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When are subordination loans used?

In the current economic climate, it is not uncommon for companies to find themselves going through periods of varying levels of financial distress. These periods of financial distress may be short-term or may be more sustained. As a result, many companies revert to entering into subordination agreements aimed at subordinating their loans in favour of third-party borrowings. A subordination arrangement may also result from an audit of the company if its auditors require that shareholder loans be subordinated to ensure that the company’s annual financial statements not be qualified regarding whether it can continue as a going concern. Typically, a subordination agreement provides that the company will not make any payments in respect of a debt until such time as the value of the company’s assets exceed the liabilities of the company.

What needs to be taken cognisance of in these circumstances, is that any arrangement will trigger the anti-avoidance rules of section 8F of the Income Tax Act in terms of which the obligation to repay any amount owing in respect of the debt instrument (capital or interest) is conditional upon the solvency of the debtor (i.e. the market value of the issuer’s assets not being less than its liabilities). Section 8F targets, in broad outline, debt instruments that are subject to an arrangement in terms of which the payment of an amount owing in respect thereof is conditional upon the solvency of the issuer (as outlined above).

The re-classification of the interest as a result of the subordination agreement gives rise to added pressures for the company. In the first instance, the company will be treated as having paid a dividend in specie in respect of any interest incurred concerning the subordinated loan. It will, secondly, be denied a deduction in respect of the incurred interest charges.

An exclusion to the adverse consequences of section 8F, however, applies where debt that is subordinated in favour of third-party creditors will result in the company continuing to claim its interest deduction on the debt. In addition, as there will be no re-classification of the interest as dividends in specie, the company will not suffer the added burden of a dividends withholding tax.

As a condition of this relief, the subordination of the envisaged debt must be subject to a request by a registered auditor, as contemplated in the Auditing Profession Act (Act No. 26 of 2005), who has certified that the payment, by a company, of an amount owed in respect of that instrument has been or is to be deferred by reason of the market value of the assets of that company being less than the amount of the liabilities of that company. The auditor’s certification of the subordination of the debt for purposes of this exclusion should be evidenced in a separate letter.

This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your adviser for specific and detailed advice. Errors and omissions excepted (E&OE).

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