Income Tax and Capital Gains Tax Implications

ON 03 SEPTEMBER 2015.

With effect from 1 January, new rules were introduced in the Income Tax Act governing the tax consequences flowing from the reduction or waiver of debts. 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 reduction or waiver of debt will constitute a disposal in the hands of the Lender. If the reduction or waiver of debt was treated as revenue in the hands of the Borrower, the amount will reduce the taxable income of the Lender. Any portion that is taxable as a capital in the hands of the Borrower will be included in determination of the capital losses of the Lender.

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. The funds could have originally been obtained to acquire both capital assets and items on revenue account. When the debt is reduced, it is necessary to allocate the debt proportionately to each of these components. Once the allocation has been completed, then the debt reduction ordering rules will be applied.

The provisions of paragraph 12A do not apply to any debt owed between companies that form part of the same group of companies, unless they form part of any scheme entered into to avoid any tax imposed by the Act. These rules make it easier for group companies to restructure debt for liquidity and solvency purposes. We have highlighted this key exclusion as being the most relevant but note that there are several other exclusions which may also be applicable.

These new regulations also allow for individuals to waive debt to the extent of R100 000 without attracting any Capital Gains Tax or Donations Tax, subject to certain conditions.

VAT implications

Lender:

If output VAT on the reduced or waived debts was accounted for, the Lender is entitled to claim the VAT portion of the reduced or waived debt as input VAT.

Borrower:

Where the Borrower, being a VAT vendor, claimed an input tax deduction in respect of the original debt, output tax must be accounted for on the portion of the debt reduced or waived.

If a debt, in respect of which an input deduction has been claimed, is not paid in full within 12 months from the date it was incurred, the Borrower may be required to make an output tax adjustment and pay the output VAT on the portion of the outstanding debt.

Where debts are payable in instalments after the tax period in which the input tax deduction is claimed, the 12-month period only starts running from the end of the month when each payment becomes payable in terms of the contract. The 12-month input claw-back provisions do not apply in respect of debts reduced or waived between companies that form part of a group of wholly owned companies.

Whilst these new provisions regarding the waiver of debt do allow for enhanced tax planning, it is imperative that you seek professional advice prior to engaging in any waiver of debt to ensure tax proper compliance. 

Prepared by  Bianca Roos for PKF Chartered Accountants