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Income Tax Implications for Debtor: Reduction Or Cancellation Of Debt Relating To An Allowance Asset

12 August 2013   (0 Comments)
Posted by: Author: Doria Cucciolillo
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Author: Doria Cucciolillo

Background

Section 19 of the Income Tax Act 58 of 1962 ("the Act”) regulates the tax implications that may arise for the debtor in the event that an amount owed to a creditor is reduced or written-off. This section is relevant for years of assessment that commence on or after 1 January 2013 and provides for the inclusion of a deemed recoupment in the debtor’s taxable income. The purpose of this recoupment is to reverse income tax deductions that resulted from the application of the borrowed funds.

Three different scenarios are addressed under section 19, which includes the acquisition of allowance assets. Allowance assets are capital assets, used or applied for business purposes, which qualify for specific deductions (known as capital allowances) in terms of the Act.  Capital allowances are granted on these assets to provide a deduction for wear-and-tear that occurs over time. 

This article investigates the implications of section 19 in the event that a waiver of debt, that was used to acquire one or more allowance assets, takes place. 

The scope of section 19

In order to avoid double taxation, the provisions of section 19 will not apply in the following instances: 

  • Where the reduction of debt constitutes a donation (as defined in section 55(1)) or a deemed donation in terms of section 58. In this instance the donor may be liable for donations tax at a rate of 20%. 
  • Where debt is owed to a deceased estate of which the debtor is an heir or legatee. If the deceased estate reduces the debt and the reduction forms part of the estate’s property, such amount may be subject to Estate Duty.
  • Where debt owed by an employee, is discharged or reduced by an employer and a taxable fringe benefit arises. The cash equivalent, calculated in terms of Seventh Schedule to the Act, will be included in the employee’s taxable income.

Capital gains tax implications 

First the provisions of paragraph 12A of the Eight Schedule to the Act need to be considered. After it has been determined that the debt relates to the acquisition of an allowance asset, it must be determined as to whether, or not, the allowance asset is still in the debtor’s possession on the date of debt reduction. 

In the instance where the asset is still owned by the debtor, the base cost of the asset will be reduced with the amount of debt reduction. This will result in a higher capital gain with future disposal of the asset. Since the base cost of an asset can only be reduced to a minimum of nil, the amount of debt reduction that exceeds the base cost of such asset will be taxed under section 19. 

In contrast to the above, an amount of debt reduction will be subject to section 19 in full if it relates to an asset that is no longer in the taxpayer’s possession. 

The implications of section 19

The reduction of debt that was incurred to fund the acquisition, improvement or creation of an allowance asset will trigger a deemed recoupment in terms of section 19(6). The recoupment is granted under section 8(4)(a), the general recoupment provision and is therefore included in "gross income”. 

In addition, section 19(6) determines that the recoupment included in the taxable income of the debtor during the year of assessment in which the debt reduction took place, is limited to the sum of all capital allowances claimed on the asset less any decline in the base cost of the asset as a result of the debt reduction. 

Section 19(7) regulates the situation where capital allowances are claimed on an asset that relates to a debt reduction transaction. Future allowances and deductions claimed by the debtor in respect of this asset may not exceed the following: The total expenditure incurred to acquire the asset less the amount of debt reduction less total deductions previously claimed by the debtor in respect of the relevant asset. 

Practical illustration

On 1 March 2012, Company X borrowed R1 800 000 of which an amount of R60 000 was used to purchase a non-depreciable asset. The remaining funds were used to purchase a new machine at a total cost of R1 740 000 that was immediately brought into use in a process of manufacturing. During the 2013 year of assessment the capital allowance claimed on the machine amounted to R696 000. During the 2014 year of assessment the creditors discharged the R1 800 000 of debt due to Company X’s inability to pay. 

Effect of the above on Company X’s 2014 year of assessment (VAT implications ignored for purposes of this example): 

Initially, an amount of R1 740 000 (the reduction in debt of R1 800 000 limited to the amount used to fund the acquisition of the asset) must be applied to reduce the base cost of the asset (paragraph 12A). The base cost of the asset on the date of debt reduction amounted to R1 044 000 (initial cost of R1 740 000 less capital allowances of R696 000). 

Once the base cost of the asset has been reduced to nil, the excess of R696 000 (R1740 000 – R1044 000) will be taxed as a recoupment in terms of section 19. It is evident that the recoupment in term of section 19 is limited to the total capital allowances previously claimed on the asset. 

No future capital allowances can be claimed on this asset due to the provisions of section 19(7). In terms of this section, future allowances may not exceed the following: The total expenditure incurred to acquire the asset (R1 740 000) less the amount of debt reduction (R1 740 000) less total deductions previously claimed on the asset (R696 000). Since the latter result into a negative amount, no capital allowances are available for future purposes. 

Finally, the Capital Gains Tax implications with any subsequent disposal must be considered. If it is assumed that the proceeds with disposal amounts to R1 440 000, the disposal will result into a net capital gain of R744 000, calculated as follows: proceeds of R744 000 (Selling price of R1 200 000 less former recoupment of R696 000) less base cost of R0. 


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