In depth 

South Africa's National Treasury has proposed a pivotal amendment to Section 8E of the Income Tax Act, targeting preference share structures that mimic debt instruments. This change, as outlined in the 2025 Draft Explanatory Memorandum to the Taxation Laws Amendment Bill, is designed to close what National Treasury deems to be a tax loophole. If the amendment goes through, it will significantly impact how preference share funding arrangements are structured and taxed.

The debt-equity mismatch

Preference shares have long been used in South African corporate finance as a flexible funding tool, as an alternative to traditional interest-bearing loan funding. While legally classified as equity, many preference shares:

• Pay fixed or preferential returns;
• Include redemption obligations; and
• May be classified as debt under the International Financial Reporting Standards (IFRS).

This duality allows issuers to treat payments as dividends – potentially tax-exempt for certain investors – while economically functioning as interest-bearing debt. National Treasury is of the view that Section 8E was originally designed to catch instruments with a redemption period of three years or less, but many structures now deliberately exceed that threshold (e.g., three years and one day) to avoid triggering the anti-avoidance rule by having embedded derivatives designed to circumvent Section 8E.

The proposed amendments to Section 8E

The amendment proposes a fundamental shift in how hybrid instruments are taxed:
The definition of a "hybrid equity instrument" as it currently stands is intended to be replaced a definition which links the exercise to the accounting treatment thereof. The proposal is that any “share” or “financial instrument” that is classified as a financial liability under IFRS by the holder will now be treated as a hybrid equity instrument for tax purposes. 

The effective date is currently set at 1 January 2026 and years of assessment on or after that date. The absence of reference to it being effective for any hybrid equity instrument issued on or after 1 January 2026, would result in the new provisions being applicable to preference shares already in issue and dividend paid on these on or after 1 January 2026.

In addition, the three-year redemption period threshold is intended to be eliminated, effectively meaning that all preference shares, regardless of redemption date would be caught by the proposed new Section 8E.

IFRS alignment: A new tax benchmark

As noted above, under the proposed amendment, South African Revenue Service (SARS) would no longer rely on the legal label of "share" to determine tax treatment. Instead, if an instrument behaves like debt, such as, for example, requiring repayment or offering fixed returns, it will be taxed like debt. The proposal is to look at IAS32 and determines if the share of financial instrument is a financial liability or not. Terms that provide for mandatory redemption, redemption at the Holder’s option and mandatory cumulative dividends would be indicative of a financial liability. Equity characteristics would be where the issuer has full discretion over payments and there is no contractual obligation to repay the principal. For example, perpetual and non-redeemable shares with no fixed maturity of where the company has a discretion as to whether to pay a dividend or not. 

Commercial impact: Expect gross-up clauses in funding agreements

If introduced as proposed, the amendment will trigger gross-up clauses and likely lead to new or renegotiated economic terms. Most preference share agreements contain gross-up clauses requiring the issuer to increase the payment to the holder so that the holder receives the full, pre-agreed net amount after any mandatory taxes or other deductions have been withheld. Essentially, the issuer assumes the tax risk.

For holders of preference shares, the reclassification of dividends as taxable income would mean that returns previously received as tax-free dividends may now be subject to income tax (e.g., at 27%). To preserve expected yields, the gross-up would kick in.

Example:

If an investor expects a net return of ZAR 100, the issuer would need to pay:

• Grossed-up dividend = ZAR 100 / (1 - 0.27) = ZAR 136.99
• Tax = ZAR 36.99
• Net received = ZAR 100

This ensures the investor's after-tax return remains unchanged, even though the tax treatment has changed. This would mean:

• Higher dividend payments; and
• Adverse impact of cash flow which could impact covenants (either affirmative or negative) by increasing expenses and reducing profitability metrics like EBITDA, potentially leading to covenant breach.

The proposed changes to Section 8E, if enacted, would mark a decisive shift in how hybrid equity instruments are taxed in South Africa. By aligning tax treatment with economic substance and removing these "structural loopholes", National Treasury and SARS is signalling a clear intent to close the gap between form and function as they perceive it.

The proposals are still subject to comment, which needs to be submitted by 12 September 2025 and we will certainly be making submission to National Treasury to either reconsider the proposal or limit the impact and application of the proposed amendments.

We encourage you to reach out to us should you wish to discuss further, as we prepare our submission to National Treasury.

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Massimo Iovino, Trainee Solicitor, has contributed to this legal update.