BY Carmen Gers
The interaction between the debt reduction rules and other provisions of the Income Tax Act
Having gone through a number of substitutions and amendments, the debt reduction rules contained in section 19 of the South African Income Tax Act, 1962 (the “Act”) and paragraph 12A of the Eighth Schedule to the Act now provide for the implications arising for a debtor where a debt owed to a creditor is waived, cancelled or capitalised by way of the issue of shares etc.
The question then arises: how do these rules interact with other provisions of the Act?
Consequential amendments have been made to a number of provisions in the Act to prevent “double counting” where the amended debt reduction rules find application. Further, section 19 and paragraph 12A also interact with pre-existing provisions in the Act. For transactions in respect of capital assets between “connected persons” (as defined in section 1 of the Act), these provisions include:
- The payment or settlement of a debt does not fall within the definition of a “concession or compromise” which is required for the application of paragraph 12A of the Eighth Schedule. Therefore, where a debt is reduced in consideration for the transfer by the debtor of an asset and no “concession or compromise” is present, paragraph 12A should not apply and the general provisions governing capital gains and losses are relevant. In this instance, the debtor should have a disposal of the asset so transferred and paragraph 35(1)(a) of the Eighth Schedule includes in the proceeds of the debtor “the amount by which any debt owed by that person has been reduced or discharged”.
- The creditor, in turn, should also have a disposal of the loan asset (which was redeemed) and its proceeds should be the market value of the asset received in exchange for the extinguishment if the debt (refer to Lategan v CIR (2 SATC 16, 1926 (CPD)). To the extent that the said proceeds are equal to the base cost, no capital gain or loss should arise.
- In a debt reduction scenario, the most likely outcome is, however, that the creditor will realise a capital loss (equal to the face value of the debt reduced, or alternatively, equal to the amount by which the face value of the debt reduced exceeds the market value of the asset received as consideration). In these circumstances, where the debtor and creditor are “connected persons”, paragraph 56 of the Eighth Schedule applies to disregard the capital loss (ie, it cannot be set-off against capital gains realised by that creditor). However, paragraph 56 does not apply to the creditor if paragraph 12A finds application to the debtor. In such circumstances, the creditor would thus be permitted to utilise the capital loss.
- Paragraph 39 of the Eight Schedule applies to ring-fence capital losses arising from disposals to a connected person. However, this paragraph does not apply if paragraph 56 finds application.
- Section 9C(2) deems any amount (subject to certain exclusions) received by a taxpayer on the disposal of a “qualifying share” to be of a capital nature. Section 9C(5) provides for the inclusion in a taxpayer’s income expenditure and losses incurred on that qualifying share and allowed as a deduction. Under the proviso to section 9C(5) there will, however, be no recoupment of expenditure or losses to the extent that the expenditure or losses relating to a qualifying share are taken into account under section 8(4)(a) or section 19 as a result of the reduction of a debt.
- Where a debt is reduced for no consideration, or not “adequate consideration”, a further enquiry is whether such debt is reduced by way of a donation (as provided for in section 55 and 58 of the Act) and, if so, whether donations tax is payable by the creditor. Where these provisions find application, the provisions of paragraph 12A and section 19 are excluded from applying. Important in these circumstances is that where an exemption from donations tax applies (for example, where the donation is between companies forming part of the same group of companies) the exclusion from paragraph 12A and section 19 would not apply, as it requires that donations tax must actually be payable (which was not always a requirement until the most recent amendment).
Transactions involving debt waivers, redemptions etc, must therefore be considered carefully to ensure that all the implications are accounted for correctly in the relevant debtor and creditor’s tax returns. This is important since while SARS may not make an assessment three years after the date of an original assessment, these limitations will not apply if there has been, inter alia, non-disclosure of material facts by the taxpayer.