35

Debt capitalisation: An analysis of the application of section 24BA of the Income Tax Act
Pieter Janse van Rensburg
BAcc, LLB, HonsBCompt, MAcc Taxation, Chartered Accountant (SA) Financial Manager, Campari South Africa (Pty) Ltd

Rudie Nel
BCom Accounting (Hons), MCom Taxation, Chartered Accountant (SA) Senior lecturer, School of Accountancy, Stellenbosch University

OPSOMMING
Skuldkapitalisering: ’n Analise van die toepassing van artikel 24BA van die Inkomstebelastingwet
Die kapitalisering van skuld in ruil vir die uitreiking van aandele is ’n algemene verskynsel en kan op drie wyses geskied, naamlik deur die  direkte uitreik van aandele (met of sonder kontantvloei), deur skuld- vergelyking en deur die omskepping van skuldinstrumente in aandele. Alhoewel bestaande literatuur aandag aan die toepassing van skuld- verminderingsbepalings in die Inkomstebelastingwet skenk, is daar egter ’n gebrek aan voldoende inligting oor die mate waartoe artikel 24BA van die Inkomstebelastingwet op die verskillende metodes van skuld- kapitalisering van toepassing kan wees. Die artikel ondersoek die moontlike toepassing van artikel 24BA op skuldkapitalisering. Elk van die metodes van kapitalisering word individueel ontleed aan die hand van die vereistes van artikel 24BA. Die artikel bevind dat met skuldvergelyking as metode van skuldkapitalisering, verskille tussen die waardes van inskrywingslening (wat voortspruit uit die inskryf op aandele) en die  markwaarde van aandele wat uitgereik word tot toepassing van artikel 24BA aanleiding kan gee. Op grond van die bevinding word daar aan die hand gedoen dat indien die omstandighede nie voorsiening maak vir verligting van die toepassing van artikel 24BA nie, kan skuldvergelyking as ’n minder gunstige metode van skuldkapitalisering beskou word.

1 Introduction
The combination in which respectively debt and equity are used to  finance assets and operations of a company (the so-called capital  structure or debt-equity ratio) depends on various of factors, of which,
the incidence of tax is one of the main influencing factors.1 This is substantiated  by  the  fact that the  Income Tax  Act2 also  acknowledges

Van der Linde Legal responses to corporate undercapitalisation: towards a proactive approach? (2011) 8.

How to cite: Janse van Rensburg & Nel ‘Debt capitalisation: An analysis of the application of section 24BA of the Income Tax Act’ 2018 De Jure  35-49
http://dx.doi.org/10.17159/2225-7160/2018/v51n1a3

58 of 1962, hereinafter the Act (any reference to a section in this article refers to a section in the Act unless specifically indicated otherwise).

36   2018 De Jure

that debt can be akin to equity as a means of funding and contains re- characterisation rules for debt (and interest) and equity (and dividends) in sections 8E, 8EA, 8F and 8FA. Given the potential tax consequences of the funding decision a company could be able to adapt the ratio of debt
and equity funding in tax planning. A method through which this can be achieved,  is  debt capitalisation.3
Debt capitalisation is an arrangement where a shareholder converts debt to equity.4 Stated differently, debt capitalisation is the process whereby the consideration for shares issued by a company takes the
form of the discharge of an existing debt.5 Not only shareholder debt but also third party debts can be capitalised in exchange for shares.6 When
debt capitalisation occurs, the quid pro quo received by the creditor company in exchange for the reduction of the debt is shares in the debtor company.7 Debt capitalisation is not only concluded at the instance  of
debtor and creditor companies, but can be required by regulation (as illustrated by section 25BB(8) of the Act pertaining to Real Estate Investment Trusts).
Debt capitalisation can be achieved either directly or indirectly8 by applying different methods and the structuring of these methods should  be  kept  in  mind  for  tax  purposes.  A  single  transaction  could     have
different tax outcomes than a series of transactions resulting in the same outcome as the single transaction.9 In the context of debt capitalisations the  effective outcome  can be  achieved by means of the  following  three
methods:10
Direct settlement: issuing shares directly in settlement of the debt;
Set-off: issuing shares and setting off the subscription loan owed by the subscriber against an amount owed by the company; and
Conversion: converting debt to shares in fulfilment of  the  conversion rights attaching to the  debt.
Prior to the effective date of section 19 of the Act and paragraph 12A of the Eighth Schedule to the Act on 1 January 2013, only Binding Private Ruling (‘BPR’) 124 issued on 22 October 2012 dealt with the tax consequences of debt capitalisation. Since then, there has been an  increase in the number of BPRs issued by SARS on debt capitalisation which could be indicative of the increased focus on the tax consequences thereof by taxpayers. The initial focus on debt capitalisation has been   on

