South Africa: Sale of a Bungalow: Appeal Upheld

In Tax Update No. 11 we commented on the decision in ITC 1702 63 SATC 242 in which the taxpayer had held a lease over a bungalow on a camping site operated by the Municipality of Cape Town. The bungalow was one of several that had come into existence as a temporary measure after the First World War to enable ex-servicemen to obtain accommodation. The scheme had continued for almost another eight decades before being finally concluded. It was this conclusion, and the actions the taxpayer was obliged to undertake as a result, that led to the case being heard in the special court.

The taxpayer had acquired the leasehold in 1973 and had spent a total of some R715 000 in 1995 Rand terms in rebuilding and improving the building, despite the fact that her t e n u re was merely in the form of a short term lease. However, the Council had made it clear that, for policy and developmental reasons, it would never cancel a lease. The situation was therefore that the taxpayer and the other bungalow lessees had, in the words of the judgment in the High Court on appeal, "a sui generis claim to the property that was close to ownership".

When in 1995, after many years of lobbying by the bungalow owners' association, the Council finally offered to sell the properties to the owners, the taxpayer was faced with a price of R802 000, a sum she could not afford. Bearing in mind the size of her investment over the years, she was anxious to protect it, the alternatives being to pay a market related rent or abandon the property. She arranged a loan from a bank on terms that provided for interest to be capitalised for a year, giving her time to sell the property and recoup her investment. This she duly did, making a profit of more than R2 million, which SARS sought to tax as being revenue in nature.

The Special Court looked only at the intention of the taxpayer at the time she acquired ownership in 1995 and found that she had clearly intended to sell it as soon as possible in order to meet her obligation to the bank. This, allied to the fact that her right to the property had always only been that of a short term lessee, persuaded the court that her intention had been re venue in nature and she was thus taxable on the profit.

In the High Court, however, where the case assumed its full description as C M Wyner v C:SARS (not yet reported), the court focused on the special title she enjoyed by virtue of the Council’s declared intention over the many years up to 1995 not to cancel leases. The only reason she had sold the property in 1995 was that she could no longer afford to keep it. The court found that "her primary concern, and she said so repeatedly, was to salvage what she had invested in the property. She had nothing but the property and could not afford to lose it. This was her subjective intention. The objectively ascertainable facts set out above do not conflict with it". With these last two sentences the court was summarising the fundamental enquiry in determining the intention of a taxpayer. What was the subjective intention as stated by the taxpayer? Do the facts support that stated intention?

The High Court found that the taxpayer had not "embarked on a scheme of profit -making". She had set out to safeguard her investment and, in order to do so she was obliged to turn "her inchoate title into one that was transmissible". She had never before dealt in immovable property. Having achieved her objective, she had then behaved just as one would expect a person to do who had no intention of embarking on a scheme of profit-making:- she repaid the loan to the bank, bought another home, and invested the rest, "exactly as one would expect a person who merely changes investments to do". The profit was therefore capital in nature .

Interestingly, the High Court judgment quoted three cases that supported its finding, none of which appears in the special court judgment. It is not known whether these cases were referred to in the special court. In CIR v Paul 21 S ATC 1 the taxpayer was obliged to buy more land than he wanted and immediately sold the unwanted portion. In I TC 427 50 SATC 25 the court found that the intention of the tax payer prior to a decision to buy and sell may properly be taken into account in determining the character of the sale proceeds. Finally, in CIR v Pick ‘n Pay Share Purchase Trust 54 SATC 271 the taxpayer had "bought when it was obliged to and sold when it was required to". The court found that each of these statements applied to the taxpayer in the present matter.

SARS Media Release No 3 of 2002, issued on 1 March this year, announced another change in the official rate of interest. The rate is used to determine whether or not employees are receiving fringe benefits in the form of soft loans and are therefore liable for tax on the values of these benefits. This is the second change to the rate in a short time as SARS responds to changes in market rates.

The rate has been increased to 11.5% from 10.5% at which level it had stood since 1 October 2001. Before that, it had been set at 13% since 1 March 2000.

