Share sale versus share buyback and subscription in South African private M&A

Anton Lockem
Shepstone & Wylie Attorneys, Durban
lockem@wylie.co.za

Chrichan de la Rey
Shepstone & Wylie Attorneys, Durban
chrichan.delaRey@wylie.co.za

Daniel Robb
Shepstone & Wylie Attorneys, Durban
daniel.robb@wylie.co.za

Bongekile Qwabe
Shepstone & Wylie Attorneys, Umlhanga

Herman de Jong
Shepstone & Wylie Attorneys, Cape Town
herman.dejong@wylie.co.za

Jenna Wilsons-Jenkins
Shepstone & Wylie Attorneys, Durban
Jenna.wilson-jenkins@wylie.co.za

Bokang Ranyabu
Shepstone & Wylie Attorneys, Umlhanga

Junior Tshikukuvhe
Shepstone & Wylie Attorneys, Umlhanga

In South African private mergers and acquisitions (M&A), a purchaser can acquire economic control of a company (the ‘target company’) either by buying existing shares from the seller or by subscribing for new shares after the target company has bought back the seller’s shares. The commercial result may look similar, but the tax result is materially different.

This article explores the position based on the involvement of a South African private company, ordinary shares, arm’s length pricing, no corporate rollover relief and no listed-share rules.

Direct sale of shares by the seller to the purchaser

For the purchaser, a direct share purchase is clean from an income tax perspective. The purchaser acquires shares and the purchase price, generally, where the shares are purchased as a capital asset, becomes part of the purchaser’s base cost for future capital gains tax (CGT) purposes. There is usually no value-added tax (VAT), because financial services are exempt supplies under Section 12(a) of the Value-Added Tax Act No 89 of 1991 (the ‘VAT Act’), read with Section 2 of the VAT Act.

The purchaser must also consider the applicability of a securities transfer tax (STT). The STT applies to transfers of listed and unlisted securities, including shares, at a rate of 0.25 per cent. For unlisted shares, the company that issued the shares is liable for STT but may recover it from the transferee.^[1] In practice, the sale of share agreement should allocate STT responsibility expressly.

For the seller, the direct sale of the shares constitutes a disposal of shares. If the shares are held as a capital asset, the seller realises a capital gain or capital loss under the Eighth Schedule to the Income Tax Act.^[2] A corporate seller’s maximum effective CGT rate is currently 21.6 per cent, being the 80 per cent inclusion rate for companies taxed at the 27 per cent corporate income tax rate. If the seller is an individual, the applicable CGT rate will be 18 per cent. If the seller is a share dealer,^[3] the proceeds may be revenue in nature. However, Section 9C of the Income Tax Act can deem amounts received on disposal of qualifying equity shares held for at least three years to be capital in nature, although shares disposed of within three years remain subject to ordinary capital/revenue principles.

For the target company, the direct sale is largely tax neutral. The target company is not disposing of an asset itself, paying a dividend or issuing shares. Its main role is administrative, by updating the securities register and, in the case of unlisted shares, dealing with STT compliance.

Share buyback followed by subscription

The alternative structure has two steps. First, the target company repurchases the seller’s shares. Secondly, and simultaneously, the purchaser subscribes for new shares in the target company. Under the Companies Act,^[4] a buyback constitutes a distribution that requires compliance with Section 46 and Section 48 of the Companies Act. Section 46 requires board authorisation and satisfaction of the solvency and liquidity test after the distribution, while Section 48 permits the board to determine that the target company will acquire its own shares if the Section 46 requirements are met.

For the purchaser, the subscription of shares is not a purchase of shares from the seller. The subscription price becomes the purchaser’s base cost in the newly issued shares (assuming that the shares are purchased as a capital asset). Because the purchaser is subscribing for new shares rather than acquiring existing shares from the seller, the transaction is more favourable from an STT perspective than a direct transfer of existing unlisted shares, as a subscription does not constitute a transfer for the purposes of the STT Act,^[5] although this would be a saving of 0.25 per cent of the purchase cost, which for most transactions would be negligible. The subscription also increases the target company’s contributed tax capital, assuming the requirements of the Income Tax Act definition are met.

For the seller, the buyback is the critical tax event. The consideration received from the target company can be split between a return of capital and a dividend. To the extent that the buyback consideration reduces the target company’s contributed tax capital (if available), it is a return of capital and is treated as proceeds on disposal of the shares for the purposes of CGT. To the extent that the consideration does not reduce the contributed tax capital, it is a dividend. That dividend is included in the gross income of the seller under paragraph (k) of the definition of gross income, but is generally exempt from normal tax under Section 10(1)(k)(i), but potentially subject to dividends withholding tax. Dividends withholding tax is a withholding tax, it is not specifically paid by the seller.

This is where the nature of the seller matters. An individual seller may be charged dividends tax at 20 per cent on the dividend component. By contrast, a South African company seller may qualify for a dividends tax exemption under Section 64F(1)(a) of the Income Tax Act, making the buyback route potentially more tax efficient than a direct sale. That efficiency is not automatic. Section 22B and paragraph 43A are anti-dividend-stripping rules dealing with extraordinary dividends on disposals of shares, and the South African Revenue Services’ (SARS) Interpretation Note 126 specifically addresses ‘extraordinary dividends treated as income or proceeds on the disposal of certain shares’^[6] under Section 22B and paragraph 43A. This would have an impact where the seller is a company. It may mitigate the efficiency of no dividends withholding tax, but this must be analysed on a per transaction basis.

For the target company, a cash buyback is not deductible. STT may also arise because STT is levied on transfers of securities, and shares are securities for this purpose. If the target company settles the buyback by distributing an asset in specie rather than cash, further company-level tax consequences may arise, including a deemed disposal at market value and possible recoupments or trading stock inclusions. Where the seller is a non-resident, one must consider the relevant double taxation agreement for the applicable dividend withholding tax percentage.

Comparative conclusion

A direct sale is conceptually simpler than a share buyback. The purchaser pays the seller, the seller accounts for CGT or income tax, the target company updates its register and STT is dealt with. It is often preferred where certainty, simplicity and clean risk allocation matter.

A buyback and subscription can be more tax efficient where the seller is a South African company and the buyback consideration is substantially dividend funded, but it carries greater technical risk. The split between contributed tax capital and dividend must be properly resolved and documented, dividends tax declarations must be obtained, STT must be considered and paragraph 43A or Section 22B may neutralise the intended tax benefit. In private M&A, the structure should therefore be selected only after modelling the nature of the seller, holding period, base cost, contributed tax capital, dividend stripping exposure and the target company’s ability to satisfy the Companies Act solvency and liquidity requirements.