Chadbourne and Parke LLP Tax Issues In Debt Restructurings (2002) 3 available from https://www.chadbourne.com/Tax_Issues_In_Debt_10-2002_ Projectfinance (accessed 09-04-2017).
KPMG “KPMG welcomes debt capitalisation tax proposal” 2015 Taxmail 1.
SARS Interpretation Note 91: Reduction of debt (2016) 10.
CIR v Datakor Engineering (Pty) Ltd (1998) (4) SA 1060 (SCA) 8.
SARS Comprehensive Guide to Capital Gains Tax (Issue 5) (2015) 139.
SARS supra n 7 at 140.
Van der Zwan Tax implications of capitalisation of loans (2014) 2 available from  http://www.pvdz.co.za  (accessed 02-04-2017).
SARS supra n 7 at 140.

Analysis of the application of section 24BA of the Income Tax Act   37

the potential application of the debt reduction provisions, however, in    the more recent BPR 246 and BPR 255 the SARS concludes by indicating that the rulings do not cover any general anti-avoidance provision to the proposed  transaction.  In  this  regard,  a  relevant  anti-avoidance  aspect
that emanates from Interpretation Note 91: Reduction of debt, is the potential application of section 24BA of the Act to debt  capitalisation.11
Section 24BA is aimed at a transaction in which a company acquires  an asset from a person in exchange for the issue by that company to that person of shares in that company. The provisions of section 24BA would then apply, barring the exclusions afforded in section 24BA(4), if the value of the asset and the value of the shares differs. Prior to the promulgation of section 24BA, tax schemes with uneven exchanges allowed   for   value   to   be   transferred   without   the   appropriate    tax
consequences.12   These   tax   consequences   arguably   include    the
avoidance of donations tax when value is transferred between taxpayers. The value shifting anti-avoidance rules contained in the Eighth Schedule proved to be ineffective in regards to companies due to the fact that in
many anti-avoidance transactions the ‘connected person’ relationship lacked.13 The purpose of section 24BA is to ensure that the value-for- value proposition applies to all asset-for-share transactions14 in cases where  ‘connected  persons’  as  defined  is  not  present.15  Although  the
section is mainly focused on asset-for-share transactions in terms of the corporate rules contained in section 42 of the Act,16 section 24BA(2)(a) specifically  refers  to  its  application  to  any  transaction.  The  potential
application of section 24BA should therefore be considered in all instances where a company issues shares and would therefore include  debt capitalisation, especially whether it can be said that the company acquires an ‘asset’ as part of the debt capitalisation which will be addressed in section 3 to section 5 which   follows.
The objective of this article is to investigate the potential application of section 24BA to each of the three methods of debt capitalisation. The article aims to conclude on whether the potential tax consequences imposed by the application of section 24BA, could result in a particular method of debt capitalisation being less favourable, compared to other methods. Section 2 of this article considers the three requirements for section 24BA to be applicable, including an analysis of relevant key terms of the three requirements. Section 3 to Section 5 deals with the different methods of debt capitalisation and the potential application of section 24BA to each method based on the three requirements of section   24BA.

Van der Zwan Tax Developments – August September 2015 (2015) 3.
National Treasury Explanatory Memorandum on the Taxation Laws Amendment Bill 2012 (2012) 39.
Ibid.
Ibid.
Lewis   Value   Shifting   Arrangements   Still   Applicable   to   Companies   and Triggering Adverse Tax Implications (2014) 1 available from https:// www.cliffedekkerhofmeyr.com  (accessed  11-05-2017).
Ibid.

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2  The requirements of section 24BA
For section 24BA to apply the following requirements should be met:
Shares issued as consideration,
Asset acquired in exchange for the shares issued, and
The value of the shares issued and the value of the asset acquired differs.

