My client is a private company with credit shareholder loan accounts. They are contemplating to capitalise the loan accounts. Will the capitalisation of the loan accounts have any tax implications for the company and also for the shareholders personally
Important:
This answer is based on tax law for the tax year ending 28 February 2020.
Answer:
In terms of section 40, of the Companies Act, the board of a company may issue authorised shares only for adequate consideration to the company. Before a company issues any particular shares, the board must determine the consideration for which, and the terms on which, those shares will be issued.
In the 2009 Explanatory Memorandum, on the Taxation Laws Amendment Bill, it was stated that:
“CTC would also include … the cancellation of a loan account owed by the company as consideration for the issue of shares.” (Note: ‘CTC” refers to contributed tax capital_.
Tax consequences for the company can only arise when section 19 of, or paragraph 12A, of the Eighth Schedule to the Income Tax Act applies. For purposes of section 19(1), or paragraph 12A, of the Income Tax Act, and with effect from 1 January 2018, ‘concession or compromise’ means any arrangement in terms of which … a debt owed by a company is settled, directly or indirectly —
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by being converted to or exchanged for shares in that company; or
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by applying the proceeds from shares issued by that company;
and, ‘debt benefit’, in respect of a debt owed by a person to another person, means … in the case of the settling of that debt by means of an arrangement described in paragraph (b) of the definition of ‘concession or compromise’, where the person who acquired shares in a company in terms of that arrangement held an effective interest in the shares of that company prior to the entering into of that arrangement, the amount by which the face value of the claim held in respect of that debt prior to the entering into of that arrangement exceeds the amount by which the market value of any effective interest held by that person in the shares of that company immediately after the implementation of that arrangement exceeds, solely as a result of the implementation of that arrangement, the market value of the effective interest held by that person in the shares of that company immediately prior to the entering into of that arrangement …
You indicated that these are shareholder loans – in other words, the person who advanced the loan is a holder of a share in the company. The phrase ‘effective interest’ is not defined in the Income Tax Act and there is no intention to do so - see the 17 January 2019 Final Response Document on Taxation Laws Amendment Bill.
For the holder of shares and the person to whom the debt is owed, there is a disposal, the conversion of the asset – see paragraph 11(1)(a) of the Eighth Schedule. The consideration, in respect of this disposal (see paragraph 35(1)(a)), will be the arm’s length price, or market value of the shares received on issue by the company. There will then be a capital gain or loss if this value is more or less than the base cost of the debt (instrument).
For the holders of shares, this is essentially a conversion of an asset. The loan account is converted into shares, further shares issued by the company. This, in itself, is a disposal for purposes of the Eighth Schedule to the Income Tax Act. A capital gain, or loss, will arise if the value of the loan differs from the value of the shares received in exchange. It is the market value of the shares, and under paragraph 38 of the Eighth Schedule, this value must be an arm’s length one when. This is because the parties are connected persons in relation to each other.