Revenue Based Finance

This resource is offered for information purposes only. It is not legal advice. Readers are urged to seek advice from qualified legal counsel in relation to their specific circumstances. We intend the resource’s contents to be correct and up to date at the time of publication, but we do not guarantee their accuracy or completeness, particularly as circumstances may change after publication. Toniic, the assisting pro bono law firms and the Thomson Reuters Foundation, accept no liability or responsibility for actions taken or not taken or any losses arising from reliance on this resource or any inaccuracies herein.

Related Content

The Germany content consists of this summary page, and separate pages for Preferred Shares in a German Limited Liability Company (“GmbH”), Silent Partnership in a Corporation, and Debt.

Executive Summary¹

In the German (debt/equity) market there is no classical “revenue-based finance” in the sense of a (customary) shareholders’/finance arrangement under which the investor has a priority right to receive repayment/distributions up to an agreed portion of “gross revenues” or “free cash flow”, until an agreed return on the investment is reached. However, the following three options come closest thereto: (1) preferred shares in a German Limited Liability Company (“GmbH”), (2) a silent partnership in a German corporation (GmbH or a stock corporation (“AG”)) or (3) a loan to a GmbH, AG or a limited partnership by shares (Kommanditgesellschaft auf Aktien (“KG aA”)) in combination with a warrant against the company’s/borrower’s shareholder(s) to call for shares (or, alternatively, to opt for a cash settlement) upon a specific trigger event.

Preferred Shares in a GmbH entitle the holder of such shares to a preferred treatment in regards of the priority of distribution of profits among the shareholders, i.e., the other (ordinary) shareholders accept that the investor has a right to repayment by way of distributions of profit (based on the revenue of the GmbH) and that such right needs to be discharged prior to other (ordinary) shareholders receiving their portion of the (remaining) amount to be distributed. Distributions and redemptions are limited by capital maintenance provisions applicable under German law to ensure that the GmbH’s funds in the amount of its registered share capital (Stammkapital) are not diminished by any profit distributions.

A silent partnership in a German corporation is an undisclosed civil law partnership. It can be designed with or without membership rights. In both scenarios, the investor participates in the corporation’s profit. In the typical case of a silent partnership, membership rights are excluded, and the investor solely participates in the corporation’s profit, for which reason the silent partnership is considered a debt instrument. The atypical silent partnership includes membership rights and/or entitles to participate in hidden reserves. Therefore, for tax and insolvency purposes, it is categorized as an equity instrument.

The combination of a loan to a GmbH, AG or KG aA combined with a warrant against its shareholder(s) combines a debt and an equity instrument. The warrant to call for shares or, alternatively, to opt for a cash settlement is mostly designed in the form of a right to demand release of proceeds. Usually, the warrant is designed without any membership rights or equivalent influence in order to avoid subordination in an insolvency scenario.

In any of the three options contestations by an insolvency administrator of repayments/distributions made to the investor needs to be considered on a case-by-case basis in the light of German insolvency law. For the instruments qualifying as equity or the investor qualifying as a shareholder or as shareholder like – which can only be assessed on a case-by-case basis -, investor’s claims are subordinated pursuant to German insolvency law.

Withholding tax on payments received by the investor is triggered in case of preferred shares. In case of the other instruments, it needs to be assessed on a case-by-case basis (details below). 

Investment Structure Summary

As in the German (debt/equity) market there is no classical “revenue-based finance” in the sense of a funding/finance arrangement under which the investor has a priority right to receive repayment/distributions up to an agreed portion of “gross revenues” or “free cash flow”, until an agreed return on the investment is reached (whether or not the investor continues to participate in the equity upside after that), the following proposal mirrors what comes closest thereto in the German debt market. This would be achieved through a loan in combination with a warrant (together, the “Transaction“):

(A) the investor as lender granting a loan (with specifics as set out below, the “Loan“) to a German law governed limited liability company (be it in the form of a GmbH, an AG or a GmbH & Co.KG or a KG aA)(the “Company“) as borrower (the “Borrower“) in combination with (B) a warrant against the Company’s shareholder(s) / partner(s) (the “Issuer“) to be acquired for an arm’s length consideration (as an option premium) which provides for a contractual right of the investor as warrant holder against the Issuer to call for shares in the Company , provided that both parties (the warrant holder as well as the Issuer) are entitled to opt for a cash settlement instead (the “Warrant“). I.E., in a nutshell, the Warrant (at least) needs to provide for a contractual right of the investor as warrant holder against the Issuer to demand a certain amount of payment upon a specific trigger event. Such trigger event can be an exit event at, a change of control in, a sale, an IPO, a refinancing or an expert opinion on the valuation (Wertgutachten) of or any equivalent with respect to the Company. The payment amount is fixed to the equivalent of a certain percentage of, depending on the type of trigger event, the net sale proceeds or the value of the Company etc. respectively (each a “Reference Value“). I.e., in principle, the Warrant usually grants a contractual right (only) to demand the redemption amount (Gegenwert) of x-percentage of shares in / the Reference Value of the Company (mostly in the form of a release of proceeds (Erlösauskehr)). (NB: A warrant does not grant an in rem position like shareholdership, partnership or equivalent. The Warrant holder is a normal stakeholder, no shareholder.) [SBA: Sehen wir auch so – war nur eine verkürzte Darstellung.]

Key features:

(A) Loan: In principle, it is a market standard loan that in such Transactions typically may contain one or any of the following features: (i) an accordion / additional uncommitted /incremental facility/ies to address growth issues of the Borrower, and (ii) an interest (base rate, i.e. EURIBOR (or any equivalent), plus margin or at times also a fixed interest) with specials like “pay if you can” or “payment in kind” (“PIK“). “Pay if you can” provisions stipulate that, in principle, no interest is to be paid in cash but only optionally, so to say, if the Borrower can. PIK provisions stipulate that, in principal, interest is to be paid in cash at designated intervals but the Borrower may, after the end of the current interest period, opt to add the total amount of interest due and payable for the last interest period to the total amount of principal outstanding under the Loan (so called “to PIK interest”).

(B) Warrant: Typically, the Warrant holder’s right to demand payment equals and is limited to a certain percentage of the Reference Value and the Warrant is exercisable only at pre-agreed trigger events.

Typical context: Startups, growth financings

Pros and cons (not captured below): 

The upside of such Transactions is that the burden of interest (Zinslast) of the Borrower can be preserved (i) by using the pay if you can/PIK option as well as (ii) by reducing the regular interest by the upside sharing of the Warrant where payment happens at a later point in time and payment does not eat into Borrower’s cash flow.

Category

Both (Debt, Equity)

Category for tax purposes

If properly structured, the Loan and the Warrant are considered separate instruments with the Loan being a (straight forward) debt instrument and the Warrant an option like instrument. For more details see below.

Governance Rights

For the Loan this is not applicable.

Warrant: Usually, the Warrant is drafted to only provide for a contractual right in the redemption amount (Gegenwert) of x-percentage of shares in / the Reference Value of the Company (mostly in the form of a release of proceeds (Erlösauskehr)), thus, only provides for a monetary contractual participation, hence, governance rights are not applicable as a matter of law. The usual Warrant holder qualifies as normal stakeholder (not as shareholder).

If so agreed, the Warrant may provide for observation or consultation rights, (very rarely) voting rights or veto/approval rights in respect of particular matters). But, regularly, granting voting or veto/approval rights are not granted as not only (A) under German insolvency law any shareholder (i.e. any person having in rem rights in the Company, i.e.) (i) holding directly or indirectly more than ten (10) percent of the shares or interests in or (ii) (it or any of its affiliates) being a managing shareholder (geschäftsführender Gesellschafter) of a German Company, is subordinated with any of its claims against the Company vis-à-vis any other (secured or unsecured) creditors, but moreover (B) it has been determined on a case-by-case basis by German case law that the same applies mutatis mutandis to any person having an equivalent influence/position (so called “shareholder like position” (gesellschafterähnliche Stellung)) in the Company, even solely out of contractual (in personam) rights. Thus, in such exceptional cases the legal or factual position of the Warrant holder pursuant to the Warrant may lead to a subordination of the investor’s rights as Lender under the related Loan.

Investor Qualification Requirements

No particular qualifications or requirements in excess of what would be required under a common, market standard loan (as debt instrument) under German law: e.g. such as a banking licence of the investor (subject to certain exceptions (other than in case of a revolving loan) such as reverse solicitation) etc.

Currency Considerations

(A) Loan: no specifics

(B) Warrant: Usually the currency denominating the Warrant and any payment obligations related thereto follow the local currency of the jurisdiction of the share capital of the Company. But that’s a pure commercial decision. If the investor wants to deviate therefrom and the Warrant shall be denominated in another currency than the share capital of the Company, usually, an exchange rate is contractually fixed.