2 1     Shares issued as consideration
The first requirement which has to be met is that a company should issue shares as consideration. A key feature of debt capitalisation is the issue of shares by a debtor company in exchange for a release from an obligation to pay debts. The remaining question is whether these shares have been issued as ‘consideration’, a word that is not defined in the Act.
The modern approach to interpretation of documents from the outset considers   the   context   and   the   language   together   with   neither
predominating over the other.17 This approach to interpretation therefore  insists  that  context  be  considered  in  the  first     instance,
especially in the case of general words, and not merely at some later   stage when ambiguity might be thought to arise.18 The Merriam-Webster dictionary,   defines   the   ordinary  meaning   of  ‘consideration’   as  the
inducement to a contract or other legal transaction; specifically an act or forbearance or the promise thereof done or given by one party in return  for the act or promise of another. In terms of the Shorter Oxford English Dictionary on Historical Principles on the meaning of ‘forbearance’ as abstinence  from  enforcing  what  is  due,  especially  the  payment  of   a
debt.19 The term ‘forbearance’ would therefore include a situation  where
the creditor offers the debtor release from its obligation to pay. In the context of debt capitalisation, the creditor gives, and the debtor company accepts, a forbearance of payment of the underlying debt in exchange for the issue of the shares by the debtor company. The amount of debt reduced or forborne by the creditor constitutes the ‘consideration’ for the share issue. The ordinary meaning is also not limited to positive performance only but allows for an interpretation of something forborne in exchange for something else. The ordinary meaning of ‘consideration’ consequently includes the forbearance of a right. In debt capitalisation the creditor’s right to claim payment from the debtor is forborne as quid pro quo for the shares issued by the debtor. This forbearance by the creditor to enforce its debt claim against the debtor should therefore also constitute ‘consideration’ for purposes of section 24BA.

Natal Municipal Joint Pension Fund v Endumeni (2012) (4) SA 593 (SCA) 16.
K & S Lake City Freighters Pty Ltd v Gordon & Gotch Ltd (1985) 315.
SARS supra n 7 at 77.

Analysis of the application of section 24BA of the Income Tax Act   39

2 2  Asset acquired in exchange for the shares issued
The issue of shares by the debtor must be in respect of acquiring an  ‘asset’ as defined in the Eight Schedule.20 The term ‘asset’ as part of the building blocks of capital gains tax should be interpreted widely.21 A
specific method of debt capitalisation should thus result in the debtor company acquiring an ‘asset’ during debt capitalisation for the second requirement to be met. The main terms in the definition of ‘asset’ in paragraph 1 of the Eighth Schedule are ‘property’ and ‘a right’ to such property. SARS describes ‘property’ as anything that can be disposed   of
and turned into money.22 ‘A right’ would include both personal rights and real rights. A real right is a badge of ownership and is enforceable against all persons, whereas a personal right is enforceable against a
specific person.23 The nature of a debt capitalisation transaction, being between a debtor and a creditor in respect of a debt owed between them  is   therefore   submitted   as   a   bundle   of   personal   rights enforceable
between the parties concerned and  not  enforceable  against  other persons. In debt capitalisation the second requirement for section 24BA  to apply would be met only if the debtor receives ‘property’ or ‘a right’   to property that can be enforced against the creditor. This specific aspect is considered in greater detail in section 3 to section 5    below.
2 3 The value of the shares issued and the value of the asset acquired differs
The final requirement for section 24BA to apply is that the ‘consideration’ received by the debtor should be different from the consideration that it would have received if the asset was acquired in exchange for the issue   of shares under a transaction between independent persons dealing at arm’s length. This requirement for section 24BA is therefore a value-for- value consideration and requires an analysis of a number of key concepts relating to value. When dealing with the issue of shares in reduction of debt,  SARS  recognises  the  distinction  between  the  ‘market  value   of
shares’, the ‘subscription price of shares’ and the ‘face value of   debt’.24
2 3 1   The ‘market value of shares’
The ‘market value of shares’ is a complicated matter as a result of valuation which can be controversial and subjective.25  Kumleben JA    in

Section 24BA(1)
Olivier “Determining a taxable capital gain or an assessed capital loss: some problems” 2007 Meditari 36.
SARS supra n 7 at 39.
SARS supra n 7 at 532.
SARS supra n 7 at 140.
PricewaterhouseCoopers Valuation & Economics (2017) 1 available from https://www.pwc.co.za/en/services/deals/valuation-and-economics.html (accessed 16-05-2017).

