Since the introduction of capital gains tax it has been a contentious issue whether capital gains tax would arise in circumstances where a testator releases a debtor from a debt owed by the debtor to the testator or where the testator would bequeath the subject matter of the debt to the debtor resulting in potential set-off or confusio.
The debate has its origin in the provisions of paragraph 12(5) of the Eighth Schedule to the Income Tax Act which provides that, if a debt owed by a person to a creditor has been reduced or discharged by the creditor for no consideration or for a consideration which is less than the amount by which the face value of the debt has been so reduced or discharged, a capital gains tax liability will arise in the hands of the debtor in an amount equal to the benefit so derived. It is important to note that the benefit is calculated with reference to the face value of the debt irrespective of whether the debt is payable on demand or only at some time in the future. For instance, if a debtor pays R60 in order to settle a debt worth R100 which is only payable in five years’ time, there will still be a capital gain of R40 in his hands.
It was always thought that one could escape capital gains should the testator bequeath an equivalent sum of money to the debtor enabling him to settle the amount owing, instead of releasing the debtor from the debt.
In a landmark decision it was held by the Gauteng Tax Court that a capital gains tax liability did arise against the following background –
- the taxpayer sold shares to a trust and left the purchase price outstanding on loan account;
- subsequently the taxpayer passed away;
- in the will the taxpayer bequeathed the amount owing by the trust on loan account to the trust.
It was held that, on the death of the taxpayer, she was deemed to have disposed of her assets for proceeds equal to the market value thereof at the date of her death. However, on behalf of the estate of the taxpayer it was argued that set-off took place as an obligation was created in the estate towards the trust by the testamentary disposition, which equalled the liability which the trust had towards the estate. Unfortunately the court did not accept this argument. It was held that the taxpayer disposed of an asset by discharging the trust’s debt for no consideration. It was this act that created the situation where the claim against the trust was extinguished by operation of law. It is not the occurrence of set-off which renders the result thereof taxable in the hands of the trust, but the act which amounted to a discharge of the debt. The act which amounted to the discharge of the debt was the drafting of the will and its coming into operation at the date of death.
From the reasoning of the court it may well be that, if the taxpayer bequeathed other assets to the trust in order to enable the trust to settle the debt, there may not have been any negative tax consequences. However, the economic consequences would be the same in each case. The unfortunate result is that a number of wills will have to be amended. Similarly, a person donating amounts on an annual basis to a trust with a view to reduce a debt owing by such family trust to the taxpayer, may equally fall within the same trap. The consequence is that the deeming provisions of paragraph 12(5) of the Eighth Schedule to the Income Tax Act will also apply to testamentary other dispositions. The consequence is that, if not properly implemented, unforeseen tax consequences may arise in these circumstances.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.