‘Seismic’ change proposed to all preference share funding structures

SA’s preference share funding arena is heading for a “seismic” change. That’s if a proposed amendment to the South African Income Tax Act relating to hybrid equity instruments is adopted into law.

The effect will be an immediate “material” increase in the cost of funding, tax professionals warn.

Read: Bigger tax burden awaits SA residents with foreign retirement income

Almost all Black Economic Empowerment (BEE) transactions, several renewable energy transactions, and many mergers and acquisitions that are funded through preference share arrangements will be caught, they add.

Industry players believe the market for preference share funding is currently around R120 billion.

Blurring the lines

National Treasury says in the recently published explanatory memorandum of the draft Taxation Laws Amendment Bill, that the sophistication of financial instruments presents ongoing challenges for tax authorities seeking to ensure equitable and effective taxation.

“Financial products are often structured with hybrid characteristics, blurring the traditional lines between debt and equity.”

Treasury refers to section 8E – an anti-avoidance rule designed to counter structures that disguise debt as equity in the form of preference shares. The core intention with the anti-avoidance rule was to prevent companies from issuing instruments that functioned like loans, but generated dividends that could be received tax-free.

“A key feature of the original section 8E of the Act targeted instruments with a redemption period of no longer than three years, identifying this as a characteristic indicative of a debt-like arrangement.”

Joon Chong, tax partner at Webber Wentzel, says preference share funding has been structured since the inception of the section in June 1989, on the basis that they are not redeemable for three years.

Three years ago, the South African Revenue Service (Sars) issued Interpretation Note 123 stating that a preference share arrangement will not be classified as a hybrid equity instrument if the redemption date is three years and one day, says Chong.

However, in the draft bill Treasury states that “these products (preference share arrangements) are often structured with a term exceeding the prescribed three-year period (e.g., three years and one day). This extended term is intentionally designed to circumvent the application of section 8E, which would otherwise deem dividends on such hybrid equity instruments to be taxable income for the recipient.”

Forked tongue

“The very feature that Treasury now identifies as a circumvention of the three-year test in section 8E, is the same feature that was expressly accepted as legitimate in the (Sars) interpretation note,” observes Chong.

A preference share will be a hybrid equity instrument if it is classified as a financial liability in the issuer’s annual financial statements, prepared in accordance with International Financial Reporting Standards (IFRS).

In a statement, Bowmans tax executives say the amendment proposes to delete the current three-year redemption test. Once the time-based safe harbour is repealed, any instrument that is classified as debt under IFRS – regardless of its contractual tenure – will fall within section 8E.

Bowmans head of tax Wally Horak says most commercially issued preference shares are expected to fall within section 8E once the amendment becomes operative.

“Most preference share funding structures rely on contractual redemption obligations together with dividend distributions. Therefore, distributions paid after the effective date will no longer be exempt dividends in the hands of recipients, but will instead be subject to normal income tax – and the issuer will not be entitled to any deduction for the payment of the dividends.”

Khurshid Fazel, head of financial services sector at Webber Wentzel, says when the cost of funding increases, people will reconsider the transactions they wanted to enter into. “This may slow down economic activities. Industry players believe the impact will be seismic.”

Morne McGrath from Nedbank Corporate and Investment Banking says in a lively LinkedIn discussion that the current drafting of the anti-avoidance rule is “going to be a disaster”, as all preference share funding deals are now tainted.

It will have a huge impact on BEE transactions.

Pieter Janse van Rensburg, partner at AJM, adds that tax principles are being removed from the Income Tax Act and replaced with IFRS treatment – a trend that has intensified this year. “We are elevating IFRS to delegated legislation over which we have no control.”

Outsourcing tax policy

In response, Tertius Troost, senior international tax manager at Forvis Mazars, says it raises questions about the legislative process and the integrity of our tax framework. By embedding IFRS principles directly into tax legislation, SA is essentially outsourcing its tax policy to an international accounting standards board.

“The implication is that any change in IFRS could automatically alter our tax treatment without parliamentary oversight, stakeholder consultation, or any of the checks and balances that should accompany legislative change. I find that concerning,” says Troost.

“Accounting standards should inform tax policy, not dictate it,” he adds.

If passed, the change will be effective from 1 January 2026. Fazel says this leaves very little time to adjust to a profound change. Since the proposal is not passed yet, nobody can act yet.

Most banks, which will be directly impacted, have tax years ending on 31 December. Generally, the bill is only signed into law late in December. Stakeholders have until 12 September to respond.

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