An overreliance on debt can lead to capital structure imbalances, which may pose significant operational and financial challenges, including pressure on financial covenants. To mitigate this, acquirers often explore restructuring mechanisms such as converting debt into equity, issuing quasi-equity instruments, or refinancing existing debt. One commonly used instrument in this context is the preference share. These instruments are attractive due to their hybrid nature, offering features of both debt and equity. However, where such preference shares function more like debt, they may trigger reclassification under section 8E of the Income Tax Act, No. 58 of 1962, as amended, with significant tax consequences.

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The section 8E tax trap
Section 8E was introduced to curb tax arbitrage where instruments are structured as shares but, in substance, behave like debt. It expands the definition of an ‘equity instrument’ to include any right or interest whose value is directly or indirectly derived from a share, ensuring that returns on debt-like shares are taxed in line with their economic substance.

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Preference shares may fall within the scope of section 8E if one or more of the following criteria is met: 

 

• the preference shares are redeemable within three years (mandatory or optional);

• the preference shares carry a return of capital obligation within that period; or 

• they pay dividends linked to interest rates or fixed timelines, rather than ordinary share performance. Additionally, shares linked to restrictive financial arrangements or whose value is derived from similar instruments may also trigger section 8E.

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So, what happens if section 8E applies?

• Any dividends declared on these instruments are treated as income in the hands of the recipient, and are subject to normal income tax rates and not the 20% dividends tax normally applicable to qualifying dividends for individuals (dividends declared to a SA tax resident company are exempt). 

• The issuer does not qualify for a tax deduction on the dividend paid. 

• The recipient is not entitled to any exemptions typically available for either dividends or interest.

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The core principle behind section 8E is to align the tax treatment of preference shares with their underlying economic reality. If an instrument functions like a loan – despite being issued as a share – then its returns are taxed accordingly. This ensures a consistent and equitable tax outcome across similar financial arrangements.

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To illustrate the implications, consider the following scenario:

ABC (Pty) Ltd (ABC) issues R1m in redeemable preference shares to XYZ (Pty) Ltd (XYZ). The shares entitle XYZ to a dividend of 70% of the weighted average prime rate of 11.25%, payable quarterly. ABC may require XYZ to redeem the shares for their original subscription value within three years.

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Year 1:
4ABC pays XYZ dividends of R78,750 over the course of the year. 

Tax treatment:

• XYZ (the recipient): The R78,750 is taxed as income, not a dividend. No exemptions apply.

• ABC (the issuer): No dividends tax is due, and no deduction is available for the dividend payment.

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Closing thoughts
Tax considerations in M&A extend far beyond compliance; they are fundamental to value preservation and creation. Where preference shares form part of the funding structure, particularly in a higher interest, post-COVID 19 environment, it is essential in any transaction to evaluate whether their use would fall within the ambit of section 8E.

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Misclassification can significantly impact the post-tax return profile and, ultimately, the commercial viability of a transaction. Careful structuring, aligned with both legal form and economic substance, is key. Engaging tax specialists early in the process is not optional – it is a strategic imperative.  

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Kheswa is a Corporate Financier | PSG Capital