In the current economic environment impacted by COVID-19, many corporate taxpayers have been negatively impacted and, in many instances, operating losses suffered have translated directly into assessed losses for tax purposes. In addition, businesses that were already in distress prior to the advent of COVID-19 and are now also suffering operational losses, could result in an increase in an existing assessed loss balance being brought forward from a prior year of assessment.
In these circumstances and because South Africa does not have a system of "group-taxation", it might be tempting to combine a profitable businesses with a not-so-profitable businesses (typically, the would benefit from having an assessed loss for tax purposes). The question that often arises is whether there are any negative tax consequences of such a transaction that could result in an adverse tax outcome and potential penalties and interest.
The response from tax practitioners is always the same: one has to have regard to the provisions of section 103(2) of the Income Tax Act, 1962 ("ITA"). deals with what is commonly referred to as "trafficking in assessed losses" which, if successfully applied, has the effect that any "diverted income" is not capable of being set-off against the assessed loss of the transferee company.
However, this may be detrimental, not only to the arrangement as a whole because it has failed in what was intended, but also to the very ability of the transferee to carry forward the assessed loss as envisaged in section 20 of the ITA in circumstances where the transferee company has not traded in the particular year of assessment.
The provisions of section 103(2) of the ITA read as follows:
- "(2) Whenever the Commissioner is satisfied —
- (a) any agreement affecting any company or trust; or
- (b) any change in —
- (i) the shareholding in any company; or
- (ii) ... ;
- (iii) ... ;
- as a direct or indirect result of which —
- (A) income has been received by or accrued to that company or trust during any year of assessment; or
- (B) any proceeds received by or accrued to or deemed to have been received by or to have accrued to that company or trust in consequence of the disposal of any asset, as contemplated in the Eighth Schedule, result in a capital gain during any year of assessment,
- has at any time been entered into or effected by any person solely or mainly for the purpose of utilizing any assessed loss, any balance of assessed loss, any capital loss or any assessed capital loss, as the case may be, incurred by the company or trust, in order to avoid liability on the part of that company or trust or any other person for the payment of any tax, duty or levy on income, or to reduce the amount thereof —
- (aa) the set-off of such assessed loss or balance of assessed loss against any such income shall be disallowed;
- (bb) the set-off of any such assessed loss or balance of assessed loss against any taxable capital gain , to the extent that such taxable capital gain takes into account such capital gain, shall be disallowed; or
- (cc) the set off of any such capital loss or assessed capital loss against such capital gain shall be disallowed."
In addition to the charging section as set out in subsection (2) of section 103 of the ITA, due regard must also be had to the provisions of subsection (4) of section 103 of the ITA which read as follows:
- "(4) If any objection and appeal proceedings relating to a decision under subsection (2) it is proved that the agreement or change in shareholding or members' interest or trustees or beneficiaries of the trust in question would result in the avoidance or the postponement of liability for payment of any tax, duty or levy imposed by this Act or any previous Income Tax Act or any other law administered by the Commissioner, or in the reduction of the amount thereof, it shall be presumed, until the contrary is proved in the case of any such agreement or change in shareholding or members' interests or trustees or beneficiaries of such trust, that it has been entered into or effected solely or mainly for the purpose of utilising the assessed loss, balance of assessed loss, capital loss or assessed capital loss in question in order to avoid or postpone such liability or to reduce the amount thereof."(our emphasis added)
In terms of section 103(4) of the ITA, the taxpayer bears the onus of proving or showing that the relevant change in shareholding or the entering into the agreement was not with the sole or main purpose of utilising an assessed loss to reduce, postpone or avoid tax. The onus of proof will be on the parties to show that their "sole or main purpose" in, for example, acquiring the businesses from another entity is not the avoidance of tax through the utilisation of an assessed loss.
In analysing the requirements of section 103(2) of the ITA, it is clear that all of the following three requirements must be satisfied before the provisions apply to a particular transaction:
- There must be an agreement affecting any company or there must be a change in shareholding in a company. It is important to note here that either of these scenarios will suffice ie, either a change of shareholding in a company or any agreement affecting a company. The latter is of utmost importance as there is a perception in the market that the relevant agreement should result in a change in shareholding which is clearly not what the provision envisages. Refer in this regard to the judgment in CIR v Ocean Manufacturing Ltd.
- Income as a direct or indirect result of the agreement or change in shareholding referred to above, must have been received by or accrued to that company during any year of assessment. The terms of the agreement or change in shareholding must result in income having accrued to or received by the company with the assessed loss. The latter is very often clearly identifiable when looking through the financial statements of a company i.e. an increase in turnover from one year to the next (for example) could result in a query from the South African Revenue Service ("SARS").
- The agreement or change in shareholding must have, at any time, been entered into or effected by any person solely or mainly for the purposes of utilising any assessed loss, any balance of assessed loss, any capital loss, or any assessed capital loss, incurred by the company, in order to avoid liability on the part of a company or any other person for the payment of any tax, duty or levy on income, or to reduce the amount thereof.
It is almost inevitable that requirement 1 and requirement 2 would be satisfied in many (if not all) scenarios because of the broad application to any agreement or change in shareholding in a company that results in a receipt or accrual of income in the company. The only defence in this scenario is to demonstrate that the transaction was entered into solely or mainly for purposes other than the utilisation of an assessed loss. At face value, it is difficult to see how the company with the assessed loss could be seen to be avoiding liability for tax (if one has regard to the judgment in Smith v CIR, where it was held that to avoid liability is "to get out of the way of, escape or prevent an anticipated liability").
Notwithstanding the latter academic point, the provisions clearly find application where the relevant transaction has been entered into solely or mainly in order to avoid liability on the part of (not only) the company but any other person for the payment of any tax, duty or levy on income. Regard must thus be had to the sole or main purpose of the transferor. The commercial rationale (other than tax) for the transaction must thus be interrogated to determine whether the sole or main purpose of the transaction is susceptible to challenge and whether any commercial reasons provided can stand up to scrutiny and cross examination in court ie, they must be evidenced and defendable commercial reasons.
In closing, it is also important to note that the Commissioner for SARS may also invoke the general anti-avoidance provisions found in section 80A of the ITA in dealing with impermissible tax avoidance arrangements, provided the respective requirements are met. These provisions can be argued in the alternative or in addition to section 103(2) of the ITA by SARS. It is also important to remember that in certain instances, these transactions are required to be reported to SARS in terms of the reportable arrangement provisions as contained in Part B of Chapter 4 of the Tax Administration Act, 2011 read together with the relevant regulations thereto.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.