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New tax laws affecting preference share transactions

Preference shares can very often be a preferable funding instruments, as an alternative to ordinary equity and debt funding, due to the fact that (a) they provide the holder with fixed dividends and preference during liquidation and (b) the dividends received or accrued in relation thereto are not subject to tax.

However, due to the fact that they contain features of debt and equity, preference shares are subject to anti-avoidance provisions contained in section 8E and section 8EA of the Income Tax Act, 1962 (Tax Act), which deal with hybrid equity instruments and third-party backed shares respectively. In relation to section 8EA, a ‘third-party backed share’ is in essence a preference share in respect of which an enforcement right (as defined) is exercisable by the holder of the preference share who requires any person, other than the issuer of the preference share, to acquire the shares from the holder or to make any payment in respect of the share in terms of a guarantee, indemnity or similar arrangement or to procure, facilitate or assist with any payment in respect of a guarantee, indemnity or similar arrangement.

Importantly, section 8EA of the Tax Act will not apply where funds derived from the issue of a preference share are applied for a ‘qualifying purpose’ (as defined), and the enforcement right is exercisable against certain specified persons at the time of receipt or accrual of the preference share dividends (commonly referred to as ‘good purpose’ preference shares). Generally, a qualifying purpose will exist where the proceeds from the issue of the preference shares are used inter alia to acquire equity shares, directly or indirectly, in an ‘operating company’ (as defined) or refinance preference shares, the funds from which were previously issued for this purpose.

The Tax Laws Amendment Act 17, 2023 (promulgated on 22 December 2023) has introduced an additional condition for preference shares to qualify as ‘good purpose’ preference shares and avoid the anti-avoidance rules of section 8EA of the Tax Act.

The new condition requires that the person who acquires the shares in the operating company with the proceeds of the preference share must retain the shares in the operating company until the dividend on the preference share is paid (Ownership Requirement). An exception to the new Ownership Requirement will be where, inter alia, unless inter alia the preference share is redeemed by the issuer within 90 days using the proceeds from the sale of the operating company shares. This new condition applies in respect of all preference share dividends declared on or after 1 January 2024, and is therefore applicable to existing preference share structures.

It is not currently clear whether, where the Ownership Requirement is not met, a settlement of any dividends, foreign dividends or interest accrued from that preference share, using the proceeds from the disposal of the operating company shares, also falls within the confines of its allowable redemption. 

The Minister of Finance’s Annual Budget Speech on 21 February 2024 therefore proposed that section 8EA of the Tax Act be amended further to include the settlement of any amounts of dividends, foreign dividends or interest accrued in respect of the redemption of a preference share where the Ownership Requirement is not met.
In addition to the above, it has also come to the National Treasury’s attention that the definition of ‘third-party backed share’ in section 8EA of the Tax Act does not clearly match the intent that either a holder of a preference share or a connected person in relation to that holder could hold that ‘enforcement right’ as required in section 8EA of the Tax Act. It is therefore proposed that the ‘third‐party backed share’ definition be clarified to address this anomaly.

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