South Africa Revenue Based Finance - Loan

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

Table of Contents

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.

Revenue Participating Loan

Investment Structure Summary

This investment structure involves a loan made by an investor to a business and instead of the investor receiving interest back on the loan, the return on the investment is calculated as a contractually agreed percentage of revenue or a contractually agreed percentage of profit.

Advantages of loans of this nature is that (a) 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, 1962 (“Income Tax Act”), and (b) the loan can be secured by taking security from the borrower and third parties. However, if security is taken from a third-party then the benefits of the tax-exempt dividend fall away.

The governance rights are contractual as opposed to a share-based structure where the governance rights can be and generally are built in to the investee company’s constitutional documents

Category for tax purposes

It is a hybrid debt instrument.

Interest received is treated under section 8FA of the Income Tax Act as a dividend. Section 8FA (2) of the Income Tax Act provides that any amount of interest incurred by an investor in respect of interest on or after the date that the interest becomes “hybrid interest” is (i) deemed to be a dividend in specie in respect of a share that is declared and paid by that company to the person to whom that amount accrued on the last day of the year of assessment of that company during which it is incurred, and (ii) is not deductible.

The definition of hybrid interest means any interest where the amount of that interest is not determined with reference to a specified rate of interest or not determined with reference to the time value of money

Governance Rights

Governance rights are generally in the form of negative undertakings and are purely contractual where the instrument is constructed as a loan. It is also possible to construct the instrument as a debt security under the Companies Act, 2008 (“Companies Act”) and therefore to include in the terms of the security certain governance rights that are built into the constitutional documents of the borrower.

These are typically constructed as a loan rather than debt security although it is technically possible to structure this investment as a debt security

Investor Qualification Requirements

There are no statutory limitations on an investor to make these loans other than that investor receiving exchange control approval, and registration as a credit provider in accordance with the National Credit Act, 2005 (“NCA”), to the extent applicable.

If a loan is acquired from a non-resident or an affected person (each as defined in the Exchange Control Regulations), the borrower is required to disclose and apply to the Financial Surveillance Department of the South African Reserve Bank (“SARB”) for approval for cross-border dealings.

In addition, if the loan is made to persons who fall within the scope of the NCA then the investor must be registered as a credit provider under the NCA. A lender who is required to be registered as a credit provider but who is not so registered, will not be able to enforce a loan agreement against a South African borrower as that loan agreement will be void in terms of the NCA.

Section 40(1) of the NCA states that “A person must apply to be registered as a credit provider if the total principal debt owed to that credit provider under all outstanding credit agreements, other than incidental credit agreements, exceeds the threshold prescribed in terms of section 42(1). Previously, the threshold of ZAR 500 000.00 excluded most casual lenders from having to register. However, on 11 May 2016, the Minister for the Department of Trade and Industry published a new determination of the threshold which has reduced the threshold to “nil R0), meaning all persons lending to persons in scope of the NCA would be required to register.

However, this applicability is limited in that the NCA does not apply to a loan agreement where the borrower is a South African juristic person and its net asset value or annual turnover of all persons related to the borrower equals or is in excess of ZAR 1 million and where the principal debt owing under the loan agreement or loan equals or exceeds ZAR 250 000 and the borrower is a juristic person whose net asset value or annual turnover is below ZAR 1 million, meaning the vast majority of corporate loans are out of scope of the NCA requirements.

Currency Considerations

The loan can be denominated in US Dollars or any other currency subject to exchange control approval, which must be obtained from the Financial Surveillance Department of the SARB in order to exchange the loan in that currency.

Collateral

A loan of this nature can be secured however, in order for the investor to benefit from receiving tax-exempt dividends as a return, security must be taken directly over the assets of the borrower. If security is taken from a third-party, then the benefit of the dividends being tax-exempt will be lost and the return will be treated as interest received for an ordinary loan and will be taxable.

Priority Payment Rights

An investment of this nature can provide for a preferential right for the investor to receive distributions based on an agreed portion of gross revenues, free cash flow or net income.

Distribution and Redemption Limitations

Unlike a distribution based on a share/equity based structure, the payment of the return as well as the redemption of the loan is not subject to any mandatory conditions. It is treated like an ordinary loan in terms of priority of ranking if the investor is a secured creditor.

Timing and frequency in payments and any mandatory conditions can be contractually agreed. Should the provisions in the loan agreement be breached, the investor is entitled to call a default and enforce against the borrower.

Legal limitations to pricing or total return

If a transaction falls within the scope of the NCA, the interest will be subject to a cap. Under common law, interest on a debt will cease to run where the total amount of arrear interest has accrued to an amount equal to the outstanding principal debt, i.e. the total amount owed at any one point cannot exceed two time the outstanding principal debt (the in duplum rule).

The NCA provides that despite any provision of the common law or a credit agreement to the contrary, the amounts contemplated in Section 101(1)(b) to (g) of the NCA that accrue whilst the consumer is in default under the credit agreement may not, in aggregate exceed the unpaid balance of the principal debt under the credit agreement as at the time that the default occurs.