Although these frequent changes are disruptive to employers in calculating the values of fringe benefits for employees’ tax purposes, the alternatives can be disastrous. In particular, if the market rate falls below the official rate and SARS does not follow suit, taxpayers suffer. For example:

Say the rate on the loan is set at 5% below prime. With prime at 14%, the employee is paying 9%, so the value of the fringe benefit is the difference between 9% and 11.5%, namely, 2.5% applied to the loan amount.

However, assume that prime falls to 10% but the official rate remains at 11.5%. The employee is now paying interest at 5%, still saving 5% on the market value. However, the value of the fringe benefit is based on the difference between the actual rate and the official rate. This difference of 6.5% takes the cost of the loan to more than the employee would have paid without the fringe benefit. Obviously SARS should, in these circumstances, reduce the official rate to not more than 10%.

In general, employers and employees should be aware of situations where the relevant market rate appropriate to the circumstances, for example, prime or the bond rate, falls to less than the official rate.

Ever since the system of provisional tax came into operation in 1963 by the introduction of the Fourth Schedule to the Income Tax Act, taxpayers have been able to use an interpretation of paragraph 19 to avoid paying provisional tax for at least their first year as taxpayers. This is about to change, as explained in SARS Income Tax Interpretation Note No 1 dated 30 November 2001. Practice Notes as they have been known for many years will now be called Interpretation Notes.

Paragraph 19 of the Schedule requires the taxpayer to submit an estimate of the taxable income for the year and to make provisional tax payments based on that estimate. It provides further that the estimate must be at least equal to the "basic amount", which in essence is the taxable income for the last year assessed.

Taxpayers in their first year of assessment have always interpreted these provisions to mean that the basic amount is zero, because there is no previous assessment. It follows that they have not had to pay provisional tax until they have been assessed for the first time. This has meant that for probably the first two, and sometimes more, years of assessment the taxpayer need make no provisional tax payments. Of course, the fact that interest runs against the taxpayer from six, or in some cases seven, months after the end of the year of assessment in respect of the taxes ultimately assessed has encouraged taxpayers to make the so-called "topping-up" payment and there by ensured that they do pay provisional tax, but nevertheless six months to a year after they would have done had they been in possession of previous assessments. This cash flow benefit has been of assistance to taxpayers but not, of course, to SARS.

The new (and first) Interpretation. Note aims to change all that. Paragraph 19(3) has always entitled SARS to call upon the taxpayer to justify an estimate and to increase it if he deems it necessary to do so. The Interpretation Note lists four circumstances in which SARS might invoke paragraph 19:

• an increase in income resulting from legislative changes, mergers or acquisitions;
• the availability of financial results that support an increase in taxable income;
• the basic amount is more than two years old;
• it is the taxpayer’s first year of assessment.

C:SARS will apparently now use his power under paragraph 19 more vigorously when the fourth circumstance applies.

It is possible to imagine paragraph 19(3) being applied in any of the first three circumstances. The first circumstance could apply, for example, where a non-resident taxpayer with substantial interest income from South African sources becomes a resident under the new definition of resident in the Act. The previously exempt interest would now form part of the gross income of the taxpayer, and the basic amount could easily and justifiably be increased to reflect the new reality. Similarly, current audited financial statements could show a substantial increase in taxable income as compared with the most recently assessed results. Thirdly, the tax assessments of the taxpayer might be several years in arrears for any number of reasons, and the taxable income in terms of the current audited (or even unaudited) statements could be far higher than the basic amount.

Applying the fourth circumstance is likely to be far more difficult, however. On what basis would the estimate be made? Profit forecasts for management? Optimistic prospectuses designed to attract investors? Rosy projections directed at bankers from whom overdraft facilities are sought? What about the fact that businesses commonly run at a loss for the first few years while they are establishing themselves? Will projected losses cut any ice with SARS, which is becoming increasingly aggressive and acquisitive in applying the Act?

We have no intention, incidentally, of criticising the efforts of the authorities to apply the law to the limit and spread the tax net as widely as possible for the greater benefit of all, not least other taxpayers. The approach does seem to cause problems at times, however, for both SARS and taxpayers, and this new approach to provisional tax is a case in point.

