The Taxation of Company Distributions in Respect of Hybrid Instruments in South Africa: Lessons from Australia and Canada

Tax legislation traditionally distinguishes between returns on investment paid on equity and debt instruments. In the main, returns on debt instruments (interest payments) are deductible for the paying company, while distributions on equity instruments (dividends) are not. This difference in taxation can be exploited using hybrid instruments and often leads to a debt bias in investment patterns. South Africa, Australia and Canada have specific rules designed to prevent the circumvention of tax liability when company distributions are made in respect of hybrid instruments. In principle, Australia and Canada apply a more robust approach to prevent tax avoidance and also tend to include a wider range of transactions, as well as an unlimited time period in their regulation of the taxation of distributions on hybrid instruments. In addition to the anti-avoidance function, a strong incentive is created for taxpayers in Australia and Canada to invest in equity instruments as opposed to debt. This article suggests that South Africa should align certain principles in its specific rules regulating hybrid instruments with those in Australia and Canada to ensure optimal functionality of the South African tax legislation. The strengthening of domestic tax law will protect the South African tax base against base erosion and profit shifting through the use of hybrid instruments.


Introduction
Economic globalisation and the development of innovative investment instruments in modern financial markets tend to outpace the domestic legislative frameworks regulating their taxation. 1 Investors and companies attempt to minimise their tax liability through innovative tax planning and complex corporate finance structures. 2 In reaction, increasingly complex domestic tax rules are designed to support the state's need to collect higher amounts in revenue and to protect its tax base. 3 These laws are often ineffective, resulting in yet more innovative tax avoidance schemes. 4 As a result of the mismatch between the rapidly changing economy and the legislation, many opportunities arise to avoid tax liability, especially in the context of hybrids, derivatives and the many varied instruments of investment available.
Tax factors can influence the choice of investment instrument and the method of returning funds to owners. 5 In many jurisdictions, returns on equity instruments such as dividends or capital gains are not deductible at corporate level, but are taxable at both corporate and shareholder level. 6 Interest paid on debt instruments is mostly deductible (principally at corporate level) and subject to only one level of taxation. 7 The distortion created by the different tax treatment of equity distributions and debt repayments can be exploited through instruments combining elements of equity and debt. 8 A hybrid instrument enables investors to separate the fundamental economic principles of their actions from the tax consequences, causing the substance of the instrument to differ from its legal form. 9 Shareholders might, for example, be able to invest in a hybrid instrument that is called an equity instrument, but is nevertheless not exposed to the risks associated with legal restrictions on equity distributions that typically link the return on investment to the performance of the company. 10 Conversely, taxpayers could structure a "debt instrument" to receive returns linked to the performance of a company in a manner typical of equity investments. Further tax problems associated with hybrid instruments include inconsistency in treatment, the different treatment of gains and losses, and the deduction of payments without an inclusion on the counter side. 11 When a company distributes a return on a hybrid instrument the tax consequences can be difficult to determine, given that tax legislation is mostly designed to tax debt and equity returns separately. Countries thus frequently enact specific anti-avoidance rules such as thin capitalisation 12 provisions, rules limiting the deductibility of interest payments, detailed classification rules, or provisions that re-classify the distributions made on such instruments. 13 The South African Income Tax Act 58 of 1962 (hereafter the ITA), in the main, re-classifies the distributions in the hands of the recipient without altering the nature of the payment for other parties. 14 The Davis Tax Committee did not address the taxation of distributions in respect of hybrid instruments but stated that an incentive to receive dividends is  Shaviro 2008 Financial Crisis 17-18;Messere Tax Policy in OECD Countries 332-333. 12 The term "thin capitalisation" refers to the corporate funding of a business being more debt-based than equity-based. See Oguttu 2011 SAYIL 79. 13 Sections 31 and 24J of the Income Tax Act 58 of 1962 (the ITA); Oguttu 2011 SAYIL 80. 14 Sections 8E, 8EA, 8F and 8FA of the ITA.
LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 4 present for taxpayers that are subject to a marginal tax rate above 42,4% (the combined effective corporate and dividend tax rate). 15 This article analyses the taxation of company distributions on hybrid instruments in South Africa from a functional perspective. It considers the application of these rules in comparison with similar provisions in Australia and Canada to determine whether the principles applied in these jurisdictions could be adjusted for South Africa in order to protect the tax base and curb tax avoidance whilst adhering to the principles of fair taxation and stimulating equity investment. Australia and Canada, as representative of two corporate tax structures different from the South African system, have been selected because they are known for their robust approaches to tax avoidance and for incentivising equity investment. Although the Australian and Canadian corporate tax structures differ from that of South Africa, the rules on hybrid instruments have a similar aim as the expressed intention of the Minister of Finance in South Africa, namely to reduce the debt bias 16 in investment patterns, which is considered undesirable. 17 We consider Australia and Canada first.

