The environment for mergers and acquisitions (M&A) in South Africa is far less clement than in previous years due to the harsh current economic climate and the global credit and liquidity crunches. These constraints have reduced the economy’s growth and led to a sharp decrease in M&A activity. The fundraising appetite for domestic financial investments is increasing, however, leading to more opportunities for the growth in the small and medium-sized business market, which remains relatively active. Larger players are still on the lookout for quality assets with long-term growth potential.
Recent changes to the South African legislative framework have significantly affected the M&A environment. Historically, there was some uncertainty regarding the appropriate method of dealing with these types of transactions from a tax and legal perspective. The South African legislator has taken steps to address this uncertainty. While some uncertainty remains, the recent changes are steps in the right direction.
Among recent developments, the most pertinent for M&As are as follows:
- a permanent, formula-driven restriction on interest deductibility for certain M&A transactions, which replaces the prior pre-approval process in which the tax authorities regulated the deductibility of interest costs for leverage buy-outs
- the introduction of a withholding tax (WHT) on interest
- the introduction of limitations on interest deductions for interest paid to, among others, non-residents
- provisions permitting the deduction of interest on debt used to acquire equity shares, where specific requirements are met.
WHT on interest
As of 1 March 2015, a 15 percent WHT is imposed on interest received by or accrued to a non-resident (that is not a controlled foreign company — CFC). An exemption applies for any amount of interest received by or accrued to a non-resident in respect of:
- government debt instruments
- listed debt instruments
- debt owed by a bank, the South African Reserve Bank (SARB), the Development Bank of South Africa (DBSA) or the Industrial Development Corporation (IDC)
- debt owed by a foreign person or a headquarter company.
South Africa is in the process of renegotiating its existing tax treaties in light of the new 15 percent WHT on interest.
WHT on service fees
Current legislation provides for a 15 percent WHT to be levied on service fees paid to a foreign person, to the extent paid from a source within South Africa (subject to treaty relief). The effective date of the legislation has been delayed to 1 January 2017 (from 1 January 2016) and may be repealed in its entirety in the 2016 amendments.
WHT on dividends
A WHT on dividends applies regarding all dividends declared and paid to non-residents on or after 1 April 2012. The dividend WHT is levied at a rate of 15 percent, subject to treaty relief.
WHT on royalties
Royalties paid by a South African entity to a non-resident are subject to a WHT of 15 percent as of 1 January 2015 (previously 12 percent).
Deductibility of interest on debt used to acquire equity
As of 1 January 2013, interest incurred on debt to finance the acquisition of the shares is deductible for tax purposes, where a South African company acquires at least a 70 percent equity shareholding in another South African operating company. An ’operating company’ includes any company that carries on business continuously by providing goods or services for consideration. Recent amendments to the provision require at least 80 percent of the receipts and accruals of the operating company to be ‘income’, that is, non-exempt amounts. Where the shares in the operating company are acquired indirectly through the acquisition of shares in a controlling company, the interest is deductible only to the extent that the value of the controlling company shares is attributable to the operating company.
Interest deductibility in respect of M&A transactions
Previously, interest on debt used to fund certain transactions (discussed below) was not automatically deductible. Approval from the South African Revenue Service (SARS) was needed in order to deduct the interest expenditure in question.
This approval process has been replaced by section 23N, which essentially limits the deductibility of interest where debt is used:
- to fund the acquisition of a business or assets from a related group entity on a tax-neutral basis
- to fund at least a 70 percent equity shareholding in a South African operating company.
In these cases, the amount of interest deductible in the year of the transaction and the following 5 years cannot exceed:
- the sum of:
- interest received
- a formula-based percentage of ’adjusted taxable in come’ (which is essentially the company’s earnings before income taxes, depreciation and amortization (EBITDA)). The percentage of the adjusted taxable income varies based on the average South African repo rate during the year of assessment and is limited to a maximum of 60 percent.
- the amount of interest incurred on debts not falling within the section.
These rules apply to transactions entered into on or after 1 April 2014, and also to the refinancing of transactions that were subject to the pre-approval process discussed above.
Where such interest is disallowed, the disallowed portion of interest is lost and cannot be carried forward.
Limitations on interest paid to non-residents
As of 1 January 2015, section 23M imposes a general limitation on interest deductions where payments are made to offshore investors (i.e. creditors), or local investors who are not subject to either income tax or IWT in South Africa, that are in a controlling relationship with a South African resident debtor.
The limitations also will apply between a debtor and creditor who are not in a controlling relationship where a creditor advances funding to the debtor and the funding was obtained from a non-resident person in a controlling relationship with the debtor (i.e. back-to-back funding).
Essentially, where section 23M applies, the interest deduction by the debtor cannot exceed:
- the sum of:
- interest received
- a formula-based percentage of ’adjusted taxable income’ (which is essentially the company’s earnings before income taxes, depreciation and amortization (EBITDA)). The percentage of the adjusted taxable income varies based on the average South African repo rate during the year of assessment and is limited to a maximum of 60 percent.
- interest incurred on debts other than debts falling within section 23M; where the interest falls within both section 23M and section 23N, the portion of the interest disallowed under section 23N is not taken into consideration in the calculation.
Any interest disallowed under section 23M may be carried forward to the following year of assessment, and deemed as interest incurred in that year.
The provisions do not apply where the creditor funded the debt advanced to the debtor with funding granted by an unconnected lending institution and the interest charged on the loan does not exceed the official rate of interest for purposes of the Income Tax Act plus 100 basis points.
Asset purchase or share purchase
The following sections address those issues that should be considered when contemplating the purchase of either assets or shares. The pros and cons of each option are summarized at the end of this report.