While one could argue that the practical application of the new policy is likely to prove difficult and subject to some debate between SARS and the taxpayer, its existence should nevertheless be borne in mind and provided for in cash flow projections.

C:SARS v Pinestone Properties CC 63 SATC 421 was heard in the Natal High Court last August. It was an appeal by C:SARS against the decision of the Special Court in I TC 1678 62 SATC 288, on which we commented in Tax Update No 9, March 2001(available on our website: www. deneys reitz.co.za ).

The facts of the case were spelt out in that comment, and we shall not dwell extensively on them here. A building had been damaged by fire and had to be extensively repaired, in the course of which certain serious defects had to be corrected in addition to the fire damage. The taxpayer claimed the excess costs and was allowed them. When new tenants could not be found, the taxpayer sold the premises at a capital profit. C:SARS added back the repair expense, on the grounds that the taxpayer had recovered or recouped it. The taxpayer appealed against this decision and the special court found against C:SARS, but did not totally reject the proposition that repairs we re subject to recoupment.

Magid J commenced his judgment in the High Court by pointing out: "This appeal involves a completely novel concept in the law of taxation of income; if the owner of property who has claimed and been allowed the cost of repairs as a deduction against his rental income sells his property for a price greater than his cost, does that profit (albeit a capital profit) represent a partial or total recoupment of such cost within the meaning of s8(4)(a) of the Income Tax Act 58 of 1962 (‘the Act’ )? " Completely novel it certainly is, not to mention disturbing in its implications.

Counsel for C:SARS persisted in arguing for a mechanistic approach to this matter, despite its rejection by the special court. He submitted that there we re only three criteria relevant to a decision in respect of s8(4)(a), which provides for the taxation of recoupments of expenditure previously allowed as a deduction. These were: the cost of the property; the selling price; and the total amount allowed as deductions in respect of repairs. Notably absent from this list and, as will be seen, a reason for the defeat of C:SARS on this appeal, is the intention of the taxpayer.

The court confirmed the decision of the special court and found that the Act did not entitle C:SARS to claim that a taxpayer had recouped the cost of a repair, or indeed other minor maintenance costs, merely because he had sold the asset at a profit. The two crucial paragraphs of the judgment are worth quoting in full:

The court did not rule out the possibility of the cost of repairs being recouped. If, for example, the owner carried out repairs necessitated by poor workmanship in the construction and then received compensation from the builder, a recoupment might well arise. Similarly, the owner might agree to sell the property on one of two bases: R5m as it stands or R6m if certain specified repairs are carried out. If the owner we re able to carry out the repairs for, say, R500 000 and then claimed that expenditure as a deduction, the court expressed the view that the taxpayer would not be able to argue that there had not been a recoupment of the expense. The court also made the undeniable point that the position would be quite different in respect of non-cash deductions such as wear and tear. These would obviously be subject to recoupment on disposal of the asset.

This brings us back to the point made earlier, namely, that the intention of the taxpayer cannot be ignored in favour of a mechanistic approach. It is mind-boggling to contemplate the prospect of analysing the countless incidents of repair and maintenance carried out on a building over a few decades in order to determine the extent, if any, of their effect on the selling price. It is moreover by no means certain that repairs would be subject to recoupment merely because they had been carried out shortly before the asset was sold.

There is a wealth of case law on the subject of repairs, and two principles relevant to the present matter are: that a repair must do no more than restore the asset to its original condition; and that the repair must take place in the course of trade. It is submitted that there can be no question of a recoupment if a taxpayer, having decided to sell an asset after using it in trade, repairs it to the extent of its deterioration through use while it is still part of the trading activity, and then sells it for m o re than it would have realised had it been sold without the repairs having been done. In such a case, the taxpayer is reacting to the effects of the trading activities. This is different from the situation described above where the taxpayer sees the chance of turning a profit from the repairs themselves.

In other words, the intention of the taxpayer must be established, and clients should be careful to determine and record their intentions in such circumstances.

