1726. Section 42 planning
May 2009 – Issue 117
The Income Tax Act No 58 of 1962 (the Act) provides for the tax-deferred treatment of transactions where a person transfers an asset to a resident company in exchange for equity shares in that company.
The application of section 42 of the Act has the effect that the transaction in question has no immediate income tax, capital gains tax, value added tax (VAT), transfer duty or securities transfer tax implications.
In order for section 42 to apply, the person disposing of the asset and acquiring the share must hold a "qualifying interest" at the end of the day on which the transaction takes place; a qualifying interest is 20% or more of the equity share capital and voting rights of an unlisted company, or any equity shareholding in a listed company. The "qualifying interest" rule does not apply where the person acquiring the shares is an individual who will be engaged on a full-time basis to render services in the business of the company or any controlled group company.
Section 42 is a helpful tax planning tool, and is widely used to capitalise companies, set up joint ventures and restructure groups of companies. However, its interplay with certain other sections of the legislation may result in unintended and costly capital gains tax consequences for shareholders where dividends are declared by the company the shares of which were acquired in terms of a section 42 transaction.
A "dividend" is defined in section 1 of the Act, with certain specific inclusions and exclusions.
It is generally understood that the distribution of a "dividend" by a resident company to a corporate shareholder results in a secondary tax on companies (STC) liability for the distributing company and an STC "credit" for the recipient (subject to certain STC exemptions not applying). The dividend is exempt from income tax in the hands of the recipient. The "dividend" definition specifically excludes distributions of share capital and share premium and any distribution by a company to another company that forms part of the same "group of companies" for tax purposes to the extent that, as a result of such distribution, the shareholder reduces the cost of its investment in the declaring company according to generally accepted accounting practice (GAAP).
One of the situations that would lead to an investment in a subsidiary being written down for GAAP purposes is the receipt of a dividend that consists of so-called "pre-acquisition" profits — in other words, profits that were earned by the subsidiary company prior to the transaction. Paragraph 32 of International Accounting Standard (IAS) 18 provides that identifiable pre-acquisition dividends are deducted from the cost of the shares in question and not credited to the income statement (as dividends are ordinarily treated).
A distribution that is excluded from the "dividend" definition falls into the definition of "capital distribution" contained in paragraph 74 of the Eighth Schedule to the Act. This results in the receipt of the distribution giving rise to a part-disposal for capital gains tax purposes in respect of the shares in the distributing company under paragraph 76A. The capital gain or loss arising on the part-disposal is calculated as follows:
· The capital gains tax base cost in respect of the part-disposal is the product of the total base cost of the shares (following a section 42 transaction, such base cost would be the original base cost of the asset transferred to the company) and the ratio of the market value of the capital distribution to the total market value of the shares immediately prior to the distribution; and · The proceeds for capital gains tax purposes is an amount equal to the capital distribution.Where a distribution is excluded from the "dividend" definition and the part-disposal rules of the Eighth Schedule apply, the tax liability on the distribution is shifted from the company declaring the distribution to the recipient. The apportionment methodology provided for in the Eighth Schedule could also result in a forfeiture of base cost.
The "dividend" exclusions and part disposal rules could apply in the context of asset-for-share transactions in two situations:
· Firstly, the company to which the asset is transferred in exchange for shares would generally account for the transaction by recognising an increase in share capital and share premium. A subsequent distribution to the shareholder could decrease the share premium balance or may be deemed to do so (for example, where a distribution is made in terms of section 46). · Secondly, where a distribution to a corporate shareholder that is part of the same "group of companies" is made out of profits that were earned prior to that shareholder acquiring the shares and the shareholder decreases the cost of the shares for accounting purposes according to IAS 18.In either of these circumstances the shareholder must account for a part-disposal. Since 1 October 2007, these proceeds must be brought into account in the year of receipt. It is submitted that the interplay of section 42 and the part-disposal rules create what appears to be an immediate tax liability for transactions that should enjoy tax-deferred status.
Edward Nathan Sonnenbergs
IT Act:S 1 definition of ‘dividend’
IT Act:S 8th Schedule par 74 and 76A
