SOLDADURA DE LA GEOMETRIA TRIDIMENCIONAL COMPLEJA

The characteristics of a leveraged buyout in South Africa are similar to a leveraged buyout in most developed countries, such as the US and the UK. Typically the private equity firm or group of firms planning a leveraged buyout would form a new company to serve as a special purpose vehicle (‘SPV’) to buy the target company. The private equity firm(s) would arrange for the SPV to borrow most of the acquisition finance and provide the remainder of the acquisition finance as equity finance. The SPV would arrange the borrowed funds in tranches ranging from senior debt, senior subordinated debt and junior subordinated debt.164 _{Levin argues that in order to obtain each} successively more junior layer of debt financing the SPV must offer a progressively higher interest rate and/or a progressively larger equity interest to each more subordinated layer.165 _{A key feature} of the leveraged buyout transaction is that the private equity firm(s) and the investors in the private equity fund are not liable for the borrowed money raised to fund the buyout.166 _{It is only the SPV} and/or the target company that would be liable to the lender for the borrowed funds.167

162_{However, in the context of a private equity fund, brief reference is made in paragraph 3.1.3(e) of chapter} two to African Life Investment Corporation (Pty) Ltd v SIR (1969) 4 SA 259 (A), CIR v Nussbaum 1996 (4) SA 1156 (A), 58 SATC 283, 1996 Taxpayer 150, and ITC 1412 (1983) 48 SATC 157. The brief discussion relates to the proceeds from the realisation of the shares in the investee company which can be said to be of a capital nature resulting in the return to the investors being liable to the lower capital gains tax.

163_{The proposed buyout of Shoprite Holdings by Brait Private Equity in 2006 is a case study of two South} African companies which was subject to the South African regulatory regime. The transaction was ultimately not concluded.

164_{Levin, J.S. (2003), ‘Structuring Venture Capital, Private Equity and Entrepreneurial Transactions’, Aspen} Publishers, 2003 edition, at pages 1-9 to 1-10.

165_{Levin, J.S. (2003), ‘Structuring Venture Capital, Private Equity and Entrepreneurial Transactions’, Aspen} Publishers, 2003 edition, at pages 1-9 to 1-10.

166Pignataro, P. (2013), ‘Leveraged Buyouts: A Practical Guide to Investment Banking and Private Equity’, John Wiley and Sons Publishers, at chapter 1.

167_{Levin, J.S. (2003), ‘Structuring Venture Capital, Private Equity and Entrepreneurial Transactions’, Aspen} Publishers, 2003 edition, at pages 1-9 to 1-10.

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The private equity firm would also secure key management, either sourced from within the target company or recruited to manage the target company once the leveraged buyout is completed.168 The private equity firm usually incentivises management, for example by way of share options in the underlying portfolio investee companies. This is an important part of private equity investing and is discussed in greater detail in chapter four.169 _{The management of the target company could also be} the originator of a leveraged buyout and would approach a private equity firm to secure the equity finance for the acquisition. This is typically referred to as a management buyout and is discussed in paragraph 3.2 of this chapter.

Nevertheless, one of the key tax features of a leveraged buyout in South Africa which would have been evident of the proposed buyout of Shoprite Holdings by Brait, would have been to optimize the interest deductions for the interest resulting from the high leverage used in the transaction. In terms of the transaction, a SPV170 _{was formed which would have been funded with approximately R9,4} billion of debt borrowed from several local and international banks.171 _{The equity finance of} approximately R2,5 billion to the SPV was largely provided by Brait, but also included key management and re-investing shareholders. Approximately 79 percent of the SPV’s acquisition funding was made up of debt. The SPV was a wholly owned subsidiary of Shoprite Checkers and Shoprite Checkers in turn being a wholly owned operating subsidiary of Shoprite Holdings.172 Thereafter, Shoprite Checkers would dispose of its business to the SPV in exchange for approximately R11,9 billion in debentures in the SPV and R700 million in equity in the SPV. The South African Revenue Service (‘SARS’) was critical of the proposed leveraged buyout because of the high gearing created by the transaction.173 _{SARS was of the view that the substantial interest} deductions would lead to a loss of revenue by the State. The introduction of debt into the SPV would have resulted in significant interest charges to the target company. The criticisms by SARS were extensively covered by the local press:

‘SA Revenue Service (Sars) Commissioner Pravin Gordhan accuses the dealmakers of ‘robbing not only the fiscus of tax revenue, but all South Africans’ … attacking transactions which ‘show complete and reckless disregard for tax morality’. Although he didn’t give names, those in the

168_{Levin, J.S. (2003), ‘Structuring Venture Capital, Private Equity and Entrepreneurial Transactions’, Aspen} Publishers, 2003 edition, at pages 1-9 to 1-10.

