The tax consequences of debt reduction can be summarised briefly as follows:
- In respect of debt used to fund the acquisition of trading stock on hand, the debt reduction amount reduces the cost price of the trading stock, taken into account for tax purposes, and the balance of the reduction amount once the trading stock cost has been reduced to zero, results in a recoupment to the extent of any deduction or allowance granted in respect of trading stock expenditure.
- In respect of debt used to fund trading stock disposed of, or other expenditure other than expenditure relating to allowance assets, the amount of the debt reduction results in a recoupment to the extent that the debt-funded expenditure was claimed as a deduction or an allowance.
- In respect of debt used to fund an allowance asset, the reduction amount will reduce the base cost of such allowance asset to zero for capital gains tax purposes. Thereafter, the reduction amount will result in an income tax recoupment. In addition, the aggregate amount of allowances or deductions which will be allowable to the taxpayer in the future will be limited to the actual amount incurred by the taxpayer, less the sum of the reduction amount and the aggregate amount of all previous allowances or deductions claimed on such asset by the taxpayer.
- In respect of debt used to fund an asset where no allowances or deductions are claimed, for example acquisition of goodwill, the base cost of the asset for capital gains tax (CGT) purposes must be reduced by the reduction amount. If the base cost is reduced to zero and there remains an amount (i.e. after the reduction amount has been used to reduce the base of the asset to zero), such a balance remaining of the reduction amount will reduce the assessed capital loss of that person.
The significance of these rules is that the tax consequences of debt reduction turns on the allocation of the debt reduction amount to specific expenditure types under a “waterfall” basis.
Practically, these “waterfall” rules pose a challenge in the case of partial debt reductions, for example where a single debt is used to fund different expenditure items, such as trading stock, interest, wages and capital assets. In such a case it may be preferential for taxpayers to allocate the debt reduction amount first to allowance assets, or other capital assets, which have high base cost – which could shield immediate tax liability. Since the new rules do not provide for a method of allocating the debt reduction in the above circumstances, it remains to be seen whether South African Revenue Service (SARS) will consent to any specific allocation which may be more advantageous to taxpayers.
It is also worthwhile pointing out that the tax reduction rules do not apply in certain circumstances, and one of the reasons is to eliminate “hardship” that may arise by virtue of the tax claw-backs. One such exception applies in circumstances where the debt is disposed of under a “donation”. In the context of business, the implication is that debts between independent parties are unlikely to be disposed of under a donation. Where a debt is waived, there may well be other tax consequences which may apply.
The real benefit of the exemption of the debt reduction rules seems to be directed at debt waivers in corporate group scenarios, where it is more common for fellow group entities to assist each other. In such scenarios, it not uncommon for a holding company to waive a debt owed by its subsidiary. That brings one to the vexed question of whether debt reductions (mostly effected by connected party creditors) supposedly in the form of a donation, can truly be said to be driven by a gratuitous disinterested benevolence? Often the need to waive a group debt may be driven by other reasons such as establishing liquidity or solvency in the debtor entity, improving the debtor entity’s balance sheet, etc. In a scenario where a debtor is a wholly-owned subsidiary of the creditor, waiver of a debt by the creditor may be off-set against an increase in the value of the shares in the debtor subsidiary, therefore questioning whether a true donation is present.
While the objective of the new tax reduction rules is to make it easier for companies, especially ones which are financially distressed, to eliminate group debts in a tax neutral fashion, the rules are complex. Taxpayers would need to be well advised to take proper advice before embarking on any debt reductions.