Post Redemption Obligation(s): a real pain in the $%# for any preference share finance transaction – Part 4

The Problem Statement and potential solutions / improvements

By: Morne Mc Grath, tax specialist

Part 1 - 3

Part 1 & 2 dealt with the general principles applicable to preference share financing transactions, the concept of a post redemption obligation and the calculation methodology thereof including the impact of section 99(4) of the Tax Administration Act(“TAA”) on the quantum and final discharge date (termination date) of the post redemption obligation. Part 3 highlighted the costs (financial and opportunity), complexities and inefficiencies of the way post redemption obligations are currently secured.

Introduction

In Part 4 we are going to try and define the problem statement which is at the heart of the post redemption obligation (and securing thereof) problem and discuss potential solutions or improvements to the current approach. The preference shareholder, rightly so, assumes a worse-case scenario at the inception of the transaction in their calculation methodology of the maximum potential post redemption obligation amount which is to be secured on the future redemption date of the preference shares. On the redemption date however, based on the facts of the transaction (actual history of the deal), the risk of a post redemption claim should be able to be calculated with more accuracy and certainty (“the probability factor”). Historically preference share investors, on redemption date of the preference shares, excluded any probability factor in determining the amount (value) of security required for a potential post redemption claim and merely continued with a worse-case scenario approach unfortunately.

The problem statement

The problem statement as I see it consist of two elements:

1. the quantum (amount) and duration (period) of the potential post redemption claim (“the post redemption claim element”); and
2. the quantum (amount), duration (period) and costs (financial- and opportunity cost) of securing the post redemption claim (“the security element”).

Solving for the problem statement ??

The optimum solution should eliminate the existence of the post redemption claim element and thereby security element of the problem statement becomes irrelevant. Whether that is possible is debatable but a bit unrealistic. The post redemption claim element is a function (result) of the Income Tax Act (“ITA”) and the TAA and significant amendments to these acts will be required to achieve the optimum solution. The following suggestion(s) or a combination thereof should contribute towards a solution that will lessen the negative impact of the problem statement:

1. Amendment or clarification – section 99(4) of the TAAThe inclusion of the phrase “hybrid instruments” in section 99(4)(c) of the TAA results in the extension of the final discharge date (prescription date) of preference share transactions by an additional 3 years. The post redemption claim element therefore only prescribes 7-years after the redemption of the preference shares. The exclusion of preference share transaction(s) from the definition of hybrid instruments in section 99(4)(c) of the TAA would significantly reduce the quantum and duration of the post redemption claim and therefore also the quantum and period of the security element. Can SARS be convinced to make an amendment to the TAA?
2. Possibility of a private binding rulingIs there an argument to be made by the parties to a preference share transaction to approach SARS with the intention of obtaining a ruling in terms of which SARS agrees to a final discharge date that is 3-years (or less if possible) after the original assessment date? Such a ruling should have the same effect as an exclusion of a preference share transaction from section 99(4)(c) of the TAA and would significantly reduce the quantum and duration of the post redemption claim and therefore also the quantum and period of the security element.
3. The “SC approach”

In the past we have seen attempts to incorporate a “probability factor” to reduce the value (amount) of security to be provided by the Borrower (Issuer). Under such a scenario the post redemption claim of the preference shareholder remains valid for the total post redemption amount and up to the final discharge date. The parties to the transaction however agree to brief a Senior Counsel (“SC”), soon after the redemption date, with the intention of obtaining an opinion (“the SC opinion”) on the “likelihood” of SARS challenging the transaction successfully. Subject to the opinion from the SC, the parties then agree on a reduced security amount (probability factor X total amount at risk). The quantum (amount) of security to be provided is significantly reduced and should result in a reduced inconvenience and cost for the Borrower.

Preference shareholders have generally been reluctant to implement the SC approach (described above) but, with an increase in awareness from Borrowers, there is no doubt that preference shareholders will have to “come to the party” and participate in finding solutions for the post redemption problem statement and merely defaulting to a worse-case scenario approach will probably not be good enough in the future.

4. Tax Indemnity Insurance (“Tax insurance”)

Tax insurance protects the taxpayer against the risk of SARS assessing the taxpayer on a particular transaction on a basis different than what was anticipated and contrary to the tax advice obtained. The Tax insurance will normally cover the actual amount of tax, interest, penalties, legal costs and the gross up of the amounts (policy benefits will be taxable therefore the need for the gross up). The Tax insurance cover period can be for up to a 10-year period. The taxpayer will normally obtain an independent tax opinion (could be a SC opinion), provide it to the Insurer who will then calculate the cost of the single premium which is normally payable upfront and can differ between 3%-5% of the amount insured (maximum exposure).

Once the taxpayer is assessed, a tax dispute arises, and it is an “insured event” the Insurer will want to control the decisions related to the dispute resolution. The Insurer would, with the co-operation of the taxpayer, be actively involved in all decision-making regarding the objection, potential appeal(s), choice of legal counsel and potential settlement of the tax dispute.

Given the fact that the Insurer is carrying all the risk he is in the “driver seat” of the dispute resolution process and the key decisions to be taken. Large corporates, including the major South African banks have been very reluctant to “outsourcing” their tax risk management decision-making to Insurers. A bank may, for example, have an internal tax risk management framework and methodology in terms of dealing with tax disputes where decision-making on whether to for example appeal or enter into settlement negotiations are not taken on an isolated basis but is part of a much larger “portfolio approach” to tax risk management. A taxpayer may for example decide to settle with SARS rather than to go to court even IF it has an exceptionally good chance of winning. The Insurer looks at the tax dispute as an isolated event while the taxpayer may approach the same dispute on a “portfolio basis” and decide on an approach to the tax dispute considering, for example:

• The current “relationship” status with SARS.
• Other tax disputes with SARS which may be impacted by the “insured” tax event.
• Media attention
• Corporate action that may be negatively impacted by a prolonged tax dispute.

Conclusion(s)

“Solutions” 1- 3 above unfortunately does not de-risk the transaction for the preference shareholder and merely limits / reduces the quantum of the claims and security to be provided. I am firmly of the view that Tax Insurance can provide a comprehensive solution to the post redemption obligation problem. It does come at a cost (upfront premium) which is a fraction of the cost that Borrowers incur currently in terms of securing their post redemption obligations. Preference shareholders and Insurers will however have to find a way of dealing with the need of the taxpayer’s group tax function to continue managing its tax affairs while the Insurer exercises its rights in defending the tax dispute with SARS. The time has arrived for tax professionals, Borrowers, preference share investors and Insurance companies to start a constructive dialogue in finding a permanent solution to the post redemption obligation problem.