Purchase of assets
The decision of whether to acquire the assets of a business or its shares depends on the details of the transaction. The advantages and disadvantages of both purchase mechanisms need to be understood in order to effect the acquisition efficiently while complying with legislative requirements.
Asset purchases may be favored due to the interest deductibility of funding costs and the ability to depreciate the purchase price for tax purposes. However, other considerations may make an asset purchase far less favorable, including, among other things, an increased capital outlay, recently promulgated legislation that may disallow the deduction of interest (discussed above), the inability to use the tax losses of the target company, and the inability to deduct or recover VAT on irrecoverable debts (unless the debts are acquired on a recourse basis).
Where assets (versus shares) are disposed of, the purchase price must be allocated between the assets acquired in terms of the sale agreement on a reasonable and commercial basis. This allocation is required to determine the tax implications on the disposal of each individual asset.
When assets are purchased at a discount, no statutory rules stipulate how to allocate the purchase price among the assets. Unless the discount can be reasonably attributed to a particular class of asset, it should be allocated among all the assets on some reasonable basis.
Withholding tax on immovable property disposals
A WHT is applicable to the disposal of immovable property by a non-resident to any other person insofar as the immovable property or a right or interest therein (i.e. including an interest of at least 20 percent in a company where at least 80 percent of the market value of the company’s shares is attributable directly or indirectly to immovable property, other than trading stock) is situated in South Africa, subject to certain exemptions.
In these cases, the purchaser must withhold 5 percent of the purchase price where the seller is a natural person, 7.5 percent if the seller is a company and 10 percent if the seller is a trust.
The purchaser is required to pay the WHT to SARS within 14 days from the date of withholding.
Where the purchaser is not a resident of South Africa, the time period for payment is extended to 28 days. If the amount is withheld from consideration payable in a foreign currency, the amount must be converted into South African rand (ZAR) at the spot rate on the date that the amount is paid to SARS.
Where the seller does not submit a tax return in respect of the applicable year of assessment within 12 months after the end of the year of assessment, the WHT is deemed to be a self-assessed final tax.
No provision exists for the write-off of goodwill for tax purposes by the purchaser. Accordingly, care should be taken to allocate the purchase price, as much as possible, among the tangible assets, providing such allocations do not result in the over-valuation of any asset.
Certain allowances or deductions may be allowed on certain assets purchased by the taxpayer. When the assets are re-sold, the potential recoupment of allowances or deductions previously claimed on these assets should be considered. If a recoupment arises, this amount is required to be added back to the taxpayer’s taxable income.
Tax losses cannot be passed on to the buyer of a business. Recoupments in the company (i.e. the difference between proceeds and tax value) are taxable to the seller where the values of certain assets realized exceed their tax values.
Crystallization of tax charges
South African income tax legislation provides for rollover relief on intragroup transfers of assets if certain requirements are met. For example, the rollover is available where assets are transferred within a ‘group of companies’, typically companies with a 70 percent common shareholding. Each of the intragroup provisions contains its own specific anti-avoidance provisions, which deem the purchaser to dispose of and immediately reacquire the assets at their market value on the day that certain events occur. Essentially, the purchaser becomes liable for all of the tax that was deferred and effectively rolled over in the intragroup transfer.
Consequently, the purchaser should satisfy itself that it has been made aware of all prior intragroup transfers of the assets that it acquires.
Value added tax
When certain intergroup income tax relief provisions apply to a transaction, the supplier and recipient are deemed to be the same person for value added tax (VAT) purposes. This implies that there is no supply for VAT purposes, provided both the supplier and recipient are registered as vendors for VAT purposes; in certain instances, the supply must be that of a going concern.
Assets or liabilities excluded from the income tax relief provisions are considered separately from a VAT perspective to determine the applicable rate of VAT to be levied, if any.
When the income tax and VAT relief provisions are applied, it was previously argued that vendors may not be entitled to recover VAT on the costs incurred on the transaction because the VAT was not incurred for the purpose of making taxable supplies. However, the SARS Draft Interpretation Note, issued 31 March 2009, states that even though a transaction may not be regarded as a supply for VAT purposes, the VAT incurred on goods and services acquired for the purpose of making the supply may still qualify as input tax for VAT purposes. The test is whether the vendor would be entitled to an input tax deduction when section 8(25) of the VAT Act does not apply. If the answer is yes, input tax can still be claimed.
Where this group relief provision does not apply and a business, or part of a business that is capable of separate operation, is sold as a going concern, VAT is payable at zero rate (i.e. charged with VAT but at 0 percent). To qualify for zero rating, both the seller and the purchaser must be registered for VAT and agree in writing that:
- the business will be sold as a going concern
- the business will be an income-earning activity on the date of transfer
- the assets needed to carry on such enterprise will be sold by the supplier to the recipient
- the price stated is inclusive of zero rate VAT.
The contract can provide that, should the zero rating for some reason not apply, VAT at the standard rate would be added to the selling price.
Transfer duty is payable by the purchaser on the transfer of immovable property to the extent the sale is not subject to VAT.
A notional VAT input credit is available to a vendor on the purchase of secondhand property from a person not registered for VAT. Where secondhand goods consisting of fixed property are acquired wholly for the purposes of making taxable supplies, the input tax claimable is calculated as the tax fraction of the lesser of any consideration in money given by the vendor or the open market value. The notional input tax is claimable in the tax period that registration of the fixed property was affected in the deeds registry in the name of the vendor.
