Employees are entitled to sick leave when a sick note has been issued. Similarly, in terms of recent tax amendments, a company with a subordinated loan may avoid the constricting implications of section 8F of the Income Tax Act, if it holds a ‘sick note’ from a registered auditor.

Essentially, section 8F provides for anti-avoidance rules that reclassifies interest in respect of so-called ‘hybrid debt instruments’ as a dividend in specie, thereby denying the income tax deduction for the issuer of the debt instrument (i.e. dividends are a distribution of reserves and not an expense, hence it is not deductible for tax purposes).  In addition, the recipient of the ‘interest’ receives a dividend in specie, which is possibly subject to dividends withholding tax (“DWT”), instead of normal income tax.

Generally, a hybrid debt instrument is a debt instrument that contains equity-like features. Without delving into excessive detail of the hybrid debt instrument definition, the problematic part of the definition is where the obligation to pay an amount in respect of that instrument is conditional upon the market value of the assets of the company exceeding the market value of the liabilities.

In the current economic climate it is not uncommon for companies to experience financial distress. As a result, many companies revert to entering into subordination agreements (often at the request of the company’s auditors) in order to remain a going concern. Typically a subordination agreement provides that the creditor company will not require payment in respect of a debt until such time as the assets of the debtor company fairly valued exceed the liabilities of the company, which could result in the debt instrument being subject to the provisions of section 8F. The subsequent application of section 8F places the distressed company under even more pressure, since the denial of the interest deduction may result in a larger tax bill. Furthermore, the company could also be liable to pay DWT on the dividend in specie.

Relief has been provided in the latest draft Taxation Laws Amendment Bill 2016 where it is proposed that section 8F will not apply in the context of debt subordination (i.e. the obligation to pay a debt is conditional upon the solvency and liquidity requirements) if it has been certified that the payment in respect of that instrument is to be deferred by reason of the market value of the assets of the company being less than the liabilities.

This certification (or ‘sick note’) must be issued by a registered auditor, as contemplated in the Auditing Professions Act No. 26 of 2005.

This amendment will apply retrospectively from 1 January 2016.  For this reason, it will be important that all loans meeting this concession be supported with adequate documentation to be provided by a registered auditor.

Written By Tertius Troost, CA(SA), Tax consultant at Mazars