Playing the long game with loss-making and debt-laden subsidiaries – is debt write-off the only way?
In the current economic climate, it is rare to find group companies with profitable subsidiaries across the African continent. African subsidiaries can often be in loss-making positions with heavy levels of intra-group debt that they are unable to service. Debt-financing has traditionally been the preferred method for groups (we previously wrote about it in this article). However, the tax knock-on effects for loss-making subsidiaries do undermine this traditional preference. For example:
- The benefit of claiming interest deductions at the level of a highly taxed African subsidiary is typically negated when that subsidiary is persistently loss-making.
- Although a loss-making subsidiary should result in assessed tax losses to offset against any future profits, many African countries restrict the carry-forward of tax losses to a fixed number of years (e.g., a seven-year carry-forward restriction) thus entirely eliminating the benefit of any in-country interest deductions.
- A debt-laden subsidiary will typically be too thinly capitalised (especially where its related party debt significantly exceeds its equity) which would, in any event, deny the subsidiary an interest deduction in-country.
- In many African countries, regardless of whether or not the subsidiary has actually paid any interest to its group lender, interest withholding taxes can still be incurred by the lender (sometimes through the imposition of so-called “deemed interest rules”).
What to do with the debt?
Therefore, what could be done in this situation? A group could consider doing one of the following:
- Writing off the intra-group debt of the African subsidiary; or
- Capitalising the debt by converting that debt to equity through a subscription of either ordinary shares or preference shares.
Writing off debt is generally an option of last resort. A debt write-off will often trigger adverse tax effects for the African subsidiary. E.g., the written-off amount is included as income and subject to tax). Therefore, capitalising in-country debt is generally preferred. Especially since the group lender is still keeping its claim alive (although in a different legal form).
Capitalising the debt
The choice is then between capitalising the debt into ordinary shares or preference shares. We believe that the use of preference shares can be underused. Preference shares are financial instruments that generally offer greater flexibility to lenders/financiers than ordinary shares with regard to. In particular, the redemption of that instrument (which in effect results in the initial lender recalling its investment) and the terms of that financial instrument. E.g., the ranking of its rights vis-a-vis the subsidiary and other ordinary shareholders with respect to dividends and capital. Furthermore, the tax treatment of preference shares in Africa is still largely aligned with that of ordinary shares. A group should be happy to accept in the case of a persistently loss-making subsidiary.
- Dividends paid in respect of those shares are generally treated as exempt in the receiving company’s hands and treated as non-deductible in the subsidiary company’s hands. A group should be willing to accept this especially if the subsidiary is, in any event, loss-making and on the brink of forfeiting its accumulated tax losses and the previously accrued income in the lender’s hands was being taxed without actually receiving the economic benefit thereof;
- The conversion of debt to preference shares should also significantly improve a subsidiary’s thin-capitalisation position with the in-country revenue authorities. This should ease pressure on the deductibility of other related-party debt and/or improve the subsidiary’s balance sheet for future intra-group lending; and
- Through converting a debt instrument into preference shares, a group will generally side-step the imposition of any deemed-interest rules and, as such, the imposition of withholding tax on interest. It is typically not the case that an African jurisdiction will impose any withholding tax on any undistributed profits.
Accordingly, if the commercial circumstances justify it, there are creative options available when restructuring in-country debt. The choice is not simply limited to writing that debt-off and living with the tax effects thereof. The use of preference shares is a viable alternative and should be considered along with other potential options. Nevertheless, each in-country jurisdiction will need to be considered. Each African country will have its own peculiar tax nuances. Whether or not the use of preference share funding is appropriate will depend on those tax laws and the particular circumstances of the group.
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