Under the Transfer Duty Act, the transfer duty is payable on the value of the property at the following rates (for natural persons and persons other than natural persons):
- on the first ZAR750,000 — 0 percent
- from ZAR750,001 to ZAR1,250,000 — 3 percent of the property value above ZAR750,000
- from ZAR1,250,001 to ZAR1,750,000 — ZAR15,000 plus 6 percent of the value above ZAR1,250,000
- from ZAR1,750,001 to ZAR2,250,000 ZAR45,000 plus 8 percent of the amounts above ZAR1,7500,000
- from ZAR2,250,001 to ZAR10 million — ZAR85,000 plus 11 percent of the value above ZAR2,250,000
- above ZAR10 million — ZAR 937,500 plus 13 percent of the value in excess of ZAR10,000,000.
Purchase of shares
Share purchases are often favored because of their lower capital outlay and the acquirer’s ability to benefit from the acquisition of any tax losses of the target company (subject to the rules governing the carry forward of assessed losses).
However, the inability to deduct the funding costs associated with the acquisition (except in limited circumstances as discussed above) is a significant barrier to this method.
Due diligence reviews
It is not unusual for the vendor in a negotiated acquisition to open the books of the target company for a due diligence review by the prospective purchaser, which would generally encompass an in-depth review of the target’s financial, legal and tax affairs by the purchaser’s advisors. The findings of a due diligence review may result in adjustments to the proposed purchase price and the inclusion of specific warranties negotiated between the purchaser and seller in the sale agreement.
The purchaser generally requires warranties from the seller regarding any undisclosed taxation liabilities of the target company. The extent of the warranties is a matter for negotiation.
Tax losses may be retained by the purchaser when the shares are purchased, unless any anti-avoidance rules apply.
Securities transfer tax
Security transfer tax (STT) is levied on every transfer of a security and was implemented from 1 July 2008 under the Securities Transfer Tax Act, No. 25 of 2007, together with the Securities Transfer Tax Administration Act, No. 26 of 2007. The STT Act defines ‘transfer’ to include the transfer, sale, assignment, cession or disposal in any other manner of securities, or the cancellation or redemption of securities. STT is not payable on the issue of securities. Only transfers that result in a change in beneficial ownership attract STT.
A security means any share or depository in a company or a member’s interest in a close corporation. STT applies to the purchase and transfers of listed and unlisted securities.
STT is levied for:
- every transfer of any security issued by:
- a close corporation or company incorporated, established or formed inside South Africa, or
- a company incorporated, established or formed outside South Africa and listed on an exchange, and
- any reallocation of securities from a member’s bank restricted stock account or a member’s unrestricted and security restricted stock account to a member’s general restricted stock account.
STT is levied at the rate of 0.25 percent of the taxable amount (according to a prescribed formula that differs depending on whether the securities are listed).
Value added tax
The supply of shares by the owner of the shares is an exempt supply for VAT purposes. Any VAT incurred on the acquisition of any goods or services for the purposes of the exempt supply is not recoverable as input tax.
Capital gains tax
Non-residents are subject to capital gains tax (CGT) only on capital gains from the disposal of certain South African property, including immovable property, an interest in such immovable property (i.e. an interest of at least 20 percent in a company where at least 80 percent of the market value of the company’s shares is attributable directly or indirectly to immovable property, other than trading stock), and business assets attributable to a permanent establishment situated in South Africa. However, in line with international practice and South African tax treaties, non-residents are not liable to CGT on other assets, such as shares they own in a South African company, unless the value of the assets is attributable to immovable property situated in South Africa (this varies depending on the treaty).
Choice of acquisition vehicle
A number of options are available to a foreign purchaser when deciding how to structure the acquisition of a local resident company. The South African Income Tax Act contains special rules for asset-for-share transactions, amalgamation transactions, intragroup transactions, unbundling transactions and liquidation distributions.
These provisions aim to facilitate mergers, acquisitions and restructurings in a tax-neutral manner. The rules are very specific and generally do not apply when one of the entities in the transaction is not a company.
Often the most crucial element to consider when choosing the vehicle is whether to structure the acquisition through a branch or a subsidiary. While the VAT implications of the branch and a subsidiary structure are the same, the income tax implications do differ.
Local intermediary holding company
The incorporation of a South African intermediary holding company affords limited liability protection. The intermediary holding company may invest in various joint ventures separately rather than through one single entity. Dividends received by the intermediary company are exempt from dividend WHT, allowing funds to be pooled at the intermediary level for re-investment or distribution.
Additional administrative and regulatory costs incurred by the intermediary holding company may not be tax-deductible because the intermediary earns no taxable income. In certain instances, any expenditure incurred by the intermediary company may have to be apportioned by taking into account the nature of its income streams (if any).
Foreign parent company
There are generally no legal restrictions on the percentage of foreign shareholding in a South African incorporated company. Payments of royalties, management fees, dividends or interest on loans are subject to the WHT regimes (as discussed above) and to transfer pricing and thin capitalization rules.
Where these structures are implemented, it is important to consider the potential VAT implications for the foreign parent company. For example, the South African Revenue Authority is of the view that the granting of licenses, etc., constitutes the carrying on of an enterprise by the foreign parent, so the foreign parent should be VAT-registered. However, the Revenue Authority grants rulings in some cases absolving the foreign parent from VAT registration.
Non-resident intermediate holding company
The foreign intermediary may separately invest into various African countries and may also be subject to foreign domestic anti-avoidance legislation, such as controlled foreign company (CFC) legislation. The intermediary would need to be established in a jurisdiction that has lower rates of WHT on dividends, interest, management fees and royalties than those stipulated in the relevant tax treaties.
Any dividends declared to the foreign intermediary are subject to dividend WHT, which may be reduced by a tax treaty.
