Monday, November 05, 2007

By Mogola Makola
The South African Revenue Service (SARS) has withdrawn the exemption from secondary tax on companies (STC) for amalgamation transactions, more commonly known as mergers.
The background to the withdrawal of the exemption is the Minister of Finance’s announcement, in February this year, that there would be reforms to the tax treatment of dividends in South Africa. While the first phase of the reforms was to take effect from 1 October 2007, certain anti-avoidance measures would take effect immediately. To this end, SARS issued a press statement to withdraw the STC exemption for amalgamation transactions, contained in section 44(9) of the Income Tax Act (“the Act”).
The exemption was withdrawn because it permitted a permanent loss of STC rather than a deferral of the liability for STC.  The permanent loss of STC occurred when the company resulting from an amalgamation (“the resultant company”) distributed the assets it acquired in terms of the amalgamation transaction, to its own shareholders.
The permanent loss arose out of the technical definition of a dividend, which regards any amount distributed by a company to its shareholders as a dividend.  The phrase “amount distributed” refers to amounts which can legally be distributed by a company in terms of the company laws and one of the important principles of company law is that a company may only distribute profits out of profits.  Therefore, a company which only has share capital and no reserves cannot legally distribute a dividend to its shareholders.  The effect of this was that a resultant company, particularly a newly established resultant company that has just acquired assets in terms of an amalgamation transaction, was unlikely to have any profits soon after the amalgamation transaction.  It could therefore argue that the distribution of assets acquired from the amalgamated company, to the shareholders of the resultant company, did not constitute a dividend because it was not made out of the profits of the resultant company.  As the distribution did not constitute a dividend, no STC liability would be payable by the resultant company.  This created a permanent exemption from STC for the resultant company. 
In order to ensure that STC was payable, SARS formally amended section 44.  The formal amendments differed slightly from the initial amendment.  Instead of removing subsection 44(9) from the Act, a new subsection 44(9A) was inserted.  SARS will use subsection 44(9A) to ensure that, like the Capital Gains Tax and Income Tax, the STC is rolled over to the remaining resultant company and eventually gets paid. 
In practice, when an amalgamation transaction occurs, the amalgamated company makes a profit on the transfer of its assets.  This profit is reflected in the value of the shares the amalgamated company acquires in exchange for its assets.  Because the amalgamated company will eventually disappear, it needs to transfer the shares that it acquired in the resultant company to the shareholders of the amalgamated company.  The shareholders then become the shareholders of the resultant company. 
The transfer of the shares in effect involves a distribution or transfer of the amalgamated company’s profit to the shareholders.  Because of subection 44(9), the transfer of these profits in terms of this step is exempt from STC. If SARS had not “plugged the hole” the resultant company would, in the absence of section 44(9A), escape a liability for STC when distributing the assets acquired in terms of an amalgamation transaction to its shareholders.
Section 44(9A) therefore achieves a roll over of the profits of the amalgamated company to the resultant company.  This ensures that any STC that was not paid by the amalgamated company is eventually paid by the resultant company.
If one has regard to the objective sought to be achieved by the corporate restructuring rules, the amendment appears to be fair.  However, there is no doubt that it will derail some large transactions.  In fact, there are rumours that it may already have derailed one or two transactions in the market. 
Mogola Makola is a senior associate at Bowman Gilfillan