Many taxpayers have huge amounts of debt resulting in a high proportion of debt to equity ratio (gearing ratio) hence affecting their creditworthiness and ability to attract potential investors. This is partly because debt financing used to be the preferred option to equity financing back in the day when, among other reasons, tax advantages such as the interest expense, was allowed as deductible in whole for the taxpayer under the tax laws. Previously, there were no restrictions on how much interest deductions a company that had borrowed, especially from its associated companies, could enjoy.
To leverage this tax advantage, many shareholders then resorted to advancing loans instead of equity to their controlled entities; but with the introduction of anti-tax avoidance mechanisms like thin capitalisation rules and the recent capping of interest expenses for members of a group, taxpayers are now faced with huge debts. Many taxpayers can’t afford to service these loans with ease as this would affect their cash-flow position and impair their ability to continue in operations. To remedy that huge debt predicament, most indebted companies have resorted to converting the said loans into equity.
The other reasons for converting the loans into equity are that the lender may need to become a shareholder of a company that they lent money and in other cases, the borrower company may fail to finance the loan and decide to settle the loan by issuing shares. After the conversion process is complete, the lender becomes a shareholder entitled to dividends as and when they are declared by the directors. The dividend payment will then be subjected to withholding tax using the applicable tax rates. This would be the immediate tax consequence for the conversion.
The process of converting the loans into equity is done by issuing shares to the lender in full settlement of the loan and in this case, there will be no amount received by the company in excess of the loan amount, hence no gain realised on the conversion. This option has no cash involved in the transaction. However, it is important to note that for the company to successfully execute this conversion, it must consider all likely consequences especially tax implications that would arise. For instance, if the loan was interest-bearing, and the interest component forms part of the amount converted into equity, then withholding tax on the interest is automatically triggered by the conversion.
It should be noted that the original reason for acquiring the loan usually has no bearing on the ultimate decision to convert the loan into equity for tax purposes but there could be other tax implications that may need to be assessed, like whether the conversion constitutes cancellation of a business debt. In such a case, the taxpayer must ensure that they have applied proper values and that they have properly documented the transaction, seek private rulings from the tax authorities where they need clarity and seek the advice of tax experts to mitigate risks. In conclusion, taxpayers have a right to convert their loans into equity as and when they deem it fit and proper regardless of whether it was provided for in the original loan agreement.