Equity-linked notes - interest-bearing?

• Published date: 01 December 2011
• Pages: 18-25
• DOI: 10.10520/EJC174527
• Author: Michael Rudnicki
• Date: 01 December 2011

18 © Siber ink

Equity-linked Notes

INTEREST-BEARING?

MICHAEL RUDNICKI

ABSTRACT

The provisions of section 24J of the Income Tax Act 58 of 1962 are complex

even when dealing with vanilla debt instruments. However, when more exotic

instruments, such as equity linked notes (‘ELNs’) are transacted, where returns

on investment are dependent, not on a f‌ixed or vanilla variable interest rate

(such as the prime interest rate), but a rate the basis of which is measured

by reference to a equity variable, not only does the calculation of the interest

charge become more complex, but the question of whether the entire ambit

of section 24J is applicable must be explored.

The ‘interest-bearing’ nature of an ELN must have regard to the intention

of the parties. If the intention of the parties is to consummate a transaction

whereby funds f‌low from a creditor to a debtor, in that capacity, and the

transaction involves the servicing of the capital outlay in the form of compen-

sation, then the transaction is likely to involve a loan arrangement as contem-

plated in section 24J. Section 24J then becomes relevant to the extent that

the instrument is ‘interest-bearing’.

An ELN that has the features of a loan arrangement by which the return

payable to the lender is calculated with reference to an equity index, will

meet the requirements of section 24J if the equity index movement consti-

tutes the basis for determining the ‘rate of interest’. The impact of section 24J

will spread the variable returns over the term of the instrument on an effective

yield methodology.

INTRODUCTION

Equity Linked Notes (‘ELNs’) are a form of investment by which two parties

transact with each another by means of an outf‌low of cash and a return

calculated with reference to the movement in value of shares or a basket

of shares (referred to as the equity exposure). The equity exposure could be

referenced to a single share or a basket of various shares. A basket of shares

comprising, say, the top 10 shares on the Johannesburg Stock Exchange,

could constitute an index, the variation of which will determine the gain

or loss for the investor.

An equity index movement could be the speculative platform for an

investor to gain or lose, or could be the platform to determine an interest

rate on money loaned between a creditor and debtor.

The taxation of interest is determined with reference to section 24J of

the Act.1 Vanilla lending transactions and related interest charges are dealt

1

58 of 1962 (‘the Act’).