Dealing with clogged losses

These cannot be used to offset gains made in other transactions by the taxpayer in the same tax year.

Dealing with clogged losses
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Since 2001, capital gains have been taxable in South Africa. Prior to that, capital, being essentially after-tax money, was untaxed.

Of course, if the seller deals regularly in the type of assets sold, the transaction could be deemed income, but that’s another discussion entirely.

Under normal circumstances, if you sell an asset at a loss, that loss can be used to offset capital gains made during the same tax year.

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Paragraph 7 of the Eighth Schedule of the Income Tax Act defines aggregate capital losses as the sum of losses exceeding any capital gains plus the annual exclusion allowed. It is a pity, though, that the paragraph does not make reference to the more specific provisions contained in Paragraph 39 of the Eighth Schedule.

This deals with ‘clogged losses’. A clogged loss is one that cannot be used to offset gains made in other transactions by the taxpayer in the same tax year.

According to Paragraph 39, if a sale takes place at a capital loss and the seller and purchaser are connected to each other, the loss must be disregarded in the aggregate capital gain or loss calculation for that tax year. That is, unless a sale in the same or subsequent tax year is made to the same connected person and a capital gain is made. Such gains can be offset against the loss made in the sale to that purchaser.

A ‘connected person’ is a company in the same group of companies or a ‘natural person’ and his or her siblings, children, stepchildren, parents and grandparents.

A group company is defined in Section 1 of the Income Tax Act as a company in which a controlling company holds, whether directly or indirectly, 70% of the equity shares.

No exceptions are mentioned in Paragraph 39. Thus, if the capital loss occurs and the parties to the transaction are connected persons as per the requirements of the paragraph, then the loss is ‘trapped’ and unusable, except to the extent that
a gain is made in terms of a sale to the same connected person during the same tax year or in a subsequent one.

A further proviso is that the parties must still be connected persons for the gain to be offset at that future date.

The paragraph does not prescribe a time limit for the carry-forward of the loss.

Obviously, the aim is to curb avoidance schemes, where parties might go into sales with connected persons in order to offset other gains made during a particular year.

Another issue is that of the write-off of loan accounts. This almost always takes place between related parties, which is obvious, because between strangers the party owed would almost certainly stand on its rights. This has to be so and is in fact the foundation of the lending system; if all creditors suddenly allowed debts to be written off, financial chaos would result!

I’ll discuss the writing off of loan accounts at a later stage.