Exempt dividends treated as income or proceeds for capital gains

Exempt dividends treated as income or proceeds for capital gains

• 18 September 2017
• Corporate Tax
• Craig Miller and Joon Chong

Important:

This article is based on tax law for the tax year ending 28 February 2018.

Authors: Craig Miller and Joon Chong (Webber Wentzel)

A common method for South African corporate shareholders to exit a South African equity investment is for the target company to repurchase the shares held by the exiting shareholders where the repurchase consideration is typically funded by a cash subscription for new shares by the new investors. Where the repurchase consideration does not reduce the "contributed tax capital" of the company, the repurchase would be a "dividend" distribution which would usually be exempt from income tax and also dividends withholding tax in the hands of the exiting corporate shareholder. In essence, the repurchase would be a "disposal" of the shares held by the exiting shareholder for amounts which are recharacterised as "dividends" for income tax purposes.

The draft Taxation Laws Amendment Bill, 2017 proposes amendments which would result in the amount of such dividends being treated as proceeds for capital gains tax (CGT) purposes where the exiting corporate shareholders held the shares in the target company on capital account. In terms of the draft proposals, these rules apply if (i) an exempt dividend is received by or accrued to the exiting shareholder within 18 months from the date of disposal of the shares held by the exiting shareholder; and (ii) the exiting shareholder (along with connected persons) held a "qualifying interest" in the target company (which is defined as more than 50%, or 20% if no other shareholder holds a majority interest).

In our view, the proposed amendments are currently too widely couched and give rise to a number of unintended adverse consequences. We identify some of these issues below.

The proposed amendments do not differentiate between cash distributions and distributions in specie that may occur outside the application of any corporate rules. An in specie distribution would typically have already been subject to CGT in the hands of the company making the distribution. The full value of the distribution in specie would again be subject to CGT in the hands of the recipient shareholder, resulting in double taxation of the same economic gain.

A company may distribute its cash or similar asset/s as a dividend to its parent company in anticipation of winding up or deregistration in a situation where the rollover relief in section 47 of the Income Tax Act for liquidation distributions does not apply. If, in these circumstances, the distributing company is wound up or deregistered within 18 months of declaring the dividend to its parent, the parent company would be subject to CGT on the value of this dividend.

There is no requirement that there be a link between the receipt of the exempt dividend by the exiting shareholder and the disposal by the shareholder of its shares in the company distributing the dividend. Where the company distributing the dividend is a listed company, it is conceivably possible that even two cycles of dividends may inadvertently be caught in the proposed amendments resulting in CGT for a passive corporate investor should it dispose of the listed shares within 18 months of any dividends so received.

The proposed rules also do not take the application of the corporate rules into account. For example, if company A declared and paid a dividend to its parent company following which, the parent (within 18 months of receiving the dividend), reorganised its group such that it transferred its shares in company A to say, another wholly owned subsidiary (company B), in terms of section 42 of the Income Tax Act, it is likely that the dividend received by the parent from company A would be subject to CGT in these circumstances.

The proposed amendments are deemed to come into operation on 19 July 2017, and apply in respect of any disposal on or after that date. This is problematic for many transactions that are currently in the process of being implemented. Many transactions involving the sale of shares in a company have been entered into and are currently awaiting fulfilment of suspensive conditions (for example, Competition Commission and SARB approvals). The sellers of shares in these circumstances would not have "priced" into their transactions the effective retrospective nature of the proposed amendments, i.e. the seller would have to include in proceeds for CGT purposes, all dividends received in the 18 month period preceding the disposal of shares on or after 19 July 2017.

In many instances, material equity shareholders in a company may choose to fund (or in fact may already have funded) the company (along with other funders) in the form of preference shares. Very often, these funding arrangements are structured on the basis of a cumulative arrear dividend which is only settled at the same time that the preference shares are redeemed. In terms of the proposed amendments, the redemption of preference shares in these circumstances would trigger a CGT liability in the hands of the material equity shareholder.

The Webber Wentzel Tax team has made submissions to the National Treasury on the issues with the current wording of the proposed amendments. We hope that the proposed amendments will deal with the anomalies set out above.

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