Special purpose vehicles (SPVs), a favoured method of funding black economic empowerment vehicles, faces a new headache in the form of Capital Gains Tax (CGT), according to Deloitte & Touche.
Alastair Morphet, associate director of the Financial Services Group at Deloitte & Touche, says that in addition to the problem of poor equity returns on the JSE hindering the chances of a decent surplus on the underlying shares to give a return on the SPVs, CGT is simply adding a new hurdle.
"If the price of the underlying equities in which the SPV had invested did not grow so that a preference share financier could get an adequate return, there would be no surplus value at the termination of the transaction to empower the previously disadvantaged group with," says Morphet.
"As a result of the intriduction of CGT in October, where equity financings have arguably been treated as being on capital account, financiers of these transactions will require their rate of return to rise to set off the CGT charge imposed by the SA Revenue Service (Sars).
Morphet says there is obviously a socio-economic need to allow previously disadvantaged persons in this country to accumulate capital, but he finds it anomalous that the introduction of CGT is having quite the opposite effect.
"The cost of capital in empowerment transactions has just become higher and it is unlikely that the financiers are going to lower their required rate of return; the inevitability is that it will be harder for the people trying to accumulate capital to do so, " he argues.
Morphet says that in empowerment equity financing transactions, the idea is to leave the ordinary shares in the company in the hands of the previously disadvantaged. The reason for putting in a preference share capital structure is because the SPV is a passive holder of underlying equity shares, so there are no cash flow to set off the interest costs. The long-term purpose of the financing is to acquire the underlying shares, hence the use of redeemable preference shares.
Since the loan would have been to acquire equity shares of a capital nature, the tax deduction would not have been allowed by Sars any way.
"While there is no taxable income in the SPV to service a semi-annual dividend on the preference shares, the dividend can accumulate until the transactions` termination," Morphet explains.
The financier can then have the preference shares redeemed with a cumulative dividend (subject to secondary tax on companies (STC) in the SPV`s hands) or paid out as a distribution in specie on a winding up of the SPV, he says.
"This means that the financier receives the underlying shares. This latter alternative assumes that the ordinary shareholders have no future commercial use for the SPV, but this transaction can be done free from STC because of the liquidation.
"If that redemption is by way of a dividend from profits realised on the sale of the underlying shares, that dividend will be subject to STC.
"However, in this year`s Budget, the Minister of Finance announced that he wished to amend the definition of "dividend" so that capital profits distributed in the course of a liquidation will be included in the definition. This means that the distribution on a winding up referred to above would also be subject to STC.
Morphet says that while this will create a level playing field between declaring a dividend and making a distribution on a winding up, the economic ability to repay the financier in these transactions becomes ever more difficult.
CGT creates a new set of problems through the so-called "cascading effect" whereby multiple tax events are triggered.
"Firstly, if such redeemable preference shares are converted into ordinary shares, this act will be a disposal within the scope of the Income Tax Act`s new Eighth Schedule. If those ordinary shares arising from such conversion are sold, that will be a further disposal, also subject to the imposition of CGT. In other words, the financier`s exit is effectively being taxed twice."
Furthermore, if the underlying shares held by the SPV are required to be sold or distributed in specie to the financier to facilitate the payment of the financier, then that will be a transaction subject to CGT. "And the financier, in giving up his preference shares to receive the underlying shares, is engaged in a further disposal, and will be subject to CGT on this transaction as well," Morphet adds.
Morphet says similar issues are faced by investment trust companies, where the company holds underlying equity shares as a pooled investment vehicle for shareholders. Since these shares are held as capital assets, with gains distributed to shareholders, the sale of those shares would now give rise to a capital gain taxable in the company, while the capital distribution to shareholders would also give rise to a taxable event.
"While Sars has introduced complex relief provisions in section 41-46 of the Income Tax Act, most of the transactions being discussed here will not qualify for those relief provisions," Morphet says.
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