Classification of instruments as debt or equity

Companies are typically funded through a combination of debt and equity.

The 'truest' form of debt would be a secured loan and returns in respect of that instrument would qualify as interest. While the 'truest' form of equity would be ordinary shares in a company and the returns in respect of such equity would qualify as dividends.

However, the Companies Act No 71 of 2008 allows companies to tailor make the debt and equity instruments that it issues, which may have a combination of debt and equity features. These instruments are referred to as hybrid instruments and it is often difficult to classify the instruments as either debt or equity.

Taxpayers worldwide have often sought to use these hybrid instruments to obtain tax benefits. In South Africa, specific legislation has been enacted to deal with hybrid instruments and perpetual debt instruments (see s8E, s8EA, s8F and s24J of the Income Tax Act, No 58 of 1962). Recently, National Treasury and the South African Revenue Service (SARS) released a document for public comment on certain proposed amendments and additions to the provisions relating to hybrid debt instruments, which reclassify the interest returns on these hybrid instruments as dividends.

Interestingly many of the debt and equity features that Treasury and SARS have indemnified in the specific hybrid instrument legislation are taken into consideration by foreign courts in determining the classification of an instrument. For instance, the proposed amended s8F provides that a hybrid debt instrument includes inter alia an instrument where:

• the company is not obliged to repay all amounts on the instrument in cash in full within 30 years; and

• the obligations to pay is conditional upon the solvency of the company.

Last year, the United States Tax Court, in the cases of PepsiCo Puerto Rico Inc (TC Memo 20012-269), Hewlett-Packard Company & Consolidated Subsidaries (TC Memo 2012-135) and NA General Partnership & Subsidiaries (TC Memo 2012-172), had to determine whether the instruments concerned constituted debt or equity. The number of factors that the court took into consideration varied between the cases. In the PepsiCo case, the court identified the following 13 factors to consider when resolving the debt-versus-equity enquiry:

• names or labels given to the instruments;

• presence or absence of a fixed maturity date;

• source of payments;

• right to enforce payments;

• participation in management as a result of the advances;

• status of the advances in relation to regular corporate creditors;

• intent of the parties;

• identity of interest between creditor and stockholder;

• 'thinness' of capital structure in relation to debt;

• ability of the corporation to obtain credit from outside sources;

• use to which advances were put;

• failure of debtor to repay; and

• risk involved in making advances.

The courts will weigh up all of the factors mentioned above in considering the debt or equity nature of the instrument concerned. Importantly, in the PepsiCo case it was indicated that the absence of any legitimate creditor safeguards afforded to the holders of the instrument was a significant factor evidencing the equity nature of the investment. It was indicated that "'no enforcement provisions, no specific maturity date, and no sinking fund from which payments of interest and principles might be made' were more appropriately characterised as equity instruments."

Despite the specific hybrid instrument provisions contained in the Act, careful consideration should thus always be given to the particular terms and conditions of the instrument to establish its true nature. It is a well-established principle that 'the courts will not be deceived by the form of a transaction: it will rend aside the veil in which the transaction is wrapped and examine its true nature and substance'. Thus, if in substance, taking into consideration the factors mentioned above, an instrument is a debt instrument, the courts may treat the returns as interest (as opposed to dividends) triggering the attendant tax implications.