plan4cgt - Disposals & deemed disposals - elaboration & examples

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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This topics on this page elaborate on aspects of disposals. The topics are in no particular order. 

 

 

Quick links to topics on this page -

Creation of assets as disposals

Extinction of assets as disposals

Donations of assets as disposals

Exchange of assets as disposals

Renunciation of assets as disposals

Scrapping of assets as disposals

Vesting of trust assets as disposals

Distribution of company assets as disposals

Options as disposals

Value shifting arrangements as disposals

 

Creation of assets as disposals!!!!!!

This is obscure, to say the least! How can the creation of an asset be a disposal?

Upon entry into a contract, (say a contract of sale), certain rights and obligations are created. For example, the seller has an obligation to take care of the asset and make it available (deliver) it to the buyer. In turn, the buyer has a right to delivery of the asset. Should the seller renege on his obligations the buyer has certain remedies. For example, he can sue for non-performance.

The lengths to which the CGT legislation extends in respect of the creation of rights such as those described above, is a matter of considerable uncertainty.

The SARS draft Comprehensive Guide to Capital Gains Tax, (on page 32) is to a certain extent instructive as to what will be regarded as a disposal in the context of the creation of an asset. In this regard they have set out certain transactions that they believe fall into this disposal category. This list, however, is not exhaustive. They are -

  • The granting of a lease, a servitude, mineral rights and a license.
  • A restraint of trade agreement.

This is what SARS has to say about leases-

    ....when the owner of a property grants a lease over that property, the owner creates a contractual right in favour of the lessee. That right is an asset for CGT purposes. The creation of this right has given rise to a disposal of part of the full right in the property that the owner previously enjoyed. In other words there has been a part disposal. As can be seen, the creation has given rise to both an acquisition and disposal.”

This is what SARS has to say about restraints of trade-

    ...the person agreeing to the restraint gives up the right to trade freely in exchange for the right to receive payment, (the right that has been created). In the case of an individual the right to trade freely would probably have a zero base cost and the proceeds would be the amount of the restraint payment received.

Turning back to the contract of sale, once the agreement has been entered into, certain rights have been created. As in the case of the lease example, has the seller not impaired his right to trade freely in the subject matter of the sale? Does the creation of that right not have a CGT effect? It seems that this wide interpretation on our part is probably a little too wide! But how far is SARS going to take the creation of a right?

One last word on this and it relates to what could be regarded as donations. If, for example, a lease has been entered into, this ‘creation of a right’ disposal event will have been triggered. Presumably the lessee is paying a market related rental, (that rental will be included in gross income and as a result there should be no CGT effect). But what if the rentals are not market related? (This situation would typically arise in connected person relationships such as groups of companies, family members and so on - watch out for this!)

 

Extinction of an asset as a disposal

This concept is generally fairly straightforward. Not surprisingly however, some problems raise their heads.

First the easy ones -

  • Your house burns down. The difference between the base cost and the proceeds should represent a capital gain/loss. But is this a disposal or a part disposal? in any event the roll-over provision may apply.
  • Your office block burns down. The same applies.
  • ( Note - Both of the above assets do not generally qualify for scrapping allowances for income tax purposes. If scrapping allowances do apply to an asset, there will usually be no CGT effect as the base cost would tend to reduce to zero.)

An asset can expire, or become extinct, in many ways. The sands of time can expire an asset. For example, a licence agreement in force for three years will expire after three years. The same can be said of restraints of trade. In both cases there should be no CGT effect as no consideration would have changed hands upon the asset’s expiration. But let’s have a closer look at  the problems related to a restraint of trade, where consideration passes.

Company A pays Company B R1million to refrain from trading in gift-wrapped CGT legislation. The restraint operates in South Africa. (At this point Company A has an asset - the restraining of Company B. That asset’s base cost should be R1million). In turn, Company B will have to account for a capital gain of R1million, (it created a right to receive R1million upon entering into the restraint).

Company B badly misjudged the effect of giving up that part of its trade, particularly in the light of the fact that the gift wrapped legislation is not selling too well elsewhere in Africa. It is prepared to pay Company A R2million for it to be released from the restraint.

    Let’s have a look at the possible CGT effect -

    Company A’s base cost in respect of the rerstraint, (it’s asset), is R1million. It has received R2million in consideration for the expiry or extinction of that asset. It therefore records a capital gain of R1million.

    Company B had previously received R1million for what really amounted to giving up its right to trade freely. Its right to trade freely in the first instance would in all likelyhood have cost nothing, so in that respect there was never any base cost. In paying R2million to reacquire what was at one time its asset, probably means that it is acquiring an asset, (i.e. that part it previously relinquished) and is not disposing of anything. So how does Company B get to claim a capital loss?    

Donations as disposals

Clearly the donation of an asset will cause a change of ownership of that asset. On this part of the site we simply want to draw your attention to the fact that the donations tax payable will in all likelihood be greater than the CGT; that there are base cost considerations that apply in respect of donated assets; that you may not even know when you have made a donation, (particularly in relation to the creation of rights); that capital losses arising in respect of donated assets will most likely be ring-fenced. But at least you can donate to registered public benefit organisations free of both CGTand donations tax.

So - watch out for donations!

(We will cover donations more fully in time to come).

Exchange of an asset as a disposal

What the legislation has in mind here is barter transactions. In this regard it is important to remember that an “amount” received in respect of the disposal of an asset does not have to be in cash, but can also be “in-kind”. Similarly, the base cost of an asset would include amounts paid “in-kind”.

In a similar vein, there is a provision in the legislation, (paragraph 34), that deals with debt substitution. In essence, where a debt to a creditor is reduced or discharged by the disposal of an asset to that creditor, the creditor must treat the market value of that asset, at the time the disposal is made, as the base cost . For example - 

A friend of yours borrowed R100 000 from you in October 2001. As part payment of the debt, you accept a  a piece of land worth R85 000.