Material restrictions or conditions for the remittance of investment proceeds outside of the German jurisdiction:

No specifics – usual restrictions and remittances and anti-money-laundering restrictions (pursuant to the Money Laundering Act (Geldwäschegesetz (GwG)) apply. As to tax implications see below

Collateral

(A) Loan: no specifics – Loans are seen secured (or unsecured) depending on the credit worthiness and/or rating of the Borrower; Collateral by all types of asset classes (shares, accounts, receivables, immaterial rights, property etc.), granted by the Borrower and its direct and/or indirect subsidiaries or third party security providers.

(B) Warrant: Usually, even if the Loan is secured, the Warrant is unsecured as it typically matures beyond the Loan. If the Warrant is secured (i) the Loan may either not be re-financeable or (ii) any security granted under the Warrant will need to be released for the purpose of the refinancing of the Loan and the Warrant would need to persist unsecured from then on

Priority Payment Rights

In principle, the Lender receives periodical interest payments. Thus, in principle, the Lender receives payments prior to any shareholder who, typically, only receives distributions annually and on the basis of the (equivalently) reduced profit. But besides that there are no further priority payment rights to receive distributions based on an agreed portion of gross revenues, free cash flow and/or net income

Distribution and Redemption Limitations

(A) Loan: For the Loan this is not applicable.

(B) Warrant: For the Warrant this is not applicable either as, usually, it does not grant shareholder rights (due to reasons described above) and grants a contractual right in the redemption amount (Gegenwert) of x-percentage of shares /the Reference Value in the Company (mostly in the form of a release of proceeds (Erlösauskehr)) only, thus, no distribution rights, such as dividend rights etc., and no redemption rights exist.

Legal limitations to pricing or total return

Customary limitations (such as violation of public policy, bonos mores (Treu und Glauben) apply and are subject to the specific circumstances of each individual case. With this regards, for example, it has been determined by German case law that a loan agreement by which a lender causes himself or a third party to be promised or granted pecuniary advantages which are clearly disproportionate (auffälliges Mißverhältnis) to the performance (i) by wilfully exploiting the weaker position (bewusstes Ausnutzen der schwächeren Position) of the borrower or (ii) by gross negligently (leichtfertig) denying (sich der Erkenntnis verschließen) that the borrower only engages in the pressuring conditions due to its weak position, will be null and void (due to breach of German public policy (pursuant to sections 138, 826 of the German Civil Code (Bürgerliches Gesetzbuch (BGB)(Wucher (usury), Sittenwidrige, vorsätzliche Schädigung)). German courts assumed such conditions in case the interest agreed increases the interest to be agreed at arm’s length by (relatively) 100 % or (absolutely) 12 %.

NB: However, these are just indicative values (Richtwerte) and it cannot be excluded that a German court will decide otherwise on a case-by-case basis.

Status in Insolvency Proceedings

It has to be taken into account that the Loan repayment claim is directed against the Company as Borrower, whereas the payment claim under the Warrant is directed against the Company’s shareholder(s) / partner(s) as Issuer. Thus, with regard to an insolvency event the following applies:

(A) Loan: In case of an insolvency event in the Company: Usually, the payment obligations of the Borrower under the Loan rank at least pari passu with all other unsecured and unsubordinated payment obligations of the Borrower, except for obligations which are accorded priority by bankruptcy, insolvency, liquidation, reorganisation or other laws of general application (e.g. secured obligations which are treated with preferred satisfaction (Aussonderungsrecht)).

Only, (as described above) in exceptional cases, where the Warrant grants a shareholder like position (gesellschafterähnliche Stellung) in the Company to the investor, the investor as Lender may pursuant to German case law be subordinated with its repayment claims under the related Loan in case of an insolvency event in the Company. Further, as such shareholder like investor is / may (on a case-by-case basis pursuant to German case law) be treated equal to a shareholder, (1) repayments on such shareholder like loans effected within the last year (365 days) prior to insolvency filing of the Borrower, or (2) granting of security to any shareholder like person within the last 10 years prior to insolvency filing, may be challenged by the insolvency administrator. Therefore, the Warrant is usually drafted as a contractual (in personam) right (schuldrechtlicher Anspruch) only without shareholder like rights.

(B) Warrant: The payment claim under the Warrant is directed against the Company’s shareholder(s) / partner(s), thus, is from a pure legal perspective not affected in case of an insolvency event in the Company (but commercially due to the potential decrease of the Reference Value of the Company). In case of an insolvency event in the Company’s shareholder(s) / partner(s) as Issuer, the payment obligation of the Issuer under the Warrant ranks at least pari passu with all other unsecured and unsubordinated payment obligations of the Issuer, except for obligations which are accorded priority by bankruptcy, insolvency, liquidation, reorganization or other laws of general application (e.g. secured obligations which are treated with preferred satisfaction (Aussonderungsrecht) – but, as described above, collateral will be rarely seen in case of a Warrant due to the refinancing issues). 

Limitation of Liability

The investor’s liability towards the Company and its creditors is limited to its funded or committed investment. There is no, nor will there be, any obligation to make additional contributions (Nachschusspflicht). 

Transfer Restrictions

(A) Loan: Due to the combined nature of such Transactions, regularly, the Loan shall not be transferred without the Warrant and vice versa, meaning, in any case the lender needs to be the Warrant holder (so called “stapled investment”). Besides that, customary transfer restrictions apply.

(B) Warrant: stapled investment (see above).

Critical Tax Considerations

If properly structured, the Loan and the Warrant are considered separate assets also for German tax purposes. Note that this requires, among other things, that the Warrant is acquired for an arm’s length consideration (as an option premium) that will forfeit (and retained by the Issuer of the Warrant) if the Warrant is not exercised. The option premium is payable (incl. by way of set off) when the Warrant is granted i.e. at the outset of the transaction. 

If Loan and Warrant are viewed as two separate assets, the tax consequences could be summarized as follows (on high-level basis and without regard to the individual case and assuming that the Warrant holder does not become a Company shareholder):

(A) Loan:

Any payments to the investor are tax deductible at the level of the Company subject to general limitations (such as the German interest barrier rule (Zinsschranke) and the add-back provisions under German trade tax).

In principle, there is no German withholding tax on such payments. However, exemptions apply if

• the borrower is a bank / financial institution,
• the Loan has hybrid features (such as profit participating loans, silent partnerships),
• the Loan is secured through German real estate, in which case the German tax administration may request the Borrower to withhold taxes in the individual case (i.e., no automatism), 
• the lender resides in a so-called non-cooperative jurisdiction, or 
• the investor is to be considered a related party of the Company (e.g., because the investor holds an equity interest in the Company) and the Loan is not at arm’s length.

Note that the Warrant should generally not “taint” the Loan in a way that the Loan is to be considered “hybrid” if Warrant and Loan are viewed as separate assets. However, there is a risk that the German tax authorities might take a different view, which would need to be analyzed on a case by case basis.

The taxation of payments in the hands of the investor depends on a number of different factors, including the investor’s tax residence and the eligibility of the investor under an applicable double taxation treaty. However, generally speaking, the investor should not be subject to German limited tax liability if the Loan is not secured with German real estate (unless in cases where the Lender resides in a non-cooperative jurisdiction). 

(B) Warrant:

The exercise of the Warrant and any payments thereunder should generally not affect the tax situation of the Company (as the Warrant is issued by the Company’s shareholder(s)). 

Furthermore, payments under the Warrant should generally not attract German withholding tax.

The taxation of payments under the Warrant in the hands of the investor depends on a number of different factors, including the investor’s tax residence and the eligibility of the investor under an applicable double taxation treaty. Generally speaking, a Warrant holder would be subject to limited taxation in Germany if (i) the Warrant was to be considered an “expectancy right” (Anwartschaftsrecht) or a “participation right” (Genussrecht), and (ii) such right would entitle its holder to participate in 1% or more of the profits/liquidation proceeds of the Company. We believe that there are arguments that the Warrant should not give rise to limited taxation if the Warrant could be structured as a virtual instrument with a mandatory cash-settlement (i.e., not entitling its holder to receive shares). However, there is no explicit case law in this respect, so that there is a risk that the tax authorities take a different view. 

Note that Warrant holders might be protected under an applicable double taxation treaty, in which case Germany should not have the right to tax payments under the Warrant. However, details would need to be reviewed on a case by case basis.

