Following its introduction by the Minister of Finance on 28 October 2020, the Taxation Laws Amendment Bill, 2020 (‘the TLAB’), was passed by the National Assembly on 17 November. One of the significant amendments proposed by the TLAB is to section 46 of the Income Tax Act, which deals with the tax treatment of unbundling transactions.
A proposed amendment to section 46 was initially published by the National Treasury for public comment on 31 July as part of the Draft Taxation Laws Amendment Bill, 2020 (‘the DTLAB’). Following the receipt of public comments on the DTLAB, the proposed amendment was substantially revised to take these comments into account, and these revisions are reflected in the TLAB.
Broadly speaking, an unbundling transaction involves the distribution by one company (referred to as the unbundling company) of all of the equity shares held by it in another company (referred to as the unbundled company) to the shareholders in the unbundling company.
Generally, in the absence of section 46, an unbundling transaction would give rise to a number of tax consequences. Firstly, the distribution by the unbundling company of the shares in the unbundled company constitutes a disposal of those shares (which, for CGT purposes, would generally be taxable in the hands of the unbundling company). Secondly, the distribution is a dividend declared by the unbundling company, which would otherwise trigger dividends tax for the unbundling company. Finally, the transfer of the shares in the unbundled company is subject to securities transfer tax.
In short, in the absence of any tax relief, the tax implications of an unbundling transaction would simply make most unbundling transactions too expensive to conclude. The problem is compounded when the unbundling company does not have a sufficient level of cash or liquid assets with which to settle the resulting tax liabilities.
The importance of unbundling transactions in the South African economy
There are many commercial benefits of unbundling transactions. These largely revolve around the unlocking of value for shareholders, the deconcentration of ownership and the enhancement of focused growth strategies. Unbundlings allow for the separation of different investment profiles, which may have different funding needs or expectations from investors with respect, for example, to dividend yields. From a competition perspective, unbundling transactions may improve competitiveness in an economy by diversifying ownership in a sector.
Given the above, it is clear that unbundling transactions are of fundamental importance not only in ensuring the existence of efficient and well-functioning markets, but also to the economy as a whole.
The purpose of section 46
The purpose of section 46 is to effectively make an unbundling transaction tax neutral. Generally, the tax consequences that would have resulted from an unbundling transaction are deferred until such time as the shareholders in the unbundling company subsequently dispose of the shares they acquire as a result of the unbundling or the unbundled company disposes of its assets.
Protection of the South African tax base
In order to protect the South African tax base, section 46 contains a number of rules that limit the circumstances under which the relief it affords will apply. It is easy to see that the tax base may be eroded where, for example, a shareholder in the unbundling company will not be subject to tax when it subsequently disposes of the shares that it has acquired pursuant to the unbundling transaction. This is particularly the case if the shareholder in question holds a significant shareholding in the unbundling company and is, as a result, able to drive the transaction.
Accordingly, prior to the amendments proposed by the TLAB, one of the limiting rules in section 46 was that the relief would not apply if, immediately after the distribution, 20% or more of the shares in the unbundled company are held by what is referred to as a ‘disqualified person’ (whether alone or together with any other disqualified person who is a ‘connected person’ in relation to that disqualified person). Generally, a ‘disqualified person’ is any person who will not be subject to tax on a subsequent disposal of the unbundled shares (such as, for example, non-South African residents, retirement funds, government and public benefit organisations).
One of the purposes of this rule was to limit the relief in circumstances where a tax-exempt shareholder has significant influence over the unbundling company and can therefore secure a tax benefit that effectively erodes the South African tax base.
The amendments to section 46 as proposed by the DTLAB
As per the Draft Explanatory Memorandum released together with the DTLAB, Government appeared to be concerned with a perceived increase in the use of unbundling transactions to erode the South African tax base, particularly where the distribution of the unbundled shares is made to non-South African residents. The concern was that significant base erosion can take place where 20% or more of the shares in the unbundled company are held by non-residents who are not connected persons in relation to each other. There could, for example, be eight non-South African resident shareholders (who are not connected persons in relation to each other), each holding 10% of the shares in the unbundled company. In this scenario, Government argued, the current limiting rule is inadequate to protect the South African tax base.
In order to address this perceived threat to the South African tax base, the amendments to section 46 proposed by the DTLAB removed the reference to ‘connected persons’ in the limiting rule. The effect of this proposal was that the relief afforded by section 46 would not apply if more than 20% of the shares in the unbundled company are, immediately after the distribution, in aggregate held by disqualified persons, irrespective of the level of shareholding of each of these disqualified persons, and irrespective of whether or not they are connected persons.
