The Taxation Laws Amendment Act 20 of 2022 substituted the further proviso to the definition of ‘contributed tax capital’ in section 1(1) of the Income Tax Act 58 of 1962 (Act). The further proviso had been inserted by the Taxation Laws Amendment Act 20 of 2021 and was scheduled to come into operation on 1 January 2023. This article explores the background to the provisos and how they operate in relation to CGT and dividends tax.
The definition of 'contributed tax capital' is fairly complex and extensive. It came into operation on 1 January 2011[1] and preceded the introduction of dividends tax on 1 April 2012. It contains transitional rules that established CTC for pre-1 January 2011 shares. The opening CTC for such shares is the amount of the share capital, share premium or stated capital immediately before 1 January 2011 less any amount that would have constituted a dividend had the share capital, share premium or stated capital been distributed immediately before that date. In essence, what would have been left was the pure share capital and share premium actually contributed by the holders of shares, excluding any accumulated profits or capitalised reserves. For shares issued on or after 1 January 2011, the CTC is equal to the consideration received by or accrued to the company for the issue of shares. CTC is determined for each class of shares and there are rules dealing with shares that convert from one class to another.
When CTC is returned to a holder of shares, it becomes a 'return of capital' which is dealt with under paragraph 76B of the Eighth Schedule to the Act as a reduction in the base cost of the share. To the extent that the base cost is exceeded, the excess becomes a capital gain under paragraph 76B(3). Most importantly, CTC can be transferred to holders of a company's shares (and hence comprise a return of capital) only if
it has by the date of the transfer been determined by the directors of the company or by some other person or body of persons with comparable authority to be an amount so transferred'.
It is therefore critical that the directors properly record their decision to award CTC in a written resolution. In addition, under paragraph 76(4) of the Eighth Schedule the holders of shares must be notified in writing by the time of any distribution or payment, of the extent to which the distribution or payment constitutes a return of capital. Failure to make such a determination will mean that any amount distributed by the company will be a dividend with potential dividends tax consequences.
It must be emphasized that CTC is a tax concept unrelated to any actual treatment for company law or accounting purposes of so-called 'pure' share capital or share premium in the books of the company. Thus, the company could distribute a dividend out of profits but elect to make the distribution out of CTC. Likewise, it could distribute pure share capital to holders of shares but not make the election to reduce CTC and the payment will be a dividend for the holders of the company's shares. This divergence from reality offers many tax planning opportunities. For example, non-resident holders of shares may prefer a return of CTC to a dividend because they will avoid dividends tax. Resident companies may prefer a dividend because dividends distributed between resident companies are exempt from dividends tax under section 64F(1)(a), while CTC would result in a base cost reduction or even a capital gain. Resident individuals and trusts may prefer CTC to avoid dividends tax.
When new shares are subscribed for, the CTC they represent is simply added to the pot and the CTC is thus averaged out over the number of shares in the particular class. This averaging can result in earlier holders benefitting from the CTC contributed by later holders. For example, in year 1 a holder acquires 100 shares for R100. Five years later a new holder acquires 100 shares for R200. The total CTC is now R300, which represents R1,50 per share (R300/200 shares). The first holder has gained R50 in CTC while the later holder has lost R50. This situation has led to companies creating so-called alphabet shares (class A, B, C and so on) with slight variations in the rights attaching to the shares so that each holder can retain the CTC that they contributed.
The first proviso
The first proviso reads as follows:
'Provided that the amount transferred by a company as contemplated in paragraph (a) or (b) for the benefit of a person holding shares of any class of shares of that company must not exceed an amount that bears to the total of the amount of contributed tax capital attributable to that class of shares immediately before the transfer the same ratio as the number of shares of that class held by that person bears to the total number of shares of that class …'
Thus, if there were two shareholders each holding 50 shares and total CTC attributable to the 100 shares of R500, it would not be possible to return more than R5 per share of CTC in any single distribution (R500/100 shares). SARS's concern with the first proviso is that it does not stipulate that each holder of shares must receive an equal amount of CTC per share. Section 37(1) of the Companies Act 71 of 2008 provides that
'[a]ll of the shares of any particular class authorised by a company have preferences, rights, limitations and other terms that are identical to those of other shares of the same class'.
But given that CTC is a tax concept and not a company law concept, it could be argued that as long as each holder of shares in the particular class receives an equal distribution (whether dividend or CTC), the company could award CTC to some holders and dividend to others as long as all holders in the class receive the same amount per share. Thus, in my example, if the one holder were a non-resident and the other a resident company, the company could distribute R250 of CTC to the non-resident (R5 × 50 shares) and R250 (R5 × 50 shares) of dividend to the resident company. That would leave R250 of CTC which could be distributed at the rate of a maximum of R2,50 per share (R250/100 shares in the next distribution). In a second distribution, the company could distribute R125 of CTC to the non-resident (R2,50 × 50 shares) and R125 of dividend (R2,50 × 50 shares) to the resident and so on until all the CTC was exhausted. It was this concern that prompted the introduction of the second proviso.
The second proviso
The first iteration of the second proviso appeared in the draft Taxation Laws Amendment Bill, 2021 and read as follows:
': Provided further that an amount transferred by a company as contemplated in paragraph (a) or (b) must not comprise a transfer of contributed tax capital unless all holders of shares in that class participate in the transfer in the same manner and are actually allocated an amount of contributed tax capital based on their proportional shareholding within that class of shares;'
This version might have worked but for the fact that it did not cater for a share buy-back from only some holders of shares. It presupposed that all holders would be participating in the award of CTC. By compelling every holder to participate, it would have meant that a share buy-back from only some holders would always have to be a dividend.
