One of the methods used by creditors to provide breathing space to their distressed debtors is to convert the debt owed to equity shares in the debtor company. The mechanics of how the conversion of debt to shares takes place commonly involves the company first issuing shares to the creditor for the subscription price equal to the debt to be converted. The subscription price may be left outstanding on the loan account, in which case the existing debt owed by the debtor will be set-off with the subscription price owed by the creditor. If the subscription price is paid in cash by the creditor, then the cash will be used by the debtor to repay the existing debt owed by the debtor to the creditor.

For the debtor, the conversion of debt to equity stops the incurral of interest and allows a future payment of "return on investment" to the creditors in the form of dividends when it meets solvency and liquidity tests. For the creditor, the conversion also makes sense because there is potential capital growth in share value when the business recovers. If interest is capitalised with no cash flows to the creditor and the debtor is in a balance of assessed loss position, this could result in tax cash outflows for the creditor for the interest accrued (even though not received) with no corresponding reduction in tax cash payment through interest deductions for the debtor.

The draft Taxation Laws Amendment Bill, 2017 proposes two amendments that are intended to facilitate the conversion of debt to equity. The proposed amendments (new sections 19A and 19B) recognise that the shareholder/creditor desires, in effect, the outcome that would have been achieved had the initial funding in the debtor company in the same group been made in the form of equity instead of debt. The purpose of the proposed amendments is thus to achieve, in broad terms, the outcome that would have been achieved had the creditor funded the company by means an equity contribution rather than by a loan.

Herein lies the fundamental conceptual issue with the proposed amendments which could render a common business turnaround strategy no longer usable. Investors may have chosen to invest in debt and not equity as creditors usually have a preferred return and rank higher in repayment than shareholders. The debt now has to be converted to equity as the alternative is a loss of the debt altogether if the distressed company is wound up. Therefore, it is perhaps inaccurate to say that the creditor had initially intended to invest in shares but had invested in equity instead.

Section 19A provides for debt between companies in the same group which is converted to equity to result in recoupment of any interest which was claimed as a deduction by the debtor and where such interest was not subject to income tax in the hands of the creditor. The recoupment would first reduce the assessed loss in the debtor, followed by the inclusion of a third of any remaining interest amounts in the income of the debtor (and subject to income tax) for the next three years. (Recoupment is a 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, ie the previous deduction must be "recouped".)

Section 19B applies when the debtor and creditor company cease to form part of the same group of companies within five years from the date of conversion of debt to equity. Should the face value of the debt converted to equity be more than the market value of the shares when the debtor and creditor cease to form part of the same group, the excess must first be reduced by any interest which is recouped in terms of section 19A, and any remaining excess is immediately recouped in year of the de-grouping.

There are a number of issues with the recoupment mechanism in section 19A.

Firstly, interest deductibility for the debtor company would have been subject to existing interest deductibility limitation rules in section 23M, which would apply in most circumstances. A debtor company could have paid interest but not have been able to claim the full amount as a deduction. This would have already resulted in a negative cash flow effect to the debtor company even before the debt is converted to equity. (Section 23M limits the deduction of interest where the interest claimed by the debtor and not subject to tax [ie interest withholding tax and income tax] in the hands of the recipient. The limitation of interest is calculated in terms of a formula.)

Secondly, large amounts of capitalised interest which are due but not payable to a non-resident creditor in the same group would on conversion of such capitalised interest to equity become due and payable and trigger interest withholding tax. The already financially distressed debtor company has to fund the payment of potentially large amounts of interest withholding tax to SARS, resulting in a significant negative cash flow impact.

Lastly, depending on the amount of assessed losses in the debtor company, the new sections may result in income tax payable through the recoupment, resulting in further significant negative cash flow for the debtor company.

Section 19B requires the debtor and creditor company to remain in the same group of companies for five years after the date of the conversion. This is overly restrictive and prevents groups from restructuring or disposing of distressed entities in the group to improve the overall performance in the group (also a common business turnaround strategy).

Various submissions were made to the National Treasury on the issues in sections 19A and 19B, including that only interest which is not subject to tax (ie both interest withholding tax and income tax) could possibly be recouped, that de grouping due to winding-up or deregistrations should be excluded, and that the recoupment value to be determined for section 19B should be the higher of market value of the shares issued on the date of conversion and date of de-grouping. The most important submission is that the recoupment of interest in the debtor company will be a significant deterrent and result in more (not less) financially distressed companies in an already depressed economy. It is hoped that National Treasury will take the submissions made and appropriate amendments made to the final bill.

Written By Joon Chong, a Partner in the Tax Practice at Webber Wentzel