Anti-dividend stripping rules – when dividends turn into capital gains

Dividend stripping has been under the watchful eyes of the South African Revenue Service (“SARS”) for some time. As a highly technical topic, we will take a look in this article only at the anti-dividend stripping rules that may apply to dividend stripping.
In South Africa, dividends are typically subject to a dividend withholding tax at a rate of 20%. Dividends declared from one resident company to another resident company in South Africa, however, are exempt from dividends withholding tax. The result – shareholders who structure their shareholding optimally can benefit from this exemption. Yet, as with all things where there is a benefit, it is also open to abuse, and the use of this exemption has been dubbed dividend stripping and used as a strategy by shareholders of a company to minimise their tax liabilities by exploiting the dividend withholding tax rules in South Africa. Whilst a legal and tax-efficient way to reduce taxes, it has also raised regulatory concerns regarding its potential abuse. The practice of dividend stripping involves declaring dividends from a company to another resident company prior to the disposal of its shares. In other words, the reserves of the company are reduced by declaring dividends out of the company. This in turn reduces (or “strips”) the value of the shares in the company, allowing a shareholder to sell their shares at a lower value. In turn, this allows investors to dispose of their shares in the company at relatively low share values or, in some instances, without the incurrence of any taxes on the disposal. To combat potential abuse of dividend stripping, South African tax laws have anti-dividend stripping provisions embodied in its framework for shares that are held as capital assets. In terms of section 43A of the Eighth Schedule of the Income Tax Act 58 of 1962 (“Income Tax Act”), the following requirements in relation to equity shares if met, would result in dividend stripping falling within the anti-avoidance dividend stripping rules: 1. A company disposes of shares, that it holds as a capital asset, in another company. 2. The disposing company held a qualifying interest at any time in a period of 18 months prior to the disposal. A shareholder will have a qualifying interest in the company if it directly or indirectly holds at least 50% of the equity shares or voting rights in the company, or where no shareholder has the majority of the shares, at least 20% of the equity shares or voting rights in the company. 3. The disposing company received an exempt, extraordinary dividend within 18 months from the date of the disposal of the shares or in respect of, by reason of, or in consequence of such disposal in relation to equity shares. What constitutes an extraordinary dividend depends on the shares that are the subject matter of the transaction. For preference shares, an extraordinary dividend is any dividend received or accrued that exceeds the amount that would have accrued had an interest rate of 15% per annum been applied to the consideration for the preference shares. If it is any other share, an extraordinary dividend is a dividend to the extent that it exceeds 15% of the higher of the (i) market value of the share at the beginning of the 18-month period or (ii) the value of the shares at the date of disposal. The terminology used in the Income Tax Act surrounding extraordinary dividends is technical and requires scrutiny when determining whether a dividend is extraordinary or not. The anti-dividend stripping provisions are broad in scope and therefore apply to all shares, whether equity or preference. It will also apply in instances where a company re-acquires its shares by means of share buybacks or redemptions making it potentially subject to the dividend stripping rules. The following example provides a basic illustration of dividend stripping and its application: Company B has 51% of the ordinary shares in Company A. Company A declares a dividend to its shareholder Company B on 01 November 2023. The dividend to Company B is R25,000.00. The dividend is exempt from dividends tax because no dividend tax is levied between South African resident companies. Company B also has a qualifying interest in Company A as it holds more than 50% of the equity shares and voting rights in Company A. The shares of Company A were valued at R50,000.00 on 01 November 2023. On 01 December 2023, Company B decides to sell all its shares in Company A to Company C. The value of the shares remains unchanged on 01 December 2023, being the date of disposal (let’s assume that this value is higher than the value of the shares 18-months prior to the disposal). The dividend received on 01 November 2023 is 50% of the value of the shares on the date of disposal. This means that 35% of the dividend received is deemed to be an extraordinary dividend. The consequence is that the extraordinary dividend will be included as part of the proceeds that Company B receives from Company C for its shares and will be taxed accordingly. In the event that the above requirements are met, a portion of the dividend is treated as part of the proceeds on the sale of the shares that are disposed of. In other words, a part of the extraordinary dividends will trigger the anti-avoidance provisions and as the dividends will be treated as proceeds, there will be a capital gains tax implication for the disposing company. Despite concerns about abuse, dividend stripping in South Africa still has the potential for legitimate tax use and can offer benefits when properly used and not abused. Given the anti-avoidance tax rules and accompanying tax consequences, it is prudent to involve a specialist corporate or tax practitioner to help you navigate the complex legal framework around dividend stripping. Disclaimer: This article is the personal opinion/view of the author(s) and is not necessarily that of the firm. The content is provided for information only and should not be seen as an exact or complete exposition of the law. Accordingly, no reliance should be placed on the content for any reason whatsoever and no action should be taken on the basis thereof unless its application and accuracy have been confirmed by a legal advisor. The firm and author(s) cannot be held liable for any prejudice or damage resulting from action taken on the basis of this content without further written confirmation by the author(s).
November 30, 2023
TRP approval: Essential for SA company transactions

TRP approval: Essential for SA company transactions

The Takeover Regulation Panel (“TRP”) is a key South African regulatory body responsible for regulating certain types of transactions undertaken by companies in South Africa. In this article, we take a look at a few transactions that specifically need to be approved by the TRP and, in particular, the requirements to give notice of such transactions.

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