A closer look at the new Debt Reduction Regime

A closer look at the new Debt Reduction Regime Herman Viviers 20 November 2014

Disclaimer Nothing in this presentation should be construed as constituting tax advice or a tax opinion. An expert should be consulted for advice based on the facts and circumstances of each transaction/case. Even though great care has been taken to ensure the accuracy of the material, the presenters do not accept any responsibility for consequences of decisions taken based on the material. It remains your own responsibility to consult the relevant primary resources when taking a decision.

SESSION OVERVIEW BACKGROUND? What is new? & Why the change? A CLOSER LOOK AT SECTION 19 Types of debt reduction transactions qualify under s 19? How does it link/integrate with par 12A of the Eighth Schedule? How is the limitation ito s 19(7) applied? What type of transactions do NOT apply under s 19? A CLOSER LOOK AT THE CGT IMPLICATIONS OF DEBT REDUCTION: Application of par 12A Capital losses between connected persons: par 39 versus par 56 CRITICAL QUESTIONS ON THE NEW DEBT REDUCTION REGIME? DEBT RELIEF: EMPLOYER & EMPLOYEE RELATIONSHIP? VAT CONSEQUENCES OF DEBT RELIEF?

LENDER Advances a loan to @ Market related interest; @ Interest-free; @ low interest rate < official interest rate BORROWER Is an interest-free loan a donation? Will the "interest-free" component be subject to Donations Tax? If the loan is waived/reduced, what will the tax consequences be? Will it be a "donation" subject to donations tax? OR Will the new debt reduction regime (ito s 19 and/or par 12A) apply? Will the tax implications change if it lender = employer & borrower = employee? What if the loan was a shareholder's loan (so called "debit" loan)? What will the VAT consequences be?

OLD DEBT REDUCTION REGIME? NEW DEBT REDUCTION REGIME? Now repealed! Ordinary revenue = s 8(4)(m) recoupment waiver of debt S 20(1)(a) Debt relating to capital amounts = par 12(5) of the 8 th Schedule New rules will cover debt iro ordinary revenue = s 19 of ITA Debt relating to capital amounts = par 12A of the 8 th Schedule REASON FOR NEW DEBT REDUCTION REGIME? Government seeks for a uniform system for the tax treatment of debt reduction or relief which will assist in local economic recovery. The uniform system will address debt relief (thus debt reductions (including cancellations) for less than the full consideration) resulting from a debtor s inability to pay. For years of assessment commencing on or after 1 January 2013.

What type of transactions DO NOT apply under s 19? [see s 19(8)] Section 19 must not apply to any debt owed by a person: that is the heir/legatee of a deceased estate to the extent that the debt is reduced by way of a donation Property owned at date of death, any right to property: movable; immovable; corporeal or incorporeal. - to the extent that - the debt is owed to the deceased estate; - the debt is reduced by the deceased estate; and - the amount of the debt reduction forms part of the property of the estate - Donation as defined in section 55 (actual donation) ; or - In terms of any transaction to which section 58 applies (deemed donation) to an employer where debt is reduced ito par 2(h) of the 7 th Schedule

Section 55(1): A "donation" means: "any gratuitous disposal of property including any gratuitous waiver or renunciation of a right" Gratuitous = for no consideration / or for free. CGT consequences: A disposal includes Par 11(1)(a): ".a donation of an asset " Par 11(1)(b):" cancellation, discharge, release, waiver, renunciation of an asset " Par 22, 8 th Schedule: Allows a portion of donations tax paid to be added to the base cost: Formula: (M A) /M x D M = market value of the asset donated, i.e. right to collect the money A = base cost of the asset, i.e. the debt reduction amount D = Donations tax payable Proviso to par 22: Where A M, the potion of donations tax to be added to the base cost is deemed to be Rnil.