The corporate tax structure in respect of company distributions
The Australian corporate tax system alleviates economic double taxation on equity instruments by integrating corporate and shareholder-level tax in a full dividend imputation system and granting relief from double taxation at shareholder level. 18 When a shareholder receives a dividend, the income 15 Davis Tax Committee 2018 https://www.taxcom.org.za/docs/20180411% 20Final%20DTC%20CIT%20Report%20-%20to%20Minister.pdf 10-11. 16 The phrase "debt bias" refers to the preference of investors to invest in debt instruments (such as debentures, loans, and hybrid instruments) as opposed to equity instruments (such as shares LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 5 that the company is distributing, as well as the tax already paid by the company on that income, is attributed to the shareholder. The shareholder receives a "franked dividend", which consists of the dividend plus a notional amount representing the value of the corporate tax that was paid by the company. 19 This adding of a notional amount to the assessable income of the shareholder as recipient is referred to as the gross-up mechanism. 20 This increased amount is offset by "franking credits" also transferred to the recipient shareholders. 21 The value of these franking credits, that essentially represent the tax already paid at corporate level, may be set off against the recipient shareholder's remaining tax liability. 22 As a result it reduces the tax liability of the shareholder and eliminates economic double taxation. 23 Returns on debt instruments do not qualify for the benefits of the imputation system. Australia thus incentivises investment in equity instruments.

The classification of investment instruments as either debt, equity or hybrid
Australia applies a specific test to classify hybrid instruments as either debt or equity. 24 It also addresses the use of hybrid instruments in combination with other instruments. 25

The distinction between debt and equity interests in tax law
The legislation emphasises the economic substance of debt or equity interests and not their apparent legal form. 26 It considers elements in a wider arrangement (for example, stapled interests 27 ) as a whole to determine the true economic character of the instruments or transactions, referred to as a blanket approach or integration rule. 28  LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 6 instruments are classified as either equity or debt without any apportionment between debt and equity elements. 29 Two tests determine whether an interest is classified as debt or equity, namely the debt test and the equity test. 30 The distinction is based on whether investment returns depend on the performance of an entity. 31 An interest is classified as a debt interest if the return does not depend on the company's economic performance, the making of a distribution, or on any other event, situation, or condition. 32 The debt test requires a reciprocal obligation (that the entity receive a benefit and provide a benefit in return) that is non-contingent. 33 The test captures the very essence of debt and is based on simple terminology promoting certainty. To satisfy the debt test, an asset must be provided to finance the entity, which is liquid or a monetary asset, or a sum of money  LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 7 As it remains possible for taxpayers to develop hybrid instruments that are neither non-contingent (debt) nor listed as equity in tax legislation, rules were developed to classify instruments as either non-equity shares or nonshare equity interests. Specific rules impose tax liability based on the dominant features of the hybrid instrument.
Equity interests other than shares are classified as non-share equity interests. 40 Returns on these are treated as non-share dividends and included in the holder's assessable income. 41 They are frankable, thus a notional gross-up amount is added to the shareholder's assessable income and a tax credit applied to reduce the tax payable in terms of the imputation system. 42 The dividends need not be paid from profit because a deeming rule regards them as paid out of profit for tax purposes irrespective of their source. 43 However, if a company has not made a profit, this is an unfrankable distribution and no gross-up and credit is applied. 44 This results in only the dividend being added to the assessable income of the taxpayer, and no reduction of economic double taxation. This rule effectively links the taxation to a profit requirement. This could discourage the use of hybrid instruments as an investment choice as there is no tax relief upon distribution on a non-share equity instrument, unless the company earns a profit. It thus adds an element of risk that is normally associated with equity investments to the tax rule, which is an innovative approach to the taxation of hybrid equity instruments.

Hybrid debt instruments or non-equity shares
A share is classified as a hybrid debt interest if the legal form of the investment is a share but the underlying economic substance is one of debt. 45 This is referred to as a non-equity share. 46 A distribution on a nonequity share is not frankable, 47 so there is no tax credit to reduce the recipient's tax liability. The approach is thus similar to that which applies to LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 8 hybrid equity where no profit is earned by the company. Investors are thus discouraged from using hybrid debt instruments.

The corporate tax structure in respect of company distributions
Like Australia, Canada integrates corporate and shareholder level tax in respect of certain dividends on equity shares. 48 However, this integration leads only to the partial reduction of economic double taxation in Canada. 49 The manner of integration depends on the nature of each corporation, the shareholder, and the type of distribution. Dividends are classified into certain categories depending on the nature, source, and timing of the payment of the dividend, as well as the type of shares held. 50 The rules of the integration system apply only to taxable dividends and eligible dividends as defined, 51 and different gross-up percentages and tax credits are allocated to each of these types of dividend. 52 Taxable dividends received by Canadian resident individuals are subject to the integration rules and a gross-up and credit mechanism. 53 Partial integration is achieved by including the dividend in the income of the shareholder and adding a grossup (a notional amount) to the dividend. 54 This gross-up is calculated at a percentage of the value of the cash dividend, 55 which is fixed in legislation and adjusted from time to time. 56 The percentage depends on the type of corporation making the distribution, and the classification of the dividend as a taxable dividend or an eligible dividend. 57 The tax payable is calculated on this higher amount, which exceeds the actual income of the LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 9 shareholder. 58 The shareholder may then subtract a non-refundable dividend tax credit (as determined in legislation) 59 once the normal computation of income has been made. 60 This amount is not linked to the corporate tax actually paid, but offsets the tax assumed to have been paid by the corporation, ensuring that an individual shareholder receives relief proportionate to this presumed tax. 61 A gross-up and credit are not available to resident corporate shareholders, but such shareholders are entitled to an intercorporate deduction that in the main corresponds to the amount of that dividend. 62 The discrimination between individual shareholders and corporate shareholders is partially remedied by the rules that allow tax-free dividends between corporations, which also reduce double taxation, 63 as these dividends are usually distributed further by the shareholder corporation.
A return on a debt instrument is not subject to the rules of the integration system. The Canadian tax system thus incentivises equity investment.

