South Africa Revenue Based Finance - Preference Shares

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This analysis was provided by White & Case SA and Citibank N.A., South Africa Branch

Table of Contents

Executive Summary

The revenue-based finance structures that have been discussed are the common structures that we see in the South African market, namely, revenue participating loans and participating preference share funding. These structures are similar in principle as both structures aim to allow investors to be able to also finance companies and startup business in a way that allows these companies to be able to build their business. Most investors believe that small and medium-sized enterprises and startup businesses have a fair amount of risk as not all start-up business will be successful. These structures are designed to give investors a share in the performance of the business.

Participating Preference Share Funding

The major considerations regarding this type of structure are the provisions of the Companies Act, 2008 and the Income Tax Act, 1962 (“Income Tax Act”). For example, failure to structure the participating preference share funding in accordance with the provisions of the Income Tax Act has the consequence that the dividends received on account of the participating preference share will be deemed to be interest / income (which is taxable) and, accordingly, the tax benefit of such preference share funding will not apply. The investor can also receive a deduction upon relying on section 12J of the Income Tax Act.

South African residents can receive tax-exempt returns. However, withholding tax would apply to any dividend paid by a resident company to a non-resident or by a non-resident company to a non-resident if the shares in respect of which the dividends are paid are listed on a South African exchange. Further, this will depend on the existence of applicable double tax treaty in place between South Africa and the country of the foreign investor. These tax treaties commonly prescribe different reduced rates of dividend withholding tax for different shareholder categories.

Another benefit of this structure is that in the event of insolvency of the borrower, a preference shareholder will rank behind secured creditors of the borrower but ahead of the ordinary shareholders of the borrower. The preference share can provide the investor with certain rights such as voting rights in relation to certain reserved matters.

Security cannot be taken from the issuing company directly but must be taken from a third party. However, this may be viewed to be a third-party backed share and, as such, tax exemption would not apply.

This structure can be more beneficial to investors as they receive a fixed dividend and can receive a tax deduction of up to 100%. Depending on the structure of the investment, the entire amount invested may be able to be deducted from the investor’s taxable income.

Profit Participating Funding

The agreed portion of the revenue or the agreed profit of the company (whichever one that has been contractually agreed to by the parties) received by the investor can be seen as a dividend and as such be subject to taxation. However, because the return is not calculated with reference to a rate of interest, it is treated as a tax-exempt dividend under section 8FA of the Income Tax Act. Withholding tax would apply to any dividend paid by a resident company to a non-resident or by a non-resident company to a non-resident if the shares in respect of which the dividends are paid are listed on a South African exchange. This is dependent on the application of the applicable double tax treaty in place between South Africa and the country of the foreign investor if there is one in place. These tax treaties commonly prescribe different reduced rates of dividend withholding tax for different shareholder categories.

Governance rights are generally in the form of negative undertakings and are purely contractual where the instrument is constructed as a loan. Furthermore, approval from the Financial Surveillance Department of the South African Reserve Bank would be required in the event that the currency of the investment is not in the South African Rand and if the investor is not a South African resident.

One of the factors that may lead parties to select this structure instead of the participating preference share is that security can be taken directly from the company instead of a third party. Further, as a secured creditor, it would have a priority ranking over secured assets and all remaining creditors would be paid from the remaining proceeds of the sale of secured assets after the secured creditor is repaid, if any.

Participating Preference Shares

Investment Structure Summary

A common revenue-based finance structure in South Africa is participating preference shares. This structure contemplates funding being provided in the form of preference share capital. The preferred shares return a dividend equal to a contractually agreed percentage of the profit of the company or a contractually agreed percentage on the revenue of the company.

Preference shares can be redeemable or not redeemable. Redeemable preference shares can be redeemed by the company either on a specified date or over a period of time. Upon redemption, the company will be required to pay all distributions which have accrued to the holder thereof and all other amounts owed to such holder. Such redemption will be undertaken in accordance with section 46 of the Companies Act, 2008 (“Companies Act”).

Category for tax purposes

For tax purposes, they will be classified as equity, in general.

Exceptionally, they can be classified as a hybrid equity instrument in terms of section 8E of the Income Tax Act, 1962 (“Income Tax Act”), or a third-party backed share as defined in section 8EA(1) of the Income Tax Act, as discussed below.

