BEE Partner, South Africa Economy Watch

Economic interest is a participant’s right to share in the economic fruits of the business. The legal form of the distribution is not important, but normally comes in the form of dividends and capital gains. The Codes define it as a claim against the entity representing return on ownership of the entity similar in nature to a dividend right.

The problem arising out of economic interest is that many businesses abused their BEE partners by stripping profits out of the entity before distributing returns. Earlier drafts of the Codes provided an anti- circumvention clause in the definition, which gave more specific guidance on what should be included in economic interest.

The current definition of economic interest was shortened in the interests of making the Codes easier to use. The problem is that in shortening it, the guidance given to users is incomplete, which may result in misinterpretation. The following is not in the Codes. However, it reveals the underlying intention of the Codes according to earlier, more comprehensive drafts.

Where a verification agency or customer identifies any of the following, the economic interest held by Black people will be calculated as a percentage of the economic interest had the circumventive strategy not existed. For example, the excessive salaries paid to non-Black people would be included as economic interest in the hands of the non-Black parties for the purposes of calculating the economic interest points.

BEE Partners’ Salaries

Salaries do not form part of economic interest. However, where a salary is paid that is not a reasonable reflection of the market value of the director or employee, the portion above market value should form part of economic interest. The problem intensifies when a person earns a salary based on celebrity status, which is difficult to measure in terms of a market standard. Verification agencies will review the reasonableness of a celebrity-related salary in terms of the benefit that person brings to the business.

In the small business environment, salaries are going to present a significent obstacle. Business owners often reduce their own salaries and extract a higher dividend for tax purposes. Alternatively, the salaries are reduced to ease the business’s cash flow.

The verification agency must apply a degree of discretion in determining the reasonableness of the remuneration package when considering what constitutes economic interest and what is a bona fide expense of the business.

Bonuses are also commonly used as a mechanism to strip profits. The verification agency will review the basis on which the bonus has been allocated. If a bonus is not based on a coherent, quantifiable, previously agreed upon methodology, such as a defined performance management system, it begins to resemble economic interest and invites further investigation.

Transfer pricing

Transfer pricing is another common mechanism for reducing economic interest paid by an entity to shareholders. Transfer pricing is where a business sells goods or services to a related business at a discount or premium on market value, to reallocate profits from one entity to another for the purpose of reducing the economic interest going to a certain shareholder.

For example, Mr A owns X CC and Y (Pty) Ltd. Mr A sells 25% of X CC to a BEE participant. In an attempt to reduce the profit share due to the BEE participant, Y (Pty) Ltd sells stock to X CC at an inflated amount above market value. X CC, holding a good BEE status level, secures the right to sell the stock to a government department. The profit distributed to the BEE participant is reduced and Mr A realises a higher profit through Y (Pty) Ltd.

Verification agencies are aware of businesses using transfer pricing to strip profits. The economic interest held by Black people will be calculated using a market-related price for the sale of goods from Y (Pty) Ltd to X CC. In addition to this, the practice may be reported as fronting.

Thin capitalisation

Thin capitalisation is similar to transfer pricing but the profits are stripped out of one business in favour of another by charging excessive interest rates. This practice will be dealt with in the same manner as transfer pricing.

Debt and preference shares

Debt in favour of a BEE party is not ownership and interest payments will not be measured as economic interest.

While senior debt in its primary form does not present a problem, the difference between debt and equity is often difficult to determine when preference shares, debentures and derivative instruments are used. The verification agency will look at the nature of the instrument to determine whether the distribution represents interest that is not measured as economic interest, or dividends that are measured as economic interest.

The characteristics of debt are:

• A fixed interest rate or fixed rate of return
• A fixed period of repayment
• Where the return is not dependent on the performance of the business.
• The characteristic of ownership is a return on investment based on the performance of the business.

Businesses choosing to structure ownership deals using preference shares or derivative instruments must fully understand the difference between debt and ownership, otherwise the verification agency will not credit them with the anticipated points.

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