The effect of the amendment proposed by the DTLAB
South African-listed groups generally have diverse shareholdings, with a significant portion comprising non-resident investors (private and institutional) and other disqualified persons. As of 2016, some 37% of the market capitalisation of the JSE was held by foreigners and another 24% was held by retirement funds. The 20% threshold would therefore almost always be satisfied for listed companies if the aggregate interest of these disqualified persons is taken into account. Accordingly, the result of the amendment proposed by the DTLAB would have been that very few, if any, unbundlings by listed companies would qualify for tax relief.
Had the amendment as proposed by the DTLAB ultimately been promulgated, this would have had a disastrous effect, not only on unbundling transactions themselves, but on South African capital markets and potentially the economy as a whole.
Public comments on the amendment as proposed by the DTLAB
Needless to say, the amendment to section 46 proposed in the DTLAB elicited a great deal of public comment.
Aside from the disastrous impact that the proposed amendment would have had, there are many reasons why, commentators argued, it was ill-considered and inappropriate.
Effect of broad definition of ‘disqualified person’
The concern of Government, as articulated in the Draft Explanatory Memorandum, appeared to be with non-residents that hold 20% or more of the shares in the unbundled company. However, the category of ‘disqualified persons’ is broader than only non-residents. It also includes the government, PBOs, recreational clubs, rehabilitation companies and trusts, retirement funds, medical schemes and various government entities. The effect of the proposed amendment was that the shareholdings of all disqualified persons in the unbundled company would need to be counted to determine whether the 20% threshold is breached. If it is, then no relief would apply to the unbundling transaction in its entirety.
Applying the rule to non-residents only was acknowledged by commentators as not being a viable solution, on the basis that this would result in a breach of the non-discrimination provisions of South Africa’s double taxation agreements with other countries. However, including all disqualified persons in such an aggregate rule, regardless of the size of their shareholdings, would have had significant implications. One option suggested by commentators was to narrow the definition of disqualified person, on the basis that, from a policy perspective, there is good reason to exclude certain of these, particularly retirement funds since such funds are not truly exempt from tax (amounts withdrawn from retirement funds are subject to tax on withdrawal and the system of taxation applicable to retirement funds is more akin to a deferral, with both contributions and returns accumulating tax-free but then being subject to tax on withdrawal).
It was implicit in the proposal that a company would need to be able to identify and determine the tax status of every beneficial owner of shares in the unbundling company (and the unbundled company) at the time of the distribution in order to determine whether an unbundling transaction would qualify for relief from tax. Conducting the analysis required to measure the proposed aggregate 20% threshold would, commentators argued, be an impossible task for any listed company. For one, the shareholding in a listed company generally changes on a regular (often daily) basis. Moreover, it is impossible for a listed company to know who all its shareholders are (let alone their tax status) on any given day, given that the shareholdings are usually held through intermediaries.
Is there really an erosion of the South African tax base?
The argument that unbundling transactions erode the tax base is easily countered when one considers the primary objective of most unbundling transactions: the unlocking of value. This may be illustrated by way of a simple example.
Assume that a listed company (Listco) has a market capitalisation of R10bn and wishes to unbundle and separately list its 100% shareholding in one of its subsidiaries (Subco). Subco has a value of R2bn and a nominal base cost for CGT purposes. A non-resident holds 10% of Listco.
Absent the unbundling relief afforded by section 46, the distribution of the shares in Subco would attract CGT and dividends tax. However, when one considers the tax base from the perspective of the individual companies and shareholders, there is no erosion of the tax base at all, assuming the non-resident is not driving the transaction with the objective of disposing of its interest in Subco in the short run.
From the perspective of the non-resident shareholder in Listco, it had an investment in Listco that was worth R1bn before the unbundling. After the unbundling, it now has a shareholding in Listco that is worth R800m and a shareholding in Subco that is worth R200m. In aggregate, its investment in the combined Listco and Subco is still worth R1bn. It has simply swapped its indirect investment in Subco for a direct investment. No value has been transferred to the non-resident shareholder. Before the unbundling, its investment with a value of R1bn fell outside the tax net. After the unbundling this is still the case. From the perspective of Listco and Subco there is also no erosion of the tax base. Their assets remain wholly within the tax net to the extent of the combined net asset value of R10bn. The only thing that has changed is that a hypothetical disposal of the shares in Subco now partially falls outside of the tax net, whereas a disposal of these shares by Listco would have been wholly within the tax net.
Shares held in unbundled company (as opposed to being held in the unbundling company)
Another concern expressed by commentators was that (as is the case prior to the proposed amendment to section 46) the test for shareholding is flawed.