SARS Media Release No 8 dated 9 April 2002 confirms the transfer duty relief for natural persons announced in the Budget Speech on 20 February, 2002. Understandably, the relief favours the lower end of the consumer scale, in keeping with recent policy. The new rates apply from 1 March 2002, to all properties whether for residential or commercial purposes. The previous table differentiated between these two categories in favour of residential properties at the lower end of the market.

No duty will be payable on the first R100 000 of the value. The previous table provided for an exemption in respect of residential property valued at not more than R70 000, and 1% on the first R70 000 of properties with values above R70 000. A rate of 5% now applies from R100 000 to R300 000, compared with R70 000 to R250 000 on the previous table. Above R300 000the rate is 8%, which formerly applied from R250 000.

The rate for all other entities remains unchanged at 10%.

A comparative table of duty payable on residential properties at different values illustrates the effect of the new rates.

It is evident that the percentage reduction in the rate becomes progressively less as the value increases so that, for example, at R2 million the difference will be (R149 700-R146 000=R3 000) or a mere 1.8%. At double that value the difference shrinks to only 0.9%.

The Media Release warns against parties to transactions purporting to cancel agreements dated before 1 March 2002 and then entering into new agreements dated later. If there is not what is referred to as "effective cancellation", the old rates will apply. Fraudulent alteration of any such agreement will, of course, be a criminal offence.

The Unemployment Insurance Act, 2001 and the Unemployment Insurance ("UI") Contributions Act, 2002 came into operation on 1 April 2002. The first-mentioned Act regulates the benefits available to qualifying persons, which comprise unemployment, maternity, illness, dependants’ and adoption benefits. This article will deal with the UI Contributions Act ("the Act"), the provisions of which apply far more widely than did its predecessor. The Act determines the contributions to be made, as well as by whom and to whom they must be made.

The first major difference between the former system and the new one is that SARS is now involved, whereas formerly all contributions were made to the Unemployment Insurance Commissioner. Any employer required to register as such with SARS in terms of the Income Tax Act and/or the Skills Development Levies Act must pay monthly UIF contributions to SARS in respect of all its employees. In the rare cases where an employer is not required to register with SARS, the monthly contributions must continue to be paid to the Unemployment Insurance Commissioner.

The second major difference is that contributions are now due in respect of all employees. In the past, these were due only in respect of employees whose remuneration did not exceed R8 099 per month. Now, contributions are due on all the remuneration of all employees, up to a limit of R8 099 per employee per month.

Every employer and employee must contribute monthly to the Fund, with four exceptions:

• employees who are employed with a particular employer for less than 24 hours per month;
• employees who receive remuneration under a registered learnership agreement;
• employees and employers in the national and provincial spheres of government;
• employees who enter South Africa to work under a contract of service and who are required to leave on expiration of the contract.

Domestic and seasonal workers will be subject to the Act only with effect from 1 April 2003.

The monthly contribution is 2% of remuneration, of which employee and employer each pay half. For this purpose "remuneration" is as defined in the Fourth Schedule to the Income Tax Act for employees’ tax purposes, excluding certain items discussed below, and before deducting contributions to pension, retirement annuity and medical aid funds. The employer is obliged to make the contribution and pay the full amount over by the 7th of the following month, and must then deduct the employees 1% from the remuneration paid to the employee. Given the limit mentioned above, the total monthly contribution per employee cannot exceed R161.98, being 2% of R8 099.

As indicated above, certain components of remuneration are excluded from the calculation. These are: commission; pensions; superannuation or retiring allowances; annuities; compensation for restraints of trade; awards received in respect of termination, relinquishment, loss or other variation of office; and lump sums from pension, provident or retirement annuity funds. Whereas some of these are unlikely to crop up very often, others are very common, such as commission. There is consequently an awkward difference between the amount on which employees’ tax is calculated and the amount used for determining UI contributions. This presumably means more work for employment package software designers.

One of the unwelcome effects of CGT is the cascade effect in groups of companies. This has been the source of much criticism since the CGT provisions were published. The effect can best be explained by means of an example.