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Sarembock v Medical Leasing Services (Pty) Ltd26 1991 1 SA 344 (A) indicated that as a general rule, the value of an article is to be determined
with reference to the price such article would fetch in the open market.27 Due to the nature of property, and an absence of transactions suitable for
comparison there may, however, be cases where the valuation is difficult. In many cases where debt capitalisation occurs, transactions are concluded between connected persons which further complicates the determination of value. The true value of related party debt, and consequently the shares to be issued, may be difficult to determine unless as part of a scheme of arrangements in terms of the  Companies
Act28 (the ‘Companies Act’), or a similar business rescue operation. A related party creditor may therefore have a significant debt claim   against
a debtor company, but the claim may be worthless in the hands of an unrelated party. This can be due to a variety of factors, including the solvency and liquidity of the debtor, its future prospects or the industry in which the debtor operates. This is substantiated by another argument that there is a contrast between the market value of debt and the book value of debt that is the result of a lack of public quotes for debt and that
debt trades infrequently.29 This anomaly in determining market value in debt capitalisation could result in potential abuse. Parties may argue that the debt that is capitalised and shares subsequently issued have no
market value, since no unrelated party will be willing to purchase the debt at face value and through this manipulate the value and number of shares issued. A possible solution for this may be found in a reference to
Wessels JA in Katzenellenbogen Ltd v Mullin,30 where the judge indicates
that the phrase ‘current value’ may sometimes be more appropriate than the phrase ‘market value’.31 When there is no active market which can determine the value of shares, the current value, or book value, may be
more appropriate measure of value.
2 3 2   The ‘subscription price of shares’
The ‘subscription price of shares’ requires a distinction between the purchase  price  of  shares  and  the  subscription  price.  A     subscription
involves the issue of new shares and the proceeds of those shares go to the company that issued those shares.32 The subscription price is a crucial consideration from a Companies Act perspective, as section 40 of
the Companies Act requires adequate consideration to be received for the issue of shares. Although in most instances the subscription   price

26    1991 1 SA 344 (A).
27 Cornelius “Banda v Van der Spuy 2013 4 SA 77 (SCA) – Quantifying a claim with the actio quanti minoris” 2013 De Jure  872.
28    71 of 2008.
29 Sweeny et al. “The Market Value of Debt, Market versus Book Value of Debt, and Returns to Assets” 1998 The CFA Digest 53.
30    (1977) 4 All SA 818  (A).
Cornelius supra n 25 at 873.
Parker SARS ruling on a share subscription transaction followed by a share (2016) 1 available from https://www.ensafrica.com/news (accessed 21-05- 2017).

Analysis of the application of section 24BA of the Income Tax Act   41

would be equal to the face value of the debt (the face value of the debt being the quid pro quo for the issue of shares) the subscription price is of less importance from a debt reduction taxation point of view. In support of  this,  SARS  has  used  examples  where,  despite  the  value  of the
subscription price, a ‘reduction amount’ is determined with reference to the market value of the shares and the face value of the debt.33 The subscription  price  for  the  shares  however  remains  relevant    when
determining the potential application of section 24BA, since the ‘asset’ that the debtor acquires during debt capitalisation, is the right to enforce payment of the subscription price against the    creditor.
2 3 3    The ‘face value of debt’
In addition to the values relating to shares the ‘face value of debt’ is the last distinct value in a debt capitalisation transaction. Apart from excluding a tax debt, the Act does not provide a definition or any further guidance on the meaning of ‘debt’ or the ‘face value’ of debt. National Treasury defines ‘debt’ to be a sum owed by one party (the debtor) to
another party (the creditor).34 Despite the fact that debt has a market value when traded no indication in the Act that the tax consequences of debt should be determined with reference to the market value of   such
debt. Paragraph 38 of the Eighth Schedule merely deems a market value for an asset for purposes of calculating a potential capital gain and as result does not alter the value of the underlying debt between the debtor nor deem a market value to such debt. It could also be argued that the provisions of paragraph 38 would not apply where an asset is received in
exchange  for  shares.35  The  market  value  of  debt  is  therefore  not
submitted as the ‘face value of debt’. Since the term ‘face value of debt’ is not defined and its ordinary grammatical meaning should be ascribed thereto as the context does not indicate otherwise, the face value of debt should only mean the amount that is due by the debtor to the creditor.  This amount should form the base value for determining the tax consequences  of  debt capitalisation.
Having established the scope and the three requirements for section 24BA to apply, each of the three methods of debt capitalisation can be separately analysed for issues relevant to the particular method of debt capitalisation.

SARS supra n 7 at 140. Section 19 and paragraph 12A of the Eighth Schedule has subsequent to the version of the guide referenced been amended and now refers to the term ‘debt benefit’ instead of ‘reduction amount’. A comparison between the market value of the shares and the face value of the debt, however, remains relevant for the new definition of ‘debt benefit’ depending on the type of ‘concession or compromise’ in respect of that debt.
National Treasury Explanatory Memorandum on the Taxation Laws Amendment Bill (2012) 31.
Paragraph 38(2)(e) read with section 24BA(4)(b).