Section 8E(2) of the Income Tax Act provides that dividends received in respect of a preference share will be deemed to be income in the hands of the recipient i.e. the holder of the preference share, if the preference share constitutes a “hybrid equity instrument”.

Section 8E(1) defines a “hybrid equity instrument” as, among other things, a preference share which is secured by a financial instrument which cannot be disposed of, unless the preference share was issued for a “qualifying purpose”. This means that the subscription proceeds which are receivable by or accrued to the issuer of the preference shares must be applied for one or more “qualifying purpose(s)”, as defined in section 8EA of the Income Tax Act. Please see the discussion under “Critical Tax Considerations” for the definition of “qualifying purposes”.

Section 8EA of the Income Tax Act defines a “third-party backed share” as a preference share in respect of which an enforcement right is exercisable by the holder of that preference share or an enforcement obligation becomes enforceable as a result of any specified dividend or return of capital attributable to that share not being received by or accruing to the person entitled thereto.

Governance Rights

As a general rule, preference shareholders do not have voting rights, however they can be afforded such rights. As the preference share is a share in the capital of the company, a preference shareholder can be granted governance rights in the terms of its issue and can have rights to vote on all terms that have been contractually agreed between the investor and the issuer including rights to vote on certain matters, appoint directors, to vote at annual general meetings, etc.

Preference shareholders do, however, in all instances, have the right to vote on any proposal to amend the preferences, rights, limitations and other terms associated with the preference shares. The governance rights can be built into the constitutional documents of the company.

Investor Qualification Requirements

If an investor is a South African resident, there are no requirements applicable however, if the investor is non-resident, whilst they are free to own shares in South African companies, they must ensure that the share certificates issued by the company are endorsed within 30 days of becoming the owner of the shares by the Financial Surveillance Department of the South African Reserve Bank (“SARB”) as non-resident or an Authorised Dealer.

Regulation 14(1) of the Exchange Control Regulations, 1961 provides that no person may, without permission granted by the SARB or a person authorised by it, and in accordance with such conditions imposed, acquire or dispose of, in any way, any share in a South African company. The relevant Authorised Dealer is generally the local commercial bank of the South African company in which the shares are held by non-residents.

Currency Considerations

The investment cannot be denominated in US Dollars or other currencies. In terms of the Companies Act, the share capital of a South African company—including preference shares—must be classified in Rand.

The payment to acquire or subscribe for shares—including preference shares—can be made as the Dollar equivalent of the Rand amount, but exchange control approval will need to be obtained from the Financial Surveillance Department of the SARB in order to exchange the amount in such currency

Collateral

The investor cannot take collateral to secure the preference share from the company that issues the share because the claim on the share is not a debt claim, and as such, there is doubt that the rights associated with those shares can be validly secured by the issuer of the share under South African law.

In theory, the investor can take security from a third-party such as guarantees. However, if the investor does so, section 8EA of the Income Tax Act becomes applicable. Also, if the purpose to which the share was issued for is not a qualifying purpose and the person providing the security is not in the category of “permitted persons” in terms of the Income Tax Act, the share will be considered a third-party backed share and the benefit of receiving tax exempt dividend will fall away.

Section 8EA(2) of the Income Tax Act provides that dividends received in respect of a preference share will be deemed to be income in the hands of the holder of the preference share if the preference share constitutes a “third-party backed share”.

Section 8EA(3) of the Income Tax Act, however, provides that a preference share secured by the assets of a third party will not constitute a “third-party backed share” if the obligations of the issuer of that preference share is secured by one of the following persons:

the operating company in respect of which the preference share funds will be applied, provided the funds were applied for a qualifying purpose;

the issuer of the preference shares, provided it was issued for a qualifying purpose;

any person that directly or indirectly holds at least 20% of the equity shares in the relevant operating company or issuer;

any company that forms part of the same group of companies as the relevant operating company, issuer or 20% equity holder;

any natural person;

any non-profit company, trust or association of persons, provided that none of the activities of that organization are directed at promoting the economic self-interest, other than the payment of reasonable remuneration, of any employee or fiduciary of that organization; or
any person who holds equity shares in the issuer of the preference shares, provided that the enforcement right or obligation exercisable against that person is limited to any rights in and claims against that issuer that are held by that person.