If a foreign company has engaged or is engaging in a course of conduct or a pattern of activities in South Africa over a period of 6 months that would lead a person to reasonably conclude that such foreign company intended to continually engage in business in South Africa or if it is a party to one or more employment contracts in South Africa, then it is required to be registered as an external company with the Companies and Intellectual Property Commission (CIPC) in South Africa. An external company is often referred to as a ‘branch’.
Once registered, the external company/branch must maintain an office in South Africa, register its address with the CIPC and submit annual returns. It is not subject to the audit or review requirements of the Companies Act, 71 of 2008.
Where a group company purchases the assets of a South African business, it may operate the business in South Africa either in an external company or in a private company established as a local subsidiary company in South Africa.
The South African income tax system is based on taxable income. ‘Taxable income’ is gross income (non-capital) received by or accrued to a resident taxpayer, less any exempt income and less all allowable expenditure actually incurred in the production of that income. Non-residents are taxed on a source basis.
Both a local subsidiary (i.e. a private company in which shares are held by the foreign company) and external company/branch are subject to a 28 percent tax rate. Branch profits are not subject to any WHT on their remittance to the foreign ‘head office’.
Resident companies are, however, subject to dividend WHT. As an external company/branch is not a separate entity, expenditure payable to its foreign head office for royalties, management fees and interest on loans is generally not tax-deductible in South Africa.
The Income Tax Act does provide for the deduction of expenditure and losses actually incurred outside South Africa in the production of income, provided they are not of a capital nature. Where the foreign company incurs expenditure outside of South Africa in the production of the South African branch’s income, such amounts normally are tax-deductible by the external company/branch. The amount of the deduction is the actual amount of expenditure incurred outside South Africa, which may not equate to the market value of the goods or services in South Africa.
The tax rates in the foreign country versus the tax rates in South Africa are an important factor in deciding whether a local subsidiary or a local branch of a foreign company would be more favorable from a tax point of view, especially as external companies/branches are not subject to dividend WHT.
An advantage of external companies/branches is that, where more than one external company/branch in the group operates in South Africa, the losses of one external company/branch may be offset against the taxable income of another external company/branch in determining the South African income tax payable. This setting-off of losses is not allowed for companies.
A foreign company may apply to transfer its registration to the South Africa from the foreign jurisdiction in which it is registered, provided that it complies with the requirements set out in the Companies Act. Such a company is referred to as a ‘domesticated company’. A domesticated company becomes subject to the South African Companies Act on transfer of its registration.
When acquisitions are to be made together with other parties, the choice of an appropriate vehicle is important. Generally, such ventures can be conducted through partnerships, trusts or companies. While partnerships are ideally suited for joint ventures, the lack of limited liability, the joint and several liabilities for debts, and the lack of separate legal existence limit their use. When a partnership is used, its taxable income is first determined and then apportioned between the partners in accordance with their respective interests.
From a VAT perspective, these unincorporated bodies of persons are deemed to be persons separate from their underlying partners/members, which can create separate VAT registration liabilities. When using such a vehicle, it is important to set it up properly from a VAT perspective to avoid irrecoverable VAT costs.
Choice of acquisition funding
The tax treatment of interest and dividends plays an important role in the choice between debt and equity funding. A hybrid instrument, which combines the characteristics of both debt and equity, may also be used to finance the purchase.
An important advantage of debt over equity is the greater flexibility it provides. Debt can be introduced from any company within a group, a financial institution or any other third party. In addition, debt can be varied as a group’s funding requirements change, whereas any change in equity, particularly a decrease, can be a complex procedure.
Further, subject to the interest limitation provisions noted above and South African transfer pricing and thin capitalization provisions, the use of debt may increase an investor’s return and thus be preferable to an equity contribution.
Deductibility of interest — foreign company
When funds in South Africa are loaned to a borrower, the interest earned by the lender, being from a South African source, is usually tax-exempt, provided certain requirements are met. The interest is subject to a WHT of 15 percent as of 1 January 2015, subject to relief under a tax treaty. Interest on foreign loan funding can be remitted abroad, provided the SARB has previously approved the loan facility, including (among others) the repayment terms and the interest rate charged.
Approval from the SARB or the authorized dealer (as the case may be) must be obtained by the South African exchange control resident before any foreign financial assistance may be accepted. This requirement is intended to ensure that the repayment and servicing of loans do not disrupt the balance of payments. For loans, this entails providing full details of the loan to be received, the purpose of the loan, the repayment profile, details of all finance charges, the denomination of the loan and the rate of interest to be charged. The loan itself does not need to be approved by the SARB for the funds to flow into South Africa, but, as already noted, the non-approval of the loan may result in restrictions on the repayment of the loan, any interest thereon and any disinvestment from South Africa.
The SARB usually accepts an interest rate that does not exceed the prime lending rate in South Africa when the loan is denominated in ZAR. Where the loan is denominated in foreign currency, the SARB accepts a rate that does not exceed the relevant interbank rate plus two basis points.
The South African transfer pricing provisions should be considered where loan proceeds are provided by a non-resident creditor (as discussed above). Additionally, under legislative proposals having effect from 1 January 2015, where a debtor incurs interest on a debt provided by a creditor that is not taxable in South Africa and these parties are connected with each other, then the interest incurred by the debtor may be limited in relation to that debt.This limitation is determined with reference to the debtor’s adjusted taxable income. Any portion of the non-deductible interest may be carried over to the following year of assessment.