Explanatory Memorandum on the TLAB, 2012:43-44 "The tax treatment of debt reductions or cancellations depends on the underlying cause of the reduction or discharge." Reductions or cancellations can thus result in ordinary income (including fringe benefit income), capital gain or even be viewed as a donation/estate transfer. One unique category of debt reduction or cancellation stems from the debtor's inability to pay. s 19 Debt reductions or cancellations caused by an inability to pay within the ordinary revenue system, can trigger one of two effects reduction of excess losses or ordinary revenue as a recoupment. par 12A Debt reductions or cancellations caused by an inability to pay within the capital gains system, can trigger one of two effects reduction in expenditure in respect of capital assets (i.e. base cost) or capital gains."

IMPORTANT DEFINITIONS: Defined in both s 19(1) & par 12A(1) Allowance asset " a capital asset in respect of which a deduction or allowance is allowable in terms of the Income Tax Act for purposes other than the determination of any capital gain or capital loss " Capital asset " means an asset as defined in paragraph 1 of the Eighth Schedule that is not trading stock " Debt " does not include a tax debt as defined in section 1 of the TAA " "An amount of tax due or payable in terms of a tax Act is a tax debt due to SARS for the benefit of the National Revenue Fund" (s 169(1) as referred to by the definition of "tax debt" in s 1 of the TAA).

IMPORTANT DEFINITIONS: Defined in both s 19(1) & par 12A(1) Reduction amount " in relation to a debt owed by a person, means: any amount by which that debt is reduced less any amount applied by that person as consideration for that reduction "

DEBT REDUCTION: Tax consequences for the debtor (the person relieved from debt) For yoa commencing on/after 1 January 2013 HOW DID THE DEBTOR UTILISE THE DEBT? To fund expenditure iro Trading Stock (TS) on hand To fund expenditure iro other expenses (except TS on hand & expenditure iro acquisition/creation/ improvement of allowance assets) To fund expenditure iro an Allowance Asset To fund expenditure iro a Non- Allowance Asset Section 19 Par 12A, 8 th Schedule s 19(3) & (4) s 19(5) par 12A(3) par 12A(4) Excess? s 19(6)

HOW DID THE DEBTOR UTILISE THE DEBT? IT effect? Section 19 Expenditure in respect of TS (not only the acquisition of TS), that was at the time of the debt reduction still on hand. Section 19(3): The debt reduction will cancel the adjustment for TS ito: s 11(a); s 22(1); s 22(2) If cancelled completely and there still remains a balance of the debt reduction? Section 19(4): This balance (excess) will be deemed to be a recoupment ito s 8(4)(a) and will be included in gross income - par (n) CGT effect? Par 12A No CGT implication. Why? TS capital asset. [See definition of capital asset in s 19(1) and par 12A(1) of the Eighth Schedule]

EXAMPLE: Reduction of debt in respect of trading stock Nocash Ltd owes a debt of R500 000 on 1 October 2014. Of the debt owing, R430 000 stems from trading stock purchased in the 2015 year of assessment and still held, while the other R70 000 relates to trading stock previously held. The creditors of Nocash Ltd discharges the R500 000 of debt due to Nocash Ltd's inability to pay. Calculate the tax implications for Nocash Ltd of the debt reduction for the 2015 year of assessment ending on 30 April 2015. SOLUTION: Year ending 30 April 2015 How did Nocash Ltd (the debtor) utilise the debt? To fund expenditure iro other trading stock (both held and already sold) First reduce the cost price of the stock held at the time of the debt reduction. Purchase of trading stock (R430 000) Debt reduction ito s 19(3) (cancel the s 11(a) deduction) +R430 000 The remaining R70 000 of the debt reduction will be a deemed s 8(4)(a) recoupment in terms of s 19(4) + R70 000 Source: Silke 2014 - adjusted

