The Income Tax Act No. 58 of 1962 (“the Act”) contains a number of provisions in terms of which assets may be transferred from one taxpayer to another on a tax-free basis, with the tax in relation to such an asset being deferred until the transferee eventually disposes of the asset. One such provision is contained in section 42, dealing with “asset-for-share transactions”.
An asset-for-share transaction is essentially a transaction in terms of which a person (“the Transferor”) disposes of an asset to a company (“the Company”) in exchange for the issue of shares by the Company, provided the Transferor holds a qualifying interest in the Company at the end of the day of the transaction (broadly speaking, 10% of the equity shares and voting rights in an unlisted company, or any equity shares in a listed company). In addition, certain qualifying debt may be assumed by the Company as part of the asset-for-share transaction, without prejudicing the application of section 42.
Broadly speaking, in relation to capital assets, an asset-for-share transaction results in no capital gain for the Transferor with the Company acquiring the asset at the same base cost at which the Transferor held it. The base cost of the asset accordingly “rolls over” to the Company and the deferred capital gain on the asset is accordingly only triggered when the Company disposes of the asset, unless any relief finds application at such time. In addition, the Transferor acquires the shares in the Company at a base cost equal to the base cost at which it held the asset disposed of to the Company.
Section 42(8) provides that a proportionate part of any qualifying debt that was assumed by the Company as part of an asset-for-share transaction will constitute an amount received by or accrued to the Transferor in respect of the disposal of any of the shares in the Company acquired in terms of the asset-for-share transaction, should such shares be disposed of by the Transferor. Essentially, section 42(8) provides that the Transferor will have additional proceeds upon the disposal of the shares equal to a proportional amount of the debt that was assumed by the Company.
The reason for this provision appears to be to counteract the base cost allocated to the shares in terms of section 42 where the assets disposed of are geared. For example: Person A borrowed R100 from a bank and utilised the funding to acquire an asset. The asset accordingly has a base cost of R100 in the hands of Person A. Assume the asset grows in value to R150. Person A then disposes of the asset to Company B in exchange for the assumption of the R100 debt and the issue of shares in Company B. Simplistically speaking, the value of the shares acquired by Person A in Company B will be R50 (being the net asset value). However, in terms of section 42, the base cost at which Person A will acquire the shares in Company B, will be deemed to be equal to the base cost at which Person A held the asset, i.e. R100. But for the application of section 42(8), if Person A were to dispose of the shares in Company B at their market value (R50), Person A will trigger a capital loss of R50 (R50 proceeds less R100 base cost). However, in terms of section 42(8), Person A will be deemed to have additional proceeds equal to the debt that was assumed by Company B in terms of the asset-for-share transaction, in this case R100. This will result in Person A triggering a capital gain of R50 upon a disposal of the shares (R50 real proceeds plus R100 deemed proceeds, less R100 base cost) which mimics the commercial gain of Person A.
Generally, the application of section 42(8) does not place the Transferor in a worse position than it would have been in had it retained the asset and was taxed on the growth in value in the asset. However, the application of section 42(8) could have detrimental consequences in certain instances:
- Firstly, most of the roll-over relief provisions in the Act do not contain explicit roll-over relief in relation to the deemed additional proceeds triggered in terms of section 42(8). Accordingly, should shares acquired in terms of an asset-for-share transaction be disposed of in terms of another transaction qualifying for corporate roll-over relief, such relief may not cater for a gain which may arise as a result of the application of section 42(8). Furthermore, the roll-over relief provisions may result in a rolled-over base cost for the transferee, despite a capital gain being triggered in the hands of the Transferor as a result of the application of section 42(8);
- Secondly, section 42(8) may give rise to detrimental consequences where the debt that was assumed in terms of the asset-for-share transaction was not applied in order to fund assets (but, for example, to fund working capital in the case of a sale of a business in terms of an asset-for-share transaction). In such an instance, the base cost of the shares will not equate to the debt that was assumed in terms of the asset-for-share transaction, which may result in additional tax in the event of the disposal of the shares.
Lastly, it is important to remember that there is no time limitation to the application of section 42(8). In terms of current law, it will continue to find application to a disposal of shares acquired in terms of an asset-for-share transaction, irrespective of the time period that elapses between the asset-for-share transaction and the future disposal of the shares. This is an aspect which should be borne in mind, inter alia, in determining whether an asset-for-share transaction is an appropriate arrangement in terms of which to implement a disposal.