This resource is offered for information purposes only. It is not legal advice. Readers are urged to seek advice from qualified legal counsel in relation to their specific circumstances. We intend the resource’s contents to be correct and up to date at the time of publication, but we do not guarantee their accuracy or completeness, particularly as circumstances may change after publication. Toniic, the assisting pro bono law firms and the Thomson Reuters Foundation, accept no liability or responsibility for actions taken or not taken or any losses arising from reliance on this resource or any inaccuracies herein.

Related Content

The Germany content consists of this summary page, and separate pages for Preferred Shares in a German Limited Liability Company (“GmbH”), Silent Partnership in a Corporation, and Debt.

Silent Partnership in a Corporation Germany Revenue Based Finance¹

Investment Structure Summary

The following proposal for the structuring of a revenue-based financing investment is based on a silent partnership of the investor in a German limited liability company (Gesellschaft mit beschränkter Haftung – “GmbH”) or German stock corporation (Aktiengesellschaft – “AG”, each of the GmbH and the AG, also the “Company”) which enables the investor to participate in the Company’s profits, without being granted any shares in the share capital of the Company. 

A silent partnership constitutes a non-public civil law partnership between the investor and the Company. As a silent partner of this undisclosed civil law partnership, the investor is generally not entitled to any membership rights in the Company, as the investor does not qualify as a shareholder of the Company. However, statutory law provides for limited information rights of the silent partner pertaining to the business of the Company. 

Under German law, the silent partnership can be structured as a so-called typical silent partnership, i.e., essentially, a silent partnership in which the investor solely participates in the Company’s profits without having any other membership rights (the “Typical Silent Partnership”), or an atypical silent partnership, i.e., a silent partnership in which the investor does not only participate in the Company’s profits but is also entitled to participate in the Company’s hidden reserves and/or is granted certain membership rights (the “Atypical Silent Partnership”). 

The silent partnership can be structured so that the silent partner’s participation is limited to the Company’s profits and excludes any participation in the Company’s losses. 

Category

Debt

If the parties to the silent partnership have not agreed on certain contractual agreements regarding the terms of the silent partnership (i.e., inter alia, agreement on (i) subordination, (ii) certain entrepreneurial control/participation rights of the silent partner, and/or (iii) participation in losses), which may qualify the contribution of the investor under the silent partnership as equity, the Typical Silent Partnership is to be qualified as a debt instrument.

Category for tax purposes

Tax law distinguishes between (a) the Typical Silent Partnerships which are considered to be debt instruments and (b) the Atypical Silent Partnerships which are considered to be equity. The determination is to be made in the individual case and depends, inter alia, on the rights of the silent partner and its loss participation: If the silent partner is entitled to participate in the built-in gains of the Company and/or participates in the Company’s losses, then a treatment as equity is likely.

Governance Rights

A Typical Silent Partnership does not grant any membership rights, except for limited information rights. The silent partner is not entitled to any voting, veto or approval rights, or basically any other membership rights, unless those are explicitly provided for in the partnership agreement. If such further rights are granted, the silent partnership may qualify as an Atypical Silent Partnership. 

Investor Qualification Requirements

Besides of laws and regulations which apply in any case of investments by certain foreign entities/individuals, no specific requirements need to be complied with due to the revenue-based financing.

Currency Considerations

Partnership contribution can be made in any currency which is provided for under the partnership agreement. 

Collateral

n/a

Priority Payment Rights

Due to statutory provisions and the characteristics of a silent partnership, the silent partner’s participation is limited to the Company’s profits. Therefore, any participation based on a profit-independent assessment basis, such as a profit-independent guaranteed dividend, a profit-independent participation in the Company’s revenues or a fixed interest on the investment bear the risk that the structure will no longer be considered a silent partnership for tax purposes, but rather be qualified as a mere loan.

If, however, certain payments shall be guaranteed (e.g., by way of a minimum amount to be paid periodically or a fixed interest), it is necessary that these payments are distributed out of the profits generated by the Company or, if that is not possible at the time of distribution, such payment will be set-off against any subsequent profit participation right. Thus, payments under the silent partnership can be based on the revenue generated by the Company, but such payments will in any case need to be made by way of a corresponding profit distribution or subsequent set-off against profit participation rights. 

Distribution and Redemption Limitations

Timing and frequency of payments in the silent partnership are subject to negotiation between the silent partner and the Company. 

Legal limitations to pricing or total return

Customary statutory limitations (violation of bonos mores, bad faith and appropriateness of profit share) can apply and are subject to the specifics of each individual case. 

Status in Insolvency Proceedings

If the investor’s contribution into the silent partnership was repaid within one year prior to the insolvency, the repayment may be contested according to the rules of the German Insolvency Code. In case of insolvency, the silent partnership will be dissolved and the silent partner’s claim for repayment of its contribution (subject to any participation in the losses if agreed in the silent partnership agreement) would (i) in a Typical Silent Partnership constitute an ordinary, unsecured insolvency claim, and (ii) in an Atypical Silent Partnership constitute a subordinated claim.

An ordinary, unsecured insolvency claim would be eligible to participate in any distributions of the insolvency quota (i.e., any distributions of the proceeds from the liquidation of the insolvency estate to the ordinary, unsecured insolvency creditors after satisfaction of all liabilities which are preferred by law such as costs of the insolvency proceedings and liabilities incurred by the insolvency administrator) whereas a subordinated claim would only be eligible to participate in any distributions after all unsecured insolvency claims and other prior-ranking claims have been discharged in full.

Limitation of Liability

The liability of the partners of a civil law partnership (Gesellschaft bürgerlichen Rechts), which is the legal form of the relationship between the Company and the investor due to the silent partnership, is not limited with regard to the creditors of the silent partnership. However, since the silent partnership forms a non-public civil law partnership, generally, no external contractual obligations will be entered into. Therefore, the silent partnership has no third-party creditors. Further, the investor as silent partner cannot be held liable for any claims of third parties against the Company. Liability vis-à-vis the Company may arise from violation of contractual obligations under the partnership agreement and any such liability is not statutorily limited to the contributed amount. 

Transfer Restrictions

The silent partnership can be transferred by way of contract assumption involving the old and new silent partner and the Company. If the identity of the silent partner is of no particular interest for the Company, it may be obliged to approve the contract assumption. 

Critical Tax Considerations

The below presents certain high-level tax consequences for a Typical Silent Partnership only. Please note that tax consequences of an Atypical Silent Partnership differ.

Any payments to the investor are tax deductible at the level of the Company subject to general limitations (such as the German interest barrier rule (Zinsschranke) and the add-back provisions under German trade tax).

Payments to the investor are generally subject to a 26.375% withholding tax, i.e., the Company has to make a respective withholding from any (interest) payments “on” the contribution of the silent partner (but not on the repayment of the principal amount).

The taxation of payments in the hands of the investor depends on a number of different factors, including the investors tax residence and the eligibility of the investor under an applicable double taxation treaty. This is also true for a potential withholding tax refund from the German tax authorities. However, without going into details, please note that German domestic law generally imposes strict substance requirements for such a refund so that the withheld tax might become final and could become a cost item for the investor.

1. Note: As an alternative to the investor’s silent participation, (i) the Company could issue participation rights (Genussrechte) regarding its future profits as consideration for the contribution by the investor, or (ii) the investor could grant a participating loan (partiarisches Darlehen). As the key characteristics and the pros and cons of such participation rights/participating loans are similar to the silent partnership, we have limited the presentation herein to the silent partnership. Any possible upsides of participation rights or participating loans compared to the silent partnership should be reviewed based on the specifics of the individual case on a case-by-case basis. ↩︎ ↩︎

This resource is offered for information purposes only. It is not legal advice. Readers are urged to seek advice from qualified legal counsel in relation to their specific circumstances. We intend the resource’s contents to be correct and up to date at the time of publication, but we do not guarantee their accuracy or completeness, particularly as circumstances may change after publication. Toniic, the assisting pro bono law firms and the Thomson Reuters Foundation, accept no liability or responsibility for actions taken or not taken or any losses arising from reliance on this resource or any inaccuracies herein.

Related Content

The Germany content consists of this summary page, and separate pages for Preferred Shares in a German Limited Liability Company (“GmbH”), Silent Partnership in a Corporation, and Debt.

Executive Summary¹

In the German (debt/equity) market there is no classical “revenue-based finance” in the sense of a (customary) shareholders’/finance arrangement under which the investor has a priority right to receive repayment/distributions up to an agreed portion of “gross revenues” or “free cash flow”, until an agreed return on the investment is reached. However, the following three options come closest thereto: (1) preferred shares in a German Limited Liability Company (“GmbH”), (2) a silent partnership in a German corporation (GmbH or a stock corporation (“AG”)) or (3) a loan to a GmbH, AG or a limited partnership by shares (Kommanditgesellschaft auf Aktien (“KG aA”)) in combination with a warrant against the company’s/borrower’s shareholder(s) to call for shares (or, alternatively, to opt for a cash settlement) upon a specific trigger event.