HOW DID THE DEBTOR UTILISE THE DEBT? Income Tax effect? Section 19 CGT effect? Par 12A Expenditure in respect of TS, but that is already sold at the time of the debt reduction OR any other expense (except expenditure in respect of the acquisition/creation/improvement to an allowance asset) to the extent that a deduction was granted ito the Act. Section 19(5): The full debt reduction is deemed to be a s 8(4)(a) recoupment to be included in gross income par (n), but limited to previous deductions allowed. Why? Because the TS is already sold, thus cannot make further adjustments to s 11(a), s 22(1) and s 22(2) No CGT implication. Why? TS capital asset. [See definition of capital asset in s 19(1) and par 12A(1) of the Eighth Schedule]

EXAMPLE: Reduction of debt in respect of other expenses On 1 October 2014 Norush (Pty) Ltd owes debt of R50 000. Norush (Pty) Ltd has used the debt to fund ordinary operating expenses (for example salaries), all of which are tax deductible under s 11(a). Norush (Pty) Ltd's creditors discharges the R50 00 of debt, due to Norush (Pty) Ltd's inability to pay. Calculate the tax implications for Norush (Pty) Ltd of the debt reduction for the 2015 year of assessment ending on 30 April 2015. SOLUTION: Year ending 30 April 2015 How did Norush (Pty) Ltd (the debtor) utilise the debt? To fund expenditure iro other expenses (except TS & expenditure iro acquisition/ creation/ improvement of allowance assets) Thus, recoup deductions previously allowed and include in gross income, but limited to the previous deductions allowed. Tax deductible expenditure [ito s 11(a)] (R50 000) Recoupment: debt reduction [s 19(5) read with s 8(4)(a)] + R50 000 Source: Silke 2014 - adjusted

HOW DID THE DEBTOR UTILISE THE DEBT? Expenditure in respect of an allowance asset (acquired on/after 1 October 2001) If asset is still held on the date that the debt reduction takes place: par 12A(3): Step 1: Reduce the asset s par 20 base cost with the debt reduction amount. If the base cost is reduced to Rnil and there still a balance remaining of the debt reduction amount, go to s 19(6): Step 2: The balance (excess) remaining after the base cost was reduced to Rnil will be regarded = s 8(4)(a) recoupment. If the asset is no longer held at the date that the debt reduction takes place: No CGT effect. The asset is already sold, so no adjustment could be made to base cost. Go to s 19(6): The full debt reduction will qualify as a s 8(4)(a) recoupment.

EXAMPLE: Reduction of debt in respect of other expenses On 1 October 2014 Nofuss (Pty) Ltd borrows R1 500 000 to acquire a new plant at R1 450 000. The remaining R50 000 was utilised to fund tax deductible administrative expenditure. Nofuss (Pty) Ltd has claimed allowances of R725 000 on the asset at the stage when Nofuss (Pty) Ltd's creditors discharge the R1 500 000 of debt, due to Nofuss (Pty) Ltd's inability to pay. Calculate the tax implications for Nofuss (Pty) Ltd of the debt reduction for the 2015 year of assessment ending on 30 April 2015. SOLUTION: Year ending 30 April 2015 How did Nofuss (Pty) Ltd (the debtor) utilise the debt? To fund other expenses and to acquire an allowance asset. Tax deductible expenditure [ito s 11(a)] (R50 000) Recoupment: debt reduction [s 19(5) read with s 8(4)(a)] + R50 000 The plant is still held on the date of debt reduction. Par 12A: First reduce the base cost of the plant: R1 450k R725k R725 000 Less: debt reduction [par 12A] (R725 000) New base cost Rnil s 8(4)(a) recoupment ito s 19(6) +R725 000 Source: Silke 2014 - adjusted

HOW DID THE DEBTOR UTILISE THE DEBT? Expenditure in respect of a non-allowance asset (acquired on/after 1 October 2001) If asset is still held on the date that the debt reduction takes place: Par 12A(4)(b)(i): Reduce the asset s par 20 base cost with the debt reduction amount. If the base cost is reduced to Rnil and there still remains a balance of the debt reduction amount, the balance (excess) will constitute a capital gain that must be set off against a possible assessed capital loss. If the assessed capital loss is cancelled out completely and there is still a balance left, the excess will not be regarded as a capital gain and it will just expire. If the asset is no longer held at the date that the debt reduction takes place: Par 12A(4)(b)(i): The full debt reduction amount must be set off against a possible assessed capital loss. If the assessed capital loss is completely cancelled out and there is still an excess amount that remains, this excess will not constitute a capital gain and will just expire. Why is the base cost not reduced? Because the asset is already sold (it is no longer held).

