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05 October 2018
An amendment to Paragraph 39 of the Eighth Schedule to the Income Tax Act (58/1962) has been proposed in the National Treasury's draft Taxation Laws Amendment Bill (TLAB), as published in July 2018 for public comment. Per the explanatory memorandum on the draft TLAB, the proposed amendment seeks to clarify that capital losses between connected persons will be ring-fenced where a person redeems its interest in the other person (eg, a company) and the two persons are connected.
Paragraph 39 of the Eighth Schedule to the act is a capital gains tax (CGT) anti-avoidance provision. It requires a capital loss to be treated as a 'clogged loss' where a person disposes of an asset to a connected person and incurs a capital loss. The clogged-loss rule applies when determining the disposer's aggregate capital gain or aggregate capital loss and requires that the loss be entirely disregarded. In this way, the capital loss is ring-fenced and may be offset only against capital gains arising from disposals to the same connected person.
The clogged-loss rule restricts the deduction of capital losses if:
The ring-fencing restrictions are extended so that the capital losses may be deducted only from capital gains that arise:
The timing of a disposal is governed by a further restriction: disregarded capital losses may be deducted only if the other person to which the subsequent disposals are made is still connected to the disposer when it makes the disposals.
Paragraph 39 becomes relevant where, for example, a shareholder disposes of an asset to their company, which is a connected person, and incurs a capital loss. In this situation, the capital loss cannot be considered when determining the shareholder's aggregate capital gains or losses for the assessment year in which the transaction took place. Instead, the disregarded capital loss may be deducted only against capital gains made from the shareholder's disposal to its company during the same or subsequent assessment years, provided that the company is still a connected person to the shareholder at the time of any subsequent disposals.
Paragraph 39 of the Eighth Schedule to the Income Tax Act is applicable only where an asset has been disposed of to a person. Taxpayers have often been confused by this aspect of Paragraph 39, as many situations give rise to an asset having been disposed of to no one in particular. The sixth issue of the South African Revenue Service's Comprehensive Guide to Capital Gains Tax demonstrates that disposing to no one is a common scenario which occurs, for example, in the scrapping or extinction of an asset or when an asset is deemed to be disposed of and the deeming provision does not specify an acquirer.
The difficulty that arises where there is no transfer to a connected person of an asset or of the rights encapsulated by the asset was brought before the Tax Court in 2012 in Income Tax Case 1859 (IT 1859). The court in this instance had to consider the applicability of Paragraph 39 where Company A purchased redeemable preference shares in Company B (within the same group of companies from various third-party banks), after which Company B redeemed the shares and Company A incurred a resultant capital loss on the redemption. The court had to determine whether the redemption of shares constituted a 'disposal to'. The court identified the difficulty herein, as although the wording of Paragraph 39 clearly covers transactions such as sales or the transfer of assets and shares from the disposer to a connected person, the legislation is unclear where there is no asset transfer.
IT 1859 was a landmark case for the interpretation of the meaning of 'disposal' under Paragraph 39. As part of its considerations, the court relied on the so-called 'canons of construction' to conclude that the use of the preposition 'to' in Paragraph 39(1) cannot be ignored. It was therefore held that, while the redemption of shares constituted a 'disposal' as defined in Paragraph 11 of the Eighth Schedule to the act, the redemption was not a 'disposal to any other person' as envisaged in Paragraph 39. The court reasoned that the redemption of shares results in the extinction and not the transfer of the rights embodied in the redeeming company's shares.
A precedent has since been set that the redemption of shares is not subject to Paragraph 39 because the shares contemplated therein have not been disposed of as set out in the provisions. The court demonstrated that a literal interpretation of the legislation must be used and relied on the meaning of the word 'to' in the Concise Oxford Dictionary to decide that "the disposal of the asset must thus be 'in the direction of', or 'so as to reach' the connected person".
The draft TLAB has directly addressed the discrepancies ensuing from IT 1859 by specifically setting out the fact that, for the purposes of disregarding capital losses in terms of Paragraph 39 of the Eighth Schedule to the Income Tax Act, where a company redeems its shares, the holder of those shares must be treated as having disposed of them to that company. As such, although the literal interpretation of Paragraph 39 will still have to be considered in view of IT 1859, the draft TLAB has clarified the legal position in respect of the redemption of shares.
For further information on this topic please contact Jessica Carr at Cliffe Dekker Hofmeyr by telephone (+27 115 621 000) or email (email@example.com). The Cliffe Dekker Hofmeyr website can be accessed at www.cliffedekkerhofmeyr.com.
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