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Convertible loans draw taxman's eye

Posted On Monday, 29 December 2003 02:00 Published by
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So-called circular arrangements are to be challenged by SARS, with a case before court next year

Professional Services Editor

FOR many years companies have been issuing convertible loans that have been structured by banks and finance houses in SA.

Finance Minister Trevor Manuel stated in this year's medium term budget policy statement that a preliminary review of convertible share of debt instruments was planned for 2004.

Gary Vogelman, a tax director at law firm Sonnenberg Hoffmann Galombik, says taxpayers who have implemented such transactions should be aware that the South African Revenue Service (SARS) is investigating these transactions among banks and holding companies.

There is also a test case lined up for early next year in which SARS is to take on a financial institution said to have been a party to such a deal.

Vogelman says the typical convertible transaction involves a company borrowing money from a bank by issuing such bank with a convertible loan. In terms of the loan, the bank is obliged to subscribe for ordinary or preference shares for an amount equal to the original loan in the company on the maturity of such loan.

Ernie Lai King, a director at Werksmans Tax, says this can best be illustrated with the following example: A fully owned subsidiary may be indebted to the amount of R300m to its holding company. The subsidiary decides to embark on a capital expansion of R500m. It opts to go to a bank for financing. The bank forms a special purpose vehicle company which is held 100% by such bank.

In terms of the arrangement, the bank lends R800m to the special purpose vehicle, which lends the money to the subsidiary. The subsidiary is able to repay R300m to the holding company and is left with a balance of R500m.

The special purpose vehicle company settles the R800m to the bank by the issue of shares. The holding company enters into an agreement with the bank that it will acquire the shares in the vehicle for R300m but will only take delivery in 10 years' time.

In 10 year's time , the shares will be delivered to the holding company.

Lai King says the subsidiary will get a tax deduction on the interest paid to the bank on the R800m.

Such transactions are commonly referred to as "circular" arrangements. It seems as though R800m has been borrowed, but in reality R500m has only been loaned, he says.

Vogelman says the advantages of arranging the loan for the company in such a manner will result in a low effective cost of finance for the group.

The company is able to claim a tax deduction for the interest incurred on the loan without the holding company being taxed on any interest income that it would have earned had it loaned the money directly to its subsidiary, he says.

However, SARS is dealing with such transactions in terms of provisions as contained in income tax laws, Vogelman says.

According to SARS, the growth in the value of the forward shares from the date on which they are acquired until the date on which they are delivered is interest income that accrues to the holding company on a yield to maturity basis over the period.

Beric Croome, a tax director at corporate law advisers Edward Nathan & Friedland, says there is a concern in SARS that such transactions are related to structured finance deals. There are also concerns that taxpayers may receive dividends from such transactions which are generally exempt from tax.

However, for every argument that revenue can raise, taxpayers will raise an equally strong argument, Lai King says.

He says structured finance arrangements should also be reviewed on their merits.

Vogelman says provided a transaction is correctly implemented, and the agreements give effect to the real intention of the parties, financing a business by way of a convertible loan can provide significant economic benefits to a company and should not result in any adverse tax consequences.

Publisher: Business Day
Source: Business Day
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