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ANALYSIS: NEW DEBT REDUCTION REGIME

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A new debt reduction regime in the Income Tax Act is aimed at supporting debtors in financial distress and contributing to local economic recovery, but will this debt relief result in deferred tax liabilities on financial statements? By Nico Fourie CA(SA) and Herman Viviers CA(SA)

The new and more uniform income tax treatment of a ‘debt reduction’ that was introduced into the Income Tax Act (58 of 1962) in 2013 for years of assessment commencing on or after 1 January 2013 will most likely be different to the treatment for accounting purposes. As a result temporary differences leading to deferred tax liabilities might arise where debt was utilised to finance the acquisition of assets.

This article will take a closer look at the deferred tax consequences of the entity that is relieved from its obligations. First, general accounting considerations when recognising deferred tax provisions and general income tax principles to be applied to account for a ‘debt reduction’ are stated. Second, the practical application of these principles is illustrated by way of different scenarios.

GENERAL ACCOUNTING CONSIDERATIONS

The tax expense recognised in the statement of other comprehensive income (SOCI) includes a deferred tax expense which reflects the tax consequences of items included within the financial statements.

The measurement of deferred tax assets and liabilities will reflect the tax consequences that would follow from the manner in which the entity expects to recover or settle the carrying amount of its assets and liabilities. According to IAS 12, the tax base of an asset is ‘the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset’ while the tax base of a liability will be ‘its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods’.

IAS 39.39 states that an entity should remove a financial liability (or part of a financial liability) from its balance sheet when it is extinguished.

INCOME TAX TREATMENT

The income tax treatment of a ‘debt reduction’ (section 19 and paragraph 12a of the Eighth Schedule to the Act) will depend on how the debt was utilised. Debt used to acquire trading stock that is still held at the date of debt reduction will result in a section 19(3) reversal of the section 11(a) deduction (or section 22(2) opening stock deduction if acquired in a previous year) to the extent of the debt reduction. If the debt reduction exceeds the tax value (cost) of the stock (due to a decrease in net realisable value) the excess will be included in gross income as a deemed section 8(4)(a) recoupment. Where the stock is no longer held at the date of debt reduction the reduction amount will be included in gross income as a deemed section 8(4)(a) recoupment to the extent that a deduction was previously allowed in terms of Act.

However, where debt is waived which was used to finance the acquisition of an allowance asset (still held at the date of debt reduction), paragraph 12A of the Eighth Schedule will reduce the base cost of the asset with the debt reduction amount. Where the allowance asset is no longer held, or it is still held but the base cost has been reduced to nil (due to any allowances claimed on such asset), any excess will qualify as a deemed section 8(4)(a) recoupment in terms of section 19(6) of the Act to the extent that allowances were deducted in respect of the asset.

Furthermore, where debt is waived which was used to finance the acquisition of a non-allowance asset (such as land) that is still held at the date of debt reduction, paragraph 12A will reduce the base cost of the asset with the debt reduction amount. Where the non-allowance asset is no longer held, or it is still held but the base cost is reduced to nil, any excess should be set off against any assessed capital loss. Any portion of the debt reduction amount in excess of the assessed capital loss will be tax-free.

THE DIFFERENT SCENARIOS

The application of the aforementioned treatments could be illustrated by way of the following scenarios:

Scenario 1: Reduction of debt used to acquire trading stock

Co A acquired inventory at R100 000 on credit from a supplier during year 1. At the end of year 1, all inventory is still on hand but the value has diminished with 10%. At the end of year 2, the supplier discharges

R80 000 of the outstanding debt due to Co A’s inability to pay; 50% of the stock was still on hand.

The deferred tax consequences will be as follows:

TablesSep2015 – see page 1

1 The closing inventory on hand at the end of year 1 will be deductible as opening stock (section 22(2)) for tax purposes against future taxable economic benefits when the carrying amount of the inventory is recovered.

