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17 May 2019
Preference share funding structures contemplate the subscription by a funder for preference shares in the share capital of a company with a pre-agreed dividend rate (often linked to a prevailing interest rate) and capital redemption profile. These types of funding structures are often preferred by banks and other financial institutions because dividends received by certain holders, including banks and other juristic persons, are exempt from income tax. Interest on loans, on the other hand, is taxable in the hands of the recipient and often cannot be deducted from the income of the borrower.
The provisions of the Companies Act and Income Tax Act need to be considered in the context of the outcome which the company wishes to achieve before a company settles the terms of a preference share funding structure. What follows is a brief overview of, and practical guide to, the application of the Companies Act and the Income Tax Act provisions relevant to preference share funding structures.
The existing share capital structure and memorandum of incorporation (MOI) of the company should be reviewed at the start of the preference share structuring process to determine whether it is necessary to increase the authorised share capital of the company in order to create the class of preference shares required for purposes of the funding venture and whether the MOI prescribes compliance with certain formalities prior to such increase being undertaken.
A share capital increase amounts to an amendment of the company's MOI and needs to be authorised by the directors and shareholders of the company in accordance with Section 36(1)(d), read with Section 16(1)(c)(i), of the Companies Act. The amendment needs to be registered with the Companies and Intellectual Property Commission – a process that can take between two to four weeks and, in some instances, even longer.
It is recommended that this process be undertaken at the start of the structuring process to ensure that the shares are in existence by the time the preference share subscription agreement, preference share terms and related security documents have been negotiated and signed.
It is therefore best to create a class of unspecified shares, the preference, rights, limitations and other terms of which are to be specified by the board of directors – and approved by the shareholders if required by the company's MOI – once the preference share terms have been agreed.
The types of preference shares available to companies wishing to establish a preference share funding structure can be categorised according to the different obligations, rights and entitlements attaching to them.
The nature of the obligations, rights and entitlements will depend on the type of funding structure that the company wishes to establish. Preference shares can therefore be categorised into the following main types.
Participating versus non-participating
Participating preference shares entitle the holder thereof to the surplus assets and profits of the company once all shareholders have been paid their dues while non-participating preference shares do not.
Cumulative versus non-cumulative
Preference shares usually entitle the holder thereof to a preferential dividend payable on a specified dividend payment date. If the company does not declare a preferential dividend on the dividend payment date, a cumulative preference share will entitle the holder thereof to an accrued dividend which will be carried over to the next dividend payment date. The cumulative dividend must usually be settled before any further dividends, whether ordinary or preferential, are paid. The holder of a non-cumulative dividend will not be entitled to such an accrual and will lose the right to receive a dividend if the company does not declare a dividend on that dividend payment date.
Convertible versus non-convertible
Convertible preference shares entitle the holder thereof to the right to convert the preference shares to ordinary shares in the share capital of the company on predetermined terms while non-convertible preference shares do not. On conversion, the preference shareholder will lose its preferential rights and will have the same rights as the holders of the class of shares into which the preference shares have been converted.
Redeemable versus non-redeemable
Redeemable preference shares can be redeemed by the company either on a specified date or over a period of time. On redemption, the company will be required to pay all distributions which have accrued to the holder thereof and all other amounts owed to such holder. Such redemption will be undertaken in accordance with Section 46 of the Companies Act.
Section 8E(2) of the Income Tax Act provides that dividends received in respect of a preference share will be deemed to be income in the hands of the recipient (ie, the holder of the preference share) if the preference share constitutes a 'hybrid equity instrument'.
Section 8E(1) defines a 'hybrid equity instrument' as, among other things, a preference share which is secured by a financial instrument or is subject to a financial instrument which cannot be disposed of, unless the preference share was issued for a 'qualifying purpose'. This means that the subscription proceeds which are received by or accrued to the issuer of the preference shares must be applied for one or more 'qualifying purpose(s)', as defined in Section 8EA.
Section 8EA provides that subscription proceeds received by or accrued to the issuer of the preference shares will be deemed to have been used for a 'qualifying purpose' if it is used for:
An 'operating company' is defined in Section 8EA as:
Section 8E(1) also defines a 'hybrid equity instrument' as, among other things, a preference share in respect of which:
It follows that the preference share terms should always set the scheduled redemption date for any preference share on a date which is at least three years and one day after the issue date of such preference share.
However, the preference share terms may provide that the issuer has the right, at any time, to voluntarily redeem the preference shares before such date without the resultant adverse consequences of Section 8E.
Since preference share funding amounts to an obligation on the issuer to pay certain amounts to the holder thereof at a future date, holders often require that the obligations of the issuer be secured.
This can be achieved through a number of security arrangements using the assets of the issuer. It can also be achieved by using the assets of a third party. However, Section 8EA(2) provides that dividends received in respect of a preference share will be deemed to be income in the hands of the holder of the preference share if the preference share constitutes a third-party backed share.
Section 8EA defines a 'third-party backed share' as a preference share in respect of which an enforcement right is exercisable by the holder of that preference share or an enforcement obligation becomes enforceable as a result of any specified dividend or return of capital attributable to that share not being received by or accruing to the person entitled thereto.
However, Section 8EA(3) does provide that a preference share which is secured by the assets of a third party will not constitute a 'third-party backed share' if the obligations of the issuer of that preference share are secured by one of the following persons:
Sections 8E and 8EA and the resultant tax consequence of the application of these provisions often require a delicate interpretation on a case-by-case basis. It is therefore advisable to always obtain tax and structuring advice in respect of each preference share funding transaction which a company wishes to undertake, since each transaction will often have its own peculiarities.
For further information on this topic please contact Dominique van der Westhuizen, Chanté du Plessis or Roelf Horn at Cliffe Dekker Hofmeyr by telephone (+27 115 621 000) or email (firstname.lastname@example.org, email@example.com or firstname.lastname@example.org). The Cliffe Dekker Hofmeyr website can be accessed at www.cliffedekkerhofmeyr.com.
The materials contained on this website are for general information purposes only and are subject to the disclaimer.
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