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3  Direct settlement
In debt capitalisation by means of direct settlement the debtor company is released from an obligation to pay the debt to the creditor. The creditor accepts, as quid pro quo for the debtor’s release from the obligation to perform, shares in the debtor. Debt capitalisation through direct settlement therefore involves only one transaction step, namely the issue of shares by the debtor in exchange for the release from an obligation to pay the debt. The issuing of shares would result in meeting the first requirement for section 24BA to apply.
The second requirement for section 24BA to apply is that an ‘asset’ should be acquired in exchange for shares issued. Given a strict interpretation of the phrases ‘property’ and ‘a right’ to property as part of the definition of ‘asset’, a release from an obligation to pay would not resort under the definition of ‘asset’ as the debtor does not acquire a right enforceable against another party but is rather released from an obligation towards the creditor. An  ‘asset’ has  also  been argued    as
synonymous with the word ‘property’ as interpreted in the Constitution.36 The property concept should as result be interpreted wider than in private law, but should be restricted to rights that are
vested in the claimant and have patrimonial value.37 From these conclusions ‘property’ and accordingly an ‘asset’ should be something that the holder thereof can control and exercise use over. During   debt
capitalisation, when the creditor relieves the debtor from its obligation to pay the debt the creditor elects to no longer exercise a claim against the debtor. In direct settlement as method of debt capitalisation the debtor does not acquire any rights exercisable against the creditor. The debtor merely issued shares as consideration for the settlement of debt and does not acquire an ‘asset’ which results in the second requirement for section 24BA not being met.
Section 24BA would therefore not apply in respect of debt capitalisation through direct issue of shares, however, the debt reduction provisions contained in the Act could still address value shifting. In terms of the debt reduction provisions, in terms of the amended section 19 and paragraph 12A, any difference between the market value of debt and the face  value  of  debt  will  constitute  a  ‘debt  benefit’  that  may  result in
adverse tax consequences for the debtor company due to the value mismatch.38

Olivier supra n 22 at 37.
Van Der Walt Constitutional property clauses: a comparative analysis (1999) 53.
Paragraph (b)(i) of the definition of ‘concession or compromise’ in section 19(1) and paragraph 12A(1) of the Eighth Schedule, read with paragraph (a)(i) of the definition of ‘debt benefit’ in section 19(1) and  paragraph 12A(1) of the Eighth Schedule.

Analysis of the application of section 24BA of the Income Tax Act   43

4  Set-off
Set-off is recognised as a method in which obligations can be settled or terminated without requiring the exchange of performances.39 Set-off would occur where two parties are mutually indebted to each other and
extinguishes obligations as effectively as if discharged by performance.40 The appellant in Ackermans v CSARS41 further contended that there   is
nothing sinister about a contractual arrangement pertaining to set-off and that set-off occurs in overabundance in commercial life. However, set-off has been submitted as one of the most complex areas in the South
African law of obligations42 and SARS notes that set-off may only be applicable in certain circumstances.43 Although SARS does not elaborate
on the specific circumstances, it is submitted that set-off will only be applicable if the legal requirements are met. Based on these legal requirements, considered in section 4 1, the application of section 24BA in the context of set-off is investigated in section 4 2.
4 1  Legal requirements for set-off to occur
The four requirements for set-off to occur are:44 (i) that both debts must be of the same nature, (ii) both debts be liquidated, (iii) both debt be due and payable and (iv) both debts must be payable by the debtor and the creditor in the same capacity and not to (or by) a third party.
For both debts to be of the same nature requires that the debts must be of the same kind for set-off to occur.45 Debts of the same nature
implies that the debts must be for the delivery of identical kinds of subject matter such as two monetary debts.46 The debts however do need to be of the same value as debt can also be partially extinguished.47
Both claims will be regarded as liquidated if for an amount of money which is agreed upon and capable of prompt ascertainment (or ascertainment  is  a  mere  matter  of  calculation).48  The  existence  of   a
liquidated claim can be ascertained without challenge in a timely manner. For both debts to be due and payable such claims should be enforceable   and   consequently   debts   subject   to   time   clauses or
suspensive  conditions  cannot  be  set-off.49  In  the  context  of   debt

Thomas et al. Historiese Grondslae  van  die  Suid-Afrikaanse  Privaatreg  1  (2000) 234-236; Van Deventer Set-off in South African Law: Challenges and Opportunities (LLM dissertation 2016 SU) 1.
Van Deventer supra n 34 at 1.
Ackermans v CSARS (2010) (1) SA (SCA) 73.
De Kock Die uitreik van aandele ten einde verpligtinge na te kom – onkoste werklik aangegaan vir inkomstebelastingdoeleindes of nie (MAcc dissertation 2012 SU) 54.
SARS supra n 7 at 140.
Van Deventer supra n 34 at 37.
De Kock supra n 7 at 55.
Havenga et al General Principles of Commercial Law (2009) 145.
Ibid.
Tredoux v Kellerman (A 459/08) (2009) ZAWCHC 227 8.
Van Deventer supra n 34 at 38.

