What you need to know about the anti-dividend stripping rules

There are various ways for a shareholder to exit a company and one of the most important factors is usually the tax payable upon exit. It is therefore not surprising that taxpayers are constantly seeking to find tax friendly ways to exit a company.

Corporate shareholders have, however, avoided income tax or capital gains tax on the disposal of shares in an underlying company. The corporate shareholder ensures that a dividend is declared prior to the disposal and thereby extracting value from the underlying company through a tax exempt dividend. When disposing of the shares thereafter, the value will be diminished and consequently income tax or capital gains tax is avoided.

Another scheme utilised by corporate shareholders is to enter into a repurchase transaction with the underlying company, which will constitute a dividend for tax purposes, on which no tax is payable. The underlying company will immediately after such a repurchase issue the shares to the new shareholder.

To curb this abuse, anti-dividend stripping rules were inserted in the Income Tax Act. Section 22B and paragraph 43A of the Eighth Schedule to the Income Tax Act provided that any exempt extra-ordinary dividend that is received by a corporate shareholder 18 months prior to the disposal of shares, or in regard to or in consequence of a disposal of shares, would be reclassified as income or proceeds for income tax or capital gains tax purposes. Effectively, the anti-dividend stripping rules ensures that the transaction is taxed as if a corporate shareholder disposed of the shares in the underlying company to a third party.

The scope of the anti-dividend stripping rules was, however, broadened with effect from 20 February 2019. Amendments were required due to the fact that the anti-dividend stripping rules were only triggered when shares were actually disposed of. Taxpayers abused this loophole by stripping the value of the underlying company and subsequently issuing shares to a third party, thereby retaining its shareholding in order not to trigger the disposal requirement. The amendments now deem a corporate shareholder to have disposed of its shareholding to the extent that its effective interest in the underlying company decreased, due to the issue of shares to a third party.

It is clear that disposal transactions may have unintended tax consequences for corporate shareholders and it is therefore important that shareholders obtain proper advice before entering into any transaction in terms whereof of its interest in an underlying company is decreased.