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Many businesses in South Africa are finding themselves faced with liquidity pressures as a result of Covid-19 and the lockdown. The inability to trade for several months has translated to significant cash flow pressures for many entities. Companies employing the vehicle of subordination agreements should, however, be mindful of the potential income tax and dividend tax implications.

In this article, we explain subordination agreements, where they are of value and discuss SARS’ position on these vehicles in the light of hybrid debt instruments. We strongly encourage that prior to implementing any subordination protocols, tax consultant services are retained for reasons discussed below.

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What is a subordination agreement?
A subordination agreement is a legal undertaking between two parties, a debtor and a creditor, to postpone debt due by the debtor to the creditor, until the condition set out in the agreement is met. The debt can be short- or long term in nature.
The value of a subordination agreement
Businesses faced with liquidity burdens enjoy an easing of the cash flow pressure with the implementation of such agreements. By essentially deferring the cash flows, the debtor is able to apply those funds to other operational commitments and debt servicing.
SARS position on subordinated debts

Subordination agreements are at risk of exhibiting characteristics of hybrid debt instruments – debt with characteristics of equity – and may as a result fall victim to the anti-avoidance provisions (of the Income Tax Act, No. 58 of 1962) that are designed to negate the effects of hybrid debt instruments.

Under the anti-avoidance provisions, interest costs of hybrid debt instruments are not deductible and constitute a dividend in specie, incurring dividends tax at 20%. Of the three types of hybrid debt instruments, one is triggered when a subordination agreement is established to defer taxpayer debt.

In certain cases, including audit certification confirming deferment is as a result of technical insolvency, the anti-avoidance provisions may not apply. It is strongly advised, however, especially in light of interventions by Government to support ailing businesses, to engage tax consultant services before assuming a subordination agreement would meet SARS scrutiny.

To talk to a MMS tax consultant for tailored advice on your subordination agreements, visit https://www.mmsgroup.co.za/tax-consultant/ or contact us on 011 672 0020 or 021 410 8709.

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