With increasing economic uncertainty and rising interest rates, the ability of businesses that are heavily leveraged to meet their funding obligations is becoming increasingly difficult. To ensure their continued viability, businesses are likely to consider restructuring their debt. The restructuring can take various forms and could include:

• the waiver/cancellation of the debt;
• the conversion of debt into equity; and
• the subordination of the debt.

In considering the form of the restructure, debtors should be mindful of the tax consequences that may arise. In South Africa, these tax consequences are governed by the Income Tax Act 58 of 1962 (Income Tax Act).

It bears noting that section 19 and paragraph 12A of the Income Tax Act specifically deal with the tax consequences for the debtor. The consequences for the creditor are governed by the general provisions of the Income Tax Act, which includes section 11, section 24J, as well as the provisions of the Eighth Schedule to the Income Tax Act.

Reduction of debt

The position of the debtor will depend on what the proceeds of the debt in question has funded. A debtor may acquire debt:

• to acquire trading stock or fund tax deductible expenses (such as operational expenses); or
• to acquire allowance assets or non-allowance assets (such as capex expenditure).

Depending on the nature of the expenditure that was funded by the debt in question, restructuring the debt may result in:

• an inclusion in the income of the debtor of deductible expenses or allowances claimed in respect of the debt;
• a reduction in the cost price of any trading stock that was funded by the debt;
• a reduction of the base cost of any capital asset that was funded by the debt; or
• an immediate capital gain for that year of assessment.

Amounts included in the income of the debtor will potentially be subject to income tax in the debtor’s hands, whilst the reduction of the base cost of an asset means that the debtor stands to realise a higher capital gain upon the disposal of the asset than would have been the case in the absence of the debt restructuring.

In the case of the creditor, it is important to understand in what circumstances a corresponding deduction from their income or a capital loss can be claimed, and in what circumstances a loss can be carried forward.

Debt converted into equity

A debt-to-equity transaction involves a creditor ‘swapping’ indebtedness owed by a debtor to it, into shares in the debtor. The debt may be converted into ordinary shares or preference shares.

In the case of the debtor, the debt reduction provisions may be triggered where the debt is directly or indirectly reduced by conversion or exchange of that debt for shares, and the shares issued have a lower market value than the face value of that debt. As a result of this mismatch, a debt benefit may arise. However, this could be a better proposition for the debtor compared to a debt reduction because the conversion of the capital portion of the debt (excluding capitalised interest) into shares will not be taxed according to the debt reduction provisions discussed above.

Similarly, as is the case under a debt reduction, it is important to understand in what circumstances a creditor can claim a corresponding deduction from their income or a capital loss, and in what circumstances a loss can be carried forward. Furthermore, a creditor will also be concerned with obtaining base cost in the new shares issued.

Debt subordination

Unlike debt waiver or debt capitalisation, the subordination of a debt does not extinguish it. Rather, subordination involves the claim of a creditor, against a debtor, subordinated in favour of another creditor’s claim against that same debtor. The effect of which is that the claim of the existing creditor will be preferred over the claim of a subordinated creditor.

The concern is where the debt is deeply subordinated to the extent that there is a change in the nature of the claim, the return on the debt (interest) will be re-characterised as a return on equity (dividend in specie). This may arise where the repayment of that debt is made conditional upon the market value of the assets of the debtor not being less than the amount of the liabilities of the debtor.

Where interest incurred on the subordinated debt is deemed to be a dividend in specie, it cannot be deducted under section 24J. As the interest is deemed to be a dividend in specie, dividend withholding tax will need to be considered.

Record keeping

Where a debt has been specifically earmarked to fund one or two items, determining the tax consequences of a restructuring of the debt may be relatively simple. This will be the case where there are clear records regarding the use to which the debt was put.

However, it is not unheard of for businesses that are considering the restructuring of their balance sheets to find themselves at a loss when having to determine the historic application of debt generally used in the business. At such a juncture, it is advisable to engage a tax advisor to plan a more tax efficient debt restructure and avoid crippling an already struggling business unnecessarily with a tax liability.

Concluding remarks

Addressing these issues prior to a debt restructure will mitigate unnecessary tax costs when implementing the debt restructure.