NEW PROPOSALS FOR HYBRID EQUITY INSTRUMENTS AND THIRD PARTY-BACKED SHARES

When the Draft Taxation Laws Amendment Bill of 2011 was released on 3 June, it contained proposed amendments to section 8E of the Income Tax Act and a proposal to introduce section 8EA into the Act.
One of the proposed amendments was intended to increase the redemption period central to the application of section 8E from three to 10 years. If the proposal became law, it would have meant that in order to avoid the application of section 8E, an investor would have had to hold a share for at least 10 years and a day before redemption, which usually would not be feasible.
Another proposal relating to section 8E was intended to extend the application of section 8E to foreign dividends, with the consequence that both domestic and foreign dividends received or accrued in respect of a hybrid equity instrument would be deemed to be interest in relation to their recipient.
The reaction to the proposal to increase the redemption period was that it would place many funding structures at risk.
Treasury has now withdrawn the proposal to increase the redemption period from three to 10 years. Therefore, the minimum redemption period for the purposes of section 8E will remain at three years and a day.
The reason given for the revised proposal is that preference share funding is often used to acquire controlling share interests in an operating company or as a tool for black economic empowerment transactions. When used in this fashion, it seeks merely to preserve tax neutrality and not to create tax losses.
In addition, Treasury proposes to extend the application of section 8E to shares which entitle their holder to dividends that are calculated with reference to a specified interest rate or the amount of capital subscribed for the share and which are derived mainly from interest as defined in section 24J of the Act.
This proposal is intended to target preference shares which entitle their holder to dividends derived from interest-bearing instruments/notes.
Section 8EA targets third party-backed shares and will treat dividends on those shares as ordinary income. In terms of the original proposal, the section would apply in specific circumstances – for instance, where the holder of a share had a put option in respect of the share which was exercisable against a third party.
Treasury has modified its section 8EA proposal. In its modified form, section 8EA will also apply to foreign dividends and will treat both domestic and foreign dividends received in respect third party backed shares as ordinary income.
Treasury also seeks to amend the definition of third party-backed shares. The consequence of the proposal is that section 8EA will apply in more limited circumstances and, in particular, as a result of the lack of a dividend:
the holder of the share or a person connected to the holder has a put option in respect of the share against a third party;
a third party has undertaken to make any payment in respect of the share;
a third party has undertaken to procure, facilitate or assist with the exercise of the put option or the making of any payment referred to above.
Section 8EA will not apply where the issuer applies the subscription amount paid for the shares to fund the acquisition of shares in a South African resident company (target company) and the rights or obligations referred to above are against the target company or any company which forms part of the same group of companies as the target company or the issuer.
The reason provided for this exception is that the use of preference shares to fund share acquisitions is commonly used to fund black economic empowerment and is generally neutral to the fiscus.
Each CRA will also be required to adopt a code of conduct, which it will be required to disclose to the public and its subscribers, along with:

the disclosure of its methodologies;

the general nature of its compensation arrangements;

its policy on publishing credit ratings; and

data about the historical default rates of its rating categories.

Whilst a CRA will have the duty to maintain the independence of its credit ratings, the Credit Rating Services Bill grants the registrar a discretion to suspend the registration of or to deregister a CRA.
He may, however, only exercise this power in limited circumstances and his decision may be taken on appeal to the board of appeals established in terms of the Financial Services Board Act.
CRAs may not, without the registrar's approval, outsource their operational functions, nor provide other services besides credit ratings services. Other powers, which are wide-ranging and extend far beyond his oversight and enforcement duties, include the power to prescribe rules for the design of rating methodologies and models, and rating assumptions.
The Bill does not, regrettably, make a separate provision for sovereign credit ratings despite the impact of such credit ratings recently being highlighted in South Africa and in other countries.
Be that as it may, the problem of specifically regulating sovereign credit ratings is that it may call into question their independence and accuracy.
This overview of certain notable aspects of the draft legislation is based on the draft published in July 2011. No date has been given for the enactment.