Do You Know Your Full Tax Liability?
In Part 1, capital distributions arising in terms of the provisions of the Companies Act, 1973 (the Act) in the context of the dividend definition and the treatment of capital distributions for capital gains tax (CGT) purposes prior to 1 October 2007 were examined. The record-keeping requirements of which shareholders would need to be aware in order to take capital distributions into account in their CGT determinations were also highlighted. Part 1 further referred, in broad terms, to the amendments to the CGT regime regarding capital distributions embodied in the Revenue Laws Amendment Act, No. 35 of 2007 (the Amendment Act). The amendments increase the urgency for shareholders to ensure that their records are complete and that they understand the CGT implications of capital distributions, including the potential cash flow implications of the amendments.
In Part 2, these amendments are explored more fully and the new treatment of dividends paid out of pre-acquisition profits to shareholders in the same group is briefly examined.
- The old and the new treatment for capital distributions
In terms of paragraph 74 of the Eighth Schedule, a ‘capital distribution’ is a distribution by a company that is not a dividend, or is a dividend that is exempt from secondary tax on companies by reason of section 64B(5)(c) of the Act. This would be, for example, where a company distributes original share premium to its shareholders instead of declaring a dividend.
Prior to the amendment, capital distributions received before to 1 October 2001 on shares disposed of after that date had the effect of reducing the base cost of the share. Whereas capital distributions received after 1 October 2001 were only added to proceeds in the year of disposal.
It is submitted that some of the difficulties highlighted in Part 1 may have prompted the amendments to paragraph 761 and 76A2 of the Eighth Schedule to the Income Tax Act. Under the old rules, capital distributions received after valuation date (1 October 2001) were treated as proceeds only on the eventual disposal of the shares (including deemed disposals, e.g. on the death of the taxpayer). Under the new regime, a capital distribution received after 1 October 2007 must, in terms of the new paragraph 76A(1)(b), be treated as a part disposal in the year received or accrued.
Part disposals are considered in paragraph 33. The approach in general is to establish the base cost that must be deducted from the capital distribution on a proportionate basis as follows:
[(capital distribution/market value of entire holding as at the date of the distribution) x qualifying paragraph 20 expenditure (or paragraph 29(4) market value at valuation date, if applicable)].
- Transitional effects
Transitional effects were introduced by the amendments to facilitate the treatment of capital distributions received prior to 1 October 2007. The implications for these capital distribution are addressed below.
3.1 Capital distributions received prior to valuation date:
Where a capital distribution was received prior to valuation date (normally 1 October 2001), the capital gain impact will occur on disposal of the share. The distribution must be treated as a reduction of the paragraph 20 expenditure. This treatment has remained unchanged by the Amending Acts. While there does not appear to be a limit to this reduction, logic would imply that paragraph 20 expenditure could only be reduced to nil. However, in determining the valuation date value in such cases, it is submitted that the taxpayer would still have the options granted in paragraphs 26 and 27. It is further submitted that should the capital distributions received prior to valuation date exceed the qualifying expenditure per paragraph 20, the adoption of market value as valuation date value would override such effects. Furthermore, as proceeds (in such a case) would always exceed such ‘reduced’ expenditure, paragraph 26 would allow the adoption of such market value and paragraph 27 would be inapplicable. It is possible that additional complications could arise in the determination of base cost, but those are beyond the scope of this article. Note that it would appear that this approach for pre-valuation date capital distributions is equally applicable to shares where the base cost is determined using the weighted average method (in contrast with capital distributions after valuation date – as
3.2 Capital distributions received after valuation date but prior to
1 October 2007 (excluding the weighted average method):
Those capital distributions that had been received between valuation date and 1 October 2007 will have to be brought to account in one of two ways:
(a) If the share is disposed of prior to 1 July 2011, the capital distributions (received to date of disposal) will be added to the proceeds at disposal date (as was the case prior to the amendment); or
(b) If the share has not been disposed of by 1 July 2011, the capital distributions accumulated since valuation date to 1 October 2007 will be treated as a part disposal of the share on 1 July 2011. This will have the potential effect of including taxable capital gains in the taxpayer’s 2012 taxable income, resulting in the associated cash outflows.
3.3 Weighted average method – capital distributions prior to 1 October 2007
Where the base cost of identical shares is established by means of the weighted average method (as contrasted with the specific identification or first-in-first-out methods) it requires somewhat different treatment due to the inherent nature of the method. This treatment applies in the case of capital distributions that were received between valuation date and 1 October 2007, and is provided for in the paragraphs 76(2) and 76A(2). Paragraph 76(2) provides that these capital distributions must be treated as a reduction of the total cost of the shares, the result being divided by the total number of shares in arriving at an equivalent weighted average cost per identical share. This treatment was (and remains) in place to alleviate problems that could otherwise arise on disposal of part of a holding of
In certain cases, the reduction to the total cost of shares by the amount of any capital distributions received between valuation date and 1 October 2007 might have resulted in a negative base cost. If the base cost at 31 December 2010 is negative in the case of those shares still held and not disposed of as at 1 July 2011, the new paragraph 76A(2) provides that the shareholder must be treated as having a capital gain equal to that negative amount, and the base cost of the shares going forward must be treated as nil. The negative amount will have to be recognised as a capital gain as at 1 July 2011.
- Post 1 October 2007 capital distributions
Irrespective of the method to determine base cost, for capital distributions received after 1 October 2007, the formula discussed above will apply, namely:
(capital distribution/market value of entire holding as at the date of the distribution) x qualifying paragraph 20 expenditure (or paragraph 29(4) market value at valuation date, if applicable).
- Dividends out of pre-acquisition profits
The proposed amendment to the dividend definition, by means of the insertion of paragraph (g) will also have CGT implications in terms of the rules for capital distributions. In terms of this amendment, with effect from 1 October 2007 any amount distributed to a shareholder that forms part of the same group (as defined in section 41 of the Act) is excluded from the definition of a dividend where that amount is treated as a reduction of the cost of the investment in accordance with ‘generally accepted accounting practice’ (that is, in the case of dividends paid out of pre-acquisition profits). The effect of this is that the company receiving the amount will not be able to treat it as a dividend accrued when determining its net dividend for STC purposes. Moreover, as the amount is not a dividend, it is a capital distribution, and must be treated as a part disposal in terms of paragraphs 76 and 76A. Fortunately the amount will not comprise a deemed dividend in terms of section 64C(2)(a), as it is excluded by means of section 64C(4)(a) – it is an amount that but for paragraph (g) of the dividend definition would have been a dividend.
- A point to note
Paragraph 76(1) and (2) was amended to exclude shares distributed in terms of unbundling transactions under section 46(1) of the Act. The base cost for such unbundled shares would be established by means of an apportionment of the base cost of the shares in the unbundling company, as they are effectively a replacement of part of the original shareholding. Therefore, the exclusion of such unbundled shares from the provisions relating to capital distributions in general is sensible. However, it should be borne in mind that this exclusion only relates to unbundlings in terms of section 46(1). Unbundled shares that do not qualify for the roll-over relief provided for in that section will be treated like any other capital distribution.
Shareholders would be advised to take steps as early as possible to establish the details relevant to capital distributions they may have received in the past. It would be inadvisable to wait until a query is received from SARS, which has ready access to full details of capital and dividend distributions, share trades, etc.
Shareholders should also take cognisance of distribution notices received to determine whether a capital distribution or dividend has been received.
Craig West BCom, MCom, CA(SA) and Peter Cramer BCom (Hon), BCompt, MBA, CA(SA), are both senior lecturers in the Department of Accounting at the University of Cape Town.