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capitalisation debt not yet due can also by agreement be  subjected to  debt  capitalisation  as  a  contractual  liability  arises  where  there  is     a
meeting of the minds and quasi-mutual assent50 and parties can change the payment terms of debts.51
The final requirement for set-off to occur is that debts must be payable by the debtor and the creditor in the same capacity and not to (or by) a third party. This is a common law requirement, known as the ‘mutuality requirement’, which means that a creditor cannot rely on set-off in a
representative capacity but that the debt must be reciprocal between the debtor and creditor.52 Furthermore, for debt capitalisation through set- off to occur regard must be given to the nature of the pre-existing debt
as an asset in the hands of the creditor. If the creditor has ceded the debt such debt will not be suitable for set-off as the cessionary succeeds the creditor.53 When a debt has been ceded, the debtor and the creditor no
longer owe the respective debts to each other in the same capacity and the subscription loan cannot be set-off against the pre-existing debt. In the absence of any encumbrances on the debt, there is however nothing that prohibits set-off for capitalisation to occur.
Based on the legal requirements for set-off to occur two parties should be indebted to each other which implies that two debts are required. A single obligation cannot be set-off against an obligation that does not  exist and set-off in debt capitalisation would consequently require a second debt obligation to be established. Prior to a debt capitalisation transaction being executed only one debt exists, being the pre-existing debt that the debtor company owes to the creditor. Any pre-existing shareholding of the creditor in the debtor company would not represent
an enforceable obligation that can be set-off against debt due to the different nature of debt and shares.54 In order to meet the requirement for  set-off  to  occur  a  second  obligation,  a  subscription  loan,     is
established. Accordingly the creditor subscribes for shares in the debtor and the subscription price is not settled in cash but rather left outstanding as a subscription loan. The subscription loan is an enforceable right which the debtor then has against the creditor and which serves as the second obligation for set-off to occur. The application of section 24BA in this context is considered in the section which follows.
4 2   Consideration of section 24BA in context of set-off
The first requirement which has to be met is that a company should issue shares as consideration. In order to create the second obligation required to perform debt capitalisation through set-off the debtor company issues

K2012150042 (South Africa) (Pty) Ltd v Zitonix (Pty) Ltd (2017) 2 All SA 232 (WCC)) 18.
Tredoux v Kellerman (A 459/08) (2009) ZAWCHC 227 8.
Ngakane & Fletcher To set-off or not to set-off? CDH Dispute Resolution Alert (2017) 4.
Van Deventer supra n 34 at 36.
CIR v Datakor Engineering supra n 6 at 9.

Analysis of the application of section 24BA of the Income Tax Act   45

shares as consideration for acquiring the subscription loan. The shares issued would satisfy the section 24BA requirement during the first transaction step required for debt capitalisation through   set-off.
The second requirement of section 24BA is that an ‘asset’ should be acquired in exchange for shares issued. When a creditor subscribes for shares on loan account, the debtor company acquires an ‘asset’ in   the
form of the loan which represents an enforceable right against the  creditor company to claim payment of the subscription price.55 Accordingly,  section  24BA  could  be  applied  if  there  is  a   mismatch
between the value of the shares issued and the value of the subscription loan. In this determination the value at which the subscription loan is recognised is a relevant consideration.
Section 40 of the Companies Act determines that a company must receive ‘adequate’ consideration when shares are issued. SARS indicates
that ‘adequate’ consideration does not mean that the subscription price will be equal to the market value of the shares.56 This view is supported and advanced by an argument that even shares issued at a discount could
amount to ‘adequate’ consideration in terms of the Companies Act.57 Since the Companies Act does not require consideration to be   market
related a debtor company can issue shares at a premium or discount to the market value of such shares. Shares issued at a discount, or a premium, based on the market value would necessitate consideration of section 24BA.
In terms of section 24BA(3)(a)(i) a capital gain will result for the debtor company if, immediately after the issue of the shares, those shares have   a market value which is less than the subscription loan (notwithstanding the fact that the issue of shares is not a disposal in terms of paragraph 11(2)(b)). The debtor company could potentially also suffer a second capital gain when set-off occurs if the value of the subscription loan differs from the value of the pre-existing debt intended to be capitalised. When the subscription loan is set-off against the pre-existing debt, the extinction of the subscription loan will result in a disposal of the asset in terms of paragraph 11. Section 40CA(a) deems the base cost of the subscription loan that is disposed of to be equal to the market value of   the shares issued. The debtor company will therefore dispose of an   asset
(the subscription loan) of which the base cost is lower than the proceeds (face value) of the debt discharged58 The creditor who receives the shares
must reduce cost actually incurred for those shares with the excess by which the face value of the debt exceeds the market value of the shares. Where the creditor holds the shares as capital assets the base cost should be reduced, whereas for shares held as trading stock the amount  taken