The classification of investment instruments as either debt, equity or hybrid
Although the integration system partially eliminates double taxation for individuals, it does not prevent the use of planning strategies involving hybrid instruments. 64 Payments in relation to hybrid instruments could lead to an interest deduction and the use of tax credits. 65 Unlike Australia, Canada has no general classification rule to distinguish between equity and debt for taxation purposes. 66 Each transaction is judged on its own facts.
Given the advantages of using equity instruments in Canada, it is not surprising that most of the specific rules for the taxation of hybrid instruments focus on hybrid equity instruments that do not involve the risks normally attached to equity investments.

Hybrid equity instruments
Distributions on equity instruments containing debt elements are subject to specific rules. Where a non-corporate shareholder receives a return on a hybrid equity instrument, there will be no credit that can be offset against the receipt as the return falls outside the integration rules which apply to taxable dividends. 67 In respect of corporate shareholders who receive dividends in relation to term preferred shares, guaranteed shares, and collateralised shares, the denial of the intercorporate deduction ensures the Canada Revenue Agency (hereafter the CRA) some protection from the abuse of the tax system. 68 In addition, the rules on taxable preferred shares (namely Part IV.I and Part VI.I tax) ensure that an appropriate amount of tax is paid on distributions on "preferred shares". 69

The denial of the intercorporate dividend deduction
A dividend received by a Canadian resident corporation is usually included in the net income of the recipient and a specific deduction is granted, subject to specific requirements. 70 In effect, dividends paid from a Canadian corporation to another Canadian corporation (as shareholder) are usually received tax-free. 71 However, specific rules exclude the intercorporate deduction based on the nature of the corporations involved, 72 the type of shares held, 73 and the nature of the underlying agreement in respect of the share. 74 These provisions prevent the avoidance of tax liability by specific types of corporation that enter into after tax financing arrangements or develop instruments exploiting the difference in the tax treatment of interest and dividends. 75 Equity instruments coupled with agreements that secure repayment of the original investment are particularly attractive to taxpayers who cannot otherwise claim interest deductions. 76 The repayment can be secured by 67 Section 82 read with s 12 (1) granting the shareholder rights to redeem, cancel or reduce share capital 77 or through less formal guarantees against risks.
The intercorporate deduction is denied mainly when dividends are paid by certain corporations on term preferred shares, 78 shares having protection or a guarantee attached to it, 79 collateralised preferred shares that allow the transfer of losses, 80 or shares that are part of a dividend rental agreement where one party carries the risk of loss while another party is entitled to the dividend. 81

The taxation of intercorporate dividends paid in respect of taxable preferred shares and short-term preferred shares
Instead of denying the intercorporate deduction, two specific types of tax (Part IV.I and Part VI.I tax) apply to dividends paid in respect of taxable preferred shares 82 and short-term preferred shares. 83 Part VI.I imposes tax on the paying corporation, irrespective of whether the recipient is an individual or corporation, whereas Part IV.I levies a tax on the recipient corporation in respect of dividends on taxable preferred shares. 84 The purpose is to prevent the transfer of losses, deductions and tax credits to corporate shareholders of taxable preferred shares in respect of which an appropriate amount of tax was not paid. 85 These taxes also prevent the use of after tax financing arrangements to obtain tax free distributions between 77 LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 12 corporations in circumstances where certain guarantees are attached to shares. 86 The combined effect of the Part VI.I and Part VI.I taxes is that the tax paid corresponds to the rate at which interest would have been taxed if the recipient corporation were taxable at a rate of 28.5 per cent. 87 This tax rate reflects the approximate combined federal and provincial tax rate. 88 This tax treatment is appropriate as the substance of the taxable preferred shares often corresponds with debt instruments.

Hybrid debt instruments
When a distribution is made by a resident corporation on a hybrid debt instrument such as an income bond or debenture in respect of interest, it is treated as a deemed dividend for tax purposesunless it is deductible for the company making the payment. 89 These deemed dividends are taxed like any other taxable dividend. 90 If the recipient is a corporation, the normal intercorporate dividend rules apply, and the dividend is deductible in terms of section 112 of the ITA 1985. 91 However, if this interest is received as part of a return on an income bond granted to provide relief to a party experiencing financial difficulty, it is not deductible by the corporation paying it. 92

The corporate tax structure in respect of company distributions
In South Africa, company and shareholder taxation is not integrated, but a hybrid dual rate system is applied. 93 The company first pays income tax on the amounts it receives, and then another layer of taxationdividend 86 Friedlander LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 13 withholding taxis levied on the beneficial owner upon the distribution of profit. 94 This could be classified as economic double taxation as the same income is taxed twice in the hands of different recipients. 95 While certain deductions and exemptions aim to reduce this double taxation, they do not prevent it completely. 96 The dividend tax rate is twenty per cent and not linked to the individual marginal tax rates. 97 For lower income-earning shareholders this rate would be higher than their marginal rate, 98 thus undermining progressivity.
The sheltering of income and the deferral of tax liability also pose challenges. National Treasury's policy is that the tax base for company distributions should be all net accretions of wealth, and not only profit. 99 In principle, the return of the amount which was originally contributed by a shareholder should not be taxable. 100 In the case of hybrid instruments, the taxation of distributions depends on the classification of the underlying investment instrument.

