Second Revenue Laws Amendment Bill: briefing

Meeting report

FINANCE PORTFOLIO COMMITTEE
17 October 2001
SECOND REVENUE LAWS AMENDMENT BILL: BRIEFING CONTINUED

Chairperson: Ms Hogan (ANC)

Documents handed out:
Second Revenue Laws Amendment Bill
Second Revenue Laws Amendment Bill: Explanatory Memorandum
Proposed changes in the Foreign Tax Policy Arena – PowerPoint presentation
Corporate Restructurings – PowerPoint presentation

SUMMARY
This briefing on the Second Revenue Laws Amendment Bill addressed the New Corporate Rules. This meeting concluded the briefing on the Bill. The amendments are generally favourable to the taxpayer.

MINUTES
Prof. Engel (SARS Drafting Team) said that all CGT regimes have relief measures for Corporate
Restructuring. The original CGT legislation had narrow relief and in this Bill the relief is being
extended. He summarised the corporate reforms:
A Corporate formations – There will be tax free formations of companies.
B Share-for-share acquisitions – when 2 entities come together
C Intra-group transfers – the shifting of assets in a group
D Unbundlings – the division of a group
E Liquidations

Policy Goals
The Bill incorporates various policy goals:
1 The first is that Corporate Restructuring Reform acts a standard measure to reduce the potential cascading impact of the capital gains tax on multi-tier groups. The cascading effect can be explained by the following example. An individual wholly owns the parent company. The parent company wholly owns a subsidiary. That subsidiary wholly owns a subsidiary that wholly owns a factory. If the factory has a value of $100 and a base cost of 20 then al the subs and the parent company has the same value and base cost if a disposal takes place then the gain of 80 is duplicated at all levels and the gain would therefore come into play four times. SARS do not want to tax this multiple gain so a relief measure is provided.

2 Corporate Restructuring Reform is consistent with international practice, thereby
keeping the South African tax system internationally competitive.

3 Corporate Restructuring Reform promotes onshore restructurings in that the relief applies
to domestic restructurings. The only off shore exemption is the participating share exemption.

4 Corporate Restructuring Reform is comprehensive, going well beyond capital gains tax
relief as it also deals with income tax and therefore it is a unified structure of relief.

Common Policy Threads
The presenter highlighted the common policy threads in the Bill:
- Tax should not apply if taxpayers simply convert direct interests in assets into indirect
share interests. If a person is transforming an interest it is not a sale and is not taxed. An example
is if a taxpayer transforms property into shares. The taxpayer still has a direct interest in the
shares.

- Tax should not apply if assets are transferred among corporate members within the same group
because all these members are akin to divisions within the same corporate legal shell. Simply put, if there is a multi-tier structure - then the moving around of the asset is not a sale.

It is important that transactions must be taxed if parties are merely cashing-out their investments
because at this time they have the cash to pay the tax.

The tax system should ensure that transactions on the JSE are competitive with international
stock exchanges, such as the New York and London exchanges. The tax system should
accordingly cater to the ebbs (combinations) and flows (unbundlings) naturally occurring within
the JSE. SA must be competitive to show that the JSE has the same benefits like the New York
or London Exchange.

Common Legal Threads
There are four common legal threads prevalent in the Bill:

- Eligible Share Types
Before there is an entitlement to a tax free exchange of shares the taxpayer must share in the upside and downside of the company. This shows that the taxpayer is putting his hope and trust in the company. The tax free treatment would therefore apply to holders of ordinary shares and participating preference shares.

- Level of Share Ownership
Before corporate restructurings are tax free a certain level of ownership is required. The test changes depending what policy is at stake. The requirement can either be a 25% interest, more than 50% interest for closely held companies, at least a 35% interest for closely held companies and a 75% interest if there is a parent-sub relationship and the sub acts as a division.

- 18-Month Anti-Avoidance Rules
SARS do not want the relief rules to be used to subvert the tax system the old rules said that if a taxpayer had a bad intent then the taxpayer loses. But this does not work for companies because any body can come up with a god intent. So the new system will say that if the taxpayer does a transaction and it stays in place for 18 months then it is a legitimate transaction. If the period is too short then the avoidance rule will be meaningless and if it is to long then arms length transactions will be caught.

- Anti-Financial Instrument Rules
There are many rules against the transfer of financial instruments because SARS is concerned about the trafficking in financial instruments. The relief is designed to promote active business. there is however still debate about how far these rules will go.

