1327. Ring-fencing of assessed losses
September 2005 – Issue 73
SARS has introduced legislation, section 20A of the Income Tax Act No. 58 of 1962 (the Act) with effect from the 2005 tax year which ring-fences assessed losses of individuals in the highest tax bracket in certain circumstances. These provisions have been introduced in order to prevent the perceived abuse of taxpayers reducing their taxable income by claiming losses from hobbies disguised as secondary trades. To provide affected individuals with a better understanding of what ring-fencing is and also to enable them to determine how and to what extent the provisions may affect their personal income tax liability, SARS has issued a guide (available at http://www.sars.gov.za/it/brochures/Ring%20Fencing%20of%20Assessed%20Losses.pdf) which sets out how SARS interprets the legislation and provides some practical examples and responses to frequently-asked questions.
What is ring-fencing?In dealing with the issue of what constitutes ring-fencing, SARS refers to it as "an anti-avoidance measure in terms of which the expenditure incurred in conducting a trade is limited to the income from that specific trade. Any excess expenditure (loss) is then carried forward and is set off against any income derived from that trade in a subsequent year of assessment".
Does section 20A override the general deduction formula and trade test?SARS has made it clear that section 20A and, in particular, the "facts and circumstances test" (which is a test set out in full in this section, and is applied in considering whether a specific trade loss may be allowed as a deduction in determining the taxpayer’s taxable income or is to be ring-fenced), does not replace either the purpose or the function of section 11(a) (the general deduction formula) and section 23(g) (the trade test) in the Act.
Whereas a loss stands to be disallowed in totality in terms of sections 11(a) and 23(g) if the activity carried on by the taxpayer is not regarded as a bona fide trade, section 20A comes into operation where there is an existