Post Redemption Obligation(s): a real pain in the $%# for any preference share finance transaction - Part 2:

The quantum and duration of the post redemption obligation and the impact of a section 99(4) of the Tax Administration Act (2011) extension of the final discharge date.

By: Morne Mc Grath, tax specialist

Introduction

In Part 1 we discussed the general principles applicable to preference share financing transactions and introduced the concept of a post redemption obligation. We defined the term “post redemption cloud” and the impact it can have on a preference share transaction. In this Part 2 we will discuss the calculation methodology of the maximum potential post redemption obligation and the impact a section 99(4) of the Tax Administration Act (“TAA”) extension has on the maximum potential post redemption obligation.

Example & Calculation- “standard” 3-year final discharge date – section 99(1) of the TAA

For purposes of the example and calculations please assume that:

1. the preference shares were issued on 01/01/2024 by the Borrower (Issuer) for an amount of R100m at an 8% dividend rate (no partial redemptions prior to 31/12/2027).
2. the preference shareholder’s year of assessment ends on 31/12 of each year.
3. the Borrower (Issuer) of the preference shares will redeem the preference shares on 31/12/2027.
4. the preference shareholder will be originally assessed by SARS 12 months after the relevant year of assessment.
5. All dividends will be “tainted” / taxable.
6. A single “tax event” is assumed and once identified all amounts will be settled with SARS immediately.
7. the “official” interest rate (SARS) is assumed to be 9% per annum.
8. An understatement penalty of 10% will be applicable (debatable given the recent Coronation case and the assumption that a section 223 of the TAA opinion will be obtained).
9. Any penalties for underpayment of provisional tax to be ignored.

Analysis

1. The preference shareholder’s maximum potential income tax exposure is an amount of R11?630 975 as at 31/12/2028 (the 2024,2025,2026,2027 original assessments have not prescribed).
2. The maximum post redemption obligation of the Borrower (Issuer) must be grossed up for tax (27%) and the maximum post redemption obligation for the Borrower should therefore be R15?932 842 as at 31/12/2028.
3. The maximum post redemption obligation of R 15?932 842 could translate into a significant investment/credit risk for the preference share investor and it will require adequate security for this amount that may potentially be at risk which is to be discussed in Part 3.
4. The final discharge date of the post redemption obligation will be 31/12/2031.

Section 99(4) of the TAA

In terms of section 99(4) of the TAA SARS may, by prior notice of at least 60 days, extend the final discharge date (which is normally 3 years after the original assessment date) by another 3 years (prescription will then be 6 years after the original assessment date) where an audit or investigation under Chapter 5 relates to:

(a)?? The substance over form doctrine.

(b)?? GAAR (section 80 general anti-avoidance).

(c)?? The taxation of hybrid entities or hybrid instruments or

(d)?? Section 31 of the Income Tax Act (Transfer pricing).

The extension of the final discharge date in terms of section 99(4) of the TAA is aimed at transactions of a complex nature or where SARS had insufficient time to consider all relevant information at its disposal to make a correct assessment because of disputes and delays in the provision of such information to SARS. The Explanatory Memorandum to the Tax Administration Laws Amendment Bill, 2015 (“EM”) seems to support such an interpretation as it states that:

“Too many of SARS’s resources are currently spent on information entitlement disputes, as opposed to conducting the audit within the period that additional assessments, if required, may be issued. This results in insufficient time to ensure SARS has all relevant information at its disposal to make correct assessment. In some cases, taxpayers, particularly large corporates, take more than six months to provide information required by SARS by simply failing to do so, disputing SARS’s right to obtain the information, attempting to impose conditions on access to the information and attempting to require specific mechanisms for accessing the information. Information entitlement disputes, particularly if pursued in the High Court, can take more than one year to resolve. These failures to provide information or information entitlement disputes are often tactical or even vexatious, given the fact that taxpayers are very much aware of the period within which SARS must finalise the audit and issue additional assessments, if required…..Additionally, some matters subject to audit may be so complex that it is impossible to meet the prescription deadline, particularly in the context of audits requiring SARS to consider the application of a general anti-avoidance rule (GAAR), or transfer pricing audits. Transfer pricing audits are fundamental to counteracting the erosion of the South African tax base and the shifting of profits to other jurisdictions – generally referred to as BEPS.” (my underlining)

Section 99(4) of the TAA can unfortunately be applicable to a normal “vanilla” preference share finance transaction because of section 99(4)(c) and the reference to hybrid instrument which is not defined in the TAA or the Income Tax Act (“ITA”). The term hybrid equity instrument is defined in section 8E and hybrid debt instrument in section 8F of the ITA, but I am not aware of any clarifications by SARS/National Treasury on whether it was the intention to include “vanilla” preference shares in the section. The use of the term’s hybrid instruments and hybrid entities, in the same paragraph, may have been aimed at hybrid instruments from a cross-border perspective i.e. where there is a difference in tax treatment of the instrument in different tax jurisdictions (cross-border impact where it is interest in one jurisdiction and a dividend in another).

In a preference share transaction I participated in recently, one of our co-investors insisted on the maximum post redemption obligation being calculated based on a final discharge date of 6 years after the original assessment date, therefore including preference shares in the application of section 99(4)(c) of the TAA. Such an interpretation was supported by a well-respected tax practitioner that provided the section 223 tax opinion for the preference share investors.

Impact of section 99(4) on the quantum and the final discharge date of the post redemption obligation.

My high-level calculations indicate that the maximum potential post redemption obligation increases from R15?932?842 to R20?566 034 while the final discharge date of the post redemption obligation claim is extended from 31/12/2031 to 31/12/2034. The impact of a section 99(4) of the TAA extension results in a significant increase in the quantum of the maximum potential post redemption obligation (30% increase) and the extended final discharge date (additional 3 years) which will then be 7 years after the redemption of the preference shares. The increase in the amount of maximum post redemption obligation is a function of increased interest (for an extra three years) and the gross-up cost of such interest for the Borrower. Securing the post redemption obligation will in all probability have a negative impact on the balance sheet of the Borrower. The Borrower will have a “contingent” liability on its balance sheet for an amount of up to R 20?566?034 for a period of 7 years after the redemption of the preference shares.

?The security arrangement must come at a cost (which is discussed in more detail in Part 3) and could be burdensome for the Borrower in terms of its day-to-day operations. I am aware of a number of potential preference share finance transactions that were abandoned (and defaulted to a “vanilla” loans) because of the post redemption obligation complexities. It is very unfortunate that the post redemption obligation and the securing thereof could prevent the implementation of a “fit for purpose” preference share transaction that benefits for all parties concerned without risk to the fiscus.

In Part 3 we are going to investigate the security arrangements that is attached to the post redemption obligation, the monetary impact thereof on the Borrower and related matters.