Tax consequences arising from the writing off of loans
October 19, 2014
We are often spoken of as an economy with high levels of debt. Even when interest rates are high, we have never been scared of gearing ourselves so that we can buy that expensive car or holiday house in Hermanus. Companies too often have high levels of debt.
In addition, in virtually every corporate structure there are a multitude of intercompany loan accounts. These loan accounts often arise either through funding being provided by one company to another or in circumstances where, for example, a company provides services or sells goods to another company and the consideration remains outstanding on loan account.
Often such loan accounts are written off, particularly in circumstances where the borrower is not able to repay the loan or, in a group context where the group wishes to "clean up” its inter-group transactions.
Debt is also written off in many other circumstances. One just needs to look at the African Bank scenario to find an example of debt being written off or reducing in value.
This article focuses on certain tax consequences arising from the writing off or waiving of debt. Assume for the purposes of this article that Company A has advanced interest-bearing loans to Company B. It is now proposed that the loan will be waived.
Section 24J of the Income Tax Act
On the basis that the loans are interest-bearing, the provisions of section 24J of the Income Tax Act (the Act) should be considered.
A gain on redemption of the loan will arise for the borrower (Company B) upon the waiver of the loan. This gain will be deemed to accrue to Company B for tax purposes in terms of section 24J(4).
Conversely, a loss on redemption of the loan will arise for the lender (Company A) upon the waiver of the loan. This will be deemed to have been incurred by Company A for tax purposes in terms of section 24J(4).
However, section 24J(4) only deems such gain or loss to accrue to, or be incurred by, the taxpayer. It must still be determined whether such gain or loss is to be of a capital or a revenue nature.
Generally, unless the taxpayer is a money-lender, an adjusted gain or loss should be capital in nature, in which case section 24J should not apply.
If the loss is revenue in nature, then Company A may obtain a deduction in relation to such loss.
A gain which is revenue in nature and which has not already been taken into account in terms of section 19 (see below), will be included in its income.
Finally, section 24J(12) states that section 24J does not apply in respect of a loan, inter alia, which is repayable on demand. Therefore, if the loan is repayable on demand, then no gain or loss arises in terms of the provisions of section 24J of the Act.
Debt reduction provisions
The "debt reduction provisions” contained in section 19 and paragraph 12A of the Eighth Schedule should also be considered in the context of any proposed waiver of loans. Essentially, section 19 deals with the income tax consequences of a loan waiver, while 12A deals with the capital gains tax (CGT) implications thereof.
Broadly speaking, section 19 applies where:
A debt that is owed by a person is reduced;
The amount of the debt was used to fund deductible expenditure, acquire allowance assets or trading stock; and
There is a difference between the amount advanced under the loan and the amount repaid in terms of the loan (Reduction Amount).
Paragraph 12A of the Eighth Schedule represents the capital gains tax equivalent of section 19. It essentially applies where the debtor applied the loan to acquire an asset which is held on capital account and there is a Reduction Amount.
Income tax implications for the borrower: section 19
In order to determine the tax implications in respect of section 19, it must be determined how the debtor applied the debt proceeds and, in particular, whether such proceeds were used to fund:
Expenditure incurred in the acquisition of trading stock that is held and has not been disposed of by the debtor at the time of the reduction of the debt; or
Expenditure incurred in the acquisition, creation or improvement of an allowance asset; or
Deductible expenditure other than set out above.
In summary, section 19 of the Act essentially functions on the following "two-step” approach:
Step 1 - Cost price reduction
The Reduction Amount will firstly reduce the cost price of the trading stock held by the debtor.
However, this cost price reduction will apply only to the extent that:
The borrowed funds were used to acquire trading stock still held by the debtor; and
That trading stock has a remaining cost price.
Step 2 - Ordinary revenue or recoupment
If the Reduction Amount falls outside the cost price reduction rules mentioned above, any residual amount will trigger a taxable recoupment. Amounts of this nature can, for example, represent:
Debt funding related to trading stock where the cost price has already been reduced to zero, or where the trading stock is no longer held;
Debt funding for allowance assets to the extent of prior depreciation (after their base cost is reduced to zero in terms of paragraph 12A); and
Debt relating to operating expenses which have been deducted for tax purposes.
In respect of the borrower (Company A), paragraph 12A(3)(b) provides that in relation to an asset held at the time of the debt reduction, the base cost of the relevant asset held by the borrower must be reduced by the Reduction Amount.
Where the Reduction Amount exceeds the base cost, such excess amount must be applied to reduce any assessed capital loss of the borrower for the year of assessment in which the reduction takes place.
Paragraph 12A(6)(d) provides that the provisions of paragraph 12A do not apply to, inter alia, any debt owed by a person to another person where that person and that other person are companies that form part of the same group of companies, unless they form part of any transaction, operation or scheme entered into to avoid any tax imposed by the Act.
The waiver of a loan by a lender should constitute a disposal of an asset in the hands of the lender.
It should then be determined whether a capital loss arises from such disposal.
Paragraph 56(1) provides that where acreditor disposes of a debt owed by a debtor who is a connected person in relation to the creditor, that creditor must disregard any capital loss determined in respect of the disposal.
However, paragraph 56(1) does not apply to the extent that the amount of that debt so disposed of represents inter alia, an amount which is applied to reduce the expenditure in respect of an asset of the debtor or any assessed capital loss of the debtor in terms of paragraph 12A, or an amount that must be or was included in the gross income of the debtor.
A donation is defined as any gratuitous disposal of property including the gratuitous waiver or renunciation of a right.
A waiver of a loan may constitute a donation.
However, section 56(1)(r) provides that no donations tax shall be payable in respect of a donation by a company to another company that is a resident and is a member of the same group of companies as the company making the donations.
In respect of the example set out above, it is unlikely that Company A will make a tax deductible loss on redemption or Company B will make a taxable gain on redemption in terms of section 24J of the Act. This is because Company A and Company B will likely hold the loans on capital account and potentially also because section 24J does not apply since the loan is repayable on demand.
The capital gains tax provisions of paragraph 12A should also not apply if the loans are waived between group entities.
However, the income tax provisions of paragraph 19 may apply to the loan if Company B used the loan proceeds to acquire allowance assets and/or fund deductible expenditure. To the extent that any amount is included in the gross income of Company B in terms of section 19, Company A would then obtain a capital loss on the loan waiver.
No donations tax implications should arise from the waiver of the loan if, inter alia, Company A and Company B form part of a group of companies.
It can be seen from the above high-level analysis that a multitude of tax issues must be considered before writing off a loan.