The reduction of debt in the Income Tax Act, 1962 is currently dealt with in section 19 and paragraph 12A of the Eighth Schedule. A reduction/waiver of debt for more than the fair value of the consideration paid by the debtor for such waiver could result in, mainly, income tax recoupments (section 19) or reductions of base costs of assets or capital losses (paragraph 12A). For example, where a creditor waives a debt owed of 100 and the debtor has not paid anything for the waiver, the recoupment to income, or reduction to base cost or capital loss would be the full debt amount of 100.
The Taxation Laws Amendment Bill, 2017 (TLAB) circulated on 25 October 2017 provides for the scope of the current “debt reduction” rules in section 19 and paragraph 12A to be expanded significantly to apply to any “concession and compromise” of debt which gives rise to a “debt benefit” to a debtor.
The version of section 19 and paragraph 12A in the TLAB spans three pages of fine print, each. This article will explain the new rules as three steps:
- Step 1: Is there a “concession or compromise”?
- Step 2: What value is the “debt benefit” to the debtor arising from the “concession or compromise”?
- Step 3: What was the debt used for by the debtor? The use of the debt will determine the tax impact of the “debt benefit” to the debtor.
The exclusions from the new rules
It is always useful to first consider the exclusions in a provision. If one of the exclusions below apply, it will not be necessary to undertake the complicated analysis of the three steps further.
The new rules do not apply in the following situations:
- debt owed to a deceased estate;
- debt reduced by way of donation;
- debt reductions which could be taxable fringe benefits on the employee;
- debt between resident debtors and creditors in the same group where the debtor did not trade in the year of assessment that the debt benefit arises, and the previous year (see step 2 for “debt benefit”); and
- the direct and indirect settlements of debt with shares between resident debtors and creditors in the same group.
All the above exclusions are for section 19 and paragraph 12A. There is a further exclusion in paragraph 12A as follows:
- debt owed by a debtor company to a connected person which is reduced as part of winding-up proceedings of the debtor to the extent any “debt benefit” which arises is less than the amount paid for the debt by the connected person.
Group relief (between resident companies) is thus only available for settlements of debt with equity and concessions or compromises with a debtor which has not traded for at least two years (see above (d) and (e)). Further, a debt benefit arising from a reduction of debt in the course of the winding-up of a debtor where the creditor is a connected person, is excluded from paragraph 12A implications, but not section 19.
If none of the above exclusions apply, it will then be necessary to consider whether there is a “concession or compromise”.
Step 1: Is there a “concession or compromise”?
A concession or compromise is
- a change in any term or condition of debt, a waiver of debt, an exchange of any obligation for the debt owed (including by novation); or
- any direct or indirect settlement of debt with equity.
The above definition is widely couched and intended to include any possible debt restructuring or refinancing strategy. A concession or compromise would include the scope of the current “debt reduction” and a lot more. The policy intent appears to be to provide for a tax trigger event for any common debt restructuring or refinancing strategies and to ensure that any benefit to the debtor when triggered results in an immediate tax impact to the debtor.
Given the broad definition of “concession or compromise”, a debtor will likely have to consider whether there is a “debt benefit” once any form of debt restructuring or refinancing is undertaken.
Step 2: What value is the “debt benefit” to the debtor arising from the “concession or compromise”?
A “debt benefit” arises for the debtor where the face value of the debt before the arrangement exceeds:
- in the context of change of terms or conditions, exchange of obligations or waivers of debt – the market value of the claim after the arrangement;
- in the context of direct or indirect settlements of debt with equity:
- the market value of the shares issued on the settlement, where the creditor did not hold any shares in the debtor prior to settlement; or
- the difference between the aggregate market value of shares held before and after the settlement, where the creditor held shares in the debtor prior to the settlement.
The “excess” calculated above is reduced by any increase in the market value of shares held by the creditor in another company which is in the same group as the debtor where the increase arises as a result of the implementation of the arrangement.
Once the “debt benefit” is quantified, the tax impact of the benefit would depend on the purpose of the debt, which is the third and final step.
Step 3: What is the tax impact of the “debt benefit” to the debtor?
This part of the analysis remains largely unchanged from the existing rules. Generally, debt used to fund expenditure in which a deduction was claimed by the debtor would result in a recoupment of the amount as income (section 19). If the debt was used to fund expenditure of a capital asset (and no deduction was claimed on this expenditure), the amount of the debt benefit would reduce the base cost of the asset and, when reduced to nil, the debtor’s assessed capital losses (paragraph 12A).
Practical issues with the new rules
A significant issue with the new rules is the increased scope in the definition of “concession or compromise”. The scope of section 19 and paragraph 12A which currently only deals with debt waivers would be expanded significantly through the new “concession or compromise” definition. Annexure C of the 2017 Budget provided for “[d]ebt settled for consideration other than cash“, with the example given of the issue of shares equal to the face value of debt. There was no mention in Annexure C of additional tax amendments for debt subordination, and changes in terms and conditions of debt.
The proposed sections 19A and 19B in the draft TLAB also only dealt with the tax impact on the conversions of debt to equity, as envisaged in Annexure C. The new rules in the TLAB have not had the benefit of the usual legislative public participation process, being submissions, presentations and additional workshops held to discuss issues and solutions on the wording.
Another issue faced by debtors is the difficulty of obtaining the value of a “debt benefit”. A debtor would need to value the “market value of claims” or “market value of shares” arising as a result of implementing the concession or compromise. These market values would then need to be compared with the face value of the debt where “debt” is defined to exclude interest. Further, there is also no provision for a deduction for the debtor, should the debt subordination be reversed, or if the debt benefit results in a negative value.
There is also the expense of having to obtain complex valuations each time the debtor enters into a “concession or compromise” which results in a debt benefit. As a concession or compromise is widely defined, the expense may be frequent for a distressed debtor, which is no relief at all. Notably, this expense is aside from the tax impact which would also be significant.
The Explanatory Memorandum (EM) to the draft Taxation Laws Amendment Bill (TLAB) provided for the proposed new debt waiver rules not to apply when the debtor and creditor companies form part of the same group of companies, including multinational groups. This would have provided relief to resident debtors receiving much needed debt reductions or waivers from their foreign holding companies. This was in line with National Treasury’s proposal in the EM to “assist companies in financial distress“. Group relief in the final bill, however, has been narrowed to apply only when the debtor and creditor companies are both residents. Further, the existing broad para 12A(6)(d) exclusion providing for unqualified group relief for any debt reduction of debt owed to another resident group creditor has also been removed.
The above issues clearly indicate that the new debt relief measures in the TLAB provide limited or no relief at all to debtors in financial distress. The Webber Wentzel Tax Team will be making submissions to the National Treasury on the issues of the new rules for inclusion in Annexure C of the 2018 Budget. We hope that these issues will be considered and resolved in the 2018 legislative process as it appears that the new rules in the TLAB would apply to years of assessment commencing from 1 January 2018.