The classification of investment instruments as either debt, equity or hybrid
The ITA contains specific anti-avoidance provisions targeting the creative structuring of finance agreements through hybrid instruments that were introduced in 2011. 101 Sections 8E and 8F respectively define "hybrid equity instrument" and "hybrid debt instrument" and together with sections 8EA and 8FA deal with the debt versus equity distinction in a flexible manner, depending on whether each instrument or the amounts distributed on it complies with certain definitions and requirements. 102 Commercial and contractual obligations underlie the classification. 103 This classification is not binding on the investor in all circumstances, but was created to facilitate the 94 Section 64EA(a) of the ITA. Van der Zwan "Companies" 692. 95 Olivier and Honiball International Tax 6. 96 Olivier and Honiball International Tax  West and West "Debt-Equity Conundrum" 633. 103 West and West "Debt-Equity Conundrum" 640.
LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 14 application of tax legislation. 104 The specific anti-avoidance measures seldom re-classify an instrument as either debt or equity, but may re-classify the income or capital distributed in relation to such instruments for tax purposes without altering the nature of the payment for other parties. 105 This re-classification is based on objective criteria and does not expressly depend on a determination by the Commissioner, although the Commissioner might invoke the GAAR or exercise other discretions under the Tax Administration Act 28 of 2011 (hereafter the TAA), when appropriate. 106 The re-classification of the instruments or the returns usually ensures that distributions are taxable in accordance with their substance and not their form. 107 The ITA regulates hybrid equity instruments, thirdparty-backed shares, and hybrid debt instruments.

Hybrid equity instruments
A taxpayer may benefit from a distribution on a hybrid equity instrument as it cannot be classified as an amount transferred "in respect of a share" as required for dividends tax liability. 108 This distribution may escape dividend tax on this basis, or be subject to income tax only, depending on the circumstances. 109 However, the holder's right to a return may not be contingent on the company's performance or profits (as is generally the case for shares), but is based on agreement between the parties. 110 The hybrid equity rules in section 8E prevent tax avoidance when a distribution is made on an equity instrument which contains elements of debt. 111 It targets the taxation of short-term investments redeemable by the investor, as these are essentially considered to be loans. 112 The definition of hybrid equity instrument covers three alternatives. Firstly, it includes a share that is not an equity share, which places the issuer under an obligation to redeem the share within a three-year period from the date of its issue, or where the share may be so redeemed, in whole or in part, 113 104 West and West "Debt-Equity Conundrum" 640. 105 Sections 8E, 8EA, 8F and 8FA of the ITA. 106 West and West "Debt-Equity Conundrum" 640. 107 Van der Zwan "Investment" 558. De Koker and Williams Silke on SA Income Tax para 9.1; Clegg and Stretch Income Tax para 12.14; Van der Zwan "Investment" 558-559. 112 Seligson 2011 BTCLQ 1. 113 Section 8(1)(a)(i) of the Taxation Laws Amendment Act 34 of 2019 amended the phrase "in whole or in part" and replaced it with the distribution of a return of capital or foreign return of capital, which can also be done in whole or in part. This broadens at the option of the holder. 114 Secondly, it includes shares, redeemable within three years 115 that either do not rank equally with equity shares or any dividend which is determined with reference to the time value of money. 116 The third alternative includes preference shares 117 secured by a financial instrument 118 or linked to a financial arrangement which prohibits the disposal of the share if it is not issued for a "qualifying purpose". 119 Preference shares issued for a qualifying purpose are not classified as hybrid equity instruments. 120 An amendment to extend the three-year period in paragraph (a) of the definition to ten years was contained in the Draft Taxation Laws Amendment Bill, 2011 but not included in the final legislation. 121 The definition of "date of issue" was amended to include redemption at a date in the future. 122 The definition in paragraph (c) addresses this timing rule by extending its application to any preference share irrespective of the three-year redemption period. 123 In this part redemption is not mentioned. One could argue that the date of issue becomes irrelevant as any redeemable preference share could still be classified as a hybrid equity instrument in terms of paragraph (c) of the definition. Paragraph (c), however, is limited to preference shares secured by a financial instrument. This instrument is specifically defined as an interest-bearing arrangement, or an arrangement which applies a specified rate of interest or the time value of money. 124 Other forms of security will not suffice. If the share is secured by an interest-free arrangement, it does not fall within paragraph (c), 125 and the three-year the scope of this definition to include the redemption of shares and returns of capital. Consequential amendments were also promulgated in s 8 of this Amendment Act to include arrangements that provide for the exercise of an option which requires a distribution of a return on capital, or foreign return of capital, in the definition of a hybrid equity instrument. 114 Section 8E(1) of the ITA, defining "hybrid equity instrument" para (a); Kruger et al.  Section 8E(1) of the ITA, defining "hybrid equity instrument" para (b)(i) (aa)-(cc). 116 Section 8E(1) of the ITA, defining "hybrid equity instrument" para (b). 117 Section 8E(1) of the ITA defining " preference share". 118 A "financial instrument" is defined in s 8E(1) of the ITA. 119 Section 8E(1) of the ITA, defining " hybrid equity instrument" para (c). S 8E(1) defines "qualifying purpose" by simply referring to the definition in section 8EA(1) of the ITA. LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 16 limitation in paragraph (a) will still apply as the subsections are disjunctive. 126 A dividend declared on a hybrid equity instrument is deemed to be income accruing to the recipient. 127 No exemptions from income tax are allowed as the amount already constitutes income as defined. 128 Because it is reclassified as income, amounts may be deducted from it as part of the normal computation of taxable income. No adjustment or re-classification is allowed in respect of this distribution in the hands of the company. 129 The company is treated as if a dividend has been paid, yet no dividend tax consequences arise from this transaction. 130 The tax treatment of hybrid equity is thus similar to the tax treatment of debt, which makes sense. Save for the amendment of the time limit, we find it appropriate that distributions received in respect of hybrid equity instruments be taxed as income.