EXAMPLE: Debt reduction on non-allowance assets Co A borrows R5 million from ABC Bank to acquire 2 vacant lots. Cost of Lot 1: R3 million (acquired after 1/10/2001) Cost of Lot 2: R2 million (acquired after 1/10/2001) Lot 2 is then sold for R1.2 million, generating a capital loss for Co. A of R800 000. Due to circumstances outside the control of Co A, Lot 1's value declined significantly. In order to alleviate Co A's circumstances ABC Bank cancels R3 million of the debt. Of this, R1 million relates to the debt to acquire Lot 1 and R2 million relates to the debt to acquire Lot 2. What is the tax consequences of the cancellation of the debt on Co. A? SOLUTION: Lot 2: Lot = non-allowance asset. Thus, s 19 can not apply (no allowances to recoup) No longer held by Co A on date of debt reduction. Capital loss R800 000 Less: Par 12A(4)(b)(ii) reduction amount (R800 000) Rnil The excess of R1.2M (R2M R800k) will not be recognised as a capital gain! [R2M ltd to R800k]

SOLUTION (continues): Lot 1: Lot = non-allowance asset. Thus, s 19 can not apply (no allowances to recoup) Still held by Co A on date of debt reduction, thus reduce the base cost. Base cost (par 20) R3 000 000 Less: Par 12A(3) reduction amount (R1 000 000) "reduced by debt cancellation" New established base cost R2 000 000 Source: Explanatory Memorandum on TLAB, 2013 - adjusted

PAR 12A: Reduction of debt that funded a capital asset: Now adjust the redetermined base cost of the asset with the "debt reduction amount". How? Reduce the base cost with amount of debt reduction. Base cost? Deemed to re-acquire @ Base cost = the same MV* Less notional CG Plus notional CL [Par 12A(5)(b)] Is the asset a pre-valuation date asset (acquired before 1/10/2001)? Yes Re-determine: 1. Acquisition date 2. Base cost Acquisition date? Deemed disposal of the asset (100%) immediately before debt is reduced: Proceeds = MV* of asset at that time [Par 12A(5)(a)] Less: Base cost = VDV par 26/27 = "notional" CG/CL No If asset is still held: Par 12A(3) = allowance Par 12A(4) = nonallowance assets No deemed disposal. Only reduce asset's base cost with amount of the debt reduction. If debt reduction > base cost, excess not recognised as a CG. Allowance asset = s 19(6) recoupment. Non-allowance asset = reduce assessed capital loss [par 12A(4)(b)].

CRITICAL QUESTIONS? How will the wear-and-tear allowances be claimed on allowance assets after the debt reduction has taken place? On which value will the allowances be based? How will it differ for different types of assets (e.g. s 11(e) vs s 12C assets)? Co B (wit a December year-end) acquires a new manufacturing asset on credit for R100 000 on 1 January 2013. He claims the s 12C capital allowance in 2013 and 2014. Due to Co B's inability to pay, Co B is released from R10 000 of its R100 000 outstanding debt on 1 January 2015. What will the tax implications of the debt reduction on 1 January 2015 be? How will the remaining s 12C allowances be claimed (if any)?

