Continuation of simultaneous disposals and acquisitions

Higher level topic - Disposals and deemed disposals - basic rules

At this level - Elaboration & examples of disposals and of simultaneous disposals and acquisitions.

 

 

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The topics on this page elaborate and give examples on simultaneous disposals and acquisitions. In effect these are deemed disposals.

 

 

Quick links to topics on this page and the related page-

On this page -

Waiver of debts

Resident/Non-resident related disposals

On related page

Conversion of asset into trading stock.

Assets ceasing to be trading stock.

Assets becoming personal-use assets

Assets ceasing to be personal-use assets

 

Waiver of debts as deemed disposal and acquisition

This type of deemed disposal differs significantly from the others in that the person not taking any action, (the debtor), usually ends up making the capital gain.

In summary it works like this -

Where a debt owing by a debtor to a creditor has been reduced or discharged for either-

  • no consideration
  • or for a consideration that is less than the face value of that debt,

the debtor is treated as having acquired a claim for the amount that was forgiven, (to which a zero base cost is attributed), and disposing of that claim for the amount forgiven.

This paragraph does not apply to transactions of this nature in the following circumstances-

  • where a capital gain has been taken into account by way of a reduction in base cost under what we refer to as the following year adjustment provisions
  • where the base cost of an asset has been adjusted downwards by reason of, for example, the debt raised on the acquisition of that asset not ever being paid
  • where the amount has been taken into account in reducing an assessed loss of the debtor
  • debts arising between spouses.

We have used the word ‘forgiven’ in the above explanation a bit liberally, in that the paragraph would also apply to situations where your own debt is reacquired at a discount, (see example 3). As such, the term ‘forgiven’ is hardly appropriate in that case. In essence then, apart from the exceptions set out in the bullets immediately above, this paragraph operates where a debt is reduced or discharged for a consideration that is lower than the face value. The outcome will be that the debtor will be treated as having a capital gain to the extent of the difference between the amount settled and the face value of the debt.

The reason for the awkward methodology applied to the process, i.e. the debtor is deemed to have acquired the claim and then disposed of that claim, is because the capital gains tax legislation deals with the disposal of assets. By acquiring a claim in this manner, the claim is treated as an asset.

In the real world it is usually those that do not have the resources to pay their debts who are going to be in need of forgiveness. Such people hardly need to be saddled with a capital gains tax liability!

Example 1 - Traditional forgiveness

A friend borrows R100 000 from you in order to pay off his gambling debts, he manages to settle R20 000 over a period of time, but as he is wont to do, he gets into more debt and is unable to repay the balance. There is no prospect of financial recovery on his part. You reluctantly waive the debt.

The CGT implications should work like this -

The face value of the reduction is R80 000. Your friend is deemed to have acquired a claim of R80 000 at a nil base cost and to have disposed of that claim for R80 000 proceeds. As such your friend has generated an R80 000 capital gain for himself. 

The problem becomes even trickier if you have to restore a company to solvency. Quite often, however, the troubled company will be shielded by a tax loss and the taxable element of the capital gain will not result in a tax liability. Furthermore, it could be that the debt reduction will itself be applied to reduce  that tax loss, (one of the exemptions to the operation of this paragraph). But this may not always be the case. If there is no tax loss or other exemption, the CGT liability will have to be catered for in bringing the company to solvency. The next example illustrates this point.

Example 2 -

Hopelessco (Pty) Ltd is part of the Clueless group of companies. It is capitalised mainly by loans from its holding company, Noidea Ltd.

The assets of Ontheballco (Pty) Ltd, an unrelated party to the Clueless group, were acquired by Hopelessco. In terms of the buy/sell agreement, Hopelessco acquired all of the operating assets of Ontheballco, amongst which were its debtors. One of those debtors was Enronco, (which happens to be a company in the Clueless group). Unbeknown to the Clueless group management, Enronco’s financial statements contained undisclosed liabilities. Upon their discovery it was placed into liquidation. Hopelessco was advised not to put in a claim for fear of having to contribute.

Hopelessco had in the meantime entered into a contract, one of the terms of which was that the customer would be entitled to cancel the contract should Hopelessco’s liabilites exceed its assets. Hopelessco needs R3million to restore itself to solvency. 

Hopelessco is unable to write off the Enronco debt for income tax purposes as it acquired the debtor in terms of a capital transaction. Furthermore, it is prevented from claiming a capital loss as Enronco is a connected person, (the loss is ‘clogged’).