Priority Payment Rights

Preference shares rank ahead of other shares and are offered preference in relation to ordinary shares in the event of distribution of dividends. Please note that dividends, which may be an agreed portion of (1) gross revenues, (2) free cash flow or (3) net income, before ordinary shareholders are paid out. As such, preference shareholders will also receive their share of the company’s residual value before ordinary shareholders in the event of liquidation. Preference shareholders will be paid after the creditors of the company, but before the ordinary shareholders

Distribution and Redemption Limitations

Restrictions on payment of a dividend or redemption of the preference share are typically regulated in the constitutional documents of the company and moreover in terms of section 46 of the South African Companies Act, a company must not make any proposed distribution unless the distribution is (i) pursuant to an existing legal obligation of the company, or a court order or (ii) the board of directors of the company, by resolution, has authorised the distribution. In order to declare a dividend, it must reasonably appear that the company will satisfy the solvency and liquidity test as set out in section 4 of the Companies Act (the “Solvency and Liquidity Test”) after completing the proposed distribution and the board of the company, by resolution, has acknowledged that that it has applied the Solvency and Liquidity Test as set out in section 4 of the Companies Act and has reasonably concluded that the company will satisfy the Solvency and Liquidity Test immediately after completing the proposed distribution.

Legal limitations to pricing or total return

Unlike a revenue participating loan, there are no legal limitations on pricing or total returns that would arise from a preference share.

Status in Insolvency Proceedings

Preference shareholders will be paid after the creditors of the company, but before the ordinary shareholders. The ranking of the other shareholders for the shares in the share capital of the company will be determined by the rights of each of those shares. Preference shareholders receive their share of the company’s residual value before ordinary shareholders in the event of liquidation

Limitation of Liability

An investor’s liability towards the company and its creditors will be limited to its funded investment. There are certain exceptions in which an investor may be liable. The most notable exception is the extension of liability to investors for environmental law breaches.

As an example, the National Environmental Management Act 1998 and the National Water Act 1998 extend the net of liability for pollution and environmental degradation to include, among others:

persons who have been responsible for or who have directly or indirectly contributed to pollution or environmental degradation; and/or
persons who negligently failed to prevent the activity being performed that resulted in the pollution or environmental degradation.

Transfer Restrictions

If the issuing company is a private company, the general rule is that the transfers are restricted. A private company is profit company that (a) is not a public, personal liability, or state-owned company; and (b) satisfies the criteria set out in section in 8(2)(b) of the Companies Act. For them, the consent of the board of directors is required for any transfer and the terms of issuance can provide for pre-approved list of permitted transferees.

In the case where the issuing company is a public company, transfers are not restricted. A public company is a profit company that is not a state-owned, private or personal liability company. The Companies Act further defines a profit company as a company incorporated for the purpose of financial gain for its shareholders.

Critical Tax Considerations

Section 8E of the Income Tax Act which targets shares and equity instruments with substantial debt features. The treatment of these shares as hybrid financial instruments ensures that debt is not disguised as short-term redeemable preference shares or any other redeemable share containing certain dividend preferences.

Section 8E deems a dividend or foreign dividend on a hybrid equity instrument to be an amount of income accrued to the recipient and will not be exempt from normal tax. The payer is also not offered a deduction for the payment of affected dividends or foreign dividends.

Section 8EA of the Income Tax Act provides that subscription proceeds received by, or accrued to, the issuer of the preference shares will be deemed to have been used for a “qualifying purpose” if it is used for:

the direct or indirect acquisition of an equity share in a company which is an “operating company” at the time of receipt or accrual of the dividend, provided that it cannot be used to acquire shares in an operating company which, immediately prior to such acquisition, formed part of the same group of companies as the person acquiring the equity shares;

the direct or indirect acquisition or redemption of other preference shares (“Original Preference Shares”) if:

the Original Preference Shares were originally issued for a “qualifying purpose”; and

the amount received by or accrued to the issuer does not exceed the amount which remains outstanding in respect of the Original Preference Shares;

the payment of dividends in respect of the Original Preference Shares; and

the partial or full settlement of debt incurred in respect of any one of the above.

An “operating company” is defined in section 8EA of the Income Tax Act as:

a company that carries on business continuously and, in the course of operating such business, provides goods and/or services for consideration on exploration of natural resources;

a company that is a controlling group company in relation to the aforementioned operating company; and

any company that is a listed company.