Where a debt owed by a person is reduced for no or inadequate consideration, the amount by which the debt is reduced less any amount applied as consideration for such reduction (‘reduction amount’) is added to income and subject to tax at 28 percent to the extent that the debt has funded tax-deductible expenditure.To the extent that the debt has funded the acquisition of capital assets, the tax cost of the assets is reduced by the reduction amount. If the asset was disposed of before the debt reduction, any capital loss available to the company is reduced by the reduction amount.
In cases where the debt was as a result of the supply of good or services, VAT input tax clawbacks should be considered.
Checklist for debt funding
- Transfer pricing for the interest rates charged and the level of debt introduced.
- The possibility of higher rates applying to tax deductions in other territories.
A purchaser may use equity to fund its acquisition by issuing shares to the seller as consideration or by raising funds through a seller placing.
Share issues are not subject to STT. However, dividends paid by a South African company are not deductible for South African tax purposes.
Previously, the South African thin capitalization provisions applied where financial assistance granted by a connected person that was a non-resident or a non-resident that held at least 25 percent of the equity shares capital/voting rights in a South African company exceeded a 3:1 debt-to-fixed-capital ratio (calculated with reference to the proportion of equity held). If so, the excessive portion of interest was disallowed as a deduction from the taxable income of that South African company.
As of 1 April 2012, thin capitalization is now treated as part of the general transfer pricing provisions. This test no longer applies a debt-to-fixed-capital ratio. Rather, it is necessary to analyze whether the financial assistance granted is excessive in relation to financial assistance that would have been granted had the investor and the connected person been independent persons’ dealing at arm’s length. These changes are intended to be compatible with the rules as set forth by the Organisation for Economic Co-operation and Development (OECD).
Non-tax reasons may exist for preferring equity, for example, where a low debt-to-equity ratio is favored. This factor is often the reason for companies choosing hybrid funding.
Dividends declared from hybrid equity instruments are deemed to be income and taxable as such. Where dividends or capital returns on the shares are hedged by a third party, the dividends declared on these shares may be deemed to be taxable (subject to certain exemptions). Otherwise, the normal tax principles relating to debt and equity apply. The provisions of the Banks Act, which regulates the issue of commercial paper, and the Companies Act, which regulates offers to the public, may need to be considered.
In certain circumstances, interest on hybrid debt instruments (i.e. debt with equity-like characteristics) may be deemed to be dividends paid (and thus not deductible in the hands of the payer).
The tax treatment of securities issued at a discount normally follows the accounting treatment. As a result, the issuer should be able to obtain a tax deduction for the discount accruing over the life of the security, provided the discount amounts to ‘interest’ for tax purposes. Similarly, the holder of the instrument may be subject to tax on the discount received over the life of the security.
The period or method of payment generally does not influence the tax nature of the proceeds. The payment for a capital asset can be deferred without altering the capital nature of the proceeds. However, where the full selling price is not clearly stipulated and payment is based on a proportion of profits, an inherently capital transaction may be treated as revenue and taxed in the vendor’s hands. Likewise, care should be taken not to have the sale proceeds characterized as an annuity, which is specifically taxable in South Africa.
Approval from the exchange control authorities is required for the exchange of shares in cross-border mergers and amalgamations and for issues of shares on acquisition of assets. To obtain this approval, the assets and shares must be valued.
When shares are issued in exchange for an asset, South African legislation deems the value of the shares issued to equal the market value of the asset acquired. Moreover, the issuing company is deemed to acquire the asset at the market value of the shares immediately after the acquisition.
Concerns of the seller
The concerns of a seller may vary depending on whether the acquisition took place via shares or via a purchase of assets. When the assets are acquired by the purchaser, for example, CGT may be levied on the capital gain realized on the disposal of the assets. Further, to the extent that any deductions were claimed against the original cost of the assets and the amount realized from the sale of the assets exceeds the tax values thereof, the seller may experience clawbacks, which it would have to include in its gross income (as defined) and would be subject to income tax at the normal rate of 28 percent.
When the seller does not receive adequate consideration for the disposal of its assets, the transaction may be subject to donations tax at the rate of 20 percent on the difference between the consideration actually given and the market value consideration.
The sale of shares also may be subject to CGT, assuming the shares were held by the seller on capital account. To the extent that the seller disposed of the shares in a profit-making scheme, the proceeds may be taxed on revenue account at a rate higher than the rate of CGT. However, the 3-year holding rule in the South African Income Tax Act would deem the proceeds received on the sale of shares held for a continuous period of 3 years to be capital in nature and thus taxable at the effective capital gains tax rate of 22.4 percent (assuming the seller is a company).
Concerns of the purchaser
To the extent that the assets are disposed of, the assessed tax losses of the seller cannot be carried forward into the new company, so the losses would be ring-fenced in the seller and thus lost.
When the seller decides to dispose of shares, the tax losses in the company remain in the company, available for future set-off. However, when the SARS is satisfied that the sale was entered for the purpose of using the assessed loss and that, as a result of the sale, income has been introduced into the company to use the loss, the set-off of the loss may be disallowed.
South Africa’s tax law does not recognize the concept of group taxation, where losses made by some group companies are offset against profits made by other group companies. Rather, companies are assessed as separate entities. However, intragroup transactions may take place in a tax-neutral manner in certain circumstances, mostly where companies form part of the same South African group of companies (unless the foreign company has a place of effective management in South Africa). For companies to be considered as part of a group, these companies are required to have a common shareholding of at least 70 percent of their equity share capital.
The overriding principle of the transfer pricing legislation is that cross-border transactions between connected persons should be conducted at arm’s length.