As such, Hopelessco has no tax loss nor capital loss to shield itself from the capital gain that awaits it in terms of this waiver of debt provision. If Noideaco, (Hopelessco’s holding company), waives R3million in claims, Hopelessco will incur a CGT liabilty R450 000. It would mean that Hopelessco is still insolvent.

Noideaco would have to waive R3 529 412 of its claims. This would give rise to a CGT liability of R529 412 on the part of Hopelessco. Hopelessco would then have the necessary R3million it needs to restore itself to solvency.

Pretty bad planning!

Example 3 - Acquisition of own debt at a discount

On 1 October 2001, Listco Ltd issues 100 000 debentures at R10 each. Interest rates increased significantly in the meantime and the debentures are trading at R9 in the market. Having positive cash flows, Listco is able to reacquire 20 000 of the debentures at R9 each.

As soon as Listco acquires its own debt, that debt is automatically estinguished by way of merger.

It is deemed to have acquired a claim for so much of the debt as has been reduced or discharged - 20 000 debentures x R10 - R9 = R20 000.

That claim is deemed to have a nil base cost and the proceeds are deemed to be equivalent to that reduction. Therefore a R20 000 capital gain arises.

Exemptions to the waiver of debts provision -

This waiver of debt provision does not apply where a capital gain has been accounted for under paragraph 3(b)(ii).

Paragraph 3(b)(ii) is one of what we refer to as following year adjusments. In terms of this paragraph, if any part of the base cost of an asset that was disposed in a previous year of assessment has been recovered or recouped in the year following the disposal of that asset, a capital gain is deemed to arise in the year of the recoupment.

The term recovery or recouped in this sense seems to refer to situations where money is received by the debtor from the creditor, as opposed to situations where amounts are simply written off by the creditor. It would therefore seem to have little application. Nevertheless, the purpose of this exemption is to avoid double taxation in cases where the gain, that would otherwise have to be accounted for under this paragraph, had been accounted for under this base cost adjustment paragraph.

 

Exemption to waiver of debt provision - Downward base cost adjustment in terms of paragraph 20(3).

This type of adjustment is very similar in principle to the one dealt with above.

In terms of the base cost provisions, the expenditure incurred that may form part of the base cost of an asset, has to be both paid and due and payable for it to be taken into account in the determination of a capital gain/loss in the year that the asset is dsposed of. There is some confusion as to why the expenditure has to be both paid and due and payable, but this is not a consideration for now. The example below considers the situation of unpaid base cost expenditure.

Struggles (Pty) Ltd acquires an asset for R100 000 from Slack Ltd. Struggles uses the asset in its business for a number of years but only pays R40 000 on account to Slack. Struggles continues to experience unfavourable trading conditions and is placed under judicial management. As part of the rehabilitation strategy the judicial manager offers Slack R20 000 of the R60 000 owing in full and final settlement, and sells the asset in the open market for R90 000.    

As far as the disposal of the asset is concerned, the base cost expenditure of R100 000 must be reduced by the amount that was not paid i.e. R40 000. Struggles, having received R90 000 proceeds upon the disposal of the asset will have to account for a R30 000 capital gain.

The R40 000 reduction or discharge has been taken into account in the determination of the base cost of the asset in terms of paragraph 20(3). Therefore the waiver of debt provision does not apply.

If the proceeds on disposal had been less than the R60 000 qualifying base cost, resulting in a capital loss on the part of Struggles, the waiver of debt issue would similarly not apply. (The provision in this sense does not require Struggles to make a capital gain on the disposal of the asset, the unpaid amount merely has to cause a downward adjusment to the asset’s base cost.)

Exemption to waiver of debt provision - Set off against assessed loss

Section 20(a)(ii) provides that an assessed loss must be reduced to the extent that liabilities arising in the normal course of trade are reduced or extinguished as a result of a compromise or concession with creditiors.

Compromised liabilities that do not arise in the course of trade do not go to reduce a tax loss.

As with the other exemptions to the waiver of debt provision referred to above, this exemption prevents double taxation.

It would be preferable for the taxpayer receiving the compromise benefit to be subject to the waiver of debt provision, rather than have a debt reduce the assessed loss.This is because a capital gain only effects the tax loss to the extent of the inclusion rate that is applied to it. For example -

Company A has a tax loss of R200 000. It compromises with a creditor to the extent that a debt of R150 000 is waived.

If it is considered that the debt arose in the ordinary course of trade, the assessed loss will reduce to R50 000.

