Saving a company without releasing a tax monster
06 February 2013
Posted by: Erich Bell
When we consider the implications of the global financial meltdown it is not surprising that an increasing amount of South African companies start to experience financial difficulties. Fortunately, the new Companies Act provides for a recovery program called "business rescue”. The aim of this program is to assist companies in financial distress and to help them avoid liquidation. The program is initiated by appointing a business rescue practitioner who will manage the financial affairs of the company and develop and implement a strategy that will maximise the company’s ability to continue its future trade on a solvent basis.
As soon as the business rescue plan is in operation, all debts owed by the company are temporarily suspended. Therefore creditors will not be able to enforce any right to receive payment for a specific time period. However, their claims will not be forfeited and they will still be entitled to receive payment in future.
Initially the implementation of a business plan itself will not result in any income tax consequences, but any subsequent agreements reached with creditors may have certain tax implications for both parties involved. This article will analyse the tax implications for a company if it is relieved from its financial obligations. It may happen that a creditor agrees to discharge the company from its total debts or perhaps just a part thereof. Unfortunately, as we all know, almost every action results into taxes, and in this case it is also true.
The waiver of debt will have the following income tax implications for the debtor company:
·If the company was discharged from debt incurred to finance an expense that entitled him to claim a deduction for Income Tax purposes, he will be taxed on the amount waived. The said amount will constitute a recoupment of the deduction previously claimed and therefore his taxable income must be adjusted. If the company has incurred an assessed loss in the previous year of assessment, the recoupment has to be set off against the balance of the assessed loss and only the remainder will be included in the company’s taxable income.
·On the contrary, the waiver of debt that did not result in a deductible expense for Income Tax purposes will not be taxed as a recoupment. Previously, it may have been subjected to Capital Gains Tax since the reduction in debt was regarded to be a deemed disposal in terms of the Eighth Schedule. In such instances the company was required to include any taxable capital gain in the calculation of its taxable income.
It is clear from the above that the Income Tax consequences relating to the business rescue program may eliminate the financial progress the Company’s Act intended to provide to companies with financial problems.
Fortunately, tax legislation was amended and from 1 January 2013 the prospects for the debtor company looks much more promising. When a company is discharged from its debt, it will no longer be regarded to have made a deemed disposal for Capital Gains Tax purposes. Instead the effect of the debt reduction will be as follows:
a) If the borrowed funds were applied to acquire a capital asset that is still in the company’s possession at the time of debt relief, the base cost of the asset will be reduced. Therefore, the company will have a smaller amount of capital expenses to set off against any proceeds received with a future disposal of the asset, resulting in larger capital gain. In the case where the base cost is exceeded by the amount discharged, the excess will be applied against any assessed capital loss incurred. Thereafter, any remaining amount of the debt relieved will be set off against a balance of assessed loss for Income Tax purposes or it will be taxed as a recoupment (only if it is a depreciable asset).
b) If the company has previously disposed of the capital asset, there will be no capital costs to reduce. Therefore, any amount of debt relief will only be applied to:
· reduce any assessed capital loss (in the case of a non-depreciable asset).
· reduce any assessed loss and after that any excess will be taxed as a recoupment (in the case of a depreciable asset).
It is clear from the above that a company discharged from a debt may still suffer certain Income Tax consequences. It will however be to a much smaller extent and not nearly as unfavourable as previously experienced.
As a result of the amendments to the legislation, a company’s tax liability will be deferred as far as possible or it will be set off against an assessed loss, if available. Although, the company may experience temporary tax relief, its future tax liabilities may increase. This will be the case when an assessed loss is reduced with the debt waived. As a result the company will have a smaller tax loss to set off against future taxable income, putting upward pressure on the normal taxes payable in the future.
In addition to the income tax implications, the company discharged from its debt might also suffer potential Value-Added-Tax (VAT) consequences if it’s a registered vendor for VAT purposes. This rule will only apply if the company was previously entitled to claim an input tax deduction on expenses relating to the obligation. In terms of the VAT Act, the company has to declare output tax on balances not paid within twelve months after supply was made. In the thirteenth month following the supply, the vendor will become liable for output tax calculated as the tax fraction (14/114) multiplied with the outstanding amount of debt. The output tax component should be included in the VAT assessment period that relates to the specific month in which the company became liable for output tax.
Although the company may suffer future tax consequences as a result of the debt relief, it should not discourage the implementation of the business rescue process. The plan will offer the company the best chance to resume its business, rather than facing liquidation that comes with large financial losses.
Source: Di Seccombe