Under the Income Tax Act, where connected persons conclude a cross-border agreement for the supply of goods or services (e.g. grant or assignment of any right, e.g. royalty agreement, provision of technical, financial or administrative services, financial assistance such as a loan), and such goods and services are not supplied on an arm’s length basis, the Commissioner of SARS may adjust the price to reflect an arm’s length price in determining the taxable income of any of the persons involved.
Essentially the focus is on the overall arrangements and the profits derived from such activities. If terms or conditions made or imposed in transactions, operations, schemes, arrangements or understandings differ from the terms and conditions that would have existed between independent persons acting at arm’s length and the difference confers a South African tax benefit on one of the parties, the taxable income of the parties that have benefited must be calculated as if the terms and conditions had been at arm’s length. In addition, the difference being calculated is deemed to be a dividend in specie, subject to dividend WHT at 15 percent.
The transfer pricing provisions now also cover any financial assistance (i.e. debt, security or guarantee) granted between connected persons. As such, the previous legislation pertaining to thin capitalization is replaced with this arm’s length test.
Foreign investments of a local target company
South Africa’s CFC legislation is designed to prevent South African companies from accumulating profits offshore in low-tax countries.
When a South African resident directly or indirectly holds shares or voting rights in a foreign company, the net income of that company is attributed to the South African resident if that foreign company is a CFC and does not qualify for any of the available exclusions. The net income of a CFC attributable to the South African resident is the taxable income of the CFC, calculated as if that CFC were a South African taxpayer and resident for specific sections of the Income Tax Act. Consequently, both income and capital gains are attributed.
The main exemptions to these rules are the foreign business establishment (FBE) exemption and the so-called ‘high-tax jurisdiction exemption’ (i.e. where the CFC would be subject to tax in that foreign jurisdiction at a rate of at least 21 percent). If a CFC’s income and gains are attributable to an FBE (including gains from the disposal or deemed disposal of any assets forming part of that FBE), they will generally not be attributed to the South African-resident parent, subject to the application of diversionary rules and a mobile passive income tests.
The Companies Act regulates companies and external companies that are incorporated in South Africa.
Where a merger or acquisition is done in relation to a South African company, then the impact of the Companies Act on such transaction needs to be considered.
A wide range of provisions may apply to M&A transactions involving South African companies and thus need to be considered, such as:
- The requisite director and/or shareholder approval required for the transaction: For example, if a company is disposing of the greater part of its assets or business, shareholder approval (in the form of a special resolution, in which 75 percent of the shareholders vote in favor of passing the resolution) is required, in addition to the approval of the board of directors of the company disposing of the greater part of its assets or business.
- Any restrictions or formality requirements that may be prescribed in a company’s memorandum of incorporation (MOI).
- Whether the acquisition of the business or of the shares in a South African company requires the approval of the Takeover Regulation Panel (TRP): The TRP and takeover regulations apply to regulated companies, which include public and state-owned companies, and to private companies if their MOI provides for their application or if 10 percent or more of its shares of such private company were transferred within the previous 24 months. The takeover regulations could apply to private companies irrespective of their size, because the test depends not on the number of shareholders or the size of shareholder equity, but rather on the percentage of shares transferred over a period. The Companies Act also includes provisions relating to required disclosure of share transactions, mandatory offers, comparable and partial offers, restrictions on frustrating action and prohibited dealings before and during an offer.
- Whether the proposed transaction contemplates the company providing financial assistance in some manner or form (lending money, guaranteeing a loan or other obligation, and securing any debt or obligation, or having a the purchase price remain outstanding on loan account) to a related or inter-related company: If so, the prior approval of the shareholder(s) of the company by way of special resolution and approval of the board of directors is required (in addition to other formalities as set out in section 45 of the Companies Act) before such financial assistance can be advanced.
Other regulatory authorities
Competition considerations — South African merger control
The Competition Act requires that prior approval be obtained from the South African competition authorities for certain transactions that are notifiable mergers. Where the transacting parties fail to obtain the requisite approval, the Tribunal may impose an administrative penalty of up to 10 percent of the firm’s annual turnover in South Africa and exports from South Africa during the preceding financial year.
The Tribunal may also order a party to sell any shares, interest or other assets it has acquired as a result of the merger or declare void any provision of an agreement to which a merger was subject.
In order for a transaction to qualify as a notifiable merger, it must satisfy a ‘control test’ under the Competition Act and meet the relevant financial thresholds set out in Government Notice 216 of 2009. These tests are discussed below.
Requirements for notification — acquisition of control
A transaction may require competition approval if the transaction involves the acquisition or establishment of control by one party (‘acquiring firm’) over the whole or part of the business of another party (‘target firm’), subject to the relevant threshold tests also being met.
The acquisition or establishment of control over a business (i.e. a ‘merger’ in terms of the Competition Act) may be effected in a number of ways, including through the purchase or lease of the assets, shares or interests of the target firm, or through an amalgamation or other combination with the target firm.
The question of whether ‘control’ has been acquired is often complex and must be answered not only with reference to section 12 of the Competition Act (which sets out instances where control is deemed to be acquired) but also with reference to a number of rulings issued by the Tribunal and the Competition Appeal Court.
Requirements for notification — threshold test
Not all mergers require prior approval of the competition authorities. Both the control test, discussed above, and a financial threshold test must be met before the merger is considered as notifiable to the Commission. In terms of the Competition Act read with Government Notice 216 of 2009, a merger is notifiable to the Commission where:
- the gross annual turnover in, into or from South Africa or the gross asset value in South Africa (whichever value is the greater) of the target company or target business (which includes entities controlled by the target company) is equal to or exceeds ZAR80 million, and
- the combined gross annual turnover in, into or from South Africa or the gross asset value in South Africa (whichever value is the greater) of the acquiring company (which includes the entire ‘control’ group of the acquiring company) and the target company or target business (which includes entities controlled by the target company) is equal to or exceeds ZAR560 million.
