Targeted Share Buy-Backs Using CTC to Remain Permissible

In edition 9/2022 of this Mailer, I noted that the Draft Taxation Laws Amendment Bill of 2022 proposed important amendments to the definition of contributed tax capital (“CTC”) but that it was unlikely that the wording of the amendments would stand the test of time. Newly worded proposals were tabled by Finance Minister Godongwana on 26 October in the Taxation Laws Amendment Bill of 2022. The new proposals, which are likely to be passed into law, strike a better balance between the flexibility sought by taxpayers and the anti-avoidance concerns of National Treasury.

To recap, CTC is a tax concept akin to the old company law concept of share capital and share premium. If an amount is received by or accrues to a company in exchange for shares issued by the company, such amount is added to the CTC attributable to the class of shares that was issued. If the company makes a distribution to shareholders, its directors may resolve that the distribution, or a part of the distribution, constitutes a return of CTC. In such a case there is a subtraction of the return of CTC from the balance of CTC attributable to the relevant class of shares. To the extent that the distribution is not resolved to be a return of CTC, it will constitute a dividend.

To a shareholder receiving a distribution from a company, there are important differences between whether what is received is a return of CTC or a dividend. If it is a dividend, the dividend will not give rise to capital gains tax, but dividends tax may be payable. There are various types of shareholders who are not subject to dividends tax - most notably, South African resident companies. On the other hand, if the distribution is a return of CTC, the amount received usually has capital gains tax consequences for the shareholder but not dividends tax consequences. However, there are various situations in which shareholders are not subject to capital gains tax in relation to shares in South African resident companies, including where the shareholder is a non-resident (with some exceptions) or an entity that is entirely exempt from income tax. Depending on the nature of a company’s shareholders and the availability of CTC for distribution, the definition of CTC currently does not prohibit a company from resolving, based on the tax consequences of the decision for its shareholders, whether a distribution will constitute a return of CTC or a dividend.

In the previous article I explained that National Treasury’s anti-avoidance concerns arise because, under the current wording of the definition, CTC contributed by a shareholder of a company may be “returned” to another shareholder and the company is able to elect whether a distribution constitutes a return of CTC or a dividend.

The wording that appeared in the Draft Taxation Laws Amendment Bill of 2022 would have had the effect that companies would, as before, still be able to allocate unequal amounts of CTC between shareholders in a distribution, provided that in all other distributions of CTC made within 91 days prior to or after the date of the non-pro rata CTC distribution, CTC was allocated on a pro-rata basis to all shareholders within the relevant class of shares. Failure to comply with this requirement would have resulted in distributions made during this running period having to be accounted for entirely as dividends, which could have resulted in problems such as the retrospective reclassifications of distributions as dividends together with associated dividends tax implications. Effectively, the 91-day periods against which the distribution would have been tested would have allowed companies to make both a half-yearly and final distribution each year, allocating CTC unequally between shareholders, provided that any other distributions of CTC during the year were made on a pro-rata basis.

The proposal contained in the tabled version of the Bill does away with the requirement to test distributions against any period. Instead, it requires that for a distribution, share buy-back, cancellation or redemption to constitute a return of CTC for any shareholder participating in the distribution etc., all of the shares participating in that distribution etc. must each receive an equal allocation of CTC. Additionally, as is the case under the current definition, the allocation of CTC per share may not exceed the total available CTC for the class of shares divided by the total number of issued shares within that class of shares.

So, for example, if there are three issued shares in a given class with a total CTC of R120, the company may buy back one of the shares and distribute up to R40 of CTC to the shareholder. In this case, there is only one share participating in the buy-back and the company may allocate CTC to the share up to its pro-rata maximum. If, instead of one share, two shares were bought back at the same time, each of the shares being bought back would have to be allocated an equal amount of CTC, up to the pro-rata maximum of R40 per share. Failure to comply with the requirements of the definition would result in the entire amount of the buy-back, for both shares being bought back, being regarded as a dividend and not a return of CTC. In the case of a regular ‘going concern’ distribution to all shareholders in a class, all shares in the class would have to be allocated an equal amount of CTC that may not exceed the pro-rata share of CTC, for the distribution to constitute a return of CTC in relation to any of the shares.

Provided that the buy-backs are truly commercially distinct, the wording allows for more than one share buy-back to occur within any given period. It may then be the case that in the respective buy-backs, different amounts of CTC are allocated to the shares that are bought back, provided that the shares that are bought back in each buy-back are allocated an equal amount of CTC.

The proposal is certainly more taxpayer-friendly than that contained in the 2021 income tax amendments, which would have had the effect that all proceeds arising in a targeted share buy-back scenario would have had to constitute a dividend and that no portion thereof could have constituted a return of CTC. As such, it is welcomed.

Assuming the Bill passes into law, the above proposal will become effective from 1 January 2023.