If it is considered that the debt was not incurred in the ordinary course of trade, the assessed loss will be unaffected by the application of section 20(a)(ii). Therefore, what remains is to apply the waiver of debt provision, (we will not repeat all the motions here, suffice to say that a capital gain of R150 000 will result).

The inclusion rate for companies is 50 percent, (meaning that only half of a capital gain will be included in its income). As such, only R75 000 of that gain will be included in income and as a result, Company A will carry forward an assessed loss of R125 000 into the following year.

Waiver of debts exemption - Transfer of assets between spouses

Paragraph 67 of the legislation disregards any capital gain resulting from the transfer of assets between spouses. The entire paragraph dealing with the waiver of debts is made subject to this provision, as such, waivers of debts between spouses can be safely ignored. 

Resident and non-resident related disposals

This category deals with the following-

  • Persons becoming resident
  • Persons becoming non-resident
  • Assets of permanent establishments, (“PE’s”)

Persons becoming resident -

Apart from any fixed property or certain defined interests in fixed property that that person may have in South Africa, that person is treated as having diposed of all of his worldwide assets on the day before becoming resident. That person will then be treated as having reacquired those assets on the same day at market value.

This provision, like certain others, does not trigger a CGT event Its purposes is to establish a base cost for CGT puproses.

As far as the base cost is concerned, the market value of such assets does not necessarily stand. This provision is made subject to the provisions of paragraph 24, which latter provision contains certain complicated rules to prevent, amongst other things, the creation of fictitious losses upon the future disposal of those assets.

The reason for the exclusion of fixed property and certain interests in fixed property from the disposal event is because non-residents are subject to CGT on disposals of such assets. There is thus no need to establish a (new) base cost for them.

 

Becoming non-resident

A person who -

  • ceases to be a resident, or
  • in terms of the application of a double tax treaty is treated as non-resident,

is treated as having disposed of all of his worldwide assets, except fixed property and certain defined interests in fixed property.

The person referred to in the first bullet is self-explanatory. This could refer to a natural person who becomes non-resident, a company, trust and so on. It would also include those persons who are treated as resident due to the time they may have spent in South Africa, (these rules are fairly complex), and become non-resident either because of having left permanently or temporarily. (It is quite possible to become non-resident for a period and resident shortly thereafter under these rules For these people CGT will be a bit of a nightmare).

The second bullet is a little obscure and probably a little unfortunate for the person concerned. As noted above persons can be treated as residents simply due to the time they have spent in South Africa over a period of time. Should South Africa, for example, enter into a double tax treaty with an expatriate’s home country, it could be that in terms of that treaty South Africa may not be able to tax that person as a resident. In other words the terms of the treaty will treat him as a non-resident for tax purposes. The day before the treaty takes effect, will be the day on which the CGT event, (disposals), take place.

This event triggers a CGT liabilty in repsect of all assets apart from those fixed property related assets referred to above. As non-residents are taxed on those fixed peroperty interests, there is no need to trigger a CGT event at the time of becoming non-resident. In this case the CGT will be collected when disposed of in some other manner.

Peculiarly, the person concerned is deemed to have reacquired the assets at the same value that was treated as the proceeds in respect of the deemed disposal. This allows that non-resident to establish a cost, (not necessarily the base cost), in respect of those assets in the event of becoming resident again. Should this eventuate, the provisions relating to commencing to be a resident will apply.

 

Permanent esablishment, (PE) related deemed disposals and aquisitions -

A permanent establishment is a terms used to describe what is usually a taxable business presence by non-resident. This would typically include branches of foreign companies, construction sites, and so on.

Unlike residents who are subject to CGT on all “assets”, non-residents are subject to CGT on the disposal of certain assets. Specifically, insofar as PE’s are concerned, the disposal of South African based assets of PE’s are taxable.

In the context of PE’s, the following events are treated as deemed disposals and acquisitions-

  1. An asset that becomes an asset of a PE otherwise than by way of acquisition, and
  2. An asset that ceases to be an asset of a permanent establishment otherwise than by way of disposal.

The first case does not give rise to capital gains and losses. This event is meant to cover situations where an asset of the foreign company is brought to South Africa for use in its local PE. This event has the effect of establishing a base cost for the asset. The timing of the event is the day before the event takes place and the base cost will be represented by the asset’s market value on that day.

The  second event is the exact opposite. This covers a situation where a PE withdraws an asset from South Africa for the company’s own use elsewhere. There is no disposal in the traditional sense of the word as the company would still own the asset upon its withdrawal from, for example, its South African branch. As such this event gives rise to the potential for CGT.