Post Redemption Obligation: a real pain in the $%# for any preference share finance transaction.

Part 1 (of 4): The “infamous” post redemption obligation.

By: Morne Mc Grath, tax specialist

Introduction to preference share finance.

The number of preference share finance transactions implemented increased in the past 10-15 years. BEE “equity” transactions and acquisition finance transactions (where interest deductibility is problematic or where A section 45 of the Income Tax Act (“ITA”) “debt pushdown” transaction cannot be implemented) contributed to the use of preference shares as an alternative finance instrument. We have also recently had preference share transactions successfully implemented in energy(solar/wind) projects.

Preference share financing creates time value of money benefits for the Issuer(“Borrower”) of the preference shares where the cashflow benefit of interest deductibility cannot be realized due to non-deductibility or where the benefit will only be realized in the future due to the presence of an assessed tax loss. Infrastructure projects such as electricity generation, with aggressive depreciation allowances (sections 12B or 12BA), results in the Borrower being in an assessed tax loss for a considerable period and therefore the applicability of preference share financing in such infrastructure transactions.

The financing-cost of a preference share is the dividend rate of the preference share. A preference share is an after-tax finance instrument and in an ideal world the dividend rate (coupon) should be equal to 73% (1- tax rate) of the equivalent loan interest rate. I use the words “in an ideal world” as the pricing of a preference share is subject to a more variables than just the corporate tax rate and the actual pricing of the dividend rate of a preference share is closer to 80% of the equivalent loan interest rate. In evaluating its financing alternatives the Borrower should, inter alia, compare the after-tax cost of a loan with the dividend rate of the preference shares. The pricing of the relevant finance instrument however is only one of a number of issues to be considered by the Borrower in terms of making a choice of finance instrument.

The benefit(s) created by preference share financing in terms of affordability and viability of BEE transactions, acquisition finance (including private equity) transactions and infrastructure projects should benefit the South African economy and stimulate investment over the longer-term without a major risk to the fiscus. I am also excited on future developments in the investor side of the preference share market where credit linked preference shares (linked to infrastructure projects for example) may create exciting new syndication opportunities for the big south African banks.

Tax Indemnity – Preserving the tax-free status of the preference share dividends.

The cashflow benefits generated by preference share financing is attributable to the pricing (dividend rate) of the preference share and the tax-exempt status of the dividend. The preference share investor’s required investment return assumes/is calculated on the basis that the dividend will be exempt from tax and accordingly requires to be indemnified against “events” that negatively impacts the exempt status of the dividends.

The indemnity / “gross-up” clauses oblige the Borrower to indemnify the preference shareholder if the dividend is not tax exempt for the preference share investor. The gross-up/top up payment can be in terms of an additional dividend payment, an adjustment to the dividend rate or both and allow for the preference share investor to retain its required after-tax return as if the dividend was tax exempt.

Examples of “events” that impacts the tax-exempt status of the preference share dividend include:

• ?a compulsory redemption of the preference shares within 3 year and 1 day from date of issue (section 8E)
• preference shares secured by a financial instrument, held by the issuer, in the absence of qualifying purpose (section 8E)
• preference shares that are secured by “permitted” third party security providers where the qualifying purpose equity shares are no longer held by the issuer – (section 8EA (3) proviso)
• preference shares secured by third party security providers that are no longer permitted security providers as contemplated in section 8EA (3).
• amendments in tax legislation

The amendment to section 8EA (3) and the inclusion of the “hold” proviso is a classic example of where a change in law can create substantial risk to the tax-exempt status of the preference share dividends.

Post redemption obligation.

Quantum

The Borrower retains the obligation to indemnify the then “former” preference shareholder post the redemption of the preference shares. As the preference shares are no longer in issue the Borrower will discharge the obligation by making a post redemption payment. The post redemption payment amount is calculated as the sum of:

·??????? the amount of tax (on the dividends)

·??????? interest

·??????? understatement penalties

incurred by the preference shareholder and will also be grossed-up for tax (post redemption payment x 100/73) as the post redemption payment will be gross income and taxable for the former preference shareholder. The post redemption payment should result in the preference shareholder retaining its required after-tax return i.e. same financial position as if the dividend received was tax exempt.

Duration

The post redemption obligation only prescribes (terminates) on the final discharge date which is, at a minimum, 3 years after the date of the original assessment of the preference shareholder and is determined in terms of sections 99 of the Tax Administration Act (2011) (“TAA”). On the assumption that the preference shareholder will submit its tax return and be assessed by SARS within 12 months from its “tax year-end” (year of assessment in which dividends accrued) the post redemption obligation will remain in force for at least 4 years after the year of assessment in which the preference shares are redeemed. ???

Section 99(2)-(4) of the TAA unfortunately allows for an extension of the final discharge date by SARS for up to an additional 3 years (see detailed discussion in Part 2) which therefore could result in the post redemption obligation only prescribing 7 years after redemption of the preference shares!!!

Securing the post redemption obligation

Once the preference shares are redeemed (preference share finance repaid) the “security package” of the preference share finance normally terminates as the “debt” has been repaid. The now former shareholder then requires an alternative security arrangement to mitigate the credit risk linked to the potential post redemption obligation. The post redemption obligation security arrangements are negotiated and contractually agreed between the parties at the inception of the preference share transaction.

The post redemption “cloud”

As a transactor and having been involved in preference share transactions over the past 20 years I can confidently state that negotiating the post redemption cloud (post redemption obligation and security thereof) have by far been the toughest and most time-consuming part of preference share finance transactions. The preference shareholder and the Borrower (issuer of the preference shares) have valid concerns with the current standard terms and conditions of the post redemption cloud and interestingly share a common feature: certainty! The preference shareholder requires certainty on the “tax status” of its dividends and the ability of the Borrower to make the post redemption payment while the Borrower requires certainty on the quantum and duration of the post redemption cloud.

The post redemption cloud is a major obstacle for any Borrower considering the use of preference share financing. The impact of the post redemption cloud should not be underestimated and can be so problematic that the Borrower eventually decides against the use of preference share financing.

Conclusion ???

Investment bankers and tax specialists must attempt to find a comprehensive solution to the post redemption cloud. Such a solution should address the needs of both the preference shareholder and the Borrower and provide the certainty required by all parties. SARS may well come into the mix as I struggle to see how a comprehensive solution is possible without their involvement/participation. My hope is that this article will stimulate discussions on this important topic and contribute towards a comprehensive solution and unlocking preference share finance transactions in the future.

In Part 2 we will discuss the calculation methodology of the potential post redemption obligation amount as well as the impact that section 99(4) of the TAA can have in terms of an extension of the final discharge date and the quantum of the potential post redemption obligation.