The recent Supreme Court of Appeal judgement of CSARS v The Executors of Estate Late Sidney Ellerine illustrates the importance of obtaining tax advice where rights, privileges or conditions of shares may potentially be affected by amendments to the memorandum of incorporation of a company.
The late Sidney Ellerine held 112,000 ZAR1 preference shares in Sidney Ellerine Trust (Pty) Ltd (the Company). Four family trusts held collectively 600 ordinary shares in the Company. Each preference and ordinary share held one vote. The deceased therefore, had controlled 99.47% of the voting rights in shareholder meetings. The Company held 40% in Ellerines Brothers (Pty) Ltd (EB Co), the investment holding company which owned the bulk of the family investments. The other 60% in EB Co was held by Eric Ellerine Trust (Pty) Ltd (EET), the company controlled by the deceased's brother Eric Ellerine.
Each preference share in the Company carried a 7% preferential coupon with no entitlement to further profits, and a preferential right to repayment of capital paid but with no further right to participate in or receive assets of capital. The preference share could be redeemed by a board resolution on one month's notice. Although the judgement did not specifically mention the terms of the ordinary shares of the Company, we submit that the ordinary shares are unlikely to be limited to a specified ZAR amount in their rights to receive ordinary dividends distributed out of profits and repayments of capital.
The articles of association were amended in 2006 to include special condition 5.8 which provided that article 34 (containing the rights of the redeemable non-cumulative preference shares), could only be amended with the prior written approval of at least 75% of each class of shares in the issued share capital of the Company and EET for as long as EET held any shares in EB. In other words, article 34 could only be amended with 75% approval of the holders of ordinary shares and preference shares in the Company, and 75% approval from each class of shares in issue in EET. The purpose of the amendment was to protect the ordinary shareholders in the Company from amendments to the terms of the preference shares which may impact their rights as shareholders.
The deceased was deemed to have disposed of his preference shares at market value on the date of death, with the market value for unlisted shares being the price which would be paid by a willing buyer and seller. The crux of the dispute was thus whether the rights to the preference shares and which entitled the holder to convert them to ordinary shares should be taken into account in the determination of the market value. Put differently, whether the ease of conversion of the preference shares to ordinary shares was the decisive factor as to whether the preference shares should be valued in the same manner as effectively, the ordinary shares in the Company.
If the holder of the deceased's preference shares could convert preference shares to ordinary shares simply with 75% approval from preference shareholders without needing 75% approval from the ordinary shareholders of the Company and 75% approval from each class of shares in EET, then each preference share would have the same market value as the ordinary shares in the Company. This was SARS' contention on the basis that the holder of the deceased's preference shares had 99.47% voting rights in the Company. The preference shares should thus be valued at 99.47% of the value of the Company. SARS had assessed the value of the preference shares at ZAR 563,376,418.
However, if the holder of the deceased's preference shares required 75% approval of each class of issued shares in the Company and EET, then each preference share in the Company should be valued at its ZAR 1 fair value. This was the estate's contention with the valuation of all the preference shares at ZAR 112,000.
The estate had argued that the holder could not convert the 99.47% preference shares held to ordinary shares without 75% approval of the ordinary (and preference) shareholders in the Company and 75% approval of each class of shares in EET. This argument was based firstly on special condition 5.8 read with article 34, and secondly on a reading of article 4.2.
First argument: The conversion would alter the preference share rights set out in article 34, thus the 75% approvals in special condition 5.8 would be required.
The estate contended that the approvals in special condition 5.8 would be required for a conversion because the rights of the preference shares of the holder as provided for in article 34 would be altered on the conversion of the preference shares to ordinary shares. Accordingly, article 34 would have been amended. The court disagreed with this argument as article 34 applied to rights, privileges and conditions of preference shares generally, and not those of a particular holder of these preference shares. The court referred to the wording of article 34 which starts with "the Preference Shares shall be subject to the following rights, privileges and conditions", and also on article 34.6 which provides that "no further shares ranking in priority to or pari passu with the preference shares shall at any time be created without the consent or sanction of the holders of such last preference shares … ".