Tax implications due to the debt reduction on 1 January 2015? Debt utilised to fund the acquisition of a capital asset The capital asset = an allowance asset acquired after 1 October 2001 Par 12A(3) applies Base cost of the asset ito par 20 on 1 January 2015? Original cost R100 000 Less: s 12C allowance (40% in 2013) (R40 000) (20% in 2014) (R20 000) Base cost (1 January 2015) R40 000 Less: debt reduction amount (R10 000) New established base cost of asset R 30 000 Effectively the CGT effect was "transferred" to when there will be an actual disposal over the asset in future.

Calculation of capital allowances (wear-and-tear) after debt reduction? S 12C(2) states that the allowance should be based on the 'cost' of the asset. The cost is deemed to be the lower of: - the actual cost to the taxpayer to acquire the asset; or - the cost which a person would have incurred under a cash transaction at arm's length in respect of the direct acquisition of the asset. Original cost to which s 12C has been applied = R100 000 But, after debt reduction, the actual cost to the TP = R90 000 S 12C allowance in 2015 and 2016 year of assessment? 20% x R100 000 = R20 000? OR 20% x R90 000 = R18 000? Should an "adjusted cost" be established to continue with s 12C allowances? Solution = s 19(7) limitation

SECTION 19(7) LIMITATION: Where a debt that was used to fund expenditure incurred to acquire, create or improve an allowance asset is reduced, the aggregate amount of deductions and allowances allowed in respect of that allowance asset MAY NOT EXCEED: The aggregate of expenditure incurred in the acquisition of that allowance asset LESS The sum of: - The reduction amount iro that debt; and - The aggregate amount of all deductions & allowances previously allowed to that person iro that allowance asset. Applied to example: R100 000 LESS R70 000 R10 000 (2013) R40 000 (2014) R20 000 Total remaining s 12C allowances on R30 000

What type of transactions DO NOT apply under par 12A, 8 th Schedule? Par 12A must not apply to any debt owed by a person: that is the heir/legatee of a deceased estate to the extent that the debt is reduced by way of a donation Property owned at date of death, any right to property: movable; immovable; corporeal or incorporeal. - to the extent that - the debt is owed to the deceased estate; - the debt is reduced by the deceased estate; and - the amount of the debt reduction forms part of the property of the estate - Donation as defined in section 55 (actual donation) ; or - In terms of any transaction to which section 58 applies (deemed donation) to an employer where debt is reduced ito par 2(h) of the 7 th Schedule 2 additional exclusions not listed under s 19(8): Where intra-group debts are waived and the debtor and the creditor are members of the same group of companies (s 41). Where the debtor (must be a co) is connected to the creditor and the debt is reduced in the course or in anticipation of the liquidation, winding-up, deregistration or final termination of the debtor.

DEBT REDUCTION BETWEEN THE EMPLOYER AND THE EMPLOYEE Seventh Schedule: par 2(h) par 13

FRINGE BENFITS: Par 2(h) & 13, Seventh Schedule 2 Types: Payment of employee's debt OR Release of employee from obligation to pay a debt - Employee owes money to employer or to a 3 rd party - Employer pays the debt or discharges the employee from it - If debt is extinguished by prescription = discharge Cash equivalent = Amount paid or discharged by employer - Must be an employee at the date of discharge (includes pensioners)

No value shall be placed on such a fringe benefit if: Subscriptions paid to professional bodies, if membership of such body is a condition of such employee's employment; Insurance premiums indemnifying the employee solely against claims arising from negligent acts on part of the employee in rendering services to the employer; and Employer pays the loan / study bursary back to the employee s former employer on the condition that the employee assumed an obligation to render services to the current employer for a period that is not shorter than the unexpired period which the employee had been obliged to render services to its former employer.

CAPITAL LOSSES REALISED BETWEEN CONNECTED PERSONS Eighth Schedule: par 39 par 56

Capital losses on disposals to connected persons [par 39] Connected irt NP? Note: Eighth Schedule definition [par 39(3)] differs from s 1 definition in ITA. If the disposal is to a connected person who was connected immediately before the disposal or immediately after the disposal: is a member of the same group of companies or trust with beneficiary that is a member of the same group of co THEN: Capital loss is CLOGGED (not disregarded!) Disregard CL in aggregate CG or CL calculation CL may be set off against CG iro the SAME connected person. If persons cease to be connected (on date of a later disposal) before a CG is realised, the CL will be permanently forfeited.

