Forgiveness Of Debt
01 November 2009
Posted by: Author: Wouter Scholtz
Forgiveness Of Debt
Difficult economic times raise the issue of debt write-offs.Whether the debtor receiving this largesse is an individual or a company beware the tax implications, cautioned Wouter Scholtz, director of audit,tax and advisory firm Mazars Moores Rowland.
The difficulty stems from a provision in the Eighth Schedule of the Income Tax Act,dealing with capital gains tax (CGT).According to Paragraph 12(5) of the Eighth Schedule,when a debt is forgiven,a capital gain is triggered.If the debtor is a company, the forgiven amount will attract CGT at an effective rate of 14%; if the debtor is an individual,the effective rate will ordinarily be 10% of the forgiven amount.
Measures similar to paragraph 12(5) are to be found in all advanced tax systems.The principles are neatly illustrated by the common practice of ‘capitalising’ debt,which involves the debtor company issuing shares to the creditor in settlement.Attempts to mask a debt write-off by over-stating the actual value of the shares will be viewed dimly by SARS.
There are,however,exceptions to the application of paragraph 12(5),said Scholtz."The first exception arises if forgiving a debt gives rise to tax liabilities under provisions other than paragraph 12(5).An example would be a debtor who borrowed funds in order to fund tax-deductible expenditure. If the debt is forgiven, the previously deducted amount will be added to the debtor’s income for tax purposes.To apply paragraph 12(5) in such circumstances would amount to double taxation.”
Scholtz said a further exception arises if the amount was lent to a debtor company by a company in the same group of companies as the debtor."For these purposes, companies will in essence be grouped on the basis that at least 70% of their shares are held,directly or indirectly,by a common holding company which heads the group.”
A final exception relates to the liquidation,winding up or deregistration of a debtor company."This exception only allows the interest owed on the debt to be forgiven, not the outstanding capital. Further, it applies only if the creditor holds at least 20% of the shares in the debtor company,and the debtor company is liquidated,wound up or deregistered within 18 months.”
Aside from cases of a general compromise reached with creditors–in terms of which they might all,for example,accept payment of 10 cents in the Rand because that is all that is likely to be recoverable forgiveness of debt is largely confined to parties that are in some way connected or related to the creditor."There is ample justification for applying paragraph 12(5) to dealings between connected parties,who might be inclined to do one another favours.”
"There seems,however,to be little justification,and more than a measure of harshness,in exacting CGT from a debtor where the creditor who has forgiven the debt has done so purely and simply because of a hard-headed realisation that there is no more to be had from the debtor,” Scholtz concluded.
Source: By Wouter Scholtz (TaxTalk)