The court held that any interpretation of a company's articles should be based on the premise that the articles confer rights or impose obligations on persons who are members of the company as a whole. The articles are not contracts made by a company with members in their private capacity. The court disagreed with the estate's submission that there was a contract between the company and the deceased in his personal capacity through article 34 and special condition 5.8.
Second argument: the rights of the ordinary shareholders would be amended with the conversion thus article 4.2 required 75% of their approval.
The estate contended that if the deceased's preference shares were converted to ordinary shares, the rights attached to the existing ordinary shares would be varied. This would result in a drastic drop in value of the ordinary shares. The drop in value would give rise to an amendment in the rights, privileges and conditions of the ordinary shares and thus article 4.2 would require the 75% approval of the ordinary shareholders.
Relying on English law, the court held that a variation of rights occurs when the rights attaching to the shares are varied and not when they become commercially less valuable. In this instance, the court held that no variation of the rights attaching to the ordinary shares would occur as the voting power is unaltered nor is there any change to the rights, privileges and conditions attaching to the ordinary shares as a class.
The court further relied on the express wording of article 7.1.10 which provides that any class of shares, by special resolution, may be converted to shares of a different class, absent any other provision in the articles to the contrary. Article 7.1.10 is not qualified by a reference to article 4.2, and both articles 4.2 and 7.1.10 were part of the original articles of the Company. Had it been intended to impose a qualification in article 7.1.10, "express language would have been required to make this position clear".
Accordingly, the SCA held that the deceased was entitled, on the date of his death, to convert the preference shares to ordinary shares and the preference shares had to be valued on that basis.
This case is authority for the principle that the market value of preference shares in a private company is to be determined by interpreting the rights, privileges and conditions of the shares in a company's articles of association. A company's articles is a contract between a company which confers rights and imposes obligations on its members generally. Any interpretation of the ease of conversion or approvals required to convert preference shares to ordinary shares in the articles should be made within this context. We submit this principle holds true for the memorandum of incorporation which is now the constitutive document for companies in terms of the Companies Act 71 of 2008. Further, there is no amendment or variation of rights of shares when shares become less commercially valuable.
This case is an example of how amendments to the memorandum of incorporation of companies may give rise to unforeseen tax consequences. We submit that special condition 5.8 was inserted in 2006 in order to add additional restrictions or approvals required before amending the rights, conditions or privileges of the preference shares in article 34. However, the insertion did not achieve the desired outcome when read in the context of the memorandum and articles in their entirety. Perhaps articles 4.2 and 7.1.10 (which are standard clauses in articles) could have subject to clause 5, of which special condition 5.8 forms part.
It is interesting that the court did not consider the euisdem generis (of the same kind)principle in interpreting the articles. This is probably because the court did not see that there was any amendment to the rights in article 34 and therefore, there was no conflict between articles 4.2 read with 7.1.10, and special condition 7.1.10.
It is also interesting that the court did not consider that the right to ordinary dividends of the ordinary shareholders had been diluted on the conversion of preference shares to ordinary shares, and thus requiring at the very least 75% approval of the ordinary shareholders in terms of article 4.2. The preference shares had the right to receive a priority 7% coupon and the ordinary shareholders all ordinary dividends distributed by the board. The cases relied on as authority in the judgement could be distinguished as they referred to voting rights, not rights to receive dividends.
Before any conversion, the shareholders of the 600 ordinary shares would receive 100% of the total ordinary dividends distributed. After the conversion, the shareholders of the 600 ordinary shares would only receive 0.57% of the total ordinary dividends distributed, with the holder of the converted preference shares receiving 99.47% of the total ordinary dividends. The initial ordinary shareholders before the conversion would after the conversion receive significantly proportionately less ordinary dividends. We submit that this was precisely the reason for special condition 5.8 requiring the additional approvals.