169_{Paragraph 2.2 of chapter four discusses the taxation of share options in investee companies.} 170_{The SPV was referred to as New Opco in the proposed Shoprite buyout.}

171_{For more detailed outline of the transaction, see Shoprite Holdings Limited Cautionary Announcement} (2006), ‘Internal re-organisation of Shoprite, in specie distribution, delisting, liquidation and further cautionary announcement’, Available at www.rhp.co.za/sites/default/files/xSHOPRITE.pdf, accessed in April 2015. 172_{For more detailed outline of the transaction, see Shoprite Holdings Limited Cautionary Announcement} (2006), ‘Internal re-organisation of Shoprite, in specie distribution, delisting, liquidation and further cautionary announcement’.

173_{Hogg, A. (2007), ‘Taxman adds pressure to block Shoprite delisting’, Moneyweb article, 15}th _{January 2007,} Available at www.moneyweb.co.za/archive/taxman-adds-pressure-to-block-shoprite-delisting/, accessed in April 2015.

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know believe Gordhan was referring to the proposed Shoprite transaction. Advisers Brait have put together a complex structure designed primarily to avoid having to pay tax of R1,4bn on the transaction …’174

The deductibility of this interest expenditure against the income of the target company would typically be determined in terms of the general deductions contained in section 11(a) of the Income Tax Act 58 of 1962. To determine the tax liability of a taxpayer, it is required to establish the ‘taxable income’, which is the amount remaining after deducting all allowable deduction and allowances from the income of a taxpayer.175 _{Section 11(a) reads:}

‘11. General deductions allowed in determination of taxable income.—For the purpose of determining the taxable income derived by any person from carrying on any trade, there shall be allowed as deductions from the income of such person so derived – (a) expenditure and losses actually incurred in the production of the income, provided such expenditure and losses are not of a capital nature.’

Consideration must be giving to section 23(g) of the Income Tax Act 58 of 1962, which prohibits the deduction of,

‘any moneys claimed as a deduction from income derived from trade, to the extent to which such moneys were not laid out or expended for the purpose of trade’.

According to De Koker et al, whether or not expenses incurred by a taxpayer can be deducted from such taxpayer’s gross income will depend on the results of an analysis of the general deduction formula, as contained in section 11(a) read with section 23(g) of the Income Tax Act 58 of 1962.176 The key requirements of the general deduction formula are:

‘a trade to be carried on; income to be derived from such trade; there be expenditure and losses; actually incurred; in the production of income; not of a capital nature’177

174_{Hogg, A. (2007), ‘Taxman adds pressure to block Shoprite delisting’, Moneyweb article, 15}th _{January 2007,} Available at www.moneyweb.co.za/archive/taxman-adds-pressure-to-block-shoprite-delisting/, accessed in April 2015.

175_{Stiglingh, M., Koekemoer, A.D., Van Zyl, L., Wilcocks, J.S. and De Swardt, R.D. (2017), ‘Silke: South African} Income Tax’, LexisNexis, Volume 1, January 2017, paragragraph 7, at pages 136-163.

176_{De Koker, A.P., Williams, R.C. and Silke, A.S. (2014), ‘Silke Tax Yearbook 2013-2014’, Butterworths} Publishers.

177_{Stiglingh, M., Koekemoer, A.D., Van Zyl, L., Wilcocks, J.S. and De Swardt, R.D. (2017), ‘Silke: South African} Income Tax’, LexisNexis, Volume 1, January 2017, paragragraph 7, at pages 136-163. For example, expenditure will only be deductible in terms of section 11(a) of the Income Tax Act 58 of 1962 if the expense results in income derived from carrying on a trade. In ITC 1476, 1989, 52 SATC 141 (T) it was held that “the carrying on of a trade involves an ‘active step’, something more than watching over existing investments that are not income-producing and are not intended or expected to be so”. In this case for a specific period, the shares and investments did not produce dividends or income and were merely investments in other companies

