Determining the base cost of the repayment of an interest-free loan acquired for less than face value

repairsAuthor: Okkie Kellerman and Esther Geldenhuys of ENSafrica

Introduction

The Eighth Schedule to the Income Tax Act, 58 of 1962 (“the Act”) creates a tax liability known as capital gains tax which applies generally where an asset is disposed of. A loan is regarded as an “asset” in terms of the definition in paragraph 1 of the Eighth Schedule as it is an incorporeal asset whereby the lender acquires a right to claim payment from the borrower. Where part of a loan is repaid it constitutes part of an asset disposed of and it will be necessary to allocate a part of the base cost of the loan to the part of the loan repaid in order to determine the capital gain or capital loss in respect of the disposal of that part. Where a loan is acquired for less than its face value, i.e. the base cost of the loan is less than the amount actually owed by the borrower; the part-disposal method in paragraph 33 of the Eighth Schedule to the Act will apply.

The base cost of the part repaid

Paragraph 33 contains two formulae for determining the part of the base cost repaid, i.e. the market value formula method and the specific identification method. The market value formula method in paragraph 33(1) of the Eighth Schedule provides that the base cost of the entire asset must be apportioned in the ratio that the market value of the part bears to the market value of the whole asset. In terms of this paragraph the base cost of the part of the loan repaid will be calculated as follows:

Base cost of the part of the loan repaid = market value of the part repaid / market value of the total loan x base cost of the total loan

The difficulty with the market value formula method is that it requires the market value of the loan to be determined immediately before each repayment. Should there be numerous repayments it would accordingly be administratively burdensome to apply this method and practically difficult to implement. As an alternative, the specific identification method can be applied to determine the part of the base cost repaid.

The specific identification method in paragraph 33(2) of the Eighth Schedule provides that the market value formula method will not apply where the expenditure as determined in paragraph 20 of the Eighth Schedule or the market value as determined under paragraph 29(4) of the Eighth Schedule can be directly attributed to the part of the asset which is disposed of or which is retained. Therefore, the market value formula method will not apply where the expenditure or market value in respect of the part disposed of can be specifically identified.

The South African Revenue Service’s Comprehensive Guide to Capital Gains Tax (Issue 4) states that the specific identification method recognises the fungible nature of a loan, that is, that all parts of the loan have an equal cost, are indistinguishable and identifiable by nomination. Therefore, in terms of paragraph 33(2) of the Eighth Schedule and following this statement, the base cost of the part of the loan repaid will be calculated as follows:

Base cost of the part of the loan repaid = amount repaid / the total loan x base cost of the loan

Therefore, where a loan with a face value of R100 million is acquired by a company at a cost of R80 million and R10 million is repaid in the first year, the base cost of the part of the loan repaid will be R8 million (i.e. R10 million / R100 million x R80 million). The capital gain will accordingly be R2 million (R10 million less R8 million) with capital gains tax of R373 340 payable at an effective rate of 18,667%. Using the above example and as all parts of the loan have equal cost, R1 of the R100 million loan will accordingly have a cost of 80 cents. This creates a simplified calculation in that should a repayment of R10 million be made on a loan with a face value of R100 million which is acquired for R80 million the base cost of the part of the loan repaid can simply be calculated as follows: R10 million x 80 cents = R8 million.

Conclusion

The specific identification method therefore recognises a simplified calculation in that all parts of the loan will have equal cost. As it will be administratively burdensome to use the market value formula method and since this method is specifically excluded in terms of paragraph 33(2) of the Eighth Schedule where the expenditure or market value in respect of the part disposed of can be specifically identified, the specific identification method will generally be used. It is, however, important to note that where the loan is interest bearing the provisions of section 24J of the Act will apply and the loan repayment should be dealt in the manner prescribed by that section.

Tagged , . Bookmark the permalink.