Preferred Shares in a GmbH entitle the holder of such shares to a preferred treatment in regards of the priority of distribution of profits among the shareholders, i.e., the other (ordinary) shareholders accept that the investor has a right to repayment by way of distributions of profit (based on the revenue of the GmbH) and that such right needs to be discharged prior to other (ordinary) shareholders receiving their portion of the (remaining) amount to be distributed. Distributions and redemptions are limited by capital maintenance provisions applicable under German law to ensure that the GmbH’s funds in the amount of its registered share capital (Stammkapital) are not diminished by any profit distributions.

A silent partnership in a German corporation is an undisclosed civil law partnership. It can be designed with or without membership rights. In both scenarios, the investor participates in the corporation’s profit. In the typical case of a silent partnership, membership rights are excluded, and the investor solely participates in the corporation’s profit, for which reason the silent partnership is considered a debt instrument. The atypical silent partnership includes membership rights and/or entitles to participate in hidden reserves. Therefore, for tax and insolvency purposes, it is categorized as an equity instrument.

The combination of a loan to a GmbH, AG or KG aA combined with a warrant against its shareholder(s) combines a debt and an equity instrument. The warrant to call for shares or, alternatively, to opt for a cash settlement is mostly designed in the form of a right to demand release of proceeds. Usually, the warrant is designed without any membership rights or equivalent influence in order to avoid subordination in an insolvency scenario.

In any of the three options contestations by an insolvency administrator of repayments/distributions made to the investor needs to be considered on a case-by-case basis in the light of German insolvency law. For the instruments qualifying as equity or the investor qualifying as a shareholder or as shareholder like – which can only be assessed on a case-by-case basis -, investor’s claims are subordinated pursuant to German insolvency law.

Withholding tax on payments received by the investor is triggered in case of preferred shares. In case of the other instruments, it needs to be assessed on a case-by-case basis (details below). 

Preferred Shares in a German Limited Liability Company (“GmbH”)¹

Investment Structure Summary

The following proposal for the structuring of a revenue-based financing investment aims at achieving the economic objective, i.e., the contribution of capital by the investor into the capital reserves of the GmbH in exchange for equity in the GmbH which grants the investor a right to repayment of its investment (including a premium) by way of distributions based on the revenue of the GmbH. This would be achieved through the investor receiving preferred shares in the GmbH (Gesellschaft mit beschränkter Haftung). Such preferred shares provide for Guaranteed Dividends (as defined below), but do not entitle the investor to any voting rights or, essentially, other rights as a shareholder of the GmbH. 

GmbHs allow for a dualistic share structure, comprising preferred shares and ordinary shares. Preferred shares can be structured in such a way that they do not grant any voting rights. As a compensation for the loss of voting rights, preferred shares can provide for certain preference rights regarding their return on the investment.

a) Generally, the distributable profits of a GmbH (the “Distributable Profits”) need to be determined by the shareholders’ meeting and the distribution of such profits will usually be resolved upon annually. Revenue-based financing requires the GmbH to make payments to the investor periodically based on the relevant revenue of the GmbH generated during a specific period which may be shorter than the financial year of the GmbH. To accommodate such a need for multiple disbursements within a year, the GmbH needs to pay interim dividends. Any such interim dividend is to be understood as a pre-payment on the expected Distributable Profits at the end of a financial year. 

b) To avoid any obligation of the investor to pay back interim dividends that exceeded the actual Distributable Profits, the interim dividends should be structured as so-called “Guaranteed Dividends”. Guaranteed Dividends allow for regular payments by the GmbH which do not necessarily have to be covered by Distributable Profits. If provided for in the articles of association, the Guaranteed Dividends can be variable in the amount, e.g., can be based on certain business benchmarks of the GmbH. The amount of Guaranteed Dividends to which the investor is entitled due to its contribution of capital can be capped at a total amount of distributions in the amount of the investment (including the premium). Once the cap has been reached, the preferred shares can be redeemed by the Company or given back by the investor without any further consideration. 

The basis of assessment and applicable caps (if any) regarding the amounts of such Guaranteed Dividends are subject to negotiation of the parties and statutory limitations (i.e., principle of capital maintenance, not harming the existence of the GmbH and breach of fiduciary duties towards minority shareholders). To prevent any uncertainties regarding the terms for (re-)payments under the Guaranteed Dividends, the articles of association of the GmbH should clearly (i) stipulate the basis of assessment, e.g., monthly revenues or expected profits, and (ii) exclude any repayment claims of the GmbH in case the Guaranteed Dividends disbursed to the investor in a financial year exceed the Distributable Profits generated by the GmbH in such year.  

Category

Equity

Category for tax purposes

Preferred shares are generally considered equity instruments also for German tax purposes. 

Governance Rights

Under German law, the voting rights of shareholders that hold preferred shares can be excluded. Certain shareholder rights however cannot be excluded, inter alia, (i) a right to information and a right of inspection, and (ii) certain mandatory rights regarding resolutions specifically affecting such shareholder (e.g., regarding a change of preference rights with respect to its preference shares). 

If the investor shall be granted voting, veto and/or other participation rights, etc., upon agreement with the shareholders of the GmbH, such rights can be granted to the investor by way of the articles of association and/or shareholders’ agreement (as applicable).

Investor Qualification Requirements

No specific requirements apply to a revenue-based financing. 

Certain customary regulatory filing requirements may apply in case the investor and/or the investment qualifies for such requirements (e.g., antitrust or foreign investment control procedures). 

Currency Considerations

The investment can be made in Euro or in any foreign currency. However, capital contributions in a foreign currency can only discharge the payment obligation of the investor if such contribution in another currency equals the corresponding registered Euro amount, deducting any costs incurred due to the payment in a currency other than Euro. 

Collateral

Collateral is not required as the preferred shares will be issued to the investor as consideration for its investment. 

Priority Payment Rights

As described above, the preferred shares provide for a Guaranteed Dividend for the benefit of the investor. The investor will receive such payments periodically. The Guaranteed Dividends should generally relate to the (anticipated) Distributable Profits of the GmbH but can be expressed in a certain percentage of the gross revenue/free cash flow/net income generated by the GmbH in a specific period.

Distribution and Redemption Limitations

Distributions in connection with Guaranteed Dividends to the investor are limited by the principle of capital maintenance. The compliance with such principle shall ensure that a GmbH has funds equal to its registered share capital (Stammkapital) at its free disposal at all times. Any payment of Guaranteed Dividends can therefore only be made from free capital, i.e., distributable profits and distributable reserves. The abovementioned requirements cannot be modified or waived in the GmbH’s articles of association. Thus, the Guaranteed Dividends can be based on a certain portion of the revenue generated, but such distributions must always be covered by free capital or free reserves.

Legal limitations to pricing or total return

Customary statutory limitations (principle of capital maintenance, violation of bonos mores, fiduciary duties, bad faith and rules of equality that apply vis-à-vis the minority shareholder) may apply and are subject to the specific circumstances of each individual case. Please also refer to the limitations noted above.

Status in Insolvency Proceedings

In case of insolvency, the previous payments of Guaranteed Dividends might be contested by the insolvency administrator according to the rules of the German Insolvency Code (details are very fact-specific and the outcome is uncertain; certain contestation periods might apply). If the administrator is successful, this would result in a repayment obligation of the investor. In addition, membership rights of shareholders generally do not constitute insolvency claims. Shareholders are only eligible to receive proceeds from the liquidation of the insolvency estate in the last rank after satisfaction of all liabilities. Thus, claims of the investor as a holder of preferred shares are, particularly, subordinate to any claims resulting from debt instruments.

Limitation of Liability

The liability of a GmbH is restricted to the GmbH’s assets. Therefore, shareholders of a GmbH are excluded from any liability vis-à-vis the GmbH’s creditors. Vis-à-vis the GmbH, the shareholders are liable for the fulfilment of their capital contribution obligations. 

Further liability may arise in certain special circumstances, e.g., in connection with unlawful distributions by the GmbH to the respective shareholder or any liability of the shareholder for willful misconduct, fraud or tort. 

Transfer Restrictions

Transfer Restrictions: In principle, shares in a GmbH are freely transferable. However, the articles of association of a GmbH may provide for certain transfer restrictions (Vinkulierungsklauseln). In particular, the transfer of the shares can be subject to the GmbH’s and/or the shareholders’ meeting’s approval. Further, the entrance of the new investor in a shareholders’ agreement regarding the GmbH requires the consent of the other shareholders due to the novation/restatement of such shareholders’ agreement.