The presenter started to go through the specific corporate reforms:
A Corporate Formations
SARS is trying to promote company formation because it leads to economic growth and small business start ups. The nature of the transaction is the following:

An individual or a company wants to from a new company and puts an asset with a R25 value and a base cost of R10 into the company. The individual in return for the asset gets 25 ordinary shares. In terms of the CGT regime this is a disposal of property. The relief measure defers the capital gain and no tax applies to the transfer. The newly formed company however will retain the base cost and the potential recoupment. The tax will be triggered if the asset is disposed of by the new company. The deferral only applies to losses and not gains. The loss is immediately triggered or else the loss will be duplicated just like the duplicated gain in an earlier example.

The policy surrounding company formations is the following:
- Tax should not apply if a taxpayer is merely transforming direct asset ownership into an indirect share interest.
- Tax must apply if a taxpayer is cashing-out.
- Tax policy should promote company formation (a hallmark of new business growth).

The requirements for the relief is that:
1. The transferor must receive at least 25 percent of the ordinary/participating preference shares because SARS wants to be sure that the transferor has a meaningful interest in the transferee company.
2. The transferor receives tax-free treatment only to the extent of the ordinary/participating preference shares received. But if the transferee gets cash or bonds this is cashing out and will be taxed. What still needs to be discussed is the situation where the transferor gets 25% ordinary shares but also gets cash or like instruments.
3. The transferor may freely transfer property subject to debt (normally associated with the property). Because the property is given up the debt is given up as well. This is a gain but will not be taxed because it will undermine company formation. It is very seldom that a property does not have a debt attached to it. So if the debt is a normal debt in the course of business there will be relief and the debt will be tax free.
4. The transferor must retain its 25 percent share interest for an 18 month period.
Requirements 1. Through 4. provide tax-free treatment on a transferor-by-transferor basis.
6. The transferee company can be newly formed or previously existing. i.e. the asset can be put in an existing subsidiary as well and the relief will apply.
7. The transferee company must be a domestic (non-exempt) company.
The transaction does not apply to the transfer of financial instruments other than trade receivables and this is to promote foreign investment.
9. Special rules exist to promote tax-free formations of foreign-owned South African subsidiaries.

SARS has put in place a series of anti-avoidance rules. The number of transactions that can be done are limited. If a new company is formed that new company cannot form another company and get a free transfer of assets for a 18 month period. There are a series of anti loss rules that prevent the trafficking in losses. Taxpayers will not be able to put losses into companies to offset the gain in the 18 month period. If SARS finds that money has been borrowed against the property just before the transfer it will be seen as a cashing out. If a loss asset is sold to a connected party loss is clogged.

B Share-for-Share Combinations
The swopping of shares is typical in SA. The law currently allows for any kind of share swopping. The Bill changes this. It will only be allowed if two companies are coming together. The transaction takes place as follows:

The Acquiring company(A) is a gold mining business and has 1 000 000 shares in the hands of the public. The Target Company (T) is a platinum mining company and has 50 000 shares in the hands of the public. A wants to acquire the platinum mining business from T because A wants to diversify and grow. Now A issues 50 000 of its shares and the shareholders of T gives up their shares for shares in A. The end result is that A owns 100% of the shares in T and the shareholders of T now own shares in A. There has not been a cash out because the old shareholders of T have an indirect interest in T. The transaction is tax deferred but the base cost of the T shares roll over to A. The losses, like in the case of company formations, are clogged.

Many other countries allow this so SA has to be competitive.

The policy considerations for share-for-share combinations are the following:
- Tax should not apply if a Target shareholder merely transforms a direct interest in Target into an indirect interest.
- Tax must apply if a taxpayer is merely cashing-out his or her investment.
- Tax policy should promote combinations on the JSE.

The tax free treatment will only apply:
- When the target shareholder gets at least 25% of the ordinary shares of A. This requirement does not apply if A is a listed company.
- When A acquires a controlling interest in T. If is closely held company A must hold at least 50% of T. If t is listed then the threshold is 35%. There is still discussion around what the proper threshold is for listed companies.
- Both T and A must be domestic companies.
- T cannot be a financial instrument holding company.
- Each T shareholder must keep the shares of A for 18 months.
- The transaction is tax free only to the extent that the T shareholder receives ordinary or participating pref shares.
- The wrongdoing of one shareholder does not effect all.

Similar anti avoidance rules apply as in company formations.