Third-party-backed shares and instruments
In essence, a third-party-backed share is a preference share in respect of which the return or yield is guaranteed by another party. 131 A specific antiavoidance rule ensures that the substance of the transaction is taxable. 132 This rule targets special-purpose vehicles using artificial financial arrangements. 133 It prevents the receipt of a tax-free dividend where a lender receives a return from the borrower, instead of interest. 134 The definition of a preference share does not include all equity shares, but only those which specifically determine the dividend payable at a specified interest rate, or with reference to the time value of money. 135 126 See ss 8E(1)(b) and (c) of the ITA, defining "hybrid equity instrument", that are separated by the conjunction "or". Section 8EA(1) of the ITA applies where a specific dividend or foreign dividend, return of capital, or foreign return of capital is guaranteed, or a return of capital is guaranteed in respect of a preference share by a third party who is not the party that issues the shares. 133 De Koker and Williams Silke on SA Income Tax para 9.32. 134 De Koker and Williams Silke on SA Income Tax para 9.32. 135 Section 8EA(1) of the ITA.
LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24)   17 The anti-avoidance rules in section 8EA of the Income Tax Act, 1962, apply to preference shares and equity instruments 136 in terms of which an enforcement right 137 is exercisable if a dividend or a return of capital is not received by, or does not accrue to the person entitled to it, and the holder has a right to enforce the payment of a dividend. 138 If the recipient receives an exempt dividend, or foreign dividend income in cash, on a third-partybacked share at any time during the year of assessment, it is deemed to be income of only that specific recipient and the paying company is treated as if a dividend has been paid. 139 No exemptions from income tax apply, and this distribution is not subject to the dividends tax provisions. 140 This "deemed conversion rule" applies to the income and not the instrument. 141 A so-called "safe haven" rule applies if the consideration paid is used to acquire equity shares in an operating company. 142 This exception allows the use of debt finance to acquire preference shares. 143 If the amounts are obtained from the issuing of preference shares for certain qualifying purposes 144 and by certain persons, 145 the shares will not be classified as third-party-backed shares. 146 The definition of equity instrument still limits the application of the provisions to situations where preference shares are involved, which, in turn, are defined to include only specific types of equity share. In the 2017 Budget Speech it was announced that the exceptions to this section are too narrow 136 The value of the rights obtained under an equity instrument must be determined with reference to a preference share or an amount derived from it. See s 8EA(1) of the ITA, defining " equity instrument". 137 The term "enforcement right" is defined in s 8EA(1) of the ITA. 138 Section 8EA(1) of the ITA, defining "third-party backed share" read with s 8EA(3) of the ITA. The definition of equity instrument is wide as it refers to any instrument in respect of which an enforcement right is exercisable due to an amount not being received or not accruing to a person who is entitled to such an amount. See s 8EA(1) of the ITA, definition of "third-party backed instrument". 139 Section 8EA(1) of the ITA, defining "third-party backed share". If the instrument no longer complies with the definition in the following tax year, the transaction will not be subject to the deeming rules. See De Koker and Williams Silke on SA Income Tax paras 9.1 and 9.34; Rudnicki 2012 BTCLQ 4. 140 Section 8EA(2) of the ITA, read with s 8EA(1) of the ITA, defining "third-party backed share". 141 De Koker and Williams Silke on SA Income Tax paras 9.1,9.32. 142 Section 8EA(3) of the ITA. 143 De Koker and Williams Silke on SA Income Tax para 9.32; Van der Zwan "Investment" 563. 144 Section 8EA(1) of the ITA, defines "qualifying purpose"; Rudnicki 2013 BTCLQ 6-8. 145 In terms of s 8EA(3) of the ITA. See De Koker and Williams Silke on SA Income Tax para 9.32; Van der Zwan "Investment" 563; Rudnicki 2012 BTCLQ 5. 146 Section 8EA(3) of the ITA, read with s 8EA(1) of the ITA, defining "qualifying purpose". and may prevent legitimate transactions. 147 At the time of writing this article no amendments had yet been proposed.