The version that appeared in the Taxation Laws Amendment Act 20 of 2021 (TLAA 20 of 2021) read as follows:
'Provided further—
(i) that an amount transferred by a company as contemplated in paragraph (a) or (b) must not comprise a transfer of contributed tax capital unless all holders of shares in that class participate in the transfer in the same manner and are actually allocated an amount of contributed tax capital based on their proportional shareholding within that class of shares; and
(ii) that no regard must be had to paragraph (i) of this further proviso if the amount transferred constitutes an acquisition by the company of its own securities by way of general repurchase of securities, as contemplated in subparagraph (b) of paragraph 5.67(B) of section 5 of the JSE Limited Listings Requirements, where that acquisition complies with any applicable requirements prescribed by paragraphs 5.68 and 5.72 to 5.81 of section 5 of the JSE Limited Listings Requirements or a general repurchase of securities as contemplated in the listings requirements of any other exchange licensed under the Financial Markets Act, which requirements are substantially the same as the requirements prescribed by the JSE Limited Listings Requirements, where that acquisition complies with the applicable requirements of that exchange;'
The counter intuitive term 'general repurchase' refers to the situation in which a listed company instructs its brokers to buy back a specified number of shares on the open market rather than buying back its shares proportionally from all its shareholders. The obvious shortcoming of this formulation was that it did not deal with the buy-back by an unlisted company from selected holders of shares and any such buy-back would have been condemned to be a dividend. After representations by SAICA and other commentators, the effective date in the TLAA 20 of 2021 was changed to 1 January 2023 to provide further opportunity to comment.
An amended version was presented at a National Treasury workshop on 19 April 2022 which sought to impose a 91-day consistency rule on either side of a distribution of CTC but this was abandoned after further comment.
The final version of the further proviso as substituted by the Taxation Laws Amendment Act 20 of 2022 now reads as follows:
'Provided further that an amount transferred by a company as contemplated in paragraph (a) or (b) must comprise a transfer of contributed tax capital only where -
(i) the shares in a class of shares, in respect of which -
(aa) a distribution is made; or
(bb) consideration for the acquisition, cancellation or redemption is paid or payable by that company,
are each transferred an equal amount of contributed tax capital in respect of that class of shares; and
(ii) the amount of that transfer per share does not exceed the total amount of contributed tax capital in respect of that class of shares divided by the total number of issued shares within that class of shares;'
The focus of this version is only on the shares in a class of shares that are the subject of a distribution or share buy-back. Under section 37(1) of the Companies Act, distributions would of necessity have to be made on the same terms to all holders of shares within the class of shares, and if CTC is awarded to one holder, the same amount of CTC per share will have to be made to all holders.
If there are say, 10 holders of shares in a class and shares are bought back from two of them, both will have to receive the same amount of CTC per share. A company could circumvent this requirement by staggering the buy-back over several months, for example, by buying a resident company's shares by way of dividend in month 1 and buying a non-resident holder's shares in month 2 out of CTC. But the scope for abuse is limited because once a holder's shares are acquired, there is no longer any scope for awarding that holder more CTC.
In addition, the holder whose shares are acquired out of CTC cannot on a per share basis obtain more than a pro rata share of the available CTC in the class. In other words, if there are 1 000 shares in the class and total CTC of R500 000 for the class, any award of CTC may not exceed R500 per share (R500 000/1 000 shares). Unlike the first proviso which focuses on the benefit to a holder which could include more than one share, the further proviso focuses on the entitlement of a single share. This would prevent a holder from arguing that they have the right to allocate CTC to best advantage within the shares they hold, particularly when the shares have been acquired in tranches at different prices per share. For example, if a holder acquired 100 shares for R100, another 100 shares for R200 and a third batch of 100 shares for R300, and they received a distribution of CTC of R600, they would have to allocate R200 to each batch of 100 shares under paragraph 76B of the Eighth Schedule, which requires that the base cost of the shares be reduced by a return of capital. To the extent the base cost is exceeded, there will be a capital gain under paragraph 76B(3). In the example, there will be a capital gain of R100 on the first batch (base cost of R100 less R200 return of capital), no gain or loss and a nil base cost on the second batch (base cost of R200 less return of capital of R200) and a remaining base cost of R100 on the third batch (base cost of R300 less return of capital of R200). If the holder had a choice, R100 could have been allocated to the first batch, R200 to the second and R300 to the third, thus preventing the capital gain on the first batch. The problem of shares acquired in tranches does not arise if the weighted average base cost method is adopted because the base cost of all tranches is averaged out. However, this identification method is limited to shares listed on a recognised exchange under paragraph 32(3A).
The final version of the further proviso was inserted by amending section 4(1)(c) of the TLAA 20 of 2021 (an amendment to an amendment). Although section 41(2) of TLAA 20 of 2022 states that the amendment is deemed to come into operation on 19 January 2022 (date of promulgation of TLAA 20 of 2021), nothing turns on this because the original effective date in section 4(2) of TLAA 20 of 2021 remains 1 January 2023 and this was not changed by TLAA 20 of 2022. .
Conclusion
After an arduous amendment process, National Treasury has finally addressed its concerns over perceived abuse of CTC without prejudicing unlisted company share buy-backs.
This article was first published in ASA June 2023