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All these requirements must be met for an expense or loss to be deductible.178 _{Failure to meet any} of the requirements will result in a disallowance of the expenditure for taxation purposes.179 _{In the} context of the proposed buyout of Shoprite by Brait the transaction was structured to derive a deduction for interest incurred by forming a SPV to acquire the operating assets of Shoprite Checkers. Therefore, the simplistic answer to the determination as to whether or not expenses incurred by a taxpayer can be deducted from such taxpayer’s gross, income will depend on the results of an analysis of the general deduction formula, as contained in section 11(a) read with section 23(g) of the Income Tax Act 58 of 1962. Nevertheless, section 24J of the Income Tax Act 58 of 1962 allows an interest deduction when income is derived from the carrying on of a trade and the interest was incurred in the production of income. Section 24J of the Income Tax Act 58 of 1962 has no requirement that interest must not be of a capital nature in order for the interest to be deductible.180

Section 24J of the Income Tax Act 58 of 1962 overrides the above mentioned general rule181 _as section 24J(1) includes premiums and discounts on financial instruments in the definition of interest. In addition, section 24J(3) requires all interest earned (as determined in terms of section 24J) to be included in the gross income of the lender irrespective of whether it is of a capital or revenue nature; and section 24J(2) provides that the interest amount on an instrument, determined in terms of section 24J must be deducted from the trade income of the borrower if the interest is incurred in the production of income.182 _{Section 24J(2) of the Income Tax Act 58 of 1962 reads:}

to enable the speculation in immovable property. The company failed to prove that the company was carrying on a trade.

178_{Stiglingh, M., Koekemoer, A.D., Van Zyl, L., Wilcocks, J.S. and De Swardt, R.D. (2017), ‘Silke: South African} Income Tax’, LexisNexis, Volume 1, January 2017, paragragraph 7, at pages 136-163. In ITC 770, 1953, 19 SATC 216 the judge stated at 217 that the definition of trade is “obviously intended to embrace every profitable activity and which I think should be given the widest possible interpretation.” From this case it can be deduced that “trade” involves an active step where the taxpayer is taking a chance by acquiring shares in companies. Undertaking a risk can be viewed as an act of carrying on a trade. Investing in other companies requires involvement in the investment from the taxpayer’s position. A taxpayer’s main purpose in acquiring shares is to receive maximum benefits in the form of dividends and/or capital gains on sale of the shares. In Port Elizabeth Electric Tramway Co Ltd v CIR 1936 8 SATC 13, at 247, Watermeyer AJP said: “Chance, in other words, increases the expenses, or makes additional expenses, but though chance causes them to arise they nevertheless remain expenses so closely linked to a necessary business operation that they can be regarded as part of the cost of performing such operation. In this case the potential liability is there all the time and is inseparable from the employment of drivers, that is to say, inseparable from the carrying on of the business.” 179_{Stiglingh, M., Koekemoer, A.D., Van Zyl, L., Wilcocks, J.S. and De Swardt, R.D. (2017), ‘Silke: South African} Income Tax’, LexisNexis, Volume 1, January 2017, paragragraph 7, at pages 136-163.

180_{In CIR v Shapiro 1928 NPD 436 4 SATC 29, Matthews J stated ‘the payment of interest on borrowed money} obviously not being an outgoing of a capital nature, the contention was that it was an outgoing actually incurred during the year of assessment in the production of the taxpayer’s income’.

181_{Namely, the general deduction formula, as contained in section 11(a) read with section 23(g) of the Income} Tax Act 58 of 1962.

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‘(2) Where any person is the issuer in relation to an instrument during any year of assessment, such person shall for the purposes of this Act be deemed to have incurred an amount of interest during such year of assessment, which is equal to

(a) the sum of all accrual amounts in relation to all accrual periods falling, whether in whole or in part, within such year of assessment in respect of such instrument; or

(b) an amount determined in accordance with an alternative method in relation to such year of assessment in respect of such instrument;

which must be deducted from the income of that person derived from carrying on any trade, if that amount is incurred in the production of the income;’

According to Haupt:

‘Section 24J was introduced into the Act in 1995 to address what was considered by the Revenue Service to be a serious problem concerning the timing of interest and finance charges for income tax purposes. A taxpayer could, for example, have borrowed R100 in terms of an arrangement which provided for the repayment of R160 after three years. The R60 premium payable at the end of the contract was claimed as a section 11(a) deduction on day 1 on the basis that it represented an expense actually incurred. Section 24J addressed such problems by providing a basis for the determination of the time of accrual and incurral of interest. Whether or not such amounts were taxable or deductible had to be determined under the normal gross income rules and section 11(a). An amendment in the 2004 Revenue laws Amendment Act changed this. As a result of the amendment which came into operation on 1 January 2005 the section now deals with the gross income inclusion and section 24J deduction in respect of interest.’183