Hybrid debt instruments and hybrid interest
A hybrid debt instrument is labelled as debt, but contains equity elements. 148 The specific anti-avoidance rules applicable to hybrid debt instruments entail a two-level approach. 149 First, the form and true nature (substance) of the instrument is evaluated. 150 Secondly, the return on that instrument is adjusted to be more closely aligned with the true substance of the payment. 151 This prevents the company from structuring payments that are similar to dividends to resemble tax deductible interest payments. 152 Otherwise the tax base would be eroded by a mismatch between the amounts deducted and the income inclusions or dividends. 153 A hybrid debt instrument is an interest-bearing arrangement or debt in terms of which the company owes an amount and there is an arrangement 154 to convert the instrument for shares, or the obligation to pay an amount is conditional on the market value of the assets exceeding the market value of the liabilities of the company, or the company owes an amount to a person connected to it and the company is not obliged to convert the amount. 155 The classification of an instrument as a hybrid debt instrument depends on the conversion rights or obligations exercisable under the instrument as a whole, and each tax year requires its own determination. 156 The deduction of interest incurred by a company in respect of a hybrid debt instrument is denied. 157 The instrument remains a debt instrument for all other purposes. 158 The interest is deemed to be a "dividend in specie" paid on the The classification of a hybrid debt instrument is supplemented by the classification rules on hybrid interest. 161 If an amount is classified as hybrid interest, its payment is re-classified as a "dividend in specie", irrespective of the nature of the underlying instrument. 162 Hybrid interest is defined as interest determined without reference to a specific rate of interest or the time value of money. 163 In addition, if the rate of interest of a specific instrument increases on the basis of the increase in profit of the company, 164 the interest is re-determined at the increased rate less the lowest amount of interest on the instrument during that year of assessment and the previous five years. 165 The conversion of interest into a dividend in specie applies to the issuer of the instrument who will be taxable under normal income tax provisions, but is denied an interest deduction, whereas the recipient will be treated as having received a dividend in specie. 166 The instrument as a whole is considered, the classification is made in every year of assessment and not only when the instrument is issued, and a wide criterion for classification is used. 167 The interest will not be deductible from the time it becomes indebted. 168 Although both the issuer and the holder of the instrument are affected, the tax consequences for these two parties differ significantly. De Koker and Williams state that the conversion has tax consequences applicable only to the issuer of the hybrid debt instrument. This leaves the hybrid debt instrument as a debt in legal form, while for tax purposes the substance of 159 Section 8F (2) Section 8FA the definition of "hybrid interest" and the definition of "issue".
LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 20 the transaction is classified as equity. 169 This view is relevant as the taxation of a distribution of an asset in specie differs significantly from that of interest or a cash dividend. SARS regards this interest payment as potentially subject to dividends tax. 170 Although there is no specific definition of the phrase "dividend in specie" in the ITA, this SARS interpretation is correct, as the definition of a dividend in section 64E includes "any" dividend as defined, which also includes dividends in specie. 171

Comparison of taxation of hybrid debt and hybrid equity in Australia, Canada, and South Africa
The comparative table below attempts to provide a practical illustration of the treatment of hybrid debt instruments and hybrid equity instruments in the three legal systems under consideration. It shows the effect where a distribution is made to individual (non-corporate) taxpayers resident for tax purposes in the same country as the company and taxed at marginal rates of 18% and 45% respectively. These rates represent the minimum and maximum marginal rates for South Africa 172 and are comparable with those for Australia (19% -45%). 173 Canada has both federal and provincial taxes on income and while federal rates range from 15% to 33%, the combined federal and provincial rate could be as much as 54% (Nova Scotia). 174 Given the diverging tax treatment of hybrid equity and hybrid debt at corporate tax level, the table shows the amount a company must earn in order to distribute the notional figure of 100 to the investor in each instance, although in practice return rates on debt and equity tend to differ in response to the tax consequences for the company and the investor. The calculation uses applicable corporate tax rates for companies not qualifying for special lower rates in Australia and Canada. For Canada, we assume the corporation is taxed in Ontario and thus apply the effective combined federal (15%) and provincial (11.5%) corporate tax rate. 175 Accordingly, we also apply the combined federal (15%) and Ontario (10%) imputation credit to 169 De Koker and Williams Silke on SA Income Tax  Government of Canada 2020 https://www.canada.ca/en/revenue-agency/ services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-taxreturn/deductions-credits-expenses/line-40425-federal-dividend-tax-credit.html. the grossed-up amount. 176 Although the deductibility of interest-like payments depends on detailed rules based on factors such as the purpose to which the borrowed funds is applied, we assume that such returns on hybrid equity instruments will indeed be deductible by the distributing company. Our notional calculation is an over-simplification that disregards other corporate and personal income and does not consider taxes on capital gains. In both Australia and Canada, the investment income of the recipient of the distribution forms part of the normal income tax computation and may thus be further reduced by other deductions and exemptions. 177 This is not the case in South Africa, where the dividend is mostly exempt from income tax and the withholding tax levied on dividends applies, as a final tax on the gross amount of the dividend. 178 176 Section 121(b)(iv) of the Canadian ITA 1985 provides that the credit is 6/11 of the amount added as a gross-up. This equates to 15.0198% of the total grossed-up value of the dividend, (6/11 x 38) / 138 = 15.0198%, which we rounded to 15%. LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 22 LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 23

The effect of the corporate tax structure
The corporate tax structure in both Australia and Canada creates an incentive to invest in equity as opposed to debt, as certain shareholders are able to apply a tax credit to reduce their eventual tax liability if dividends were distributed to them. The integration of shareholder and corporate level tax in these two jurisdictions nevertheless results in the taxation of dividends at the marginal tax rates of the individual shareholders (or the flat rate that applies to companies in Australia only). In South Africa, by contrast, dividends are taxed at a flat rate of 20%. The exemption for dividends under s 10(1)(k) results their exclusion from income taxed at the taxpayer's marginal tax rate. The Davis Committee is correct in its analysis that for shareholders taxed at a marginal rate in excess of the effective combined corporate and dividend rate of 42,4 per cent, there is an incentive to receive dividends. But most taxpayers are subject to lower marginal rates and are disincentivised from equity investment. Unlike in Australia and Canada, the application of the rules of the corporate tax structure in South Africa results in a compromise of progressivity, which undermines the principle of equity. South Africa would do well to consider a more equitable corporate tax structure.

