Section 20A was introduced with effect from 1 March 2004. It is a ring-fencing provision which limits the utilisation of an assessed loss from a tainted trade to the income from that trade. It only applies to natural persons (individuals).
Section 20A is discussed in detail in the Guide on the Ring-fencing of Assessed Losses from Certain Trades Conducted by Individuals (“ring-fencing guide”). It is not the intention of this Note to deal comprehensively with section 20A since that task is taken care of by the above guide. Rather, an overview of the main issues which are likely to affect game farmers, many of whom are natural persons who conduct their operations on a small scale on a part-time basis, will be provided. Inevitably when losses arise from game-farming operations and the taxpayer is a natural person, the issue will arise whether or not the loss from carrying on that trade may be set-off against other taxable income.
Section 20A does not replace sections 11(a) and 23(g). Any expenditure which does not qualify under section 11(a) or which is denied as a deduction under section 23(g) will be permanently lost. By contrast, section 20A does not permanently deny a set-off of the affected assessed loss but merely ring-fences it by only permitting it to be set off against future taxable income from that trade.
Section 20A contains four steps which determine whether an assessed loss can be ring-fenced. These are as follows:
Step 1 [section 20A(2)] – The maximum marginal rate of tax pre-requisite
Under this step it is first necessary to adjust taxable income by adding back any assessed loss and balance of assessed loss carried forward from the previous year of assessment.
If the amount so determined falls within the highest tax bracket for individuals, the taxpayer will have met the first step in the potential ring-fencing process and must proceed to steps 2 to 4.
Conversely, if the adjusted taxable income is below the level at which the maximum marginal rate of tax becomes payable, the assessed loss may not be ring-fenced. There is then no need to proceed to steps 2 to 4.
Step 2 [section 20A(2)(a) and (b)] – The “three-out-of-five-years” pre-requisite or alternatively, the “listed suspect trade” pre-requisite
Step 2 is also a pre-requisite for the application of section 20A. It comprises two alternative tests – if either of these tests is passed section 20A will potentially apply, if neither of the tests is passed section 20A can be disregarded.
Under the “three-out-of-five-years” pre-requisite, a person who makes assessed losses from game farming in at least three out of five years will meet this requirement. The five year period includes the current and four previous years of assessment. This rule applies to persons carrying on game farming on a full-time basis (see below).
Under the “suspect trade” pre-requisite section 20A lists eight suspect trades. An assessed loss arising from any one of these trades will be subject to potential ring-fencing. Farming or animal breeding is listed as a suspect trade unless such activities (including activities of a similar nature) are carried out on a full-time basis.45 It follows that game farming which is conducted on a part-time basis will be subject to potential ring-fencing. While full-time farming is not listed as a suspect trade, it could be subject to potential ring-fencing if losses are made in three out of five years of assessment (see the “three-out-of-five years” pre-requisite above).
Step 3 [section 20A(3)] – The “facts and circumstances” test (the escape clause)
Step 3 is an escape clause. In other words, an assessed loss that qualified for potential ring-fencing under steps 1 and 2 can escape ring-fencing under step 3.
Under section 20A(3) the ring-fencing provisions will not apply to a trade that constitutes a business in respect of which there is a reasonable prospect of deriving taxable income (other than taxable capital gains) within a reasonable period. Special regard must be had to –
• the proportion of the gross income derived from the trade in the year of assessment in relation to the amount of the allowable deductions incurred in carrying on that trade during that year;
• the level of activities carried on by the person or the amount of expenses incurred by that person in respect of advertising, promoting or selling in carrying on that trade;
• whether the trade is carried on in a commercial manner, taking into account –
the number of full-time employees appointed for purposes of that trade (other than persons partly or wholly employed to provide services of a domestic or private nature);
-the commercial setting of the premises where the trade is carried on;
-the extent of the equipment used exclusively for purposes of carrying on the trade; and
-the time that the person spends at the premises conducting the business;
• the number of years of assessment during which assessed losses were incurred in carrying on the trade in relation to the period from the date when that person commenced carrying on the trade and taking into account –
-any unexpected events giving rise to any of those assessed losses; and
-the nature of the business involved;
• the business plans of the person and any changes thereto to ensure that taxable income is derived in future from carrying on the trade; and
• the extent to which any asset attributable to the trade is used, or is available for use, by the person or any relative of that person for private use (recreational purposes or personal consumption).
For a detailed discussion on these special factors, see the ring-fencing guide.
Step 4 [section 20A(4)] – The “six-out-of-ten-years” requirement (the “catch all” provision)
Step 4 is a “catch all” provision that applies even if a taxpayer has escaped ring-fencing under step 3. However, it does not apply to farming operations. Thus even if a game farmer incurs losses in six out of the last ten years, ring-fencing can be prevented if the taxpayer can satisfy SARS that a business is being carried on with a reasonable prospect of deriving taxable income within a reasonable period.