Critical Tax Considerations

Distributions on the preferred shares are not tax deductible at the level of the GmbH. 

Furthermore, such distributions are generally subject to a 26.375% withholding tax, i.e., the GmbH has to make a respective withholding from any payments “on” the preference shares. Please note that this also applies to a “repayment” of the “principal” amount (i.e., the amount contributed for the subscription of the preferred shares). Certain exceptions apply, e.g., if and to the extent the distribution is made out of the so-called capital contribution account (steuerliches Einlagekonto), which is, however, only the case if the GmbH does not have any distributable profits as of the end of the year preceding the distribution (i.e., any distributable profits are distributed first). 

The taxation of the distributions in the hands of the investor depends on a on a number of different factors, including the investors tax residence and the eligibility of the investor under an applicable double taxation treaty. This is also true for a potential withholding tax refund from the German tax authorities. However, without going into details, please note that German domestic law generally imposes strict substance requirements for such a refund so that the withheld tax might become final and could become a cost item for the investor. 

Please note that the above is a high-level summary of certain key aspects only. The specific tax consequences always need to be reviewed by taking into consideration all relevant details of the individual case. 

1. Note: Under German corporate law, besides the GmbH and certain partnerships, the stock corporation (Aktiengesellschaft) is another form of entity which may be a possible target for such revenue-based financing. The following presentation focuses only on the GmbH as, due to strict statutory requirements and limitations regarding the stock corporation, guaranteed dividends cannot be granted with regard to preferred shares in a stock corporation and, therefore, the structuring proposal as described herein is not applicable. Any dividends to be disbursed by the stock corporation must be based on the profit generated by the stock corporation and the disbursement of such profits must have been formally resolved upon by the shareholders’ meeting. Therefore, the structuring of revenue-based financing with regard to stock corporations should be structured by way of a silent partnership. For further details, please refer to the investment structure described below under B.). ↩︎

This resource is offered for information purposes only. It is not legal advice. Readers are urged to seek advice from qualified legal counsel in relation to their specific circumstances. We intend the resource’s contents to be correct and up to date at the time of publication, but we do not guarantee their accuracy or completeness, particularly as circumstances may change after publication. Toniic, the assisting pro bono law firms and the Thomson Reuters Foundation, accept no liability or responsibility for actions taken or not taken or any losses arising from reliance on this resource or any inaccuracies herein.

This analysis was provided by White & Case SA and Citibank N.A., South Africa Branch

Related Content

The Analysis for South Africa includes articles on Revenue Based Finance – Loans, and Revenue Based Finance – Preference Shares

Executive Summary

The revenue-based finance structures that have been discussed are the common structures that we see in the South African market, namely, revenue participating loans and participating preference share funding. These structures are similar in principle as both structures aim to allow investors to be able to also finance companies and startup business in a way that allows these companies to be able to build their business. Most investors believe that small and medium-sized enterprises and startup businesses have a fair amount of risk as not all start-up business will be successful. These structures are designed to give investors a share in the performance of the business. 

Participating Preference Share Funding

The major considerations regarding this type of structure are the provisions of the Companies Act, 2008 and the Income Tax Act, 1962 (“Income Tax Act”). For example, failure to structure the participating preference share funding in accordance with the provisions of the Income Tax Act has the consequence that the dividends received on account of the participating preference share will be deemed to be interest / income (which is taxable) and, accordingly, the tax benefit of such preference share funding will not apply. The investor can also receive a deduction upon relying on section 12J of the Income Tax Act.

South African residents can receive tax-exempt returns. However, withholding tax would apply to any dividend paid by a resident company to a non-resident or by a non-resident company to a non-resident if the shares in respect of which the dividends are paid are listed on a South African exchange. Further, this will depend  on the existence of applicable double tax treaty in place between South Africa and the country of the foreign investor. These tax treaties commonly prescribe different reduced rates of dividend withholding tax for different shareholder categories.

Another benefit of this structure is that in the event of insolvency of the borrower, a preference shareholder will rank behind secured creditors of the borrower but ahead of the ordinary shareholders of the borrower. The preference share can provide the investor with certain rights such as voting rights in relation to certain reserved matters. 

Security cannot be taken from the issuing company directly but must be taken from a third party. However, this may be viewed to be a third-party backed share and, as such, tax exemption would not apply. 

This structure can be more beneficial to investors as they receive a fixed dividend and can receive a tax deduction of up to 100%. Depending on the structure of the investment, the entire amount invested may be able to be deducted from the investor’s taxable income.

Profit Participating Funding

The agreed portion of the revenue or the agreed profit of the company (whichever one that has been contractually agreed to by the parties) received by the investor can be seen as a dividend and as such be subject to taxation. However, because the return is not calculated with reference to a rate of interest, it is treated as a tax-exempt dividend under section 8FA of the Income Tax Act. Withholding tax would apply to any dividend paid by a resident company to a non-resident or by a non-resident company to a non-resident if the shares in respect of which the dividends are paid are listed on a South African exchange. This is dependent on the application of the applicable double tax treaty in place between South Africa and the country of the foreign investor if there is one in place. These tax treaties commonly prescribe different reduced rates of dividend withholding tax for different shareholder categories.

Governance rights are generally in the form of negative undertakings and are purely contractual where the instrument is constructed as a loan. Furthermore, approval from the Financial Surveillance Department of the South African Reserve Bank would be required in the event that the currency of the investment is not in the South African Rand and if the investor is not a South African resident.

One of the factors that may lead parties to select this structure instead of the participating preference share is that security can be taken directly from the company instead of a third party. Further, as a secured creditor, it would have a priority ranking over secured assets and all remaining creditors would be paid from the remaining proceeds of the sale of secured assets after the secured creditor is repaid, if any.

Participating Preference Shares 

Investment Structure Summary

A common revenue-based finance structure in South Africa is participating preference shares. This structure contemplates funding being provided in the form of preference share capital. The preferred shares return a dividend equal to a contractually agreed percentage of the profit of the company or a contractually agreed percentage on the revenue of the company.

Preference shares can be redeemable or not redeemable. Redeemable preference shares can be redeemed by the company either on a specified date or over a period of time. Upon redemption, the company will be required to pay all distributions which have accrued to the holder thereof and all other amounts owed to such holder. Such redemption will be undertaken in accordance with section 46 of the Companies Act, 2008 (“Companies Act”).

Category

If the preference share is not redeemable then it would be classified as equity. If the preference share is mandatorily redeemable, within three years after the issue date of such preference share, then it may be classified as debt.

Category for tax purposes

For tax purposes, they will be classified as equity, in general. 

Exceptionally, they can be classified as a hybrid equity instrument in terms of section 8E of the Income Tax Act, 1962 (“Income Tax Act”), or a third-party backed share as defined in section 8EA(1) of the Income Tax Act, as discussed below. 

Section 8E(2) of the Income Tax Act provides that dividends received in respect of a preference share will be deemed to be income in the hands of the recipient i.e. the holder of the preference share, if the preference share constitutes a “hybrid equity instrument”. 

Section 8E(1) defines a “hybrid equity instrument” as, among other things, a preference share which is secured by a financial instrument which cannot be disposed of, unless the preference share was issued for a “qualifying purpose”. This means that the subscription proceeds which are receivable by or accrued to the issuer of the preference shares must be applied for one or more “qualifying purpose(s)”, as defined in section 8EA of the Income Tax Act. Please see the discussion under “Critical Tax Considerations” for the definition of “qualifying purposes”.

Section 8EA of the Income Tax Act defines a “third-party backed share” as a preference share in respect of which an enforcement right is exercisable by the holder of that preference share or an enforcement obligation becomes enforceable as a result of any specified dividend or return of capital attributable to that share not being received by or accruing to the person entitled thereto.

Governance Rights

As a general rule, preference shareholders do not have voting rights, however they can be afforded such rights. As the preference share is a share in the capital of the company, a preference shareholder can be granted governance rights in the terms of its issue and can have rights to vote on all terms that have been contractually agreed between the investor and the issuer including rights to vote on certain matters, appoint directors, to vote at annual general meetings, etc. 

Preference shareholders do, however, in all instances, have the right to vote on any proposal to amend the preferences, rights, limitations and other terms associated with the preference shares. The governance rights can be built into the constitutional documents of the company. 

Investor Qualification Requirements

If an investor is a South African resident, there are no requirements applicable however, if the investor is non-resident, whilst they are free to own shares in South African companies, they must ensure that the share certificates issued by the company are endorsed within 30 days of becoming the owner of the shares by the Financial Surveillance Department of the South African Reserve Bank (“SARB”) as non-resident or an Authorised Dealer.

