Due to the ongoing COVID-19 pandemic and the impact of the lockdown measures implemented, many South African entities have found themselves in financial distress.

As a result, companies may enter into subordination agreements whereby they subordinate related party loans in favour of third-party loans. Such subordination agreements may also be entered into on the advice of auditors in order to avoid the issuing of a modified audit opinion or an emphasis of matter on the basis that the company is not a going concern. Subordination is essentially where a related creditor agrees to make no claim for payment of their loans until the assets (fairly valued) of the company exceeds its liabilities.

Subordination agreements fall within the scope of section 8F of the Income Tax Act which deals with hybrid debt instruments. The aim of this section is to re-characterise loans which have equity or dividend like features.

Paragraph b of the definition of a hybrid debt instrument states that a hybrid debt instrument includes an arrangement whereby “ the obligation to pay an amount so owed on a date or dates falling within that year of assessment has been deferred by reason of that obligation being conditional upon the market value of the assets of that company not being less than the amount of the liabilities of that company”

Where companies have entered into such agreements the Income Tax Act prescribes that two things must happen. Firstly, the interest payable on the debt is recharacterized and is deemed to be a dividend in specie declared and paid by such a company on the last day of the year of assessment. Secondly such interest will not be deductible for income tax purposes.

It should be noted however that whilst the dividend in specie may be exempt from dividends tax for declarations deemed to have been made to South African resident companies the same will not apply to declarations deemed to have been made to non-resident entities. In such instances the obligation to declare and pay the dividends tax will be on the South African resident company declaring the dividend.

Where a subordination agreement has been entered into solely because of going concern problems section 8F of the Income Tax Act will not be applicable (i.e. the debt recharacterization rules will not apply). This will only be the case if the company is in receipt of certification by a person registered as an auditor in terms of the Auditing Profession Act. Such certification must state that the subordination agreement was entered into due to going concern problems. The 2016 explanatory memoranda states that “It is envisaged that the auditor’s certification of the subordination of the related party debt for purposes of this exclusion should be evidenced in a separate letter.”

Taxpayers that are in possession of such certification may deduct the interest incurred on the subordinated loans and such interest will not be recharacterized into a dividend in specie.

It is therefore important that where taxpayers have entered into subordination agreements due to going concern difficulties documentation in the form of certification by a registered auditor is maintained and kept so as to avoid the application of section 8F to such loans. The burden of proof that an amount is deductible is on the taxpayer and as such appropriate documentation should be kept at all times.

If you require assistance or clarification re any of the above, please don’t hesitate to contact one of our PKF Octagon Partners.