According to Stiglingh et al:

‘At the time of its introduction, it was commonly accepted that s 24J merely aimed to regulate the timing of interest accruals and deductions and that it did not represent a charging section. Amounts were accordingly taxed by virtue of the fact that the constituted “gross income”, or they qualified for deduction as a result of the application of s 11(a). In other words, s 24J was directed solely at the timing of accrual or incurral of interest. Subsequent amendments altered the principles outlined above:

- Section 24J(2) now specifically provides for the deduction of interest.

183_{Haupt, P. (2012), ‘Notes on South African Income Tax’, 31}st _{edition, at pages 534-535. See also Stiglingh,} M., Koekemoer, A.D., Van Zyl, L., Wilcocks, J.S. and De Swardt, R.D. (2017), ‘Silke: South African Income Tax’, LexisNexis, Volume 1, January 2017, paragraph 23, at pages 726-774.

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- Section 24J(3) makes provision for the inclusion of amounts in gross income.

These amendments were deemed necessary by the legislature as taxpayers and the tax authorities contended that certain amounts of discount, premium and interest that were treated as interest under the provisions of s 24J were not taxable or deductible due to their capital nature.’184

Therefore section 24J of the Income Tax Act 58 of 1962 is the main section under which interest will be either deductible or included in income, as opposed to section 11(a) of the Income Tax Act 58 of 1962. For the sake of clarity, it must be reaffirmed at this point that it is not the intention of this thesis to discuss all the tax implications with regard to the deductibility of interest where borrowed funding is used, specifically all the fundamental concepts contained in section 24J of the Income Tax Act 58 of 1962.185 _{Nonetheless, the substantive provisions of section 24J of the Income Tax Act 58 of 1962}

are summarised succinctly by Stiglingh et al:

‘- where there is any form of financial arrangement - in terms of which one taxpayer (the borrower/issuer) - undertakes to another (the lender/holder)

- to pay interest

- or to pay a premium (an amount greater that the amount that the borrower received when the instrument was issued) on an instrument that premium is in addition to the face value of the capital sum or because the instrument has been acquired at a discount on face value - the following results ensue in terms of s24J:

o in the hands of the taxpayer incurring the liability, the total financing cost to him over the total period of the arrangement is deemed to have been incurred on a day-to-day basis

o in the hands of the recipient, there is an accrual of the interest on a day-to-day basis until he disposes of the instrument or until maturity of the instrument.’186

Furthermore, in calculating the interest expense incurred by issuers of financial instruments, the provisions of section 24J of the Income Tax Act 58 of 1962 apply to all ‘instruments’ as defined.187 Section 24J(1) of the Income Tax Act 58 of 1962 defines ‘instrument’ as:

184_{Stiglingh, M., Koekemoer, A.D., Van Zyl, L., Wilcocks, J.S. and De Swardt, R.D. (2017), ‘Silke: South African} Income Tax’, LexisNexis, Volume 1, January 2017, paragraph 23, at page 728.

185_{Section 24J of the Income Tax Act 58 of 1962 is detailed, complex and contain numerous fundamental} concepts and provisions. A detailed discussion of all such concepts and provisions is beyond the scope of this thesis.

186Stiglingh, M., Koekemoer, A.D., Van Zyl, L., Wilcocks, J.S. and De Swardt, R.D. (2017), ‘Silke: South African Income Tax’, LexisNexis, Volume 1, January 2017, paragraph 23, at page 734.

187_{Stiglingh, M., Koekemoer, A.D., Van Zyl, L., Wilcocks, J.S. and De Swardt, R.D. (2017), ‘Silke: South African} Income Tax’, LexisNexis, Volume 1, January 2017, paragraph 23, at page 735.

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‘…(c) any interest-bearing arrangement or debt; (d) any acquisition or disposal of any right to receive interest or the obligation to pay any interest, as the case may be, in terms of any other interest-bearing arrangement; or (e) any repurchase agreement or resale agreement ... but excluding any lease agreement (other than a sale and leaseback arrangement as contemplated in section 23G)or any policy issued by an insurer as defined in section 29A ...’

Nevertheless, to restate the abovementioned: the basis of section 24J(2) of the Income Tax Act 58 of 1962 is that the taxpayer can deduct the interest expense from income from carrying on trade,