You might assume that all shares are alike and entitled to dividends, but such a presumption could lead to costly oversights. Recently, there has been a significant shift regarding preference share dividends for South African tax purposes. The amendment to section 8EA of the South African Income Tax Act, effective for years of assessment beginning on or after 1 January 2024, is at the heart of this change.
In essence, this section deems certain dividends to be taxed as income, thereby disqualifying them from the usual dividend exemptions. Previously, the complex requirements of this section, particularly regarding the timing of acquisition of the shares, led to some confusion. In today’s newsletter, we examine the new rules, but first let’s take a closer look at shares in general.
What is a share?
Simply put, a share represents ownership of a company. By holding a share, an individual, company, trust, foundation or any other similar entity becomes a shareholder of the respective company. This ownership entitles shareholders to potential rewards, such as dividends. Importantly, when a company raises funds by issuing shares, known as share capital, the South African Income Tax Act draws a distinction between equity shares and preference shares.
What is the difference between equity and preference shares?
When comparing equity and preference shares, several key distinctions generally emerge. Generally, equity shares grant shareholders voting rights, whereas preference shares do not. Additionally, while equity shares are non-redeemable, preference shares can be redeemed. Moreover, preference shares generally take precedence in distributions over equity shares. Of course, these are just a few of the differences, with various subtypes adding further complexity to the equation.
Why does this distinction matter?
At the heart of the matter lies the fact that the tax treatment of dividends is diametrically opposite to the tax treatment of interest.
Thus, in certain circumstances lenders will be incentivised to inject funds in the form of preference shares even though the substance of the funding arrangement is no different to an interest-bearing loan.
Exploring the latest amendment to preference share dividends
Now that the fundamentals have been established, let’s delve into the recent amendment regarding preference share dividends, effective for years of assessment commencing on or after 1 January 2024.
The amendment pertains to section 8EA of the South African Income Tax Act and covers both local and foreign dividends. In essence, this section classifies dividends received by persons as income if the share is deemed a “third-party backed share”, at any time during the year of assessment. Of course, a “third-party backed share” has a lengthy definition but essentially includes preference shares or defined equity instruments where another person guarantees or indemnifies the preference shareholder in the event of a default.
Where this section applies and the dividend is classified as income, the shareholder would not be able to claim any exemption (whether resident or non-resident). Dividends tax would also no longer be applicable as the dividend would be subject to income tax.
To avoid classification as income, preference shares must meet various criteria, including being issued for a “qualifying purpose.” This definition is quite complex but generally will be met where proceeds are used from the issuing of preference shares to acquire equity shares in an operating company, or to refinance preference shares previously issued for this purpose. To address confusion caused by this definition surrounding the timing of equity share ownership in the operating company, a new proviso introduces an ownership requirement.
Unpacking the amendment: a new proviso
In a nutshell, the proviso mandates that the person acquiring shares in the operating company with preference share proceeds must continue to hold the shares in the operating company for so long as the preference shares are still in issue. Failure to comply subjects the dividend to income tax in the hands of the shareholder.
There are a couple of situations where the new proviso does not apply, namely, if the dividend comes from selling shares in the operating company, and such dividend is used to redeem the preference share within 90 days of the sale of the shares in that operating company. Or, if an equity share in the operating company is swapped for another listed share under certain arrangements approved by a licensed exchange, as long as these arrangements meet the same standards as those of the JSE Limited.
The takeaway
In light of these changes, it’s crucial for shareholders to review existing preference share structures to ensure compliance with tax obligations and optimise financial strategies. If you’re a shareholder expecting preference share dividends, seeking professional guidance can help navigate these complexities and maximise your investment potential. Contact us today for further information!
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