Regulation 14(1) of the Exchange Control Regulations, 1961 provides that no person may, without permission granted by the SARB or a person authorised by it, and in accordance with such conditions imposed, acquire or dispose of, in any way, any share in a South African company. The relevant Authorised Dealer is generally the local commercial bank of the South African company in which the shares are held by non-residents.

Currency Considerations

The investment cannot be denominated in US Dollars or other currencies. In terms of the Companies Act, the share capital of a South African company—including preference shares—must be classified in Rand. 

The payment to acquire or subscribe for shares—including preference shares—can be made as the Dollar equivalent of the Rand amount, but exchange control approval will need to be obtained from the Financial Surveillance Department of the SARB in order to exchange the amount in such currency

Collateral

The investor cannot take collateral to secure the preference share from the company that issues the share because the claim on the share is not a debt claim, and as such, there is doubt that the rights associated with those shares can be validly secured by the issuer of the share under South African law. 

In theory, the investor can take security from a third-party such as guarantees. However, if the investor does so, section 8EA of the Income Tax Act becomes applicable. Also,  if the purpose to which the share was issued for is not a qualifying purpose and the person providing the security is not in the category of “permitted persons” in terms of the Income Tax Act, the share will be considered a third-party backed share and the benefit of receiving tax exempt dividend will fall away. 

Section 8EA(2) of the Income Tax Act provides that dividends received in respect of a preference share will be deemed to be income in the hands of the holder of the preference share if the preference share constitutes a “third-party backed share”. 

Section 8EA of the Income Tax Act defines a “third-party backed share” as a preference share in respect of which an enforcement right is exercisable by the holder of that preference share or an enforcement obligation becomes enforceable as a result of any specified dividend or return of capital attributable to that share not being received by or accruing to the person entitled thereto. 

Section 8EA(3) of the Income Tax Act, however, provides that a preference share secured by the assets of a third party will not constitute a “third-party backed share” if the obligations of the issuer of that preference share is secured by one of the following persons: 

1. the operating company in respect of which the preference share funds will be applied, provided the funds were applied for a qualifying purpose; 

2. the issuer of the preference shares, provided it was issued for a qualifying purpose; 

3. any person that directly or indirectly holds at least 20% of the equity shares in the relevant operating company or issuer; 

4. any company that forms part of the same group of companies as the relevant operating company, issuer or 20% equity holder;

5. any natural person; 

6. any non-profit company, trust or association of persons, provided that none of the activities of that organization are directed at promoting the economic self-interest, other than the payment of reasonable remuneration, of any employee or fiduciary of that organization; or
7. any person who holds equity shares in the issuer of the preference shares, provided that the enforcement right or obligation exercisable against that person is limited to any rights in and claims against that issuer that are held by that person. 

Priority Payment Rights

Preference shares rank ahead of other shares and are offered preference in relation to ordinary shares in the event of distribution of dividends. Please note that dividends, which may be an agreed portion of (1) gross revenues, (2) free cash flow or (3) net income, before ordinary shareholders are paid out. As such, preference shareholders will also receive their share of the company’s residual value before ordinary shareholders in the event of liquidation. Preference shareholders will be paid after the creditors of the company, but before the ordinary shareholders

Distribution and Redemption Limitations

Restrictions on payment of a dividend or redemption of the preference share are typically regulated in the constitutional documents of the company and moreover in terms of section 46 of the South African Companies Act, a company must not make any proposed distribution unless the distribution is (i) pursuant to an existing legal obligation of the company, or a court order or (ii) the board of directors of the company, by resolution, has authorised the distribution. In order to declare a dividend, it must reasonably appear that the company will satisfy the solvency and liquidity test as set out in section 4 of the Companies Act (the “Solvency and Liquidity Test”) after completing the proposed distribution and the board of the company, by resolution, has acknowledged that that it has applied the Solvency and Liquidity Test as set out in section 4 of the Companies Act and has reasonably concluded that the company will satisfy the Solvency and Liquidity Test immediately after completing the proposed distribution.

Legal limitations to pricing or total return

Unlike a revenue participating loan, there are no legal limitations on pricing or total returns that would arise from a preference share. 

Status in Insolvency Proceedings

Preference shareholders will be paid after the creditors of the company, but before the ordinary shareholders. The ranking of the other shareholders for the shares in the share capital of the company will be determined by the rights of each of those shares. Preference shareholders receive their share of the company’s residual value before ordinary shareholders in the event of liquidation

Limitation of Liability

An investor’s liability towards the company and its creditors will be limited to its funded investment. There are certain exceptions in which an investor may be liable. The most notable exception is the extension of liability to investors for environmental law breaches.

As an example, the National Environmental Management Act 1998 and the National Water Act 1998 extend the net of liability for pollution and environmental degradation to include, among others:

1. persons who have been responsible for or who have directly or indirectly contributed to pollution or environmental degradation; and/or
2. persons who negligently failed to prevent the activity being performed that resulted in the pollution or environmental degradation.

Transfer Restrictions

If the issuing company is a private company, the general rule is that the transfers are restricted. A private company is profit company that (a) is not a public, personal liability, or state-owned company; and (b) satisfies the criteria set out in section in 8(2)(b) of the Companies Act. For them, the consent of the board of directors is required for any transfer and the terms of issuance can provide for pre-approved list of permitted transferees.

In the case where the issuing company is a public company, transfers are not restricted. A public company is a profit company that is not a state-owned, private or personal liability company. The Companies Act further defines a profit company as a company incorporated for the purpose of financial gain for its shareholders.

Critical Tax Considerations

Section 8E of the Income Tax Act which targets shares and equity instruments with substantial debt features. The treatment of these shares as hybrid financial instruments ensures that debt is not disguised as short-term redeemable preference shares or any other redeemable share containing certain dividend preferences.

Section 8E deems a dividend or foreign dividend on a hybrid equity instrument to be an amount of income accrued to the recipient and will not be exempt from normal tax. The payer is also not offered a deduction for the payment of affected dividends or foreign dividends. 

Section 8E(1) defines a “hybrid equity instrument” as, among other things, a preference share which is secured by a financial instrument which cannot be disposed of, unless the preference share was issued for a “qualifying purpose”. This means that the subscription proceeds which are receivable by or accrued to the issuer of the preference shares must be applied for one or more “qualifying purpose(s)”, as defined in section 8EA of the Income Tax Act.

Section 8EA of the Income Tax Act provides that subscription proceeds received by, or accrued to, the issuer of the preference shares will be deemed to have been used for a “qualifying purpose” if it is used for: 

1. the direct or indirect acquisition of an equity share in a company which is an “operating company” at the time of receipt or accrual of the dividend, provided that it cannot be used to acquire shares in an operating company which, immediately prior to such acquisition, formed part of the same group of companies as the person acquiring the equity shares; 

2. the direct or indirect acquisition or redemption of other preference shares (“Original Preference Shares”) if: 

1. the Original Preference Shares were originally issued for a “qualifying purpose”; and 

2. the amount received by or accrued to the issuer does not exceed the amount which remains outstanding in respect of the Original Preference Shares; 

3. the payment of dividends in respect of the Original Preference Shares; and 

4. the partial or full settlement of debt incurred in respect of any one of the above. 

An “operating company” is defined in section 8EA of the Income Tax Act as: 

1. a company that carries on business continuously and, in the course of operating such business, provides goods and/or services for consideration on exploration of natural resources; 

2. a company that is a controlling group company in relation to the aforementioned operating company; and 

3. any company that is a listed company. 

Section 8E(1) of the Income Tax Act also defines a “hybrid equity instrument” as, amongst other things, a preference share in respect of which: 

1. the issuer thereof is obliged to redeem the preference share in whole or in part within a period of three years from the date of issue of that preference share; 

2. the holder thereof has the option to redeem the preference share in whole or in part within a period of three years from the date of issue of the preference share; or 

3. the existence of the company issuing such preference share will be, or is likely to be, terminated within a period of three years from the date of issue of the preference share. 

8EA(2) of the Income Tax Act provides that dividends received in respect of a preference share will be deemed to be income in the hands of the holder of the preference share if the preference share constitutes a “third-party backed share”. 

Section 8EA of the Income Tax Act defines a “third-party backed share” as a preference share in respect of which an enforcement right is exercisable by the holder of that preference share or an enforcement obligation becomes enforceable as a result of any specified dividend or return of capital attributable to that share not being received by or accruing to the person entitled thereto. 