The classification of hybrid instruments for tax purposes
All three of the jurisdictions analysed rely on specific rules to prevent the circumvention of the normal tax consequences of company distributions through the use of hybrid instruments. Different approaches were observed.
Australia classifies most instruments as either debt or equity, which is a commendable approach from the perspective of simplicity. The classification of a debt instrument is based on whether the payment of a return depends on the performance of the entity or is contingent in any way, while equity instruments are classified in terms of a list of characteristics contained in legislation. Classification depends on clear principles and normal legal terminology which is easier to apply than the unique terminology in the South African legislation. The Australian effort of enhancing clarity through specific classification lists for equity instruments enables legislators to better align the law with the speed at which new instruments are developed, as such lists can be changed reactively to include new transactions without changing the underlying legal principles. The specific rules regulating distributions on hybrid instruments provide added protection for the tax base.
In contrast, Canadian tax legislation requires that each transaction be judged based on the nature of the underlying agreement. It then re-classifies amounts, or applies other rules in respect of specific types of shares. If an amount is paid to an individual in respect of a hybrid debt instrument, this distribution is re-classified as a deemed dividend in relation to certain hybrid instruments. If a dividend is paid to a corporation on shares that are guaranteed, or issued with preferential terms, or that contain debt-like elements, the inter-corporate dividend deduction is denied. This discourages the use of hybrid instruments. The Canadian rules are quite varied, complex and comprehensive, leaving very little room for tax planning through distributions on hybrid instruments.
The South African ITA, like the Canadian ITA 1985, regulates the taxation of hybrid instruments without classifying the nature of the instrument as either debt or equity. In most cases the distribution is re-classified only so as to calculate the tax liability of the recipient, while the nature of the payment remains unchanged from the company's perspective.
As South African tax legislation defines hybrid instruments as either hybrid equity instruments, hybrid debt instruments, or third-party-backed shares, and applies different rules to the reclassification of distributions on them, the comparison below considers the treatment of each of these in the different jurisdictions, despite differences in terminology.

Hybrid equity instruments
The jurisdictions observed use different terminology to classify hybrid equity instruments. Australia refers to these as non-equity shares while Canada classifies them as term preferred shares, taxable preferred shares, or guaranteed shares, and South Africa uses the term hybrid equity instrument. The tax rules for distributions on these instruments also differ.
Although the general rules in Australia classify an instrument as either debt or equity, specific anti-avoidance rules apply to non-equity shares, which is the Australian equivalent of South Africa's hybrid equity instruments. A distribution made on non-equity shares is taxable as a frankable dividend if a company derived profit corresponding to the taxation of dividends on "normal" equity instruments. However, if no profit was derived, this dividend is not frankable and the rules of the imputation system will not apply to it. These rules send a clear message that the policy rationale is to link the normal risks of investing in equity instruments to the tax consequences that apply to a distribution in respect of hybrid equity instruments. This could encourage investment in equity shares where the gross-up and credit mechanism applies to all dividends, irrespective of whether or not the company actually derived profit.
In Canada, the inter-corporate dividend deduction is denied for dividends paid to corporate shareholders on term preferred shares or guaranteed shares (hybrid equity instruments). When a distribution is made to an individual or a corporation on such an instrument, the taxable preferred share rules might apply. The definition of a taxable preferred share is wide and includes the granting of conversion or redemption rights, a guarantee arrangement, or other preferences or conditions attached to these shares that are not ordinarily available to equity shares. This wider approach is commendable and an approach which South Africa could consider in future to broaden its tax base. In contrast, the hybrid equity rules in South Africa have many exclusions and limitations (such as the qualifying purpose exclusion, the linking of the equity share definition to preference shares and limitation of the form of security to instruments linked to the specified interest rate or time value of money), which could lead to distributions on hybrid equity escaping tax liability.
In terms of section 8E of the South African ITA, dividends paid in relation to hybrid equity instruments are re-classified as income in the hands of the recipient. Section 8E applies to hybrid equity instruments as defined.
Amongst other requirements, this definition demands that the instrument must not be an equity share and must contain an obligation or option for redemption within three years. This requirement creates anomalies and restricts the ambit of the rules regulating hybrid equity. We think that shares redeemable at any stage should be classified as hybrid equity instruments. This corresponds to the Canadian approach to term preferred shares and taxable preferred shares, which, although subject to different rules, in principle attaches no time limit to the conversion or redemption of the hybrid equity instruments. Both short-term and long-term arrangements are targeted in Canada, and the characteristics of the instrument and extent of control of the investor are emphasised, while specific additional rules apply to short-term preferred shares. South Africa could learn much from Canada's approach. The removal of a time limit will clarify the perceived uncertainty concerning the time of the redemption and broaden the tax base to include both short-and long-term arrangements. This would enhance neutrality and horizontal equity and also align with the timing rules for hybrid debt instruments, which require continuous evaluation for each year of assessment.

