Base Erosion and Profit Shifting – Future implications for South African M&A transactions.
The Davis Commission released its first interim report on Base Erosion and Profit Shifting (‘BEPS’) on 23 December 2014. The report provides an overview of the OECD action points and their relevance in the South African context and outlines broad recommendations for legislative reform.
One of the BEPS action points which will likely have a material impact on South African M&A transactions relates to the neutralisation of the effects of so-called ‘hybrid mismatch arrangements’. Broadly speaking, the action is targeted at the use of so-called hybrid instruments and entities where, due to a ‘mismatch’ in the tax treatment followed in different jurisdictions, a tax benefit is derived. A typical example in the context of M&A transactions would be cross-border acquisition funding arrangements which result in a tax deduction of interest expenditure in the target jurisdiction, but yields exempt dividend income in the hands of the investor.
In the South African context, efforts to curb hybrid mismatch arrangements predate the global BEPS initiative. Significant milestones in this regard include the amendments to the hybrid equity (8E) and hybrid debt (8F) rules in 2003 and the series of significant changes introduced since 2011, ranging from the acquisition debt limitation rules (23K, 23N), the connected party debt limitation rules (23M), the revised hybrid debt and equity rules (8E, 8F, 8FA) and the third party backed share rules (8EA). The report echoes concerns voiced within the M&A tax community that the piecemeal approach followed by the legislature has resulted in an overly complex, disjointed set of rules which hinders legitimate commercial arrangements whilst facilitating unintended planning opportunities. One example mentioned in the report is the use of the new hybrid rules to achieve an artificial reclassification of an instrument as debt or equity, thus achieving the exact outcome which these rules were intended to prevent. The recommendations of the Davis Commission in this regard include the following:
- the simplification of the hybrid rules by favouring anti-avoidance principles which can be applied to a broad range of transactions rather than targeted avoidance rules;
- revising the existing disclosure obligations pertaining to hybrid arrangements;
- introducing a holistic approach to the deductibility of interest in terms of principles of general application, combined with a consolidation of existing interest deduction rules; and
- implementing a ‘linked’ approach where the deductibility of expenditure depends on the tax implications for the recipient of the income.
Although the proposal to simplify the existing rules and favour a principle based approach should be welcomed from a technical perspective, the practical implementation of similar initiatives in the past have had mixed results. For example, the lack of guidance from SARS and the absence of case law dealing with general principles such as the General Anti Avoidance Rules and the Transfer Pricing rules have resulted in a great deal of uncertainty whilst incentivising risk-taking behaviour among sophisticated taxpayers.
Given the ambitious nature of the aforementioned proposals, it would seem unlikely that significant amendments will be introduced during the 2015 amendment cycle in the aforementioned regard. However an overhaul of the existing rules may be forthcoming in the near future and transactors would be well advised to keep an eye on policy initiatives for purposes of ‘future proofing’ their transaction structures.