Authors: Stephen Lavetan and Taryn Solomon of ENSafrica
With effect from 1 January 2013, new rules were introduced in the Income Tax Act No. 58 of 1962 (‘the Act’) governing the tax consequences flowing from the reduction or waiver of debts. According to the Explanatory Memorandum, the amendments were prompted in response to the global financial crisis and the unusually large number of companies facing financial distress. The intention was therefore to establish a mechanism which facilitated debt reductions without creating an additional obligation to pay further tax.
In terms of the amended provisions, it is important to identify the purpose for which the funds were borrowed. The reason for this is that if the debt was used to fund deductible expenditure or an allowance asset, the debt reduction or discharge will be taken into account in terms of the ordinary revenue rules. The rules for capital gains apply as a residual category. Once the purpose of the debt is identified, then the relevant ordering rules will apply in determining the tax treatment of the debt reduction or waiver, namely section 19 in the case of debt used to fund deductible expenditure or an allowance asset and paragraph 12A of the Eighth Schedule to the Act in the case of debt used to acquire capital assets.
The effect of section 19 is that it deems any deduction or allowance granted in terms of the Act in respect of the expenditure to be an amount that has been recovered or recouped by that person for the year of assessment in which the debt is reduced.
In accordance with the provisions of paragraph 12A, the base cost of the capital asset must be reduced by an amount equal to the amount by which the debt is reduced. If the amount of the base cost of the capital asset is reduced to Rnil, the excess of the reduction amount over the base cost of the capital asset will be utilised to reduce any assessed capital losses of the taxpayer. If the taxpayer does not have assessed capital losses, then the remainder of the reduction amount will not be taxable.
The above rules are relatively easily applied in circumstances where there is a clear delineation of the purpose for which the debt was incurred. However, in practice it may not always be apparent as to the purpose for which the funds were borrowed. For example, a taxpayer acquires a business on loan account in terms of an intra-group transaction. It can be assumed that the loan was allocated to the various components of the business. Subsequently, a third party purchases a portion of the loan account together with shares in the taxpayer. At a later stage, it is determined that there is little likelihood that the third party will be able to repay that portion of the loan account acquired from the taxpayer.
The practical question which arises is what was the purpose of the loan account acquired by the third party? A claim was bought by the third party which originally arose in relation to the acquisition of a business comprising both capital assets and items on revenue account. Does the nature of the claim retain the same purpose for which it was originally created? Or is there a different purpose associated with the third parties’ acquisition of the loan account?
The Explanatory Memorandum issued by the South African Revenue Service does not provide any indication as to what will occur in the circumstances as described above. In addition, there is no case law at this stage addressing the operation of the provisions in the Act in such a scenario. It therefore seems that a practical way of determining the purpose of the debt is to consider the original purpose of the debt in acquiring the business. It is assumed that such purpose will not be altered when a portion of the debt is acquired by the third party from the taxpayer. The third party effectively assumes an obligation as opposed to advancing any debt for a specific purpose.
It is then necessary to separate the various components of the business into capital assets on the one hand, and those components which are treated on revenue account and in respect of which a deduction has been claimed on the other. In so doing, it is possible to allocate the debt proportionately to each of these components and determine the purpose for which the debt was incurred. Once the allocation has been completed, then the debt reduction ordering rules will be applied.