The NCA applies to all credit agreements between parties dealing at arms-length (where there is no personal interest between the parties). “Arms-length” means that the transaction should have the substantive financial characteristics of a transaction between independent parties, where each party will strive to get the utmost possible benefit from the transaction.

The NCA does not apply to a loan agreement where the borrower is a South African juristic person and its net asset value or annual turnover of all persons related to the borrower equals or is in excess of ZAR 1 million and where the principal debt owing under the loan agreement or loan equals or exceeds ZAR 250 000, and the borrower is a juristic person whose net asset value or annual turnover is below ZAR 1 million.

A juristic person is considered to be ‘related’ to another juristic person if (a) one of them has direct or indirect control over the whole or part of the business of the other; or (b) the same person has direct or indirect control over both of them.

In a Supreme Court of Appeal judgement (Asmal v Essa (38/2013) [2013] ZASCA 62 (14 May 2014), the court considered whether moneys advanced were loans and the profit share amounts upon which the parties agreed constituted ‘a use consideration’ for the said loans. In light of section 4(5)(a) of the NCA, the loan transactions constituted credit agreements.

A credit agreement, as defined in the NCA, entails credit being granted and the imposition of a ‘fee, charge or interest’ in respect of the deferred repayment, for the use of the credit. The profit share contained in the credit agreement qualified as a ‘charge’, one of the three wide terms used in section 8(4)(f) of the NCA to describe payment for the use of money owed. The court held that the loans including the profit share construct constituted credit agreements and were subject to the provisions of the NCA and because the respondent was not registered as a credit provider, thus putting it in breach of section 40(1)(b) of the NCA. This resulted in the credit agreements being found to be unlawful and thus void in terms of section 89(2)(d).

Status in Insolvency Proceedings

In a case of a liquidation, there are 3 types of creditors to be considered when ranking creditors:

Secured creditors are creditors holding security for their claims in the form of a special mortgage, landlord’s hypothec, pledge or right of retention. They rank first and are paid from the proceeds of the sale of the secured asset. All types of security (other than general notarial bonds where the mortgagee has not taken possession of the property subject to the bond) will, if validly created, constitute the holder of a security interest as a secured creditor in relation to the secured asset. No special priority applies among the secured creditors, as each secured creditor has a secured claim in respect of a particular asset. To the extent that creditors have security over the same asset, the creditor granted security earlier in time usually has a higher-ranking claim in respect of that asset. Where a secured creditor’s claim is not satisfied in full, the unpaid balance is considered a concurrent claim as dealt with in terms of (c);

Preferent creditors are creditors who do not hold specific security for their claims, but rank above concurrent creditors. They are paid from the proceeds of unencumbered assets in a predetermined order as set out in the Insolvency Act, 1936. Preferent creditors include employees’ remuneration (up to a prescribed amount) and the South African Revenue Services. The holder of an unperfected general notarial bond is also a preferent creditor; and

Concurrent creditors are paid from any proceeds of unencumbered assets that remain after preferent creditors have been paid in full. They are paid in proportion to the amounts owing to them. Any amount that remains after the payment of all concurrent claims in full must be used to satisfy the interest on concurrent claims from the date of liquidation to the date of payment, in proportion to the amount of each concurrent claim

The ranking of claims during business rescue—the regime analogous to bankruptcy in terms of South African law—is slightly different from the general liquidation process and ranking. It is also subject of some controversy, but is regarded as being as follows:

fees and expenses (including legal and the other professional fees) of the practitioner incurred during business rescue proceedings;
amounts due to employees which become due and payable after the commencement of business rescue;
claims of secured lenders or creditors before business rescue (although this is open to some debate);
secured claims by post-commencement financiers, lenders or creditors in the order in which the claims were incurred;
unsecured claims by post-commencement financiers or creditors in the order in which they were incurred;
remuneration of employees which became due and payable before business rescue commenced; and
unsecured claims of lenders or creditors incurred prior to business rescue.

Limitation of Liability

An investor’s liability towards the company and its creditors will be limited to its funded investment. There are certain exceptions to this, an investor may be liable the most notable example of which is the extension of liability to investors in 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, persons:

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

It would however be difficult to show that the investor would have been empowered to prevent the activity being performed that resulted in the pollution or environmental degradation.

Transfer Restrictions

It is possible to transfer the loan to another investor provided it is permitted under the terms of the loan agreement and it is not restricted. A transfer in whole would generally not be restricted unless it is contractually restricted however, a transfer in part would require consent from the borrower which consent can either be given at the time of transfer or as an exclusion in the loan agreement to allow for partial transfer.

Critical Tax Considerations

These loans would be typically structured to fall within the ambit of section 8FA of the Income Tax Act so that the returns are received by investors in the form of dividends which are tax exempt. South African investors receive a tax-exempt return. It’s not clear if this is the case for a foreign investor, as they may be 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

South Africa Revenue Based Finance – Loan

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