A merger that meets these thresholds but does not exceed the higher thresholds (see below) is considered to be an ‘intermediate merger’ and is required to be formally notified to the Commission.
If the merger exceeds the following two upper thresholds, the transaction is considered to be a ‘large merger’:
- the gross annual turnover in, into or from South Africa or the gross asset value in South Africa (whichever value is the greater) of the target company or target business (which includes entities controlled by the target company) is equal to or exceeds ZAR190 million, and
- the combined gross annual turnover in, into or from South Africa or the gross asset value in South Africa (whichever value is the greater) of the acquiring company (which includes the entire ‘control’ group of the acquiring company) and the target company or target business (which includes entities controlled by the target company) is equal to or exceeds ZAR6.6 billion.
For purposes of determining the ‘gross asset value’, only assets in South Africa or arising from activities in South Africa must be taken into account.The turnover and gross asset values as per the previous year’s audited financial statements must be used.
Internal group restructures
Intragroup restructures are not exempt from the merger notification requirements set out in the Competition Act. In the Competition Appeal Court decision in Distillers Corporation (SA) Ltd/SFW Group Ltd and Bulmer (SA) (Pty) Ltd/Seagram Africa (Pty) Ltd (08/CAC/May01), the court confirmed that every acquisition of direct control (even in a group context) is notifiable if the relevant financial thresholds are met.
Notwithstanding this judgment, the Commission’s current approach is that intragroup transactions are not required to be notified, provided that the group companies involved all form part of one ‘single economic entity’ for competition law purposes. However, neither the Competition Act nor the case law supports the Commission’s approach. Therefore, despite the Commission’s practice, parties to notifiable intragroup transactions implemented without the requisite approval of the competition authorities are at risk of being fined.
Given the apparent uncertainty in the approaches of the competition authorities and in order to obtain clarity on whether a proposed intragroup transaction should be notified, parties can obtain a non-binding opinion from the Commission requiring it to confirm its approach to the specific transaction. If the intragroup transaction is later challenged on the basis that pre-approval of the competition authorities should have been obtained before implementation, the advisory opinion may be used in mitigation when theTribunal is considering administrative penalties.
A ‘merger’ that does not meet the aforementioned financial thresholds is deemed to be a ‘small merger’. A party to a small merger is not required to notify the Commission of the merger and may implement it without the Commission’s approval. However, within 6 months after a small merger is implemented, the Commission may require the parties to the merger to notify the Commission if, in the opinion of the Commission, the merger may substantially prevent or lessen competition or cannot be justified on public interest grounds.
The Small Merger Guideline, issued on 17 April 2009, provides that the parties to a small merger are advised to voluntarily inform the Commission by letter of their intention to enter into the transaction, if at the time of entering into the transaction any of the firms, or firms within their groups, are:
- subject to an investigation by the Commission in terms of Chapter 2 (which deals with horizontal and vertical prohibited practices) of the Competition Act, or
- respondents to pending proceedings referred by the Commission to the Tribunal in terms of Chapter 2 of the Competition Act.
After receipt of the notification letter, the Commission will respond to the parties in writing and inform them whether a formal merger filing is required.
JSE listing requirements
The Johannesburg Stock Exchange (JSE) listing requirements apply to all companies listed on the JSE and to applicants for listings. The requirements were introduced in 1995 and have since been subject to many amendments. The requirements aimed to raise the levels of certain market practices to international standards and account for situations unique to the South African economy and culture.
Integral functions of the JSE are to provide facilities for the listing of the securities of companies (domestic or foreign), to provide users with an orderly marketplace for trading in such securities, and to regulate accordingly.
The listing requirements reflect, among other things, the rules and procedures governing new applications, proposed marketing of securities and the continuing obligations of issuers. The requirements are intended to ensure that the business of the JSE is carried on with due regard to the public interest.
With respect to M&A, the JSE listing requirements regulate transactions of listed companies by rules and regulations to ensure full, equal and timely public disclosure to all holders of securities and to afford them adequate opportunity to consider in advance, and vote on, substantial changes in the company’s business operations and matters affecting shareholders’ rights.
The JSE listing requirements are numerous and may be onerous. To comply, a listed company considering a transaction with another party should assess the proposed transaction on the basis of its size, relative to that of the listed company, to determine the full extent of these requirements and the degree of compliance and disclosure needed.
No cross-border merger or acquisition should be contemplated without considering the likely impact of the strictly enforced South African Exchange Control Regulations.
The exchange control authorities allow investments abroad by South African companies, although a case would have to be made proving, among other things, the benefits to the South African balance of payments, the strategic importance of the proposed investment, and the potential for increased employment and export opportunities. A minimum 10 percent shareholding is generally required. Under a new dispensation, JSE-listed entities may establish one subsidiary to hold African and offshore operations that will not be subject to any exchange control restrictions (various conditions must be met, including that the subsidiary be a South African tax resident).
Remittance of income
Income derived from investments in South Africa is generally transferable to foreign investors, subject to the following restrictions:
- Interest is freely remittable abroad, provided the authorities have approved the loan facility and the interest rate is related to the currency of the loan, such as the Great British Pound Sterling at the London Interbank offered rate (LIBOR).
- Payment of management fees by a South African company to a non-South African exchange control resident company or beneficiary is subject to exchange control approval. The amount paid must be reasonable in relation to the services provided. Payments of such fees by wholly owned subsidiaries of overseas companies are not readily approved. Authorized dealers may approve, against the production of documentary evidence confirming the amount involved, applications by South African residents to effect payments for services rendered by non-residents, provided that the fees payable are not calculated on the basis of a percentage of turnover, income, sales or purchases.