SARS supra n 7 at 333.
SARS supra n 5 at 11.
Brincker “The Tax Consequences of Sweat Equity” (2011) CDH Tax Alert.
Paragraph 35(1)(a) to the Eighth Schedule to the Act.

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into account in respect of those shares in terms of section 11(a) or 22(1) or 22(2) should be reduced.59
In the event that the market value of the shares exceed the face value
of the subscription loan, the excess will be deemed to be a dividend in specie paid by the debtor company.60 Section 40CA in this case vests the base cost for the subscription loan which will result in a capital loss when
set-off takes place (due to the base cost being higher than the face value of the debt). This benefit is however offset by the debtor having been deemed to distribute an asset in specie,61 but only to the extent that no
exemption or reduction in the rate of tax applicable to dividends in specie
in terms of section 64FA applies. Section 24BA does not regulate the base cost of the shares acquired by the creditor where the market value of the
shares issued is higher than the face value of the debt62  and  under  normal principles, the creditor will be deemed to acquire the shares at
the lower face value of the  debt.
From the analysis above, section 24BA is submitted as a relevant consideration when debt capitalisation is done through set-off. If established that none of the exclusions to the section are relevant, both the debtor and creditor should consider the tax consequences of section 24BA, as both shares issued at a premium or discount to the value of the subscription loan has tax consequences.

5  Conversion
Apart from direct settlement and set-off debt capitalisation could also occur by means of conversion. Conversion is recognised in  the Companies Act, which makes provision for the conversion of debt instruments into shares of a company in Part D of Chapter 2. In terms of section 43(1)(a) of the Companies Act a ‘debt instrument’ includes securities other than the shares of a company. Section 1 of  the  Companies Act defines ‘securities’ as any shares, debentures or other instruments issued by a company. ‘Convertible securities’ are in turn defined in section 1 of the Companies Act as any securities of a company that  may  be  converted  into  other  securities  based  on  the  terms   that
attach to those securities. Such convertible instruments would include convertible debentures63 and contingent convertible capital instruments.64  In  the  context  of  hybrid  debt  instruments,  National
Treasury indicates that a key feature of debt is the ability by the holder of the debt to redeem the capital within a reasonable time65. Debt which

Section 24BA(3)(a)(ii) of the Act.
Section 24BA(3)(b) of the Act.
SARS supra n 7 at 334.
Ibid.
SARS Interpretation Note 43: Circumstances in which certain amounts received or accrued from the disposal of shares are deemed to be of a capital nature (2017) 7.
Liebenberg et al. “Pricing contingent convertible bonds in African Banks” 2016 SAJEMS 369.

Analysis of the application of section 24BA of the Income Tax Act   47

does not allow for redemption within a reasonable time would be akin to equity. The period for capital redemption or conversion of convertible debt instruments is regulated through agreement and the terms of discharging the obligation are fixed before the debt instrument is issued. In relation to a ‘debt instrument’, the Companies Act defines a ‘security document’ as a document that embodies the terms and conditions of the
debt instrument, although a ‘security document’ is not a prerequisite for the issue of debt instruments66 and could also occur in a private context. In the case of debentures the redemption or conversion is regulated by
an indenture document67 and bonds are regulated by a convertible bond listing.
The discharge of a debtor’s obligation in terms of a debt instrument  can be achieved either through the conversion of the debt instrument to shares or through the redemption thereof in cash. Section 8F(1) of the Act defines ‘redeem’ as the discharge of all liability to pay an amount in  terms of the instrument and also acknowledges that taxpayers can ‘convert’ or ‘exchange’ debt instruments for shares. Section 24J contains a similar definition for ‘redemption’ of an instrument, being  the  discharge of all liability to pay an amount in terms of the instrument. SARS indicates that ‘conversion’ involves a substantive change in the
rights that attach to assets.68
In the case of redemption in cash the debtor would not issue shares in exchange for the release from the obligation and no debt capitalisation accordingly takes place. The fact that no shares are issued by the debtor would result in the first requirement for section 24BA not being met. Indirectly debt capitalisation  would then only occur in cash redemption   if the creditor applies the cash proceeds to subsequently subscribes for shares in the debtor at their own   discretion.
In the case of conversion of debt instruments the debtor would issue shares in terms of the provisions of the convertible instrument resulting   in the first requirement of section 24BA being met. When considering the second requirement, namely if an ‘asset’ has been acquired  by  the  debtor, the contractually regulated provisions of the security document would be decisive. The security document would stipulate the performance required of the debtor and the creditor respectively and the resulting rights and obligations flow as result of conversion. The proposition is that in conversion the debtor and the creditor in essence intend  to  release  a  debt  obligation  through  the  issue  of  shares.   The

