Proposed Amendments to Anti-Dividend Stripping Rules

The concept of “dividend stripping”
 
“Dividend stripping” is a practice that results in a reduction of the taxes payable on the disposal of shares in a target company. In a normal sale of shares to a third party, the seller would be liable for income tax or CGT on the gain realised (depending on whether the target company shares are held as trading stock or capital assets).
 
However, where the seller is another South African tax resident company, the target company could declare a dividend to the seller prior to the sale, thereby reducing the value of the target company shares and therefore also reducing the taxable gain realised on the sale.
 
As dividends between South African companies are exempt from income tax and dividends tax, the seller has now disposed of the target company shares with a significantly reduced tax bill.
 
Another application of dividend stripping is where the third party subscribes for shares in the target company and the target company utilises such subscription proceeds to repurchase the exiting shareholder’s shares. The default position is that the share buy-back is treated as a dividend for tax purposes. Therefore, where the exiting shareholder is a South African company, the seller has received a tax-exempt dividend and effectively disposed of its target company shares tax free.
 
2017 amendments
 
In response to such arrangements, with effect from 19 July 2017 National Treasury made significant changes to the anti-dividend stripping rules contained in section 22B of the Income Tax Act No. 58 of 1962 (“the Act”) and the CGT equivalent paragraph 43A of the Eighth Schedule to the Act.
 
These anti-avoidance rules provide that a tax exempt dividend must be treated as income or CGT proceeds (depending on whether the target company shares are held as trading stock or capital assets). This includes to the extent that the exempt dividend constitutes an “extraordinary dividend” and where the seller held a “qualifying interest” in the target company at any time during the 18 months prior to the disposal.
 
In relation to preference shares where the preference share dividends are determined with reference to a rate of interest, an “extraordinary dividend” is currently defined as so much of any dividend as exceeds an amount determined at a rate of 15 percent.
 
In relation to any other share, an “extraordinary dividend” is defined as so much of any dividend received or accrued within a period of 18 months prior to the disposal of the share, or any dividend received or accrued “… in respect, by reason or in consequence of” the disposal, as exceeds 15% of the higher of (1) the market value of that share as at the beginning of the 18-month period, and (2) the market value of that share as at the date of disposal of that share.
 
These thresholds seek to scope “normal” dividends out of the anti-dividend stripping rules.

Therefore, where a seller company held a “qualifying interest” in a target company at any time during the 18 months prior to the disposal and the seller disposes of its shares in the target company (including through a sale to a third party or through a share buy-back), a portion of the exempt dividends received by the seller may be subject to income tax or CGT.
 
A “qualifying interest” means an interest held by the seller company in a target company, whether alone or together with any connected persons in relation to the seller, that constitutes at least:

  • 50% of the equity shares or voting rights in the target company; or
  • 20% of the equity shares or voting rights in the target company if no other person holds the majority of the equity shares or voting rights in the target company.

In order to prevent abuse of the corporate reorganisation rules contained in Part III of the Act, the 2017 amendments made it clear that the corporate reorganisation rules do not override the anti-dividend stripping rules.
 
Proposed amendments
 
After the 2017 amendments, concerns were raised regarding the meaning of “extraordinary dividend” in relation to preference shares, as the definition was considered to be unclear. Furthermore, it was found that legitimate corporate reorganisation transactions, where no tax abuse was present, were being inappropriately impacted by the anti-dividend stripping rules.
 
As a result, National Treasury has clarified that a “preference share” for the purposes of the anti-dividend stripping rules should bear the same meaning as “preference share” contained in section 8EA of the Act.

Furthermore, an “extraordinary dividend” in relation to a preference share has been clarified as so much of the amount of any dividend actually received or accrued as exceeds the amount that would have accrued, had that amount been determined with reference to the consideration for which the preference share was issued by applying an interest rate of 15% per annum for the period in respect of which that dividend was received or accrued. The changes to “extraordinary dividends” in relation to preference shares has been backdated to 19 July 2017.
 
Furthermore, to prevent the inappropriate negative impact of the anti-dividend stripping rules on legitimate corporate reorganisation transactions, amendments have been proposed. They are to the effect that the anti-dividend stripping rules will only override the corporate reorganisation rules where a company that acquired shares in terms of a corporate reorganisation transaction then disposes of such shares within 18 months in terms of a transaction that is itself not a corporate reorganisation transaction (referred to as a “deferral transaction” in the anti-dividend stripping rules).
 
Essentially, National Treasury wishes to target a disposal to a third party where the initial disposal is a “deferred transaction”, but a subsequent disposal within 18 months thereof is not a “deferral transaction”.
 
In such a case, the “extraordinary dividends” received in the 18 months prior to the ultimate disposal would be included in income or CGT proceeds of the seller as the case may be. The anti-avoidance rules have been drafted widely to also cater for a scenario where the seller disposes of the target company shares to an intermediate company in terms of a “deferral transaction” and then disposes of these “new shares” in the intermediate company to the third party, rather than the shares in the target company.

Despite requests from industry stakeholders for the above change to be backdated to 19 July 2017, these proposed amendments are only effective from 1 January 2019.
 
Conclusion
 
The clarity in respect of preference shares as well as the more measured approach to the interaction between the corporate reorganisation rules and the anti-dividend stripping rules is welcomed. However, it is important for taxpayers to note that corporate reorganisation transactions entered into prior to 31 December 2018 remain fully subject to the anti-dividend stripping rules.

For more information, please contact your Moore Stephens tax advisory team