Assessed losses: Companies versus other taxpayers
09 May 2013
Posted by: Author: Doria Cucciolillo
Source: Doria Cucciolillo
When a taxpayer incurs an assessed loss during a year of assessment, it may be utilised to reduce taxable income earned during the same or a future year of assessment. The type of the taxpayer will determine whether it will be entitled to set off these losses against its taxable income. The purpose of this article is to compare the different treatment of assessed losses for individuals and companies.
An assessed loss (or a balance of assessed loss) incurred during a specific year of assessment may reduce the taxable income derived from any other trade carried on by that taxpayer. The term "trade” is defined in section 1 of the Income Tax Act and it has a wide meaning. It must be noted that taxpayers other than companies will also be allowed to set off an assessed loss against income derived from non-trading activities. These activities generate passive income (like interest and dividends on investments) that is automatically generated without the need of any active involvement by the taxpayer. Although the latter represents the current legal implications of assessed losses, it is the practice of the South African Revenue Service (SARS) to allow companies to set off assessed losses against non-trade income.
In certain instances, a taxpayer is not allowed to set off an assessed loss against its taxable income. The Act specifically states that a taxpayer is not allowed to reduce its taxable income with any of the following:
an assessed loss of any company or closed corporation in which he or she is a shareholder or a member. This means that the assessed loss may only be utilised by that specific company or closed corporation in the current or future year of assessment (if no restrictions apply).
an assessed loss that was incurred through a trade carried on outside South Africa. The assessed loss may only be applied to future taxable income derived from such a trade.
any assessed loss incurred by that taxpayer to the extent that taxable income constitutes a lump sum benefit from a retirement fund. This means that the taxable portion of these lump sum benefits will be subject to normal income tax and may not be reduced by an assessed loss.
If a taxpayer does not reduce taxable income derived from one trade with an assessed loss incurred in another trade, the unused balance can be carried forward to future assessment periods. These accumulated assessed losses are known as "a balance of assessed loss” and can be utilised to reduce the taxable income in future assessment periods. However, if the taxpayer is a company, it will lose its right to carry forward a balance of assessed loss to a subsequent year of assessment if it fails to carry on a trade during a specific year of assessment. In this instance the balance of assessed loss will be set at zero. Therefore, any balance of assessed loss at the beginning of the year of assessment will be forfeited and may not be used to reduce taxable income earned during future assessment periods. It is not required that the company carries on a trade during a full year of assessment and therefore the requirement will be met even if a trade was only carried on for a single day during the period of assessment.
The question arises whether it will be considered that the company carried on a trade during an assessment period in which no income (gross income less exemptions) was derived. In this regard case law provides contradictive rulings. In ITC 777 the company was allowed to carry forward its assessed losses although no income was derived. The fact that the company made efforts to derive income was sufficient to prove that it carried on a trade although these efforts were unsuccessful. In contrast the court concluded in the ITC 1679-case that income needs to be derived in order for trading to effect. In practice, SARS puts a strong emphasis on the income requirement in order to determine whether or not the company carried on a trade. If no income was derived during a year of assessment, it will be a strong indication that the company did not carry on a trade. However, if there is sufficient evidence to prove that a trade was carried on by the taxpayer (although no income was derived), SARS will allow the company to set off the balance of assessed loss in future assessment periods.
Finally, the ring-fencing of assessed losses in terms of section 20A must also be considered. This section is not applicable to companies but only to taxpayers who are natural persons and falls within the maximum tax bracket (therefore, he or she will earned taxable income that exceeds R638 600 during the 2014 year of assessment). When the provisions of section 20A apply, the natural person will be prohibited from setting off an assessed loss incurred within a certain trade against taxable income derived from any other trade. In other words, the assessed loss incurred within that specific trade may only be set off against future taxable income derived from that trade. This section will apply if the trade qualifies as a suspect trade and there is no reasonable expectation that the trade will generate taxable income within a reasonable period. The Act provides a list of suspect trades – in essence it constitutes activities that will normally considered as a hobby (for example gambling and sport) but are carried out by the taxpayer as part of a professional trade. If a trade is not listed in the Act as a suspect trade, the provisions of section 20A may still apply if the taxpayer incurred losses in that trade for at least three out of five years. Once again, the taxpayer has to prove that there are reasonable grounds that taxable income will be derived from that trade within a reasonable period in order to avoid the ring-fencing of that loss. In both instances section 20A will apply if an assessed loss was incurred in that trade during six out of ten years, with the exception of a suspect trade that involves farming.
It is clear from the above that the nature of the taxpayer will have a significant impact on the treatment of assessed losses in terms of legislation and SARS’s practice. The requirements to set off assessed losses seems to be much more stringent for a company when compared to the requirements that apply to other taxpayers. However, taxpayers who are natural persons may be subject to the provisions of section 20A that will forbid these taxpayers to set off an assessed loss incurred in a certain trade against other trades.
List of References
South African Revenue Service (SARS). 2010. Interpretation note no 33 (Issue 2). Assessed losses: Companies: The "trade” and "income from trade” requirements.
Stiglingh M, Koekemoer AD, van Schalkwyk L, Wilcocks JS & de Swart RD. 2012. Silke: South African Income Tax 2013. Durban: LexisNexis Butterworhts.