Dividends
1547. Share buy-backs
August 2007 – Issue 96
Introduction
Various companies have recently undertaken a repurchase of their shares from the market. It will be considered exactly what it requires for a company to undertake such a buy-back. In addition, what portion of the consideration utilized to effect a share buy-back constitutes a dividend for income tax purposes, is analysed.
Under a share buy-back (also known as a share repurchase), a company will buy back its shares from the market, which effectively will reduce its number of shares in the market. This will result in an increase in the relative ownership stake of each investor in that company since there are fewer shares or claims on the earnings of the company. More often than not, when a company announces a buy-back it is usually perceived positively by the market which often causes the share price of that company to escalate.
There are many reasons why a company will undertake a share buy-back. Some of these are:
· the company will regard the buy-back as the best use of capital at a particular time during its business;
· where the company feels that the market has discounted its share price too steeply, which can be as a result of weaker than expected earnings results, an accounting scandal or just a poor overall economic climate;
· to improve the company’s balance sheet ratios. This should, however, not be regarded as the primary objective but rather as a consequence of such buy-back. Financial ratios that are improved would be, amongst others, the return on assets and the return on equity ratios. These ratios improve as a result of the reduction in assets (the cash forked out by the company in buying back its shares) because there is less outstanding capital. Hence, the price earnings ratio of the company will also be improved; or
· to reduce the dilution that is often caused by generous employee stock option plans.
The Companies Act
Before considering the income tax consequences in respect of share buy-backs, one needs to understand under what circumstances a company may re-acquire its own shares. Essentially section 85 of the Companies Act No. 61 of 1973 provides for certain situations under which a company (including a public and private company) may acquire shares issued by it. Of particular importance is section 85(4) which provides that a company shall not make any payment to buy back shares issued by it if there are reasonable grounds to believe that:
· the company is or would after such payment be unable to pay its debts as they become due in the ordinary course of its business; or
· the consolidated assets of the company fairly valued would after the payment be less than the consolidated liabilities of the company.
To this end, assuming that the company does not contravene the above conditions, then the shares acquired by the company under section 85(8) shall be cancelled as issued shares and shall be restored to the status of authorized shares in that company.
Hence, section 85(4) mirrors the provisions of section 90 of the Companies Act, which section deals with payments to shareholders and authorises when a company may make payments to its shareholders. The provisions of section 90(3) provide that payments may be made by the company to its shareholders in money or by way of a transfer of the company’s assets. It must be noted that the provisions of section 90 will only apply if that payment is made to a shareholder by virtue of its shareholding in that company and consequently the provisions will not apply where payment is made by that company to its shareholders in repayment of the latters’ loan accounts or some other type of indebtedness.
The amendments in the Corporate Laws Amendment Act No. 24 of 2006 will not have any impact on the current provisions of section 85 read with section 90 of the Companies Act.
Definition of a dividend
Section 1 of the Income Tax Act No. 58 of 1962 (the Act) defines the concept of a "dividend" as any amount distributed by a company to its shareholders. The expression "amount distributed" includes in terms of sub paragraph (c) of the dividend definition so much of the sum of any cash and the value of any asset given to a shareholder as exceeds the cash equivalent of the nominal value of the shares so acquired from such shareholder where a company acquires shares under section 85 of the Companies Act.
In terms of section 1 of the Act, the term "nominal value" means, in relation to the shares issued by a company, where the shares have a par value, such par value or where the shares do not have a par value, an amount equal to the amount at which the par value of those shares would be determined, if the company were to convert the shares into shares having a par value.
An issue that is often overlooked, having regard to the definition of a "dividend", is the various provisos pertaining thereto. Essentially the provisos deal with various scenarios where reserves have been capitalized. It follows that the underlying principle in respect of these provisos is that reserves retain their character despite being capitalized. In particular paragraph (iii) to the first proviso provides that in the event of any acquisition of shares in terms of section 85 of Companies Act, any portion of any cash or any asset given to shareholders that represents a return of share capital or share premium will be deemed to be a profit available for distribution to the extent of the availability of reserves, which reserves would include capitalized reserves.