National Treasury Explanatory Memorandum on the Taxation Laws Amendment Bill 2013 (2013) section 2.1.
Section 43(1)(a)(i) of the Companies Act defines a ‘debt instrument’ to include any securities other than the shares of a company, irrespective of whether or not issued in terms of a security document.
Johannesburg Stock Exchange Debentures (2017) 3 available from https:// www.jse.co.za/content/JSEEducationItems/Debentures.pdf	(accessed 201707-01).
SARS supra n 7 at 77.

48   2018 De Jure

debtor’s release from a debt obligation in exchange for the  issue  of shares would in principle be similar to debt capitalisation through direct issue of shares. The interpretation of the phrases ‘property’ and ‘a right’ as part of the definition of ‘asset’ in the Eighth Schedule to the Act discussed in section 3 is consequently submitted as relevant. The debtor does not acquire an enforceable right against the creditor but is rather released from an obligation to perform and as result the debtor does not acquire an ‘asset’. The second requirement for section 24BA is accordingly not met and section 24BA is submitted as not being applicable to conversion as a method of debt   capitalisation.

6  Conclusion
The increase in recent BPRs relating to debt capitalisation could be indicative of the concern of taxpayers in respect of the application of the debt reduction provisions to debt capitalisation. In respect of  the  different methods which can be employed to perform debt capitalisation due consideration of applying section 24BA is also emphasised by findings of this article.
Debt capitalisation through direct issue of shares and conversion of debt instruments to shares would not result in the application of section 24BA. For these two methods no ‘asset’ as defined in the Eighth Schedule is acquired by the debtor company when shares are issued. The debtor company would merely be released from an obligation to perform in a different manner. For debt capitalisation through set-off the debtor  would, however, acquire an ‘asset’ in the form of an enforceable subscription loan when shares are issued. In this case of set-off the interaction between the value of the subscription loan and the value of   the shares issued would be decisive in the application of section 24BA. If the   shares   are   issued   at   market   value   and   the   subscription  loan
recognised at the market value of the shares section 24BA is not applicable.69 If the shares are issued at a discount or premium to the market value of such shares the following would  apply:
Shares issued at a discount to the value of the subscription loan, section 24BA(3)(a) applies in terms of which the debtor will realise a capital gain;
Shares issued at a premium to the value of the subscription loan, section 24BA(3)(b) applies in terms of which the debtor would be deemed to distribute an asset in specie (resulting in consideration of dividends tax).
Despite the potential adverse tax consequences imposed by section 24BA would not apply if the debtor and creditor form part of the same

69 Despite section 24BA not being applicable the debtor would still have to consider capital gains tax consequences in respect of the set-off of the subscription loan against the debt being the subject of the set-off. As the debtor disposes of an asset (debt claim) at consideration of the subscription loan acquired possible capital gains tax could arise if the value of the debt claim (base cost) and the subscription loan (proceeds) differs.

Analysis of the application of section 24BA of the Income Tax Act   49

group of companies, are connected persons (and paragraph 38 applies)    or the creditor holds all the shares in the debtor after the shares  have  been issued. When set-off of the subscription loan against the pre- existing debt is done as a second transaction step in set-off, the debtor  will realise either a capital gain or capital loss, depending on the value of the pre-existing debt compared to the base cost of the subscription loan acquired  during  the first transaction step.
The article has shown that the method of debt capitalisation used by taxpayers would not only be relevant in considering the application of   the debt reduction provisions of the Act but also in considering the application of section 24BA. Having considered the impact of section 24BA in respect of set-off as a method of debt capitalisation, it is submitted that selecting set-off as a method of capitalisation requires careful consideration.