND 8EA

This ruling determines whether a participatory interest held by a class member in a collective investment scheme (CIS) in securities constitutes a hybrid equity instrument as defined in section 8E or a “third-party backed share” as defined in section 8EA. The portfolio of a collective investment scheme in securities is in accordance with the provisions of Part IV of the Collective Investment Schemes Control Act 45 of 2002 (CISCA) and the class members are resident natural persons, trusts, companies and pension funds.

The CIS is open to the public and generally invests in dividend yielding instruments in accordance with the provisions of Board Notice 90 issued by the Financial Sector Conduct Authority and the provisions of the CISCA.

The preamble to the Board Notice reads as follows: “The Financial Sector Conduct Authority, under section 44(4) of the Financial Advisory and Intermediary Services Act, 2002 (“the Act”), read with section 281(3)(b) of the Financial Sector Regulation Act, 2017, hereby exempts particular persons from provisions of the Act and certain measures promulgated thereunder, to the extent set out in the Schedule.”

The CIS proposes to amend its investment portfolio and will, in future, invest in rated preference shares, bank preference shares, unit trust funds and interest-bearing investments which provide an appropriate return. The precise instruments in which the applicant proposes to invest, as well as the terms of those instruments, were furnished to SARS and were duly examined. The proposed transaction relates to the returns which will be received and distributed by the CIS in future.

The value of the participatory interest which the class members hold in the CIS will be determined partly with reference to the money market fund investments and partly with reference to preference share investments. The participatory interests held by the class members are not subject to any arrangement in terms of which the issuer of that equity instrument is obliged to redeem that equity instrument or to distribute an amount constituting a return of the issue price in whole or in part.

The CIS will not invest in any instrument contemplated in paragraphs (a), (b) and (c) of the definition of a “hybrid equity instrument” as defined.

The terms of the participatory interest do not entitle the class members to any of the rights contemplated in the definition of an “enforceable right”.

This binding class ruling is subject to the following additional condition and assumption:

a) The ruling is applicable solely to the investments made by the CIS as set out in the facts and which were examined by SARS.

The ruling made in connection with the proposed transaction is as follows:

a) The participatory interest in the CIS, held by a class member will not constitute a “hybrid equity instrument” as defined in section 8E nor a “third-party backed share” as defined in section 8EA.

Some background info of Sections 8E and 8EA

SECTION 8E is an anti-avoidance provision that targets shares that have substantial debt features. Should the section be applicable, the dividend is deemed to be an amount of income that is accrued by the holder of the preference shares and not exempt from income tax. The issuer of the preference shares can equally not deduct the amount concerned even though it is recharacterised as income in the hands of the holder of the preference shares.

A key features of section 8E is that a preference share will be deemed to be a so-called hybrid equity instrument to the extent that the issuer of the preference share is obliged to redeem the preference share within three years from the date of issue.

The date of issue of a share is not only confined to the actual date upon which the share is issued by the company, but it includes the date on which:

  1. the company that issued the share undertakes the obligation to redeem the share in whole or in part; or
  2. the holder of the share, at any time after the share has been issued, obtains the right to require that that share been redeemed in whole or in part, other than as a result of its acquisition by the holder thereof.

The effect of this definition is that a date of issue can also arise to the extent that there is subsequently an undertaking by the issuer of the preference share to redeem the preference share within a period of three years.

SECTION 8EA of the Income Tax Act provides that subscription proceeds received by or accrued to the issuer of the preference shares will be deemed to have been used for a “qualifying purpose” if it is used for:

a. the direct or indirect acquisition of an equity share in a company which is an “operating company” at the time of receipt or accrual of the dividend, provided that it cannot be used to acquire shares in an operating company which, immediately prior to such acquisition, formed part of the same group of companies as the person acquiring the equity shares;

b. the direct or indirect acquisition or redemption of other preference shares (Original Preference Shares) if:

i.  the Original Preference Shares were originally issued for a “qualifying purpose”; and

ii. the amount received by or accrued to the issuer does not exceed the amount which remains outstanding in respect of the Original Preference Shares;

c. the payment of dividends in respect of the Original Preference Shares; and

i.  the partial or full settlement of debt incurred in respect of any one of the above.

d. An “operating company” is defined in s8EA of the Income Tax Act as:

i.  a company that carries on business continuously and, in the course of operating such business, provides goods and/or services for consideration or carries on exploration of natural resources;

ii. a company that is a controlling group company in relation to the aforementioned operating company; and

e. any company that is a listed company.

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