Section 8EA(3) of the Income Tax Act, however, provides that a preference share which is secured by the assets of a third party will not constitute a “third-party backed share” if the obligations of the issuer of that preference share is secured by one of the following persons: 

1. the operating company in respect of which the preference share funds will be applied, provided the funds were applied for a qualifying purpose; 

2. the issuer of the preference shares, provided it was issued for a qualifying purpose; 

3. any person that directly or indirectly holds at least 20% of the equity shares in the relevant operating company or issuer; 

4. any company that forms part of the same group of companies as the relevant operating company, issuer or 20% equity holder;

5. any natural person; 

6. any non-profit company, trust or association of persons, provided that none of the activities of that organization are directed at promoting the economic self-interest, other than the payment of reasonable remuneration, of any employee or fiduciary of that organization; and 

7. any person who holds equity shares in the issuer of the preference shares, provided that the enforcement right or obligation exercisable against that person is limited to any rights in and claims against that issuer that are held by that person. 

Section 12J Investments

A holder of participating preference share can also receive a deduction upon relying on section 12J of the Income Tax Act. Section 12J was legislated to incentivise South African taxpayers to invest in local companies and to receive a tax deduction of up to 100% of the amount subscribed in a qualifying company i.e. the entire amount that is invested can  be deducted from the investor’s taxable income.

Section 12J has requirements at the level of the “qualifying company” and at the level of the venture capital company (“VCC”) who holds the shares of the qualifying company. A VCC is taxed as a company and does not enjoy any special tax concessions because of its VCC status.

Section 12J(1) defines a VCC as a company that has been approved by the Commissioner of the South African Revenue Services and in respect of which such approval has not been withdrawn in terms of subsection (3A), (3B), (6) or (6A) of the Income Tax Act. It order for a Commissioner to approve a VCC, it must be satisfied that (i) the company is a resident, (ii) the sole objective of the company is the management of investments in qualifying companies, (iii) the tax affairs of the company are up to date and in order and (iv) the company is licensed in terms of section 8(5) of the Financial Advisory and Intermediary Services Act, 2002.

Section 12J(2) allows a taxpayer, subject to certain conditions, to claim a deduction from income in respect of a year of assessment for expenditure actually incurred by that taxpayer in acquiring any venture capital share issued to that taxpayer during that year of assessment. Expenditure incurred by a company must not exceed ZAR5 million and reviseda person other than a company must not exceed ZAR2,5 million.

The term “venture capital share” is defined in section 12J(1) to mean “an equity share held by a taxpayer in a venture capital company which was issued to that taxpayer by a venture capital company, and does not include any share which — 

…

(b) would have constituted a hybrid equity instrument, as defined in section 8E(1), but for the three-year period requirement contemplated in paragraph (b)(i) of the definition of ‘hybrid equity instrument’ in that section; 

(c) constitutes a third-party backed share as defined in section 8EA(1); or;

(d) was issued to that taxpayer solely in respect or by reason of services rendered or to be rendered by that taxpayer in respect of the incorporation, marketing, management or administration of that venture capital company or of any qualifying company in which that venture capital company holds or acquires any share.” 

The term “equity share” is defined in section 1(1) of the Income Tax Act to mean – “any share in a company, excluding any share that, neither as respects dividends nor as respects returns of capital, carries any right to participate beyond a specified amount in a distribution”.

A distribution can take the form of a distribution of profits (dividends) or capital. As long as the right to participate in either of these types of distribution is unrestricted, the share will be an equity share. The share will not be an equity share if both of these rights are restricted. Fundamentally, the shares in the VCC must take the form of equity share and must not be a hybrid equity instrument or constitute a third-party backed share.

liable for withholding tax. Whether or not that dividend withholding tax can be reduced is dependent on the existence and applicability of the double tax treaty between the country of the foreign investor and South Africa

This resource is offered for information purposes only. It is not legal advice. Readers are urged to seek advice from qualified legal counsel in relation to their specific circumstances. We intend the resource’s contents to be correct and up to date at the time of publication, but we do not guarantee their accuracy or completeness, particularly as circumstances may change after publication. Toniic, the assisting pro bono law firms and the Thomson Reuters Foundation, accept no liability or responsibility for actions taken or not taken or any losses arising from reliance on this resource or any inaccuracies herein.

This analysis was provided by Hogan Lovells

Related Content

The Analysis for Mexico includes articles on Revenue Based Finance – Debt, and Revenue Based Finance – Equity

Investment in Preferred Shares 

Investment Structure Summary

Under Mexican Law it is possible for companies to issue preferred and common shares. The rules for preferred shares may be set by the General Shareholders’ Meeting authorizing their issuance. 

Upon the liquidation of the company, preferred shares will be paid in first place prior to the payment of the common shares. Preferred shares may also have special distributions or dividends and may have special economic rights or preferred dividends based on revenues. These preferred shares may have a preferred right to receive a dividend in an amount equal to a percentage of the revenues prior to any distribution to common shares.

Category

Equity

Category for tax purposes

Preferred Shares and the payment of dividends will be subject to the payment of taxes and the corresponding withholding.

Governance Rights

Yes, preferred shares may grant to their holders corporate rights over the management of the company that may be determined by the General Shareholders’ Meeting authorizing their issuance. 

Moreover, it can be structured to issue specific series of preferred shares with special economic rights based on revenues; having preferred dividends over revenues. In which case, such preferred shares may have a preferred right to receive a dividend in an amount equal to a percentage of the revenues prior to any distribution to common shares. 

Investor Qualification Requirements

As long the shares are issued in a private offering to less than 100 offerees, there are no qualification requirements. If the preferred shares are offered to more 99 offerees, the investors may need to be institutional or qualified investors to avoid triggering a public offering.

In limited industries there may be foreign-investment and foreign-ownership restrictions.

Currency Considerations

Shares need to be registered in Mexican Pesos although they could have special coupons or payments denominated in foreign currency. However, as a general rule, under Mexican law, payment obligations denominated in foreign currencies and payable in Mexican territory may be discharged by paying the amount equivalent in Mexican Pesos pursuant to the exchange rate set forth by the Mexican Central Bank (Banco de México) one day before the applicable payment date

Collateral

Preferred shares, as they are equity, cannot be secured or guaranteed by any type liens or collateral. 

Priority Payment Rights

Payment of preferred shares will be made after all employees and creditors are paid but before common shares.

Distribution and Redemption Limitations

As a general rule, all companies shall hold an annual shareholders’ meeting approving their annual financial statements reflecting the net losses or profits of the corresponding year. Dividends cannot be distributed before annual financial statements reflecting net profits are approved. 

Moreover, companies are required to severe  5% of the net profits to form a “statutory reserve” until this reserve amount to the 20% of the capital stock of the company. 

No distribution of dividends is allowed if there are no net profits or if 5% of the net income has not been separated for forming the statutory reserve. 

In this sense, for purposes of clarity, while distributions need to be approved by the General Shareholders’ Meeting, the shareholders  may undertake to make such distributions. As such, dividends may only be distributed only after the corresponding financial statements have been approved reflecting the existence of net profits; regardless if the amount of the distribution is based on revenue, net profits need to exist to make such distribution. Further, distributions cannot exceed the net profit or retained earnings shown in the financial statements approved by the General Shareholders’ Meeting and a statutory reserve of 5% of the net profits needs to be created each profitable year until the reserve equals 20% of the paid-in capital. 

There are no restrictions to redemption if the redemption is approved by the General Shareholders’ Meeting. Note that companies are forbidden to buy back their shares but they can redeem them subject to approval of the General Shareholders’ Meeting. According to the law, redeemed shares should be determined randomly but shareholders can waive this requirement

Legal limitations to pricing or total return

No limitations to pricing or to the total return of the investment in preferred shares except that no share (preferred or common) may be issued for less than par value

Status in Insolvency Proceedings

In case of bankruptcy, holders of preferred shares are paid after all employees and creditors and only prior to common shares.

Limitation of Liability

As a general rule, investors’ liability towards the Company its limited to the payment of their shares. 

However, there are certain exceptions derived from tax, antitrust and criminal law. There are also some recent precedents of plaintiffs being able to pierce the corporate veil.

Transfer Restrictions

As a general rule, by law, there is no mandatory restriction for the transfer of preferred shares. However, the shareholders may include transfer restrictions in the bylaws or in shareholders’ agreements.

Also note that public offerings may be subject to registration and authorization by the securities regulator (Comisión Nacional Bancaria y de Valores) and in limited industries there may be foreign-investment and foreign-ownership restrictions.

Critical Tax Considerations

Any payments made to the investors would be subject to the corresponding withholding and payment of applicable income taxes at the corporate level.

