The previous article on debt relief focused on the legislation: the general application of the provisions and recent amendments. To recap: the provisions apply when a taxpayer obtains a “debt benefit” in consequence of a concession or compromise in respect of a debt. Cancellation, waiver, redemption and debt to equity conversions all are actions that may give rise to a debt benefit. See our previous article Debt Relief Part I
The tax treatment of the debt benefit depends on how the initial debt was applied.
Trading stock – Section 19(3), (4) and (5)
The tax treatment of a debt that was used to acquire trading stock will depend on whether the stock is still “held and not disposed of”. A taxpayer is entitled to a deduction in terms of section 11(a) in respect of the cost of trading stock acquired. So much of the stock that is still held at the end of the tax year is included in his taxable income as closing stock. This amount is carried forward to the subsequent tax year as opening stock and taken into account as a deduction. (Section 22(1) and (2))
If the trading stock is still held and not disposed of at the time the debt benefit arises, section 19(3) provides that the amount taken into account in terms of section 11(a) or 22(1) or (2) must be reduced by the amount of the debt benefit. In certain circumstances, the amount of the debt reduction may exceed the amount taken into account for purposes of subsection (3). This would for instance be the case where the taxpayer had opted to reduce the value of the trading stock as a result of a decrease in market value. In terms of section 19(4) any excess amount of the debt benefit will, for purposes of section 8(4)(a), be deemed to be an amount that has been recovered or recouped and will be included in the taxpayer’s income.
In the instance where the taxpayer has already disposed of the trading stock when the debt is reduced, he would be deemed to have recovered or recouped any amount that had been allowed as a deduction in respect of the acquisition of the trading stock.
Goods and services – Section 19(5)
Subsection 19(5) applies to all other expenses, as well as stock no longer held (see above). To the extent that the taxpayer had been granted an allowance or deduction in respect of the expense, the amount of the debt reduction will be deemed to be an amount that has been recovered or recouped for purposes of section 8(4)(a) and will be included in his income.
Allowance assets – Section 19(6) and Paragraph 12A(3)
Allowance assets are strange creatures, forever crossing the capital/revenue divide. Accordingly, it is necessary to consider the implications for both CGT and income tax if the debt used to fund the acquisition of an allowance asset is reduced.
If the taxpayer still owns the asset when the debt is reduced, the starting point is paragraph 12A(3). The aim of this provision is to reduce the base cost of the asset by the amount of the debt reduction. Section 19(6) then kicks in and any excess amount of the debt reduction (to the extent that it exceeds the base cost of the asset) is applied to deductions or allowances granted in respect of the asset. These amounts are deemed to have been recovered or recouped for purposes of section 8(4)(a) and are thus included in income.
The interaction between paragraph 12A, dealing with CGT, and section 19, catering for income tax, can be demonstrated in the following example:
In Year 1, Mr. A buys a machine for R1 000 000 on credit. He is entitled to a wear-and-tear allowance of R200 000 p.a. By year 2 his machine has an adjusted base cost of R600 000. He runs into financial difficulties and the creditor waives R750 000 of the R1 million loan. In Year 3 he decides to sell the machine for R800 000. His liability for tax is calculated as follows:
Now let’s do a time warp and switch the two events. Mr. A sells the machine in Year 2, while the waiver giving rise to the R750 000 debt benefit occurs in Year 3. Prior to the recent amendments, only the accumulated wear-and-tear allowance of R400 000 would have been deemed to be an amount recovered or recouped for purposes of section 8(4)(a). Furthermore, since there is no longer an asset in respect of which paragraph 12A(3) can apply, the amount of the debt reduction can only be offset against his assessed capital loss. If no such loss, one very happy taxpayer could have skipped into the sunset.
Well, the fiscus decided that it was not going to have any skipping, and as from the 1st of January 2019, this loophole has been closed. Section 12A(4) now provides that where a debt benefit arises in respect of an asset that had been disposed of in a previous year of assessment, the “absolute difference” between the capital gain or loss in respect of that disposal and the amount that would have been determined had the debt benefit been taken into account in the year of the disposal, must be treated as a capital gain in the year in which the debt benefit arises.
Prior to the amendments, the tax consequences for Mr. A would have been as follows:
Had the debt benefit occurred in the same year, the capital gain would have been calculated as follows:
The absolute difference between this gain and the loss incurred by Mr. A in Year 2 is R600 000. This amount must be taken into account as a capital gain. However, in terms of paragraph 8 the gain must be set off against the capital loss of R200 000 carried forward from Year 2. He therefore has a net capital gain of R400 000.
Non-allowance assets – Paragraph 12A(3) and (4)
It is much simpler to account for the reduction of a debt used to fund the acquisition of a non-allowance asset (an asset in respect of which no deduction or allowance is granted in terms of the Act). If the asset is still held by the taxpayer at the time of the reduction, paragraph 12A(3) provides that the base cost of the asset must be reduced by the amount of the reduction. As mentioned above, the base cost can only be reduced to zero and the provision cannot create a negative base cost. Any excess must, in terms of subparagraph (4), be applied to reduce the taxpayer’s assessed capital loss. If he has no assessed capital loss, that is the end of the road and the debt reduction has no further tax implications.
If the taxpayer no longer holds the asset, subparagraph (4) applies in the manner explained above, except that there would be no recoupment of allowances.
The underlying message to taxpayers is that there is no such thing as a free lunch. When a taxpayer incurs an expense, whether to purchase stock or pay rent or buy a machine or fixed property, certain tax consequences arise. He may be granted an outright deduction or an allowance, and at the very least he will end up with a base cost that he can deduct from proceeds should he sell his asset. When the debt is reduced or compromised, the taxpayer is left with only the tax benefit. The debt benefit provisions aim to rectify this situation by effectively reversing or neutralising the tax benefits originally obtained by the taxpayer. In practice, the application of the provisions may prove problematic because it is not always possible to specify how borrowed funds were applied. Many businesses are funded by both borrowings and earnings and do not necessarily keep track of which funds are used to finance which expense. Going forward, it might be a good idea to keep accurate records of how borrowed funds were applied.
Specialist Tax Consultant