Before capital gains tax (CGT), when you made a profit, you would build up capital through repeated additions of after-tax profit and investment surpluses. The capital, represented by farm land, buildings and the other solid or paper holdings – shares, unit trusts, bonds and the like – would grow peacefully without any interventions by the taxman until the death of the owner. Then estate duty would be levied.
‘Capital’, according to the Gross Income Definition within the Income Tax Act is still tax-free, but subject to the provisions of the Income Tax Act, which of course incorporates the Eighth Schedule that regulates capital gains, and Section 26A of the Income Tax Act, which adds the taxable portion of the capital gain into the taxable income of the taxpayer.
Only that portion of capital exempt from CGT, such as certain jewellery, personal use assets, furniture, and cash, is now free of tax. One of the inviolate principles of tax is that funds spent in the making of income are deductible against tax. The funds must, however, be revenue and not capital. Thus, if you were to build a dairy with cash money that was sitting in a current account, not using any loans at all, the funds spent on the building would not constitute a deduction against taxes, as such funds are capital in nature.
So we have ‘capital allowances’ built into the fabric of the Income Tax Act to encourage you to spend capital in building capital facilities for the creation of income. Factories, plants, mines and farms are examples of capital facilities that (potentially at least) give rise to income. Naturally, the revenue authorities are delighted when capital is employed in the creation of such capital facilities, because the more capital development that takes place, the more taxable income is earned and, also, the lower the amount of social spending that has to be made, because employment is stimulated by capital development.
Capital allowances vary per industry and per item of capital. A lawyer’s books, for instance, may be written-off in the year of their purchase. In other words, a 100% capital allowance is provided for. At the other end of the scale, certain industrial machines are written off over five years or more, while certain commercial buildings have a much longer write-off period.
This means the businessperson who spends their capital will obtain tax relief over the term of the write-off period of the capital item.
Savvy tax planners advise the use of bank finance or loans of capital in order to finance the capital equipment. This is because the interest on a loan made in the production of income is tax deductible. For example, a loan made in order to fund the purchase of a tractor is capital money, but the interest upon the loan is tax deductible, because the loan is made in anticipation of the production of income by the tractor. Money invested in the bank is capital, while the interest on the capital is income in the hands of the investor. The cash ‘stockpile’ is capital, the fruits – the interest – is revenue.
Peter O’Halloran is head of tax at BDO, Gaborone. Contact him on 00267 390 2779 or at [email protected]. Please state ‘Tax’ in the subject line of your email.