In terms of the relevant rule, unbundling relief will not apply where, immediately after the distribution of the shares in the unbundled company, 20% or more of those shares are held by disqualified persons. This would include shares that may not have been held by the unbundling company (and in respect of which no relief is sought). This problem is illustrated by way of the following example. Assume the unbundling company holds 60% of the shares in the unbundled company, and other shareholders (who are not otherwise involved in the unbundling transaction at all) hold the remaining 40% of the shares in that company. Where the unbundling company distributes its 60% shareholding in the unbundled company to its shareholders, the shareholding of the other shareholders in the unbundled company could affect whether or not the unbundling company qualifies for unbundling relief.
Accordingly, it was argued by commentators that, in determining whether unbundling relief applies, no regard should be had to any shares that are not held by the unbundling company in the unbundled company and that are not distributed under the unbundling transaction.
The effective date of the proposed amendment to section 46 in the DTLAB was 31 July 2020 (i.e. the date on which the DTLAB was published for public comment). Commentators argued that this had an effect on unbundling transactions that were, at 31 July, already underway. Accordingly, and in light of the fact that unbundling transactions often take many months to finalise, it was argued by commentators that this date should be reconsidered.
Revised proposal as per the TLAB
As is reflected in the TLAB (introduced in Parliament on 28 October and passed by the National Assembly on 17 November), Government has, to a certain extent, acknowledged some of the concerns expressed during the course of the public comment process, and the revised proposed amendment in the TLAB is a significant improvement on the original proposal.
In terms of the revised proposal, a ‘prorata’ rule will apply instead of the ‘all-ornothing’ rule. In this regard, tax deferral under section 46 will not apply in respect of any equity share that is distributed by an unbundling company to any shareholder that:
Moreover, as is evident from the above, in determining whether unbundling relief applies, no regard will be had to any shares that are not held by the unbundling company and that are not distributed under the unbundling transaction.
The revised proposal is a much welcome improvement on the original proposal. From a practical perspective, it will no longer be necessary to identify and determine the tax status of every beneficial owner of shares in the unbundling and unbundled companies at the time of the unbundling distribution. In addition, the revised proposal undoubtedly results in a more equitable outcome. This is on the basis that shares distributed to persons that are not disqualified persons will benefit from tax deferral, which will only be disallowed to disqualified persons who hold more than 5% of the shares in the unbundling company. In this regard, it was acknowledged by National Treasury that the ‘all-or-nothing’ rule, which would have disallowed tax deferral in its entirety in the circumstances in which it applied, would have been too punitive.
Regarding the effective date of the proposed amendment, the TLAB has changed this date from 31 July 2020 to the date of introduction in Parliament of the TLAB (i.e. 28 October 2020). Although commentators requested a later effective date National Treasury was unwilling to accommodate this request on the basis that the revised proposed amendment is ‘softer’ than the original proposal. Moreover, National Treasury argued, the possibility that the revised proposal would be adopted was communicated during the course of the public consultation process, which should have provided sufficient time for taxpayers to plan accordingly.
Outstanding concerns Although the revised proposal is a welcome improvement on the original proposal, there are still some concerns. One example of these concerns relates to the overly broad definition of ‘disqualified person’. In this regard, National Treasury stated, in the Draft Response Document on the DTLAB, that:
'To exclude pension funds or any other category of persons from the definition of “disqualified persons” would not be desirable as there is no policy change in ensuring that the corporate reorganisation rules continue to operate as tax deferral provisions and not exemptions (as would be the case if tax deferral is allowed for transfers to persons outside of the South African tax net)’.
The above statement ignores the fact that retirement funds are not truly ‘outside of the South African tax net’ – amounts withdrawn from retirement funds are subject to tax on withdrawal – and simply ignores the submission that there is therefore good reason, from a policy perspective, to exclude them from the definition of ‘disqualified person’. Some listed companies do have retirement funds that hold more than 5% of the shares in the company. The Government Employees Pension Fund is a notable example in this regard and was the reason why the 20% threshold was introduced in the first place.
As a general matter, there is concern relating to the undue emphasis placed by National Treasury on the fiscal effect of granting a tax deferral in the context of an unbundling transaction. As discussed above, unbundling transactions are fundamentally important in the South African economy (and, in fact, in any economy).
In this context, the concern of Government with the erosion of the tax base as a result of tax deferrals arising from unbundling transactions is, it is submitted, misplaced. Tax relief for unbundling transactions should not be seen as an ‘incentive’ or as a ‘special dispensation’. Instead, the appropriate enquiry should be as to whether the tax regime facilitates or hinders unbundling transactions.
The amendment to section 46 proposed by the TLAB, although an improvement from the proposal in the DTLAB is, unfortunately, still likely to act as a hindrance to unbundling transactions.
This article first appeared on pwc.co.za.
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