Securities Lending – Tax Implications Arising From The Taking of Cash Collateral
23 October 2013
Posted by: Author: Magda Snyckers & Kelle Gagne
Author: Magda Snyckers & Kelle Gagne (ENS)
South African residents are taxed on their worldwide income. In particular, the Income Tax Act includes in "gross income” any amount received or accrued that is not of a capital nature. Based on case law, an amount "accrues” to a taxpayer when the taxpayer becomes unconditionally entitled to receive it (CIR v Genn and Company (Pty) Ltd, (20 SATC 113)).
Where a taxpayer receives collateral from another party under a securities lending agreement in the form of an outright transfer of cash, it is necessary to consider if such amount of cash collateral should be included in the taxpayer’s "gross income”.
On the basis of the principles established in the Genn case (supra) where the Appellate Division held that borrowed money is not received or accrued by the borrower within the meaning of such terms in the definition of "gross income”, the receipt of cash collateral should be no different. In particular and in the context of a loan of money, Schreiner JA in the Genn case held as follows:
"It is difficult to see how money obtained on loan can, even for the purposes of the wide definition of "gross income”, be part of the income of the borrower, any more than the value of the tractor which a farmer borrows is to be regarded as being income received otherwise than in cash. Though a borrowing for use differs from a borrowing for consumption in that the borrower in the former case does not become the owner of the thing borrowed and must return it in specie, while in the latter case he does become the owner and is only obliged to return what is similar, for present purposes there would seem to be no difference between the two cases...
It certainly is not every obtaining of physical control over money or money’s worth that constitutes a receipt for the purposes of these provisions… At the same moment that the borrower is given possession he falls under an obligation to repay. What is borrowed does not become his, except in the sense, irrelevant for present purposes, that if what is borrowed is consumable there is in law a change of ownership in the actual things borrowed.”
As is the case with a borrower of money, the recipient of cash collateral is obliged to return the collateral once the collateral giver has discharged its obligations in terms of the securities lending agreement.
Therefore, where a taxpayer receives cash collateral under a securities lending agreement, such amount should not be included in the taxpayer’s gross income.
In addition, a further requirement for inclusion in the gross income definition is that such amount is not of a capital nature. The cash collateral should therefore be received as part of a scheme of profit making in order for it to qualify as gross income. As the recipient of the cash collateral is typically required to pay interest on the cash collateral to the collateral giver, the mere receipt of the collateral would not in itself be an indication of a revenue intent.
If contrary to what is set out above, the cash collateral is included in a taxpayer’s gross income, then the taxpayer should be entitled to deduct the value of its obligation to return the cash collateral. To the extent that this is in the same year of assessment, the taxpayer should be neutral on the receipt of the collateral.
On this basis the receipt of cash collateral on an outright transfer basis should be no different from a tax perspective compared to the receipt of collateral under a cession in securitatem debiti.
From a legal point of view, on the other hand, the outright transfer of cash collateral is preferable for the taxpayer that is the secured party. On the occurrence of a default by the collateral transferor, the secured party need not take any steps to enforce its rights against the cash collateral. Whether pre-insolvency (under the contractual terms of the securities lending agreement) or post-insolvency (in terms of section 35B of the Insolvency Act, 24 of 1936), the secured party can simply set off its obligation to return the cash collateral against the defaulted obligations owing to it by the defaulting party. Where cash is pledged and ceded in securitatem debiti, procedural steps must be taken in order to take over the cash collateral, which steps may result in delays and losses for the secured party. Given that the tax treatment of cash collateral should be the same whether transferred outright or ceded in securitatem debiti, parties to securities lending agreements would be prudent to continue receiving cash collateral by outright transfer.
This article was first published on ENS.co.za