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No good deed goes unpunished: Writing off debts

In the current tragic economic climate of South Africa, largely due to the recent COVID-19 outbreak, various corporates and businesses are facing the likelihood of corporate insolvency and the effects of large debt overhangs. For many group companies, this may have resulted in increased inter-company loans and / or internal group corporate restructurings which may have led to a waiver of such inter-company loans.

The decision to write-off a debt may be to facilitate a corporate group-restructuring, a merger and acquisition, or a sale. Whatever the commercial reasoning, the Income Tax Act (herein the “Act“) prescribes certain tax implications that must be considered, prior to writing-off or reducing a debt. Section 19 of the Act deals with the income tax implications of a debt reduction and paragraph 12A of the Eighth Schedule to the Act deals with the capital gains tax (herein “CGT“) consequences of a debt waiver (hereinafter collectively and broadly referred to as the “Debt Reduction Rules“).

The Debt Reduction Rules may result in unwanted tax consequences for a debtor, in the event where:

  • by reason of a “concession” or a “compromise” reached in respect of a “debt” owing by a debtor to a creditor; and
  • which concession or compromise results in a “debt benefit“; and
  • provided the amount of the debt was applied by the debtor as envisaged in the Debt Reduction Rules; and
  • further provided no exemption (as provided for in the Act) finds application.

A “concession” or a “compromise” is defined in the Act as any arrangement in terms of which a “debt” is:

  1. cancelled or waived; or
  2. extinguished by way of a redemption of the claim to that debt, by the debtor or a person connected to the debtor; or by way of a merger in terms whereof the debtor acquires the claim in respect of that debt; or
  3. settled through a conversion to or exchanged for shares in a company (for example where the debtor would subscribe for shares in a company and the subscription price is set-off against the debt owing by the debtor to that company).

A “debt benefit” in turn, is defined for each specific “concession” or a “compromise” (as referenced in (a) through to (c) above), and each which is calculated differently:

  • With respect to a concession / compromise referenced in (a) above, the amount cancelled or waived will be the debt benefit;
  • With respect to a concession / compromise referenced in (b) above, the amount by which the face value of the claim held by the person to whom the debt is owed, exceeds the expenditure incurred in respect of either:
    • the redemption of that debt; or
    • the acquisition of the claim in respect of that debt; and
  • With respect to a concession / compromise referenced in (c) above:
    • where the person who acquired shares in a company in terms of that arrangement did not hold an effective interest in the shares of that company prior to the entering into of that arrangement, the amount by which the face value of the claim held in respect of that debt prior to the entering into of that arrangement exceeds the market value of the shares acquired by reason or as a result of the implementation of that arrangement; or
    • where the person who acquired shares in a company in terms of that arrangement held an effective interest in the shares of that company prior to the entering into of that arrangement, the amount by which the face value of the claim held in respect of that debt prior to the entering into of that arrangement exceeds the amount by which the market value of any effective interest held by that person in the shares of that company immediately after the implementation of that arrangement exceeds the market value of the effective interest held by that person in the company immediately prior to the entering into of that arrangement.

Accordingly, the Debt Reduction Rules; will apply if:

  • A debt owed by a debtor is reduced by an amount; and
  • The debt was used, directly or indirectly, to fund certain expenditures; and
  • The amount of the reduction of the debt exceeds the consideration advanced by the debtor for the reduction (i.e. a “debt benefit” is realised).

The resultant effect of the Debt Reduction Rules is that a “debt benefit” will be subject to normal tax, provided the debt funded and “expenditure“. Section 19 will apply if the debt funded expenditure for which a deduction or an allowance was granted under the Act, whereas paragraph 12A will apply if the debt funded expenditure for which a deduction or an allowance was not granted under the Act (i.e. expenditure of a capital nature); or incurred in respect of an allowance asset.

One must carefully consider the tax implications associated with the reduction or write-off of debt when embarking on a restructure or transaction that will result in a debt write-off.

This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your legal adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

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