Proposed Tax Amendments Will Assist Business Rescue
31 January 2013
Posted by: Author: Di Seccombe
Proposed Tax Amendments Will Assist Business Rescue
Chapter 6 of the Companies Act No. 71 2008 (the Companies Act) introduced the concept of business rescue. At the core of the business rescue process is the business rescue plan. The Companies Act governs the general framework of the business rescue plan which must contain details and proposals in respect of the manner in which the business rescue practitioner envisages that the company will be rescued. These proposals are likely to include the extent to which the company may be released from the payment of its debts.
Once the business rescue plan is adopted, the plan is binding on both the company and its creditors. Section 154 of the Companies Act provides that once a business rescue plan is implemented, in accordance with its terms a creditor will lose the right to enforce the relevant debt or part of it to the extent that the creditor has acceded to the discharge of the debt.
The income tax consequences of any debtor, including (but not limited to) a company entering into business rescue, benefiting from a debt reduction for less than the full consideration of the debt are the focus of this article. It is important to note that while not addressed, there are serious VAT implications of debt relief for debtors who are VAT vendors. In respect of debt on which input VAT was claimed when the debt was incurred, should the debt remain unpaid for a period exceeding 12 months, deemed output VAT will arise on the unpaid portion of the debt in the 13th month. Output VAT may also be triggered for a VAT vendor to the extent that a debt is waived.
Currently the Income Tax Act (the Act) provides that where a debtor benefits from a compromise or a waiver by a creditor in of some or all of a debt owed (debt relief), the tax consequences are dictated solely by whether the amounts originally advanced by the creditor were used by the debtor to fund expenditure of which a deduction or allowance was claimed by the debtor for normal tax purposes. Examples would include a debtor using borrowed funds to purchase trading stock, fund income-generating activities or to purchase a depreciable asset. In the event of debt relief, sections 20 and 8(4)(m) of the Act require that the debtor first reduce any assessed loss, then recoup back into income any amount of the debt waived that exceeds the debtor’s assessed loss.
The capital gains tax (CGT) effect of any debt relief is regarded as a residual effect as CGT will only arise to the extent that sections 20 and 8(4)(m) do not apply. Paragraphs 20(3) and 12(5) of the eighth schedule to the Act require that debt relief in respect of capital assets will reduce the base cost of the asset if the asset is still held by the debtor at the time of the debt relief; or if the asset is no longer held by the debtor, the debtor will suffer a capital gain to the extent of the debt waived determined in accordance with the face value of the debt outstanding.
The net effect of all these provisions is that a debtor will suffer some form of normal tax consequence as the result of the debt relief. This is counterintuitive especially in light of provisions like the business rescue regime specifically created by the Companies Act to assist businesses in financial distress. A compromise with creditors cannot be specifically provided for as a solution in one piece of legislation only to create further liabilities for the distressed entity in another. This is made all the more absurd when it is recognised that one of the debts a debtor may have compromised or reduced are taxes owing to SARS.
While many of the tax consequences raised are often absorbed by any assessed tax loss the debtor may have, it must be borne in mind that preserving an assessed tax loss is in itself important in assisting a distressed debtor as the assessed tax loss will shelter the debtor from paying tax should the trading activities of the debtor again start to generate the much anticipated profit.
In the Taxation Laws Amendment Bill 2012 (TLAB) and as explained in the accompanying explanatory memorandum (EM), recognition has been given to the fact that the current tax system may act as an impediment to the recovery of companies and other taxpayers in financial distress where the economic benefit of debt relief is undermined by the consequent negative tax implications.
The proposed amendments will not affect the tax consequences of any debt relief that is regarded as a donation and triggers donations tax, a bequest that may form part of an estate and trigger estate duty or that falls within the framework of remuneration and may trigger employees’ tax. The proposals are most easily understood when examining the type of debt relief.
In respect of debt previously incurred in respect of depreciable capital assets, the proposed amendments essentially reverse the existing tax consequences, making them more favourable to the debtor. Namely, the remaining base cost of the depreciable asset is reduced first by the debt waived. Only once the base cost of the depreciable asset is depleted, will the taxpayer suffer a recoupment into income of any remaining portion of the debt waived, thereby triggering a revenue tax consequence only at the last instance.
Taxpayers must be aware that in the calculation of future tax allowances that may be claimed on depreciable capital assets in respect of which a debt was waived, the allowances may not exceed the aggregate of the expenditure incurred by the taxpayer of the asset less the sum of the allowances previously claimed on the asset and the amount of the debt reduced. In effect, the amount by which the remaining base cost of a depreciable asset is reduced by the waiver of a debt will not be available to the taxpayer to either claim future tax allowances against, or in calculating a capital gain or loss on the disposal of the depreciable asset.
In respect of capital debt (debt not used to finance deductible expenditure or depreciable assets; for example, debt incurred to purchase vacant land or a shareholder loan to a company), the debt relief will be regarded as reducing the base cost of any asset purchased with the debt, if an asset was purchased and is still held by the debtor. To the extent that the debt relieved exceeds the base cost of the asset (if relevant), the remaining debt relieved will be set off against any assessed capital losses the debtor may have (assessed capital losses resulting from the disposal of capital assets at a net capital loss that a taxpayer may carry forward to set off only against current or future capital gains are not to be confused with assessed tax losses). Unlike the current legislation, no further CGT consequences will arise should the amount of the debt relieved exceed both the base cost of the asset and any assessed capital loss the debtor may have.
A further concession has been made in respect of a fully or partially waived tax debt by SARS. A tax debt waived will no longer be regarded as debt for the purposes of the capital debt reduction provisions and will therefore not trigger a reduction of the base cost of an asset or an assessed capital loss as set out immediately above.
In respect of debt the EM calls "ordinary” debt relief (for example, debt incurred to purchase trading stock or accrued interest), the proposals favour the debtor although to a lesser degree. The debt relieved will first reduce the tax cost of any trading stock, provided the debt was originally used to acquire the trading stock and only to the extent the trading stock remains with the debtor and has a tax cost. Where the debt relieved exceeds the tax cost of any trading stock, the debt relieved will be recouped into the income.
Debtors who are in financial distress will presumably have accumulated large assessed tax losses as they continued to trade and the recoupment of an amount into the income of the debtor will in effect reduce any assessed tax loss. However, the proposed amendments seek as far as possible to ensure the reduction of an assessed tax loss occurs as a last resort and in respect of capital debt waived, will not arise at all.
The proposed amendments will apply in respect of debts reduced or cancelled on or after 1 January 2013. As capital debt waived under the proposed regime will have little to no tax impact on taxpayers, taxpayers may be tempted to write off loans made to trusts and by shareholders to companies. Taxpayers must bear in mind the donations tax consequences as well as the vulnerability of transactions entered into merely to avoid tax.
Source: By Di Seccombe Mazars (TaxTalk)