To be clogged, to be ignored, to be disregarded or to be utilised? Herman Viviers takes a closer look at the tax treatment of capital losses as a result of debt relief between connected persons
There are many circumstances under which different types of taxpayers could be classified as connected persons for income tax purposes. These circumstances and the specific requirements to be met are contained in the definition of “connected person” in terms of section 1 of the Income Tax Act 58 of 1962.
Various provisions in the Act contain special rules pertaining to taxpayers who are classified to be connected persons in relation to each other. These provisions are often quite complex, making it difficult to interpret and to be applied in the correct manner.
To complicate matters even further, there are differences in how a “connected person” is classified for its application in terms of the Act, as opposed to its classification under the Eighth Schedule to the Act. A spouse, for example, will be classified as a connected person in terms of the Act but is excluded from the scope of connected person in relation to a natural person for capital gains tax purposes due to the roll-over relief between spouses provided for within the Eighth Schedule.
One of the scenarios where special rules need to be applied is where debt relief occurs between connected persons. Two paragraphs in the Eighth Schedule to the Act deal with the tax treatment of capital losses between connected persons. Paragraph 39 regulates “capital losses determined in respect of disposals to certain connected persons” while paragraph 56 deals with the tax treatment of a capital loss realised due to the “disposal by a creditor of debt owed by a connected person”. Comparing the formulation of and the terminology used in each paragraph and also how the two paragraphs refer to one another makes it difficult to determine which paragraph will take precedence in the hands of a creditor releasing a connected person from its debt.
In terms of paragraph 11(1)(b) in the Eighth Schedule to the Act, the release or waiver of a right to receive payment (an asset) will constitute a disposal for capital gains tax purposes. The proceeds in the hands of a creditor releasing a connected person from its fully impaired and non-recoverable debt would be zero, while the base cost will be equal to the amount of the debt waived, resulting in a capital loss for the creditor.
Now the question is raised: Which paragraph of the Eighth Schedule will regulate the tax treatment of a capital loss in the hands of a creditor?
As paragraph 56 specifically deals with the disposal by a creditor of debt owed by a connected person, this paragraph is considered first:
Paragraph 56(1) determines that:
Where a creditor disposes of a debt owed by a debtor, who is a connected person in relation to that creditor, the creditor must disregard any capital loss determined in consequence of that disposal.
The term “disregard” is not formally defined in the Act, but the Oxford dictionary defines “disregard” as to “pay no attention to; ignore”. It therefore appears as if creditors would lose the capital loss benefits which could have been applied against other capital gains in order to reduce their overall capital gains tax liability.
As a debt relief transaction between connected persons – for example between two connected resident companies – are not excluded from the scope of paragraph 39, the provisions of paragraph 39 dealing with the tax treatment of capital losses determined in respect of disposals to certain connected persons are considered.
Paragraph 39(1) determines that:
[A] person must … disregard any capital loss determined in respect of the disposal of an asset to any person who – (a) was a connected person in relation to that person immediately before that disposal …
Although it appears, just like under paragraph 56(1), as if the capital loss will once again need to be ignored by the creditor, paragraph 39(2) states that the capital loss will be allowed as a deduction against any capital gain realised by way of a disposal to the same connected person. This deduction could either be in the current or any subsequent year of assessment, on the condition that the parties are still connected at the time of the subsequent disposal.
It therefore seems as if the word “disregard” has a different meaning in terms of paragraph 39 than in terms of paragraph 56(1). Under paragraph 39 the capital loss is in effect ring-fenced, generally referred as being “clogged”, meaning that it could still be retained and utilised but only against capital gains realised with the same connected person, while in terms of paragraph 56(1) it appears as if the capital loss will be forfeited, thus totally ignored.
As paragraph 39 states that it should be applied “when determining the aggregate capital gain or the aggregate capital loss of a person”, it could be argued that if the creditor’s capital loss is already to be disregarded in terms of paragraph 56(1), there would be no need for it be considered under paragraph 39 at the stage of getting to the calculation of the aggregate capital gain or aggregate capital loss. “Aggregate capital gain and “aggregate capital loss” are defined in paragraphs 6 and 7 respectively of the Eighth Schedule to the Act and only include the sum of capital gains and losses “that are required to be taken into account” in determining a taxpayer’s aggregate capital gain or aggregate capital loss. It is therefore submitted that the capital loss to be ignored in terms of paragraph 56(1) are no longer required to be taken into account.
It should however be noted that paragraph 56(2) does provide relief (to a certain extent) under specific circumstances by stating that: “Despite paragraph 39, subparagraph (1) does not apply in respect of any capital loss determined in consequence of the disposal by a creditor of a debt owed by a debtor …”
It is therefore submitted that the creditor’s capital loss will not be “clogged” in terms of paragraph 39, neither will it be “ignored” in terms of paragraph 56(1), but it will be allowed as a deduction against any other capital gain realised by that creditor irrespective of whether that capital gain is realised with the same connected person or not.
This rule of exception in terms of paragraph 56(2) will apply to the extent that the amount of the debt disposed of by the creditor:
• Was applied to reduce the base cost of the debtor’s asset or the debtor’s assessed capital loss in terms of paragraph 12A of the Eighth Schedule, or
• Could be proven by the creditor to be included in the gross income of any acquirer of that debt, or
• Must be or was included in the gross income or income of the debtor or taken into account to determine the debtor’s balance of assessed loss in terms of section 20(1)(a) of the Act, or
• Could be proven by the creditor to be included as a capital gain as part of the aggregate capital gain or loss of any acquirer of the debt
From the discussion above it is clear that the provisions of the Eight Schedule regulating capital losses between connected persons are quite complex. Connected persons should therefore carefully consider whether their capital losses will be disregarded, either as being clogged or ignored, or whether such losses will be allowed to be utilised without any limitations. ❐
Author: Herman Viviers CA(SA) is a senior lecturer in the School of Accounting Sciences at North-West University, Potchefstroom Campus