The base cost of the land in your hands will be R85 000.

If that land was a capital asset, your friend, (the debtor), would have to figure out the CGT consequences of disposing of that land at its R85 000 market value. (Note - the legislation referred to above does not deal with the debtor’s side of the transaction).

If the R85 000 land was “paid” to you in full and final settlement of the R100 000 debt, the donations tax consequences, (on your part), would need to be considered - there may well be none!  Assuming there are no donations tax consequences you should be able to claim a R15 000 capital loss. In this latter situation, on the debtor’s part, there has been a waiver of R15 000 of the debt. This would probably create further unfavourable CGT consequences for your friend.

What follows is an example of a straight barter transaction.

You acquire a piece of land on October 2001 for R100 000. You exchange that land in 2008 for a holiday home to the value of R400 000.

The R400 000 market value will be recognised as proceeds and the land’s base cost is R100 000. As such, a capital gain of R300 000 arises upon the disposal of the land. The base cost of the holiday home acquired will be R400 000.

Similarly, if the holiday home was a capital asset in the hands of the other party, that person would treat the market value of the land on disposal of the holiday home, (presumably R400 000), as proceeds, and would account for the capital gain/loss on the disposal of the holiday home accordingly, (we do not know its base cost). The base cost of the land in that person’s hands would presumably be R400 000.

Renuciation of an asset as a disposal

The term renounce in this context would mean to repudiate or decline.

Say, for example, you are offered an asset and decline the offer, for whatever reason, (pride, you feel you are not deserving of it). This should not trigger a disposal.

It is considered that in order for a CGT event to arise in this respect, the taxpayer would have to renounce his rights to that asset once he has the rights to that asset. This could happen, for instance, where a legatee has been bequeathed an asset under a will and repudiates that asset. It is quite likely that in most cases, the CGT consequences will be mimimal, as assets are transferred to legatees at the market value upon date of death, (there could of course have been a change in value in the interim period). The same could not be said of spouses. In this case the base cost of assets tranferred to the surviving spouses is the same as that that applied to the deceased during his or her lifetime.

It is most likely that the donations tax will far outweigh the CGT.

 

Scrapping of asset as disposal

This form of disposal may or  may not trigger a CGT liability, depending upon whether or not proceeds were received. In this regard an insurance payout would constitute proceeds as would proceeds received upon the sale of the scrapped asset.

In this latter context, there are sometimes (favourable) income tax consequences. Assets such as plant and machinery used by a taxpayer in the course of its trade, usually, but not always, qualify for a scrapping allowance. This allowance usually equates to the quantum of the remaining tax value of that asset, after acounting for any proceeds recieved. Where this happens it is likely that the base cost of the asset will be reduced to zero, thereby resulting in no capital loss.

 

The vesting of a trust asset as a disposal

The CGT treatment of trusts, settlors, donors and beneficiaries is highly complex and not for the faint-hearted.

Briefly, assets of a trust may vest in a beneficiary in a number of ways, for example - after a period of time; at the discretion of the trustee and so on. Assets may also vest in a beneficiary but retained in the trust. It is upon the vesting of the asset in a beneficiary that triggers a CGT event. The subsequent delivery of that asset to the beneficary is an event that is specifically excluded from disposals.

 

Distribution of company assets as disposals

This should come as no surprise as it involves a change of ownership. A sizeable portion of the CGT legislation is dedicated to company distributions. The income tax and possibly secondary tax on companies (STC) consequences are likely to be more significant that the CGT effects.

 

Options as disposals of assets

The creation of an asset, the first topic dealt with on this page, constitutes a disposal. An option falls into this category, however, the CGT legislation specifically caters for not only the creation, (or “granting”), of an option, but the renewal, extension or exercise of an option. Any of these events are regarded as disposals.

Options may be granted over almost any type of asset. But it is not the underlying asset itself to which this part of the legislation refers. Rather, the granting of an option is itself the asset and it is the act of granting that option that constitutes a disposal on the part of the grantor.

For example, you may grant a potential buyer a three month option for R10 000 to acquire your residence for R600 000. That act of granting the option is a disposal of an asset, (the option), on your part. The base cost of the option on your part will be nil and the proceeds will be R10 000. As such your capital gain will be R10 000.  

Further points relating to options as disposals -

Clearly the renewal and extension of an option falls into a similar category as the granting of the option, as such these events should also constitute disposals.

If that person excercises the option and pays the R600 000 purchase price clearly the option will have expired - another disposal.

The overall CGT treatment of options is complex. As such, we have dedicated more of the site to the discussion of this topic.

One last point on options -  be careful with giving options to connected persons, (group companies, family members and so on).

Value shifting arrangements as disposals

The decrease in value of a person’s interest in a company, trust or partnership as a result of a value shifting arrangement is treated as a disposal.

A value shifting arrangement typically arises in family relationships, therefore the scope of value shifting arrangements is confined to those arrangements that arise between connected persons only i.e. you can value shift to a friend free of CGT, (but beware of donations tax).

A value shifting arrangement is best dealt with by way of example.

Suppose you hold 100 percent of the “A” class shares in company Z. Your son holds 100 percent of the “B” class shares.

Suppose that you pass a resolution to the effect that the rights and entitlements of the “A” shares change in such a way that the value of the “A” shares diminish. If these “A” and “B” shares are the only shares in the company, it follows that the “B” shares would increase in value by a corresponding amount i.e. value has been shifted from the “A” shares to the “B” shares, (in essence value has been shifted from yourself to your son).

It is that decrease in value of your interest that constitutes a disposal on your part.

For more on value shifting....