When a loan owed by a company is settled by conversion into share capital, it holds potential tax implications for both the debtor and creditor. The purpose of this article is to focus on the tax implications for the debtor.
Section 19 of the Income Tax Act considers the tax implications for the debtor where there is a concession or compromise in respect of a debt. The tax implications of loans settled by conversion into share capital (section 19) were amended and the new amendments are deemed to have come into operation on 1 January 2018 and are applicable in respect of years of assessment commencing on or after that date. This means that the new rules apply for the first time to a company that has a December 2018 year-end.
The new rules
Where a debt owed by a company is settled by conversion or exchange into shares, or by applying the proceeds from shares issued by that company, this will be read into the definition of a ‘concession or compromise’. The term ‘debt’ is broadly defined and includes any amount owed by a person. Where no shares are held in the company before the conversion, the ‘debt benefit’ is calculated by comparing the face value of the claim (including outstanding interest) before the conversion as exceeds the market value of shares acquired. Where existing shares are held in the company before the conversion, the ‘debt benefit’ is calculated by comparing the face value of the claim before the conversion as exceeds the market value of shares acquired solely as a result of the conversion.
Broadly, section 19 does not find application if there are other tax implications − that is, donation tax is applicable or between intra-group debt in certain situations. Further, section 19 is not applicable to non-interest-bearing loans conversions.
Section 19 is not applicable to non-interest-bearing loan conversions, and by implication section 19 therefore only applies to interest-bearing loan conversions. When section 19 does apply to interest-bearing loans, the ‘debt benefit’ is only recouped with reference to outstanding interest and not to the capital portion.
A loan owed by a company of R1 000 000 is settled by conversion into share capital of R800 000 − that is, the market value of shares after the arrangement. No shares are held in the company before the conversion. The R1 000 000 loan owed represents R900 000 capital and R100 000 interest.
The loan settled by conversion into shares is a concession or compromise respect of a debt. Even though the debt benefit is R200 000, section 19 will trigger a recoupment of R100 000. In other words, only the outstanding interest is recouped and not the capital portion.
The explanatory memorandum does not provide insight into the policy thinking for not triggering a recoupment of the capital. It can be argued that the debtor would have potentially benefited by applying the loan to fund tax-deductible expenses or allowance assets. It is submitted that the reason for excluding capital is to place the creditor in the position of a shareholder had the creditor invested in shares at the outset (that is, the company could have then also applied the share capital to fund tax deductible expenses or allowance assets). A further tax implication for the debtor is that the ‘contributed tax capital’ of the company will be increased.