Debt compromises – the debtor giveth and SARS taketh away

In a previous article we dealt with the VAT implications of debt compromise arrangements. In this article we explore the income tax and capital gains tax implications of debt compromise arrangements.

Introduction 

The COVID-19 global pandemic caused a significant contraction in most (probably all) global economies. South Africa did not escape the mayhem. The World Health Organisation recently remarked that the lock-downs implemented in most countries contributed very little to containing the virus, but significantly exacerbated global poverty. 

In South Africa the damage to the South African economy is clearly visible in an increase in irrecoverable debts and debt compromises being entered into between debtors and creditors. While a compromise with a creditor may provide relief for a debtor, the income tax and capital gains tax implications must not be lost sight of. 

The relevant requirements in the Income Tax Act are quite challenging to read, understand and interpret. In this article we have attempted to unpack the rules in understandable terms. 

The rule in a nutshell

As a general guiding principle one can postulate that where a debt compromise has been entered into, the previous income tax implications of the expenditure funded with the debt must be reversed. 

If the debt funded deductible expenditure and trading stock, the previous deductions claimed must be reversed. If the funds were used to acquire capital assets, the tax implications must be re-determined as if the debt relief never formed part of the original cost of the assets.

Let’s look at the rules in a little more detail …

The debt financed deductible expenditure

This would apply to expenditure of an operating nature which are deductible for income tax purposes as well as the acquisition of trading stock. 

Without delving into the details of the relevant sections of the Income Tax Act, the impact is that any deduction previously claimed in respect of trading stock or other deductible expenditure, must be treated as taxable income in the year of assessment that the debt benefit accrues to the debtor. That would be when the debt compromise is finalised.

The debt financed capital expenditure 

In the case of debt that financed capital expenditure, a distinction must be drawn between capital expenditure on which capital allowances could be claimed for income tax purposes (allowance assets), and capital assets that did not qualify for any tax relief (non-allowance assets).

Non-allowance assets 

In the case of non-allowance assets, a debt compromise does not have any income tax implications but does have capital gains tax implications.

Essentially the base cost for capital gains tax purposes is reduced by the amount of the debt benefit if the taxpayer still owns the asset at the time of the debt benefit accruing to the taxpayer.

If the asset had already been disposed of at the time that the debt benefit accrues to the taxpayer, the previous capital gain or loss computed on the sale of the asset must be recomputed to give effect to the impact of the reduction in the base cost of the asset. Any adjustment required to the original capital gain or loss computed must be disclosed in the year of assessment that the debt benefit accrues to the taxpayer.

Allowance assets 

With regards to allowance assets, a debt benefit may have an impact of both income tax and capital gains tax, depending on the amount of the debt benefit. 

If the tax value of the allowance asset at the time of the debt benefit accruing to the taxpayer exceeds the amount of the debt benefit, the base cost of the asset is reduced by the debt benefit. The taxpayer may continue claiming capital allowances on the asset, but the total allowable deductions are then limited to the new base cost. More confusion calling for an example …

If the original cost of an allowance asset was R100 and the cumulative tax allowances amounted to R40 (i.e. the tax value of the asset is R60), and the debtor negotiates a debt benefit of R10, the new base cost of the asset would be R50 (R100 – R40 -R10). Under these circumstances the taxpayer may continue to claim capital allowances on the asset computed on the basis of the original cost, but the cumulative future capital allowances cannot exceed R50.

If the tax value of the allowance asset at the time of the debt benefit accruing to the taxpayer is less  than the amount of the debt benefit, the base cost of the asset is reduced by the debt benefit to nil. The reminder of the amount of the debt benefit is treated as a taxable recoupment that must be included in the taxpayer’s taxable income. Example…

If the original cost of an allowance asset was R100 and the cumulative tax allowances amounted to R40 (i.e. the tax value of the asset is R60), and the debtor negotiates a debt benefit of R70, the new base cost of the asset would be Rnil (R100 – R40 -R60). The excess debt benefit of R10 is taxed as a normal recoupment of capital allowances and no further capital allowances may be claimed on the asset.

Bad debt relief for the creditor?

Technically in the case of a compromise the creditor cannot claim a deduction for the bad debt. It is our understanding though that in practice SARS allows the deduction as a bad debt.

Summary

The above represents a birds eye view of quite a complex set of rules. Hopefully the above will raise the awareness of the major red flags. In practice we recommend that professional assistance always be sought.