2 The tax base of accounts payable is its carrying amount of R100 000, less any amount that will be deductible for tax purposes in respect of that liability in future periods (nil; section 11(a) deduction already allowed in year 1).

TablesSep2015 – see page 2

1 The closing inventory on hand at the end of year 2 will have a nil value for tax purposes. The debt reduction amount (R80 000) exceeds the cost of the inventory and the excess (R35 000) is included in gross income (section 8(4)(a) recoupment), thus no future deduction against taxable economic benefits when the carrying amount of the remaining inventory is recovered.

2 Recognise the deferred tax liability at the normal corporate tax rate to reflect the tax consequences that would follow from the manner in which the entity expects to recover the carrying amount of inventory.

3 The debt reduction reduces the carrying amount of the account payable and a corresponding ‘gain on debt reduction’ is recognised in profit or loss.

Scenario 2: Reduction of debt in respect of a depreciable asset with an intention to use the asset

On the first day of year 1, Co B acquired a new manufacturing machine on credit from a supplier at R100 000. Co B accounts for manufacturing machinery in accordance with the cost model and depreciates it over its useful life of six years with a nil residual value. It is Co B’s intention to only use the manufacturing machine (never sell it). The remaining useful life and residual value remained unchanged. Owing to Co B’s inability to pay, the supplier discharges R25 000 of the debt owed to the supplier at the end of year 2, at a time while the machine was still held by Co B.

The deferred tax consequences will be as follows:

[Table to be inserted]

1 The tax base of the machine is the remaining R60 000 capital allowances that will be deductible for tax purposes against any future taxable economic benefits of the entity when it recovers the carrying amount of the machine.

2 The carrying amount of the depreciable machine will be recovered through the use of the machine, which will generate taxable profits. The entity will measure the deferred tax liability at the normal corporate tax rate.

3 The resultant deferred tax movement (expense) is recognised in profit or loss; in the same way the transaction was recognised. [Table to be inserted]

[Table to be inserted]

The tax base of the machine is the remaining R40 000 capital allowances that will be deductible for future tax purposes against any taxable economic benefits of the entity when it recovers the carrying amount of the machine, reduced with the debt reduction of R25 000 in terms of paragraph 12A of the Eighth Schedule.

2 The R14 467 consists of the sum of the temporary differences at the normal corporate tax rate due to the difference in depreciation (R33 333) and the wear-and-tear allowance (R60 000) as well as the temporary difference of R25 000 on the waiver.

Scenario 3: Reduction of debt in respect of a non-depreciable asset

Co C acquired land at R300 000 on credit during year 1 for capital appreciation purposes. Co C accounts for land in accordance with the revaluation model. The first and only revaluation occurred on the last day of year 1. Land was revalued upwards with R120 000. Owing to Co C’s inability to pay, the supplier discharges R70 000 of the debt owed to the supplier during year 2.

The deferred tax consequences will be as follows:

[Table to be inserted]

1 SARS does not recognise revaluations when determining the tax base of an asset. According to IAS 12.15B, the manner of recovery of a revalued, non-depreciable asset such as land is through sale. Therefore the tax base of land is its base cost that will be allowed as a deduction against the proceeds to determine the capital gain when the asset is sold.

2 Recognise the deferred tax liability at the effective capital gains tax rate.

3 The resultant deferred tax movement (expense) is recognised in SOCI; in the same manner as the revaluation was recognised.

[Table to be inserted]

1 The tax base of land is its base cost that will be allowed as a deduction against the proceeds to determine the capital gain when the asset is sold. The base cost of the asset should first be reduced with the debt reduction amount in terms of paragraph 12A of the Eighth Schedule.

CONCLUSION

Debt reductions will often result in the deferred tax expenses and deferred tax liabilities to be recognised in the hands of financially distressed entities.

Entities on the receiving end of debt relief must be aware of these consequences in order to correctly account for these arising temporary differences.

Authors: Nico Fourie CA(SA) and Herman Viviers CA(SA) are both senior lecturers in the School of Accounting Sciences at North-West University (Potchefstroom)