A holding company Holdco has a 100% subsidiary operating company Opco. Opco pays R1 million for all the shares in another company Propco, which owns a property that Opco needs in its business. Some years later the property has ceased to be of use and Propco sells it, realising a capital profit of R4 million. This is a capital gain for Propco, and it will pay CGT of 4 000 000 x 50% x 30% = R600 000, leaving a capital reserve of R3.4 million.

Propco has now served its purpose, so the group procures its winding up. Opco receives R4.4 million as a liquidation distribution, made up of a R1 million return of capital and the R3.4 million capital reserve. This reserve is a capital gain in terms of paragraphs 76 and 77 of the Eighth Schedule to the Income Tax Act. Opco is therefore liable for CGT of 3 400 000 x 50% x 30% = R510 000, leaving a balance of R2 890 000 as a capital reserve.

Assume that Holdco now sells its shares in or liquidates Opco, as a result of which it will similarly be liable for CGT on its gain amounting to 2 890 000 x 50% x 30% = R433 500, so that its net cash benefit will be R2 456 500. The person who holds all the shares in Holdco now disposes of them. The gain, all other things being equal, will be R2 456 500, which will attract CGT of that amount x 25% x 40% = R245 650 at the maximum marginal rate for an individual.

Note that the disposal need not be voluntary, and these effects do not necessarily require the liquidation of some or all of the companies. If the shareholder dies or emigrates, for example, the shares will have to be valued and they will reflect these valuations.

The aggregate CGT effect will be:

So on a capital gain of R4 million the ultimate shareholder has paid CGT of just under 45%.

This seriously adverse effect has been addressed, to a certain extent at any rate, by the introduction of sections 41 to 46 of the Income Tax Act, which are collectively described in the Explanatory Memorandum as the Corporate Rules. They provide rules for five different corporate situations:

• company formations
• share-for-share transactions
• intra-group transactions
• unbundling transactions
• transactions relating to liquidation, winding-up and deregistration.

These provisions replace and go further than the former rationalisation and unbundling provisions, as well as dealing with situations not covered by them. We shall look at each in turn, and then consider whether they assist in countering the cascade effect.

The definitions in s41 are largely self-explanatory: book value, capital asset, depreciable asset, equity share, listed company, market value and unlisted company need no explanation. However, the concepts of a group, a controlling company and a controlled company need to be clarified. A controlling company is one that holds for its own benefit, directly or through others companies in the group, at least 75% of the equity of any other company, the controlled company. In determining the degree of control regard must be had for any right to acquire an equity interest at no or a nominal value. A group of companies is a controlling company and at least one controlled company.

Reference to trusts in this discussion excludes special trusts.

The transaction contemplated here is where a person other than a trust ("the transferor") transfers an asset to a company ("the transferee") in exchange for a qualifying interest in equity shares in the company. For this purpose a qualifying interest is any holding if the company is listed and more than 25% if it is unlisted.

Normally this would trigger a CGT effect because the transfer would be a disposal, with the result that a reorganisation within a group could have serious cash flow consequences. However, in a qualifying situation the disposal will be deemed to have taken place at base cost to the transferor, and the transferee will be deemed to have acquired the asset on the date that the transferor acquired it. In other words, any capital gain will take place in the hands of the transferee when it disposes of the asset. Any allowances for bad or doubtful debts or future expenditure, when adjusted in the next year will be added back to the income of the transferee .

In order to discourage abuses of the Corporate Rules where the intentions of the parties are not genuinely what they purport to be, the Rules use a period of 18 months as the minimum required to show that a transaction is genuine. This limitation is applied twice in s42:

• the concession will not apply in situations where the transferor is a company and not more than 18 months ago it acquired the asset in terms of another such transaction, or its own shares were acquired in a share-for-share transaction; and
• where the transferee is an unlisted company and the t ransferor ceases to hold a qualifying interest within 18 months other than by an intra-group transaction, an unbundling or a liquidation distribution, the original transaction is effectively deemed to have taken place at market value.

In this situation the transferor disposes of equity shares in a resident company (the target) to another resident company in exchange for shares in the latter. Two conditions must apply after the exchange: the transferor must hold more than 25% of the equity of the transferee if it is unlisted and any holding if it is listed; and the transferee must hold at least 50% of the equity of the target if it is unlisted, and at least 35% if it is listed or will be listed within six months. The 35% requirement falls to 25% where no other shareholder holds as much equity as the transferee.