Section 8E(1) of the Income Tax Act also defines a “hybrid equity instrument” as, amongst other things, a preference share in respect of which:

the issuer thereof is obliged to redeem the preference share in whole or in part within a period of three years from the date of issue of that preference share;

the holder thereof has the option to redeem the preference share in whole or in part within a period of three years from the date of issue of the preference share; or

the existence of the company issuing such preference share will be, or is likely to be, terminated within a period of three years from the date of issue of the preference share.

8EA(2) of the Income Tax Act provides that dividends received in respect of a preference share will be deemed to be income in the hands of the holder of the preference share if the preference share constitutes a “third-party backed share”.

Section 8EA(3) of the Income Tax Act, however, provides that a preference share which is secured by the assets of a third party will not constitute a “third-party backed share” if the obligations of the issuer of that preference share is secured by one of the following persons:

the operating company in respect of which the preference share funds will be applied, provided the funds were applied for a qualifying purpose;

the issuer of the preference shares, provided it was issued for a qualifying purpose;

any person that directly or indirectly holds at least 20% of the equity shares in the relevant operating company or issuer;

any company that forms part of the same group of companies as the relevant operating company, issuer or 20% equity holder;

any natural person;

any non-profit company, trust or association of persons, provided that none of the activities of that organization are directed at promoting the economic self-interest, other than the payment of reasonable remuneration, of any employee or fiduciary of that organization; and

any person who holds equity shares in the issuer of the preference shares, provided that the enforcement right or obligation exercisable against that person is limited to any rights in and claims against that issuer that are held by that person.

Section 12J Investments

A holder of participating preference share can also receive a deduction upon relying on section 12J of the Income Tax Act. Section 12J was legislated to incentivise South African taxpayers to invest in local companies and to receive a tax deduction of up to 100% of the amount subscribed in a qualifying company i.e. the entire amount that is invested can be deducted from the investor’s taxable income.

Section 12J has requirements at the level of the “qualifying company” and at the level of the venture capital company (“VCC”) who holds the shares of the qualifying company. A VCC is taxed as a company and does not enjoy any special tax concessions because of its VCC status.

Section 12J(1) defines a VCC as a company that has been approved by the Commissioner of the South African Revenue Services and in respect of which such approval has not been withdrawn in terms of subsection (3A), (3B), (6) or (6A) of the Income Tax Act. It order for a Commissioner to approve a VCC, it must be satisfied that (i) the company is a resident, (ii) the sole objective of the company is the management of investments in qualifying companies, (iii) the tax affairs of the company are up to date and in order and (iv) the company is licensed in terms of section 8(5) of the Financial Advisory and Intermediary Services Act, 2002.

Section 12J(2) allows a taxpayer, subject to certain conditions, to claim a deduction from income in respect of a year of assessment for expenditure actually incurred by that taxpayer in acquiring any venture capital share issued to that taxpayer during that year of assessment. Expenditure incurred by a company must not exceed ZAR5 million and reviseda person other than a company must not exceed ZAR2,5 million.

The term “venture capital share” is defined in section 12J(1) to mean “an equity share held by a taxpayer in a venture capital company which was issued to that taxpayer by a venture capital company, and does not include any share which —

…

(b) would have constituted a hybrid equity instrument, as defined in section 8E(1), but for the three-year period requirement contemplated in paragraph (b)(i) of the definition of ‘hybrid equity instrument’ in that section;

(d) was issued to that taxpayer solely in respect or by reason of services rendered or to be rendered by that taxpayer in respect of the incorporation, marketing, management or administration of that venture capital company or of any qualifying company in which that venture capital company holds or acquires any share.”

The term “equity share” is defined in section 1(1) of the Income Tax Act to mean – “any share in a company, excluding any share that, neither as respects dividends nor as respects returns of capital, carries any right to participate beyond a specified amount in a distribution”.

A distribution can take the form of a distribution of profits (dividends) or capital. As long as the right to participate in either of these types of distribution is unrestricted, the share will be an equity share. The share will not be an equity share if both of these rights are restricted. Fundamentally, the shares in the VCC must take the form of equity share and must not be a hybrid equity instrument or constitute a third-party backed share.

liable for withholding tax. Whether or not that dividend withholding tax can be reduced is dependent on the existence and applicability of the double tax treaty between the country of the foreign investor and South Africa

South Africa Revenue Based Finance – Preference Shares

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