A critical analysis of the tax implications of debt reductions

Abstract

Recent legislative changes placed considerable emphasis on the provision of assistance to companies experiencing financial difficulties, as illustrated by, for instance, section 19 and paragraph 12A of the Eighth Schedule to the Income Tax Act. Where debt is reduced, these sections, as well as other sections in the Income Tax Act and the VAT Act, may become applicable. Misinterpretation of the legislation or failure to view it holistically can potentially increase a taxpayer s tax burdens (including potential penalties and interest) and may also affect the revenue due to government. The main purpose of this study was to critically analyse the debt reduction provisions contained in the Income Tax Act and to consider how those provisions interact with other sections of the Income Tax Act as well as with the VAT Act. Practical difficulties and uncertainty with regard to the current legislation were considered and highlighted. The study contemplated the meaning of debt, how hybrid instruments are treated and potential reclassification between debt and equity by SARS. The study further considered what would constitute a debt reduction, how debt is reduced and how share capitalisations as repayment of debt are treated. The sections of the abovementioned Acts that impact on debt reductions were considered. The findings of the study suggest that hybrid instruments create a form of mismatch when a debt reduction occurs that is not in line with the recommendations of the Davis Tax Committee. In certain instances a hybrid instrument reclassifies the interest or dividend component, but the classification for purposes of the debt reduction provisions may be different. When share capitalisations occur as settlement for outstanding debt, care should be taken to ensure that the debt is discharged in order to guarantee that the shares are taken as consideration for purposes of the debt reduction provisions. This will avoid a potential tax liability on a larger amount. Taxpayers should align their processes and procedures to comply with the tracing burden placed on them by the debt reduction provisions. Clarification of the legislation is recommended on how the debt reduction provisions should be applied in a situation where a debt was used for a dual purpose and a partial debt reduction occurs. In the case of debt reductions, an additional tax burden can exist for a financially distressed taxpayer in terms of section 19 of the Income Tax Act and the relevant VAT legislation. It is recommended that the interaction between paragraph 20(3)(b) of the Eighth Schedule and the debt reduction provisions be clarified in the legislation. The study also considered an intragroup loan in terms of section 45 and the potential that exists for a creditor company to claim a capital loss in the case of a debt reduction.