Without this provision the transfer, being a disposal for CGT purposes, would trigger a capital gain in the hands of the transferor (if the shares were transferred at a loss, the loss would be ignored). Instead, provided the qualifying conditions are met, the base cost of the shares for the transferee and their date of acquisition are deemed to be the same as those of the transferor in the shares in the target given in exchange.

The 18 month principle applies here in four instances to discourage abuse.

• Firstly, the tranferor must hold the new shares for at least that period, failing which the transaction will be deemed to have taken place at market value. If the proceeds of this disposal exceed the market value, predictably the actual proceeds are used in the calculation of the gain. However, a disposal as part of an intra-group transaction will not attract the penalty.
• Secondly, if the transferor has disposed of any other share to the transferee during the past 18 months at a loss, the current disposal is deemed to have taken place at market value. The resultant taxable capital gain may not exceed the previous loss or losses. The base cost to both parties in such a case is deemed to be the sum of the base cost to the transferor and the taxable capital gain.
• Thirdly, the section is not available where the target company acquired the shares less than 18 months ago under a company formation transaction.
• Finally, it does not apply where the transferor acquired the shares less than 18 months ago in a share-for-share transaction.

The section is also not available where the transferee is exempt from tax under s10.

Financial instruments are subject to several limitations in the Corporate Rules, the first of which appears here. The provisions of s43 are not available where more than 50% of the assets of the target company by market value or by cost consists of financial instruments, other than shares in its controlled companies.

This is a transaction where an asset is disposed of between two resident companies in the same group. For s44 to apply, both parties must jointly elect that it should apply to the transaction. In such a case, the transfer is deemed to have taken place at base cost to the transferor.

Where the asset is depreciable in terms of the Act, the transferee takes over all the tax characteristics of the asset as though the asset had always belonged to the transferee. This means that the transferee is deemed to have received any provisions granted in respect of the asset, such as doubtful debts, wear and tear, the debtors’ allowance in respect of credit agreements, and future expenditure on contracts. Any future recoupments would accrue to the transferee as well.

The safeguard against abuse in this instance is that, if both companies at any time in the future cease to be members of the group before the transferee disposes of the asset, the transferee is deemed to have disposed of the asset and to have reacquired it on that date at market value.

The section is not available where:

• the asset is a financial instrument, unless the transfer is of a business as a going concern; or the total value of financial instruments does not exceed 5% of the total assets;
• the transferee is exempt from tax under section 10 of the Act;
• more than 50% of either the market value or actual costs of all the assets of the transferor and its controlled companies consists of financial instruments other than shares in its controlled companies.

The transfer is not deemed to be a dividend and it is therefore exempt from STC.

In an unbundling transaction, a company distributes to its shareholders the shares it holds in another company, usually in order to unlock the value trapped in the other company because its shares are not sufficiently available in the market. Normally such a transaction would be treated as a dividend distribution and, because it is a disposal, it would have CGT implications for the transferor.

Section 45 provides that such a transfer will take place at base cost to the transferor in the case of an unbundling transaction, which is defined as one where:

• in the case of a listed company, the holding is transferred to its shareholders; or
• in the case of an unlisted company, the holding is transferred to its holding company. For this purpose, "holding company" is defined as one with an interest of at least 75% in the unbundling company.

A distributable share is one held by the unbundling company where:

• if the unbundled company is listed, its interest in the unbundled company is at least 35% of the equity or, if no other shareholder holds an equal or greater share, 25%;
• the unbundled company is unlisted, its interest is at least 50%. In such a case, where the unbundling company is listed, the unbundled company must list within six months.

The effect of these definitions is that the share investments of an unlisted company may only be unbundled to its holding company as defined. The share investments of a listed company may be distributed directly to its shareholders. This may be illustrated as set out below:

Assume that a listed company holds 50% of the equity of an unlisted company (the company to be unbundled). The listed company may distribute its 50% holding in the unbundled company to its shareholders.

