The draft Taxation Laws Amendment Bill, 2017 (DTLAB) provided for new sections 19A and 19B in the Income Tax Act 58 of 1962 (the Act) to provide for recoupment of interest arising from conversions of debt to equity.

Recoupment is an income tax concept which generally means expenses which were previously claimed as a deduction for income tax purposes must now be added to income and subject to income tax, i.e. the previous deduction must be "recouped". The DTLAB also provided for section 19 (dealing with recoupments on debt waivers and reductions) not to apply when debt is converted to equity.

Webber Wentzel participated in the 26 September 2017 workshop where National Treasury discussed revised proposals for these amendments in response to written submissions on the DTLAB and workshop discussions. The proposal was for the initial claw-back provisions in sections 19A and 19B which provided for recoupment of interest and on de-grouping to be removed from the final bill.

Section 19 and para 12A of the Eighth Schedule of the Act would be amended to include all forms of debt restructuring, including debt waivers, debt compromises, subordination agreements, debt concessions and conversions of debt to equity. The definition of "reduction amount" in section 19 and para 12A would be deleted and replaced with two new concepts, namely "debt benefit" and "concession or compromise".

A "concession or compromise" would include a waiver of debt, a change in any condition or term of debt, and any direct or indirect settlement of debt with equity (including conversions of debt to equity). A change of terms on interest may be excluded. This new definition is significantly wider than the scope of the current "reduction amount", which essentially covered debt waivers or reductions. A "concession or compromise" event would trigger the recoupment in section 19 or reduction in base cost in para 12A. The recoupment or base cost reduction amounts would be determined in terms of a "debt benefit".

A "debt benefit" arises for the debtor where the face value of the debt exceeds:

1. in the context of debt waivers and change of conditions or terms of debt, the market value of the debt after the waiver or change.
2. in the context of conversions of debt to equity;

• the market value of the shares issued on the conversion, where the creditor did not hold any shares in the debtor prior to conversion; or
• the difference between the aggregate market value of shares held before and after the conversion, where the creditor held shares in the debtor prior to the conversion.

Para (2) may exclude section 8F hybrid debt instruments. Hybrid debt instruments are essentially debt instruments which are treated as equity for anti-avoidance purposes with the interest on the debt deemed to be a dividend in specie and not deductible by the debtor.

Further, there would only be group exemption where there is conversion of debt to equity between resident debtors and creditors in the same group (i.e. "group" as defined in section 41). There is no proposal for group relief for para (a) debt waivers or debt subordinations but this may be reconsidered in the 2018 amendment bill.

The proposal is for the above amendments to apply for years of assessment commencing on or after 1 January 2018.

A number of issues have been highlighted to the National Treasury on the above proposals, including the practical difficulty of valuing the market value of debt (relative to its face value). In the context of debt subordination, the market value of capital amounts of debt giving rise to a debt benefit is affected by macro-economic factors which are beyond the control of the debtor and creditor, and factors in the debtor which may have little to do with the debt. Further, there is also no provision for a deduction for the debtor, should the debt subordination be reversed, or if the debt benefit results in a negative value.

The group exemption for conversions of debt to equity is only available for resident creditors and debtors. This means that a conversion of debt which includes capitalised interest due but not payable to a non-resident creditor, could trigger interest withholding tax for the debtor. Interest withholding tax cannot be set-off against assessed income tax losses of the debtor and would result in tax cash outflows for the debtor. This results in greater (not less) financial distress for an ailing debtor.

The scope of section 19 and para 12A which currently only deals with debt waivers would be expanded significantly through the introduction of the "concession or compromise" definition. Annexure C of the 2017 Budget provided for "[d]ebt settled for consideration other than cash", with the example given of the issue of shares equal to the face value of debt. There was no mention in Annexure C of additional tax amendments for debt subordination, and changes in terms and conditions of debt. These new proposals have not had the benefit of the usual legislative public participation process, being submissions, presentations and additional workshops held to discuss issues and solutions on the draft bills. There is thus no further opportunity to comment on the wording of these proposals before the final bill is tabled.

National Treasury has indicated that they are working towards introducing the final bills at Parliament on 25 October 2017. This is also the date for the tabling of the anticipated Medium Term Budget Policy Statement. Given the proximity of this date, the hope is that should the above proposals be included in the final bill, that the effective date of the amendments would be a date to be determined by the Minister of Finance through publication in the Government Gazette.

This would achieve the purpose of including these amendments in the 2017 final bill and also provide members of the public to make further submissions on the wording in the 2018 legislative cycle. Further refinements to the wording on these proposals can then be included in the 2018 amendment bill.

Written by Joon Chong, Partner, Tax Practice, Webber Wentzel