Par 56: Disposal by creditor of debt owed by connected person When is par 56 applied? Creditor and debtor are connected persons. Par 56 is only applicable to the creditor! Par 56 is triggered when the creditor is waiving its right to collect the debt = disposal in terms of par 11(1)(b) Included within the scope of par 56 is "Reduction of debt" under s 19/par 12A What is the effect of par 56 on the creditor? Par 56(1) = Normal rule: Disregard any capital loss on disposal. Par 39 requires the capital loss to be "clogged" between connected persons. Par 56(2): Can take the capital loss into account (thus par 56(1) will not apply) and the capital loss will not be "clogged" (despite par 39) in the circumstances as indicated in par 56(2)(a) to (d).

Requirements to be met ito par 56(2)(a) to (d) to retain capital loss: If the amount of the debt disposed: (a) reduced the base cost of the asset of the debtor ito par 12A; OR reduced any assessed capital loss of the debtor ito par 12A; (b) could be proven by the creditor, is or was included in the gross income of any acquirer of that debt; (c) is or was included in the gross income or income of the debtor, OR taken into account to determine the balance of assessed loss of the debtor in terms of s 20(1)(a); (d) could be proven by the creditor, represents a capital gain that was included in the aggregate capital gain or loss of the acquirer of the debt.

VAT CONSEQUENCES OF DEBT REDUCTION VAT Act s 22(3) = Debtor s 22(1) = Creditor

VAT ACT: SECTION 22(3) - Deemed supply Debtor s 22(3): Normal rule: Debtor purchase on credit already claimed input VAT (100%) on a purchase, but have not paid the full amount within 12 months must then charge output VAT on the portion not yet paid. VAT output = 14/114 x outstanding debt older than 12 months. Limitation: Output limited to the input claimed! Proviso to s 22(3): see (ii)(dd) If person ceases to be vendor Additional output VAT on all outstanding amounts (owed to creditors) iro supplies during 12 months before person ceased to be a vendor. VAT output = 14/114 x outstanding debt not paid within the last 12 months before the person ceased to be a VAT vendor.

VAT ADJUSTMENTS: IRRECOVERABLE DEBT [s 22] Creditor If vendor charges output on a taxable supply and the consideration later becomes irrecoverable: claim input Input [s 22(1)] = output charged x (irrecoverable debt total consideration) - If the irrecovaerable debt is recovered later on: Again charge an output tax [s 22(2)] Exception for Group of companies Section 22(3A): Problem Definition: s 1 of IT Act 70% is replaced by 100% Operate internal loan accounts for commercial reasons without clearing these accounts for many years. No written agreements between group companies for each VAT transaction processed via loan account. S 22(3) normal rule no longer has to be applied on inter-group loans, BUT then the creditor supplying credit to an indebted Group Co within the group could also not claim an input VAT on a bad debt written of.

LENDER (creditor) Income: Section 11(i) LENDER (creditor) Capital: If not connected persons: Donations tax Normal capital loss (par 22?) If connected persons: Par 56, 8 th Schedule Par 39 of the Eighth Schedule? If lender = employer Normal capital loss Advances a loan/credit to and then debt reduction occurs Income Tax consequences? BORROWER (debtor) BORROWER (debtor) Income: Section 19 & Section 8(4)(a) 'deemed' recoupment Capital: Par 12A, 8 th Schedule and/or Section 19 & Section 8(4)(a) 'deemed' recoupment If borrower = employee Par 2(h) & 13, 7 th Schedule (Fringe benefit)

Presenter s contact details Herman Viviers herman.viviers@nwu.ac.za

Thank you.