“Debtors in distress seeking relief are a recurring economic concern. With the recent global financial crisis, an unusually large number of companies are experiencing financial distress. Relief for these companies is essential if local economic recovery is to occur.”
In the Explanatory Memorandum on the Taxation Laws Amendment Bill, 2012 SARS explained why it was necessary to introduce a new regime to determine the tax consequences when a debt is reduced for less than full consideration. This goal was achieved by adopting a two-pronged approach. Section 19 of the Income Tax Act (“the Act”) deals with the income tax implications of debt reduction, while paragraph 12A of the Eighth Schedule to the Act addresses the capital gains tax (“CGT”) consequences.
Since then, the relevant provisions have undergone a number of tweaks, a major overhaul in 2018 and, more recently, some fairly substantial amendments. A bit like Hollywood stars and plastic surgery; there is a recognisable core, but on the surface almost everything has changed.
Initially the legislation tackled “debt reduction”, referring to any amount by which a debt is reduced less any amount paid by the debtor as consideration for that reduction. “Debt” simply meant any debt but for a tax debt, i.e. an amount owing to SARS. Along the way, the definition of “debt” was specifically amended to exclude interest. In the latest version, the term is defined as “any amount that is owed by a person in respect of expenditure incurred by that person, or a loan, advance or credit that was used, directly or indirectly, to fund any expenditure incurred by that person”. Tax debts are still excluded, but interest is back in the game.
Debt reduction has now become “concession or compromise in respect of a debt”, and it follows that the relevant definition would have gained a few pounds. In addition, it has a new best mate. “Concession or compromise” goes hand in hand with “debt benefit” and the two need to be considered as a collective. In short, the new look section 19 and paragraph 12A regime applies to the following scenarios:
- When a debt is cancelled or waived, the debt benefit consists of the amount so cancelled or waived.
- Where the debtor (or a connected person to the debtor) redeems the claim in respect of the debt, or effects a merger by acquiring the claim in respect of the debt and in so doing extinguishes the debt, the debt benefit is the amount by which the face value of the claim before this arrangement, exceeds the amount of any expenditure incurred in respect of the redemption of the debt or the acquisition of the claim in respect of the debt.
- A special new dispensation is created to cater for debt to equity conversions, where companies settle their debts with equity, whether by converting debt claims into shares, exchanging debt for shares or by applying the proceeds from shares issued to settle the debt. The tax consequences depend on whether the person acquiring the shares had an “effective interest” in the debtor company before the arrangement. Incidentally, the Final Response Document issued by Treasury in respect of these amendments, declined to furnish a definition of “effective interest”. In the context, it is assumed that the term refers to an interest held either directly or indirectly by the person acquiring the shares.
a) If that person did not have an effective interest prior to the arrangement, the debt benefit is the amount by which the face value of the debt claim before the arrangement exceeds the market value of the shares acquired in terms of the arrangement.
b) If, however, the person did have a prior effective interest, the debt benefit is the amount by which the face value of the debt claim exceeds the amount by which the market value of that person’s interest after the arrangement exceeds the market value of the interest prior to the arrangement.
But, and this is a big but, the “debt to equity conversion” rules only apply to the extent that the amount that is so converted represents interest incurred. Furthermore, the rules do not apply at all if the debtor and creditor form part of the same group of companies.
Before examining the mechanics of the provisions, it is perhaps a good idea to note the general circumstances in which the debt reduction provisions do not apply:
- To the extent that the debt is reduced by way of a donation as defined in section 55(1) of the Act, or is deemed to be a donation in terms of section 58 because it was disposed of (reduced) for inadequate consideration. The first instance requires an element of gratuity or liberality. In very simplified terms this could be explained as the absence of any commercial reason, like the financial distress of the debtor, for the reduction of the debt. As far as the second provision (the deeming provision) is concerned, it has been held that the motive for the disposal is irrelevant; it is simply a question of whether the consideration given for the disposal is considered adequate by SARS. (Reference Welch’s Estate v C: SARS 66 SATC 303 as quoted in SARS Interpretation Note 91). The original version of this provision left an enormous loophole, as not all transactions that qualify as “donations” are subject to donations tax. Think of inter-spousal donations, for instance. The amendment that came into effect on 1 January 2019 clearly stipulates that it is only donations in respect of which donations tax is actually payable that qualify for the exemption.
- The debt is reduced by a deceased estate and the amount by which the debt is reduced forms part of the property of the deceased estate for purposes of the Estate Duty Act. In this scenario, it not necessary for the amount to be subject to Estate Duty (it may for instances qualify for exemption), but merely that it forms part of the property of the deceased estate. According to the Final Response Document this mismatch might be addressed by an amendment to the Estate Duty Act in the next legislative cycle.
- The debt that is reduced qualifies as a fringe benefit as contemplated in paragraph 2(h) of the Seventh Schedule to the Act. If an employer releases an employee from the obligation to pay a debt owing to the employer, the amount that was owing is treated as a taxable benefit and included in the employee’s gross income.
Special exemptions apply to companies. The debt relief rules are not applicable to intra-group transactions where the debtor company has not traded for the year in which the debt benefit arises, as well as the preceding year of assessment. An exclusion unique to paragraph 12A is where a debt owed by a company to a connected person is reduced in the course or anticipation of the liquidation, winding-up or deregistration of that company. There is however no similar exclusion under section 19 and the reduction of the debt may have adverse consequences on the income tax side.
For section 19 and/or paragraph 12A to apply, the debt in question must be owed in respect of expenditure incurred by the debtor, or in respect of a loan, advance or credit used to fund expenditure incurred by the debtor. The tax treatment of the debt benefit will depend on the type of expenditure incurred.
The practical application of the debt reduction rules will be discussed in our next edition.