It is not uncommon for loan accounts owing by a company ("debtor company") to a shareholder ("creditor") to be sold by the creditor together with the shares in the debtor company. So too may creditors be tempted to dispose of a loan owed by the debtor company in circumstances where the debtor company can't service it because of the prevailing economic downturn. In these instances, the market value of the loan may be invariably less than the face value and also the base cost; and, as such, may be sold at a "discount to face value" resulting in a capital loss.
Where the debtor company is a "connected person" as defined in section 1(1) of the Income Tax Act, 1962 (as amended) ("ITA") in relation to the creditor and the loan is sold at a price less than the base cost of the loan (and assuming the base cost is equal to the face value of the loan), it is crucial that the tax consequences of both the creditor (ie, the seller) and the "acquirer of the debt" (ie, the purchaser) be considered carefully. This would too be imperative to ensure that the transaction is structured in tax-efficient manner. For purposes of this article, we assume that the loan is interest-free or a non-interest bearing loan, and therefore do not address the provisions of section 24J of the ITA.
Generally, the capital loss as a consequence of the disposal by the creditor of the loan owed by the debtor company would be disregarded for capital gains tax purposes. However, we will take a closer look at when the capital loss need not be disregarded and what would be required from the creditor.
Paragraph 56 of the Eighth Schedule to the ITA ("8th Schedule") was introduced to prevent persons from receiving a benefit of losses on debt when the debt most likely represents a disguised gift or contribution, neither of which would otherwise create a capital loss (Explanatory Memorandum on the Taxation Laws Amendment Bill, 2001, p 87). Thus, paragraph 56 was inserted as a loss limitation rule to avoid the tax base from being eroded by overstated or disguised losses as a consequence of debt between connected persons.
Paragraph 56(1) of the 8th Schedule provide that, where a creditor disposed of a debt owed by a connected person, the creditor must disregard any capital loss determined as a consequence of that disposal. It matters not whether the creditor disposed of the debt to a connected person, but only that the debt must be owed by a connected person. Importantly, paragraph 56(1) does not apply to capital gains since these constitute taxable income (section 26A of the ITA) that contributes to the tax base. Paragraph 56(1) is, however, not altogether absolute.
Paragraph 56(2) of the 8th Schedule provide for carve-outs to avoid the unintended consequences of paragraph 56(1) (Explanatory Memorandum on the Revenue Laws Amendment Bill, 2002, p 62 and Explanatory Memorandum on the Revenue Laws Amendment Bill, 2004, p 82). Notably, the carve-outs relate to those circumstances where the amount of the debt results in some form of tax in the hands of the debtor or the acquirer of the debt. In this respect, paragraph 56(2) provides that the capital loss need not be disregarded by the creditor if:
- the amount reduces the expenditure in respect of an asset of the debtor or must be taken into account by the debtor as a capital gain (paragraph 56(2)(a));
- the amount which the creditor must prove must be or was included in the gross income of the acquirer of the debt (paragraph 56(2)(b));
- the amount must be or was included in the gross income of the debtor or taken into account in the determination of the balance of assessed loss of the debtor (paragraph 56(2)(c)); or
- the amount which the creditor must prove must be or was a capital gain in the hands of the acquirer of the debt (paragraph 56(2)(d)).
The circumstances referred to in paragraph 56(2)(a) to (d) of the 8th Schedule, arguably, is keeping in step with the mischief at which the loss limitation rule of paragraph 56 is aimed. However, paragraph 56(2)(b) and (d) specifically provide that the "creditor must prove" that the acquirer of the debt must be or was subject(ed) to normal tax. But so too does section 102(1) of the Tax Administration Act, 2011 (as amended) ("TAA") provide that the creditor bears the onus of proof. The burden of proof must be discharged as a matter of probability.
The standard is often expressed as requiring proof on a "balance of probabilities" but that should not be understood as requiring that the probabilities should do no more than favour the creditor in preference to the South African Revenue Service ("SARS"). What is required is that the probabilities in the creditor's case be such that, on a preponderance, it is probable that paragraph 56(2) of the 8th Schedule would apply.
Although paragraph 56(2) of the 8th Schedule does not explicitly state that the circumstances referred to therein requires the application of these circumstances to a hypothetical transaction, in our view, on a purposive interpretation to make sense of these provisions, it must be so. In fact, SARS holds the same view. SARS' Comprehensive Guide to Capital Gains Tax (Issue 9) calls for a hypothetical enquiry.
It is however not as easy as to assert that – from a hypothetical point of view – one of the exceptions in paragraph 56(2) of the 8th Schedule would apply to the amount of the debt so disposed of.
Given the potential tax implications and complexities involved in the circumstances referred to paragraph 56(2) of the 8th Schedule, it is essential for creditors to consult with their experienced tax lawyers before the disposal of debts owed by connected persons. By doing so, creditors would obtain certainty as to whether the capital loss determined in consequence of the disposal of debts owed by connected persons would be caught by the clutches of paragraph 56(1) – but also to ensure that the creditor would be able to prove its case and utilise the capital loss arising from such disposal.
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.