C Intra-Group Transfers
In this transaction the parent company owns all the shares of sub 1 and sub 2. I corporate SA each sub is like a division to make internal management easier and to spread the risk.
Sometimes thew wrong asset is in the wrong sub. Because sub 1 and sub 2 are separate entities relief is granted to move around the asset in the group. The roll over regime will apply i.e. the gain is preserved and unlike in company formations and share-for-share combinations in intra-group transfers the loss is also rolled over.

The policy for intra-group transfers is the following:
- Tax should not apply to transfers between corporate members that are akin to divisions.
- The tax attributes of the asset transferred (e.g., base cost and potential recoupment) should roll over to the transferee company like an inter-divisional transfer.

To enjoy the relief these requirements must be met:
- Both the buying and selling member must be part of the same group (i.e., they both must be directly or indirectly controlled by the same common parent).
- The group relationship must have been in existence 18 months before the transfer.
- Both the selling and buying member must elect tax-deferred treatment.
- Tax-deferred treatment lasts until the buying member sells the asset outside the group, or until the buying and selling members are not part of the same group.
- Both the buying and selling members must be domestic residents.
- - Tax-deferral does not apply to the transfer of financial instruments (but financial instruments such as shares and notes can be received in exchange)

There are anti avoidance measures in place in the intra-group context to prevent the trafficking in
losses.

D Unbundling
This transaction involves the downsizing of the group. In Europe it is called demergers and in the
US it is called spinoffs. The nature of the transaction is that the parent company owns all the
shares in the sub and the Parent distributes the shares in the sub to the shareholders of the
parent company. For each share held in the parent the shareholder will get one share of the Sub.
The base cost is apportioned between the two shares held by the shareholder. There will be no
tax payable for the purposes of CGT, Income Tax and stamp duty. There was already an existing
provision that no STC was payable. The gain will only kick in if the share is sold.

The policy considerations are the following:
- The purpose of unbundlings is to promote the division of companies where the parental interest in the subsidiary is depressing the value of the subsidiary shares (i.e., the parts are worth more than the whole).
- Unbundlings should not be allowed as a general mechanism to disguise tax-free cash/property dividends.
- Tax policy should promote standard divisions on the JSE.

The unbunding rules are flexible because normally the shares could only g to the general pubic but now the shares of the sub can go to listed shareholders or company members within the same group. Unbundlings can also be done to divisions. The division can be transferred into a new company and then unbundled. The rationale is that it is one and the same thing if a sub or a division is unbundled.

Requirements for unbundling:
- Tax-free treatment applies only if Parent distributes a Subsidiary in which Parent has a controlling shareholder interest as follows:
a) a more than 50 per cent level for closely-held subs; or
b) a 35 per cent level for listed subs.
The 50% and 35% per cent level is required for each sub distributed.
- Both the parent and subsidiary companies must be domestic residents. In addition, distributions to non-residents holding more than 5 per cent trigger tax. If the shares are allowed to move off shore it would be like an exemption not a deferral.
- Sub cannot be a financial instrument holding company
- The 50% and 35% per cent level in the subsidiary must generally be held for an 18 month period before the unbundling.
- The unbundling distribution must reduce share premium before profits. SARS do not want
the unbundling process to reduce STC liability.

E Liquidations
This refers to company to company liquidations. The nature of the transaction can be illustrated as follows. The Parent company owns all the shares in the sub. The parent has a base cost of R20 in the sub. The sub owns a factory with a base cost of R35. When the sub liquidates into the parent, the liquidation is tax deferred for CGT, income tax and STC purposes. The base cost in the factory is transferred to the parent. The parent inherits the factory and goes forward with the asset just as the sub would have.

The policy considerations are the following:
- Liquidations of one corporation into a controlling parent are akin to the combination of
divisions in single shell.
- The flexible format of the proposed liquidation regime promotes asset merger-type combinations.

No 18 month rules apply to liquidations. A company could do a share-for-share merger and then immediately to a liquidation transaction.

To be entitled to this relief the following requirements must be satisfied:
- The parent must own 75 per cent of the shares in the liquidating subsidiary.
- The parent need not hold the 75 per cent level for an 18 month period before the liquidation, thereby allowing for a share-for-share combination to follow a liquidation (to create the effective equivalent of an asset merger).
- The subsidiary must not act as a financial instrument holding company.
- Both the parent and subsidiary must be domestic residents.
- The liquidation rules contain anti-loss trafficking rules, including the loss of all regular and capital assessed losses in the subsidiary.
- The parent inherits the tax liability of the liquidating subsidiary to prevent the use of liquidations to avoid tax.

Prof. Engel indicated that the briefing on the Second Revenue Laws Amendment Bill was now complete. There were no questions or comments and the meeting was closed.