From a practical perspective, assuming that the company buys back its shares by utilizing its share premium account, then the return of pure share premium (contributed in cash) will be excluded as a dividend in terms of paragraph (f) of the dividend definition. It follows that a share buyback funded from tainted share premium, will constitute an amount distributed as a dividend and consequently will be subject to secondary tax on companies (STC).
To the extent that the share buy-back is funded out of true share premium, then that amount will not constitute a dividend as defined and thus the amount distributed to shareholders will be taxable (as either gross income or capital proceeds), in the hands of those shareholders. Conversely, where a share buyback was funded from tainted share premium, then that amount will constitute a dividend and subsequently will be subject to STC in the hands of the company making the distribution. The shareholders will in this instance receive a dividend that is exempt from tax under section 10(1)(k)(i).
From the above it is of paramount importance that shareholders be aware of the way in which the purchase price, which they have received for their shares from the company, has been funded, that is, whether such amount was funded from pure or tainted share premium since each scenario will have a different tax consequence in their hands.
The Revenue Laws Amendment Act No. 20 of 2006 added paragraph (cA) to the definition of a "dividend" and it includes as part of an amount distributed, in the event of the reduction of the capital of a company, pursuant to that company acquiring its own shares by means of a distribution from any other company, the amount of any reduction of the profits of that company as were available for distribution to shareholders. The Explanatory Memorandum to the Revenue Laws Amendment Bill, 2006, states that regarding the insertion of this paragraph, the rules are unclear when a company receives its own shares as a dividend from a subsidiary. This situation often arises in a group context if a subsidiary acquires shares of a parent company followed by that subsidiary’s distribution of parent shares back to the parent. The amendment effectively triggers a deemed dividend for the parent to the extent that the parent’s earnings and profits are reduced (in addition to the usual dividend treatment for the subsidiary making the distribution). Essentially paragraph (cA) deals with the situation where a holding company acquires its own shares via a dividend from its subsidiary. Generally the subsidiary will acquire its holding company’s shares on the open market and then distribute them to its holding company. It is at this point that the paragraph triggers a deemed dividend in the hands of the holding company to the extent that the holding company’s profits available for distribution are reduced.
It is noteworthy that this type of transaction is what proviso (bb) to section 64B(5)(f) had intended to guard against in that the exemption of any dividend declared by a company which accrues to a shareholder will not apply insofar as that dividend consists of any shares in that shareholder. IAS32 (AC125) which deals with financial instruments provides that if an entity re-acquires its own equity instruments, those instruments shall be deducted from equity. No gain or loss shall be recognized in profit or loss on the purchase, sale, issue or cancellation of an entity’s own equity instruments. In turn the concept of equity is defined in the "Framework for the Preparation and Presentation of Financial Statements" as the residual interest in the assets of the entity after deducting all its liabilities. Equity therefore includes funds contributed by shareholders, retained earnings, reserves representing appropriations of retained earnings and reserves representing capital maintenance adjustments. It follows that the deduction from equity as mentioned above covers any reduction in a company’s retained income as a result of the cancellation of the company’s shares which, in principle, is envisaged by paragraph (cA).
In conclusion, it is clear that when a company embarks on a share buy-back, it should consider not only the various provisions of the Act when determining whether the "amount distributed" to its shareholders will constitute a dividend, but one would also be required to consider the provisions of the Companies Act which provisions would in principle be the first gateway for the company to enter since where these provisions are not met, then any type of share buy-back will be prohibited. From an income tax perspective it is important that when one determines whether the payments made to shareholders in respect of the repurchasing of their shares can be said to constitute an "amount distributed" and therefore a dividend, one reads the inclusions (paragraph (c) of the dividend definition) together with the provisos (paragraph (iii) read with paragraph (i) of the first proviso). In addition, one should take note of the new paragraph (cA) of the "dividend" definition insofar as a holding company acquires its own shares by way of a dividend from its subsidiary company.
Edward Nathan Sonnenbergs Inc.
IT Act:S 1 definition of "dividend", "nominal value",
Companies Act No. 61 of 1973: s 85, s 90
Revenue Laws Amendment Act No. 20 of 2006: par (cA)
