Writing off capital debt

Reduction in a company’s debt is covered by Paragraph 12A of the 8th Schedule to the Income Tax Act.

Peter O’Halloran - Tax advice

When company debt is cancelled, a capital gain is brought about by the provisions of Paragraph 12A. A gain occurs if a corresponding reduction in the base cost of the asset is brought about under Paragraph 12A and the reduction represents the loan account to the extent that the loan account exceeds any consideration paid for the reduction.

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Where no such asset exists, the reduction is the assessed capital loss for the year, to the same amount as the reduction in debt.

Thus, if the debt is reduced, the asset base cost is reduced. When the asset is disposed of, because the base cost is much lower, the gain and the tax generated will be higher.

But in tax law there are often exceptions, and Section 12A does not apply if the debt is written off in terms of a will, or if the debt is between related companies, or if it is written off prior to the winding up of the entity concerned. On the other hand, if the debt reduction exercise is undertaken with a view to tax avoidance, and the debt is between related companies, this will trigger the application of Paragraph 12A.

For estate planning purposes, this means that loan accounts created in estate planning exercises should now be able to be forgiven in the will without triggering capital gains tax. This will apply if the loan account was an asset in the deceased estate, or was owed to the deceased estate and reduced by the deceased estate – but the amount of the loan will have to be reflected for estate duty purposes.

For clarity, if a loan account exists – because, say, an asset was sold to trust on loan account – and the loan is forgiven in the will so that the estate owns the loan, then the capital gains consequences will be nil. This applies as long as the loan is taken into account for estate duty purposes.

In this example, a healthy estate planning outcome would have been achieved because the growth in value of the asset would have occurred in the trust. Estate duties would still apply, but double tax is avoided. In short, if Section 12A does not apply, there will be no adverse capital gains tax consequence resulting from the write-off of a capital loan account.

If the loan account was interest-bearing, one would have to consider the implications of Section 24J of the Income Tax Act, which deals with interest, and Section 19, which might apply when the provisions of the 8th Schedule do not find application or where the loan was gone into for the purchase of trading stock.

This article was originally published on 15 April 2016 in Farmer’s Weekly.