- Agreements for the payment of royalties and similar payments for the use of technical knowhow, patents and copyrights require the prior approval of the exchange control authorities.
- All license agreements relating to the use of technology in manufacture are first vetted by the Department of Trade and Industry. Other license agreements are submitted directly to the exchange control authorities.
- Distributions to shareholders, whether from capital or revenue profits, are freely remittable abroad, provided that the formalities for such distribution as set out in the Companies Act and the South African company’s MOI are complied with and the share certificate to which the distributions relate have been endorsed ‘non-resident’. The directors of a company may not effect a distribution to shareholders without being satisfied that, at the time of the distribution, the company is solvent and liquid. The non-resident endorsement can be achieved by submitting to an authorized dealer proof that the funds have flowed to South Africa from abroad were used for the original purchase of the shares at market value.
Structuring the transaction
Acquisitions are generally structured either as a purchase of a business (i.e. the acquisition of assets, assumed liabilities and employees) or the purchase of all or the majority of the shares in a company. The continued existence of the acquired company is not affected by the introduction of the new majority shareholder.
Mergers and amalgamations
The Companies Act, which came into effect on 1 April 2011, introduced a statutory mechanism to give effect to ‘mergers or amalgamations’. These provisions do not regulate all mergers or amalgamations in the generic sense; they only regulate those contemplated in section 113 read together with 116 of the Companies Act.
A merger or amalgamation (as contemplated in section 113 read together with 116 of the Companies Act) is a transaction in which the assets of two or more companies become vested in or come under the control of one company, the shareholders of which then consist of the shareholders (or most of the shareholders) of the merged companies. The single company that owns or controls the combined assets of the merged companies may be either:
- one of the merged companies whose share capital was reorganized to enable it to be the vehicle of the merger
- a new company formed for the purpose of the merger.
Parties are not obligated to apply these provisions. Mergers can be effected using the traditional sale of business or shares mechanisms, as the requirements to give effect to the statutory mechanism are administratively burdensome. For example, the statutory mechanism requires that every creditor of the merging businesses be given notice of the merger and that within a prescribed period after delivery of such notice, a creditor may seek leave to apply to a court for a review of the amalgamation or merger on the grounds (only) that the creditor will be materially prejudiced by the amalgamation or merger. This mechanism is beneficial to use if there is litigation in one of the companies being merged/amalgamated because, while litigation cannot be moved from one company to another without the consent of the other litigation party, this is not the case where the merger and amalgamation provisions (as contemplated in section 113 of the Companies Act, as read with section116) are applied. The litigation proceeding or pending by or against an amalgamating or merging company continues to be prosecuted by or against any amalgamated or merged company.
Note, however, that the definition of ‘amalgamation or merger’ in the Companies Act is not aligned with the concepts of amalgamation and merger as contemplated in the South African Income Tax Act.
An acquisition or takeover is a transaction in which control over a company’s assets is obtained by the acquisition of sufficient shares in the company to control it. The continued existence of the acquired company is not affected by the introduction of the new majority shareholder.
Structuring and South African tax relief
The South African Income Tax Act contains special rules relating to asset-for-share transactions, amalgamation transactions, intragroup transactions, unbundling transactions and liquidation distributions. The purpose of these provisions is to facilitate mergers, acquisitions and restructurings in a tax-neutral manner. The rules are very specific and generally do not apply cross-border or when one of the entities in the transaction is a trust or natural person.
- Profitable operations can be absorbed by loss companies in the acquirer’s group, thereby effectively gaining the ability to use the losses (subject to general anti-tax avoidance rules).
- Interest incurred to finance an asset purchase may be deductible, subject to the interest limitation provisions and transfer pricing rules.
- Assets may be encumbered to assist in financing the acquisition.
Comparison of asset and share purchases
Advantages of asset purchases
- The purchase price (or a portion) can be depreciated or amortized for tax purposes.
- No previous liabilities of the company are inherited.
- It is possible to acquire only part of a business.
Disadvantages of asset purchases
- Possible need to renegotiate supply, technology and other key agreements.
- Need to change stationery and other company documentation.
- A higher capital outlay is usually involved (unless debts of business are also assumed).
- May be unattractive to the vendor, thereby increasing the price.
- Accounting profits are affected if acquisition goodwill is written-off.
- The benefit of any tax losses incurred by the target company remains with the vendor.
- Tax disallowance of trade receivables purchased without recourse when proven uncollectible.
- Registration of registerable assets and consents required for transfer of agreements and licenses.
- When the acquirer will not use the assets to make taxable supplies, VAT or transfer duty become an additional cost.
- If debts are also assumed, no tax deduction or VAT claim can be made on irrecoverable debts.
- Interest on debt funding may not be deductible.
Advantages of share purchases
- Lower capital outlay (purchase net assets only).
- Likely to be more attractive to vendor, so price is likely to be lower.
- May benefit from tax losses of target company (subject to general anti-tax avoidance rules).
- Existing contracts normally are unaffected, so the purchaser may gain the benefit of existing supply or technology contracts.
- In certain cases, interest incurred on debt to acquire equity may be deductible where certain provisions of the Income Tax Act are met, as discussed above.
Disadvantages of share purchases
- Assumption of all liabilities that are in the target company, including tax liabilities.
- STT applicable on the higher of the market value or consideration paid for the shares is payable by purchaser.
- Depending on the transaction, no tax deduction of the funding cost may be permitted.