Withholding rate varies depending on the tax residence of the investor and its beneficial owners and available tax treaties

Investment in Debt with Interest over Gross Revenues

Investment Structure Summary

Under Mexican Law it is possible for companies to issue debt, linking both principal  and interest payments to gross revenues. If principal repayment is based on revenues and the amount payable is higher than the originally disbursed amount, then the excess will be deemed interest. If the amount payable is lower than the originally disbursed amount, then a write off / haircut on principal shall be deemed to have occurred. 

In this case the amount owed by the company will be treated as a liability.

Category

Debt

Category for tax purposes

Interest and fees payable to investors will be deemed as income sourced in Mexico (if the issuer is a Mexican entity) and subject to withholding taxes. The rate varies depending on the tax residence of the investor and its beneficial owners and availability of tax treaties

Governance Rights

No, debt instruments do not grant to their holders any type of corporate or voting rights over the company or its management. However, control over management may be achieved through affirmative and negative covenants. Breach of affirmative and negative covenants may only trigger debt acceleration and payment obligations and it will not be possible for investors to enjoin any action taken by the company in breach of those covenants. 

Investor Qualification Requirements

No, there is no need investors need to comply with any particular qualification or requirement.

Currency Considerations

Debt may be denominated in foreign currency. 

However, as a general rule, under Mexican law, payment obligations denominated in foreign currencies and payable in Mexican territory may be discharged by paying the amount equivalent in Mexican Pesos pursuant to the exchange rate set forth by the Mexican Central Bank (Banco de México) one day before the applicable payment date.

Collateral

Debt instruments, can be secured or guaranteed by any type liens or collateral, or third-party guarantees.

Priority Payment Rights

Ranking will depend on whether the debt is secured or unsecured. Unsecured debt is generally paid after all employees, secured creditors and other creditors with special preferences are paid. See Status in Insolvency Proceedings below for further detail.

Distribution and Redemption Limitations

For the payment of debt instruments there is no limitation or restriction. Investors or holders are considered creditors and are to be paid and liquidated at the maturity of the instrument.

Legal limitations to pricing or total return

In all instances usury laws shall be honored. Usury laws generally provide that interest shall not be that disproportionate or excessive preventing the investor from gaining an excess profit. 

Pursuant to Mexican law, there is no statutory definition of usury, however it is sanctioned by both civil and criminal laws.

Article 2395 of the Federal Civil Code caps ordinary interest rates by providing that when such an interest rate is so disproportionate that it creates the appearance of abuse by the creditor due to the debtor’s ignorance or inexperience, a debtor may request the judge to equitably reduce it to the legal interest rate. Likewise, under civil law, the legal annual ordinary interest rate is 9%, unless otherwise agreed by the parties. 

On the other hand, under Article 387 subsection VIII of the Federal Criminal Code, usury is a felony, sanctioning usury advantages by means of contracts or agreements providing for higher yields or profits than those usual in the market.

In commercial law, according to several precedents issued by the Mexican Supreme Court of Justice, usurious interest rates are prohibited by law. In this sense it has ruled that upon judges’ knowledge of an interest rate that may be considered usurious in a commercial proceeding, they are obliged to analyze it ex officio and reduce it to market standards.¹

Additionally, below please several court precedents regarding usury and the parameters to be observed for its determination:

Under court precedent 1a./J. 46/2014 (10a.)² issued by the First Chamber of the Mexican Supreme Court of Justice, the Supreme Court resolved that usurious interest rates contravene the provisions of Article 21 paragraph 3 of the American Convention on Human Rights (the “Convention”), which provides that all forms of exploitation of man by man, including usury, must be prohibited by law. In this sense, if a judge notices an excessive or usurious interest rate, it must disregard the agreed interest rate and impose a cautious interest rate in a reasoned and motivated manner according to the particular circumstances of the case at hand. Interest accrued at the usurious interest rate cannot be collected by the lender. 

Under court precedent 1a./J. 47/2014 (10a.)³, the First Chamber of the Mexican Supreme Court of Justice ruled that judges must reduce excessive interest rates to avoid usury. To determine whether an interest rate is usurious, judges have to take into consideration the following parameters:

The nature of the relationship between the parties; 

The nature of the parties involved in the credit and whether the creditor’s activity is regulated; 

The credit purpose;

The credit amount; 

The use of the proceeds; 

The tenor of the credit;

The existence of collateral or guarantees; 

The interest rates of the banking institutions for similar operations to those under analysis (this element only constitutes a reference);

The variation of the national inflationary index during the actual life of the loan;

Market conditions; and, 

Other matters that generate conviction in the judge.

On top of the foregoing, judges must evaluate whether there are circumstances that reflect any kind of disadvantage of the debtor in the credit relationship with the lender.

In conclusion, there is no objective standard or percentage of what is considered usury being subject to court interpretation considering the court precedents previously mentioned. 

In this sense, it is not that this limitation would prohibit revenue based financing, as long as the interest is proportionate to gross revenues, irrespective of the fact that there could be periods with high payments. What must be observed is the principle of no excessiveness and usury, taking into account the parameters and considerations mentioned above. 

Status in Insolvency Proceedings

Below is the waterfall of payments in an insolvency proceeding:

• Employee-creditors (wages, salary and other employment benefits accrued during the last year);
• Credits regarding essential expenses for the operation of the debtor’s business, or credits regarding expenses for the conservation, protection and administration of the insolvency estate, approved by the estate’s representative;
• Singularly privileged creditors (burial and illness expenses);
• Secured creditors;
• Tax creditors and other employee and labor creditors;
• Special privileged creditors;
• Unsecured (common) creditors; and
• Subordinated creditors.

As of the day of company’s declaration of insolvency:

• Unsecured capital and ancillary obligations of credits arranged in Mexican currency will stop accruing interest and will be converted into UDIs (a Mexican-inflation pegged index);
• Unsecured capital and ancillary obligations of credits arranged in foreign currency will stop accruing interest and will be converted into Mexican currency and into UDIs;
• Secured credits will be maintained in the agreed currency or unit and will only accrue interest up to the collateral value

Limitation of Liability

Lenders’ liability is limited to disbursing committed funds in agreed terms. They are not liable vis-à-vis third parties for actions or omissions of the company. 

Transfer Restrictions

No statutory restriction except that public offerings may be subject to registration and authorization by the securities regulator (Comisión Nacional Bancaria y de Valores)

Critical Tax Considerations

Interest and fees payable to investors will be deemed as income sourced in Mexico (if the issuer is a Mexican entity) and subject to withholding taxes. The rate varies depending on the tax residence of the investor and its beneficial owners and availability of tax treaties

1.  Court precedent VI.2o.C. J/32 (10a.) Digital Registry: 2019367, issued by the First Chamber of the Supreme Court of Justice of Mexico, published in the Weekly Judicial Journal of the Federation, Book 14, February 2019, Volume II, page 2395 entitled “USURIOUS INTEREST IN CIVIL MATTERS. THE SAME RULES THAT APPLY IN COMMERCIAL MATTERS MUST BE APPLIED.” ↩︎
2. Court precedent 1a./J. 46/2014 (10a.) Digital Registry: 2006794, issued by the First Chamber of the Supreme Court of Justice of Mexico, published in the Weekly Judicial Journal of the Federation, Book 7, June 2014, Volume I, page 400 entitled “PROMISSORY NOTE. ARTICLE 174, SECOND PARAGRAPH, OF THE NEGOTIABLE INSTRUMENTS AND CREDIT TRANSACTIONS LAW, ALLOWS THE PARTIES TO FREELY AGREE ON INTEREST AS LONG AS SUCH INTERESTS ARE NOT USURIOUS. INTERPRETATION IN ACCORDANCE WITH THE CONSTITUTION [ABANDONMENT OF COURT PRECEDENT 1a./J. 132/2012 (10a.) AND OF ISOLATED THESIS 1a. CCLXIV/2012 (10a.)].
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3.  Court precedent 1a./J. 47/2014 (10a.) Digital Registry: 2006795, issued by the First Chamber of the Supreme Court of Justice of Mexico, published in the Weekly Judicial Journal of the Federation, Book 7, June 2014, Volume I, page 402 entitled “PROMISSORY NOTE. IF THE JUDGE NOTICES THAT THE INTEREST RATE AGREED UPON BASED ON ARTICLE 174, SECOND PARAGRAPH, OF THE NEGOTIABLE INSTRUMENTS AND CREDIT TRANSACTIONS LAW IS NOTORIOUSLY USURIOUS, HE MAY, EX OFFICIO, REDUCE IT PRUDENTIALLY”. ↩︎