Third-party-backed shares
In addition to hybrid equity instruments, distributions made in respect of a further category of hybrid instruments, third-party backed shares, are separately regulated in South Africa. If a share is defined as a third-partybacked share (a share with an enforcement right attached to it), a distribution made in relation to it is re-classified as income in South Africa.
In Australia, the rules on non-equity shares would apply in respect of such an instrument. The Canadian approach is to regard distributions made in respect of shares with a guarantee against loss as taxable in principle. This is achieved by denying the inter-corporate dividend deduction. Similarly, the rules on taxable preferred shares, which could include an obligation to pay a return on the investment, impose tax liability for distributions on such shares in a manner similar to interest on debt instruments. Thus, although the detailed rules may differ, the basic principles in all three jurisdictions correspond. This makes sense as the substance of the investment agreement is closer to a debt instrument.
The South African rules applicable to distributions on third-party-backed shares pertain to "equity instruments". This concept includes preference shares only. We consider an even wider approach to be necessary, and that any share which includes a guarantee against loss or an enforceable right to claim a distribution attached to it should be subject to these rules. This would broaden the scope of the third-party-backed share rules significantly. Once again, South Africa could learn from the wider ambit of the Canadian inter-corporate dividend deduction and taxable preferred share rules.
Further, the exclusion from the third-party-backed share rules that apply to trusts, associations, non-profit organisations, and operating companies in the mining industry as well as listed companies, limits the scope of application of these rules and could be reconsidered. Such anomalies could be avoided if South Africa followed the Australian approach.

Hybrid debt instruments
While the terminology and mechanisms differ, the specific rules on hybrid debt instruments achieve a similar goal in each jurisdiction. In Australia, returns on non-share equity instruments are taxable as non-share dividends, are included in assessable income and are frankable as part of the imputation system, and so taxed similarly to returns on regular equity instruments. Canada also taxes returns on hybrid debt instruments in the same way as other returns on equity instruments through a deemed-dividend rule. Both of these approaches make sense as the substance of the instrument resembles equity despite its formal debt instrument label. In South Africa, the payment of hybrid interest or a distribution made in respect of a hybrid debt instrument is deemed to be a "dividend in specie" for the recipient. The company making the distribution is taxed as if interest had been paid. However, this interest is specifically disallowed as a corporate deduction, as is also the position in Australia and Canada.
In principle, the Canadian approach of taxing such a distribution as a deemed dividend is one we suggest South Africa adopt. We recommend that the phrase "dividend in specie" be replaced with "dividend". As the payment of interest is, in the main, an amount rather than an asset, we also recommend that a return on a hybrid debt instrument be treated as a deemed dividend. This will result in the tax liability falling onto the recipient, while the company would not qualify to deduct the distribution as interestin other words, the normal tax treatment of a distribution of dividends in respect of equity shares. Following the Canadian approach would improve the clarity of the South African legislation and would also align the South African rules with those in Australia.
Further, to ensure that the payment of interest in the form of assets such as convertible notes or negotiable instruments is included in the deeming provision, we suggest that assets paid as "interest" be taxable as a distribution of an asset in specie. This would align the taxation of assets distributed in relation to hybrid debt instruments with that applicable to shares. It would also promote certainty and equity, as the tax implications would follow the substance rather than the form of the instrument.

Conclusion
It remains challenging to develop tax rules for distributions on the many possible variants of hybrid instruments. Shaviro and Messere state that the only sensible way of reforming tax legislation in this context is to apply a reactive piecemeal method that discourages specific transactions. 179 This approach is evident from the tax legislation of Australia, Canada and South Africa, where rules were developed and adjusted from time to time to suit each jurisdiction's unique tax environment. LG TREDOUX AND KE VAN DER LINDE PER / PELJ 2021 (24) 28 on hybrid instruments in accordance with their substance and not their form. This enhances certainty for both the taxpayer and the fiscus, conforming to this well-known maxim of taxation. As the SARS is faced with an economic crisis in South Africa and specific revenue collection targets to address the budget deficit, there is a risk that tax collection might become more aggressive in future. Taxpayers should therefore not be ignorant of the rules on the taxation of distributions in respect of hybrid instruments. Similarly, caution should be exercised before an investor is lured into investing in instruments or schemes that promote the possibility of escaping tax, no matter how lucrative the tax planning might seem at face value. The application of the specific rules in this context requires expert analysis, which could also significantly increase the costs of compliance for investors.
Unless investment in equity instruments is incentivised, taxpayers will continue using hybrid instruments in tax avoidance schemes and legislatures will respond by adjusting existing anti-avoidance measures. South Africa can learn two important lessons from Australia and Canada. First, noting the more prominent incentivising of equity investment in Australia and Canada, it should revisit its corporate tax structure to incentivise broad-based equity investment. Secondly, it should aim for a more robust approach to curbing the avoidance of the normal tax rules. In this regard, the comparative perspective indicates that Australian and Canadian principles such as the removal of time limits in classification rules and a broadening of the instruments to which the rules apply, would strengthen the current South African approach to the taxation of hybrid instruments.