Since 1 January 2013, section 19 of the Income Tax Act, 1962 (the "Act") and paragraph 12A of the Eighth Schedule to the Act (the "Eighth Schedule") have determined the tax implications where a debt owing by a taxpayer is cancelled, waived, forgiven or discharged for no consideration (or for consideration that is less than the amount of the debt).
Broadly speaking, prior to the recent amendments brought about by the Taxation Laws Amendment Act, 2017 (the "TLAA") detailed below, section 19 and paragraph 12A provided for the taxation of the "reduction amount", which is the amount by which a debt is reduced less any consideration given by the debtor for the reduction (depending on how the funds raised by way of the debt was initially applied). Generally, section 19 applies to debts used directly or indirectly to fund expenditure in respect of which a deduction or allowance was granted in terms of the Act, with paragraph 12A being the capital gains tax equivalent.
Prior to the recent amendments under the TLAA, the scenario where a debt was settled through a capitalisation (ie, issuing shares) was not addressed by section 19 and paragraph 12A and was the subject of a number of binding private rulings ("rulings") by the South African Revenue Service ("SARS"). Generally, the rulings provided that no tax implications would result from such "capitalisations" without specific reference to the value of the shares issued in settlement of the debt.
The TLAA, promulgated on 14 December 2017, substituted both section 19 and paragraph 12A in their entirety. These came into operation on 1 January 2018, applicable in respect of years of assessment commencing on or after that date.
The basic mechanics of section 19 and paragraph 12A remain the same. Essentially, what changes is the trigger for the application of the provisions and the method of calculating the "debt benefit" (previously the "reduction amount"). The trigger for the application of the provisions now includes a change or waiver of the terms or conditions of a debt, a novation of the obligation in terms of which a debt is owed and the indirect capitalisation of a debt through issuing shares or the use of the proceeds from a share issuance to settle debt.
However, the major change brought about by the TLAA relates to the calculation of the "debt benefit". The market value of the debt or shares following the arrangement, as the case may be, will now be compared to the face value of the debt prior to entering into the arrangement. Prior to this change, and in terms of the rulings, a company could settle a debt through issuing shares without giving rise to any adverse tax implications, notwithstanding the fact that the market value of the shares issued did not correspond to the debt being settled.
This is no longer the case. For example, should a person who did not previously hold any shares in a company (such as an external creditor) subscribe for shares in the company, with the subscription price being used to settle debt owing to that external creditor and the market value of the shares issued is less than the face value of the debt prior to entering into the arrangement, this will constitute a "debt benefit" with the resultant adverse income tax or capital gains tax implications (as the case may be) flowing therefrom.
A further major change that taxpayers should be aware of is that the trigger events for the application of the debt reduction rules are now much wider. In terms of the TLAA, a "concession or compromise" is defined to include, inter alia, any arrangement in terms of which any term or condition applying in respect of a debt is changed or waived, or any obligation is substituted, whether by means of novation or otherwise, for the obligation in terms of which that debt is owed. This means that even an amendment of the relevant interest rate, repayment terms or period of the loan could potentially trigger the debt reduction provisions provided for under TLAA.
According to the Explanatory Memorandum to the Taxation Laws Amendment Bill, 2017, the removal of the definition of "reduction amount" and its replacement with "debt benefit" was necessitated for the following reasons:
"The current definition of a reduction amount has technical limitations in respect of covering the different types of debt concessions. For example, debt compromises such as debt subordination agreements that recognise that the market value of the claim that a creditor holds is less than the face value of the claim are currently not covered. In addition, conversions of debt into equity are also not covered. As a result it is proposed that a new definition of a debt benefit that will seek to tax the benefit to a debtor resulting from a concession or compromise of a debt entered into with a creditor be introduced."
It should further be noted that in terms of the TLAA, the exemption to section 19 and paragraph 12A in respect of debt reductions within the same group of companies will only apply if the debtor is a dormant group company (ie, it has not carried on any trade during the year of assessment in which the "debt benefit" arises as well as the immediately preceding year of assessment). As such, the exemption will not apply to all debt benefits undertaken within the same group of companies.
In conclusion, the TLAA has brought about major changes to the debt reduction rules. Firstly, capitalisations are now legislated and may have tax consequences as the market value of the debt or shares following the arrangement (as the case may be) will now be compared to the face value of the debt prior to entering into the arrangement. Secondly, a "concession or compromise" is defined very widely and may include any change in the terms of the debt.
David Marais is a candidate attorney in ENSafrica's tax department.