Now assume that the listed company holds 75% of the equity of an unlisted company, which in turn holds 50% of the equity of another unlisted company (the company to be unbundled). The unlisted company may distribute its 50% holding in the unbundled company to the listed company. The listed company will then in turn be able to unbundle the shares to its shareholders provided the unbundled company lists within six months, and only after another 18 months have passed. The effect will be the same if the unbundled company is listed.

The shareholder will then have two holdings, in the listed company and in the unbundled company. The base cost in the records of the shareholder will be allocated in proportion to the market values of the two shareholdings, as illustrated below.

The distribution is not deemed to be a dividend and consequently does not attract STC.

The 18 month principle applies in that the unbundling company must have held the shares for at least that period of time, unless it acquired them under the previous provisions for unbundling or rationalisation.

The distribution will reduce the net asset value of the unbundling company. For tax purposes the reduction will be deemed to take place out of share premium and then out of undistributed profits.

The provisions of the section are not available where more than 50% of the market value or the actual costs of all the assets of the unbundled company and its controlled companies, if any, consists of financial instruments.

They are also not available to the extent that shares are distributed to any non-resident, unless that shareholder acquires not more than 5% of the unbundled shares.

The situation envisaged here is when a company in a group distributes an asset to its holding company in the process of liquidation or deregistration. Normally this would have a CGT implication because the distribution would be a disposal. However, s46 provides that in appropriate circumstances the distribution is deemed to take place at base cost and together with the tax characteristics of the asset, if any.

The conditions for application of the section are that the shares of the liquidating company must be at least 75% held by its holding company, and the distribution must be part of a liquidation, winding-up or deregistration process. If these conditions exist, the distribution is deemed to have been a disposal at base cost, and all the tax characteristics of the asset accompany it.

The 18 month limitation applies in respect of any subsequent disposal of such assets by the holding company during that period. Capital gains or losses from such disposals may only be set off against each other.

The familiar exclusions apply: the holding company may not be exempt from tax under s10, and not more than 50% of the assets of the liquidating company and any controlled companies may consist of financial instruments other than shares in controlled companies.

It is obvious that the company formation provisions are not applicable in this instance. If Propco were to dispose of the asset to another company in the group in exchange for shares in the other company, it would merely be transferring the gain to that company. Sooner or later, the gain would be realised and the cascade process would take place, but this time with yet another layer.

The same argument would apply if the shares of Propco were shifted to another group company.

Similarly, if the property were transferred to another group company, the gain would ultimately have to be accounted for in the group. However, if the transferee is the top company in the group, Holdco in this case, the cascade effect will be avoided, because the deemed base cost to Holdco will be the same as that to Propco and the capital gain will only pass through one company. The condition, of course, is that the group must be willing to defer the sale for 18 months.

Assuming that the Holdco group is unlisted, Opco could unbundle its shares in Propco to Holdco, but not individual shareholders. This would achieve a similar result to an intra-group transaction, but would eliminate one intermediate layer. If Holdco is listed, the shares in Propco could be unbundled to the shareholders of Holdco after being unbundled to Holdco by Opco. However, the shares in Propco would then have to be listed, and this would scarcely be an option in the circumstances. The unbundling provisions would therefore not be of assistance in this situation.

Propco could, in the process of liquidation, distribute the asset to Opco. It could not bypass Opco and distribute the asset to Holdco. Opco would then have to hold the asset for 18 months and then itself carry out an intra-group transfer or a liquidation process. Holdco in turn would have to hold the asset for another 18 months before disposing of it. Therefore, the liquidation provision could be used to eliminate the cascade effect, but at great inconvenience and only over 36 months.

Although the Corporate Rules go some way towards alleviating the cascade effect, they do not do so sufficiently and even then only within the strict limitations of their respective requirements. It is to be hoped that the authorities will take remedial steps in this regard. The most effective solution would be to provide for internal neutrality in regard to capital gains and losses in groups, similar to the provisions relating to STC, where dividends may in certain circumstances be passed upwards through a group with STC being payable only when the dividend leaves the group.