Don’t forgive debt when converting it to equity

A method which is sometimes used to settle a debt is the conversion of the debt owed by a company to its creditor into equity in that company.

Graeme Palmer

New provisions on the conversion of debt to equity, contained in the “debt forgiveness” (i.e. a waiver of debt) rules in section 19 and paragraph 12A of the 8th Schedule to the Income Tax Act, 1962, came into operation on 1 January 2018.

Section 19 deals with the tax implications of a debt that was previously used to fund deductible expenditure and provides for a recoupment that is subject to normal tax if the debt was used to fund such expenditure. Paragraph 12A deals with debt that was used to fund capital expenditure and provides for the reduction of the base cost of the asset still on hand with any remaining balance then being used to reduce assessed capital losses of the person.

Debt conversion arrangements are common and are usually done for a legitimate purpose, such as improving the company’s balance sheet.  For example, a shareholder’s loan may be converted to equity by issuing shares at market value to the shareholder for the face value of the loan owed by the company. SARS previously issued rulings regarding these arrangements advising that they do not trigger the “debt forgiveness” rules.

However, some conversion arrangements were being structured in such a way to avoid the tax implications of the “debt forgiveness” rules. This prompted the current change to the rules which now apply where a “debt benefit” in respect of a debt owed by a person arises by reason, or as a result of, a “concession or compromise” in respect of that debt. Importantly, a “concession or compromise” has been defined to include a debt being settled by being converted to or exchanged for shares. In other words, the new rules may, in certain circumstances, apply to a conversion arrangement. But, before the new rules apply, there would have to be a “debt benefit” for the debtor.

A “debt benefit” would arise where the face value of the debt exceeds the market value of the shares being issued to the creditor. If the creditor is an existing shareholder, the face value of the debt would have to exceed the difference between the market value of the shares held before and after the conversion. There is also an exemption from the new provisions that may apply to a “group of companies” as defined in section 41.

This article has been written by Graeme Palmer, a Director in the Commercial Department of Garlicke & Bousfield Inc

NOTE: This information should not be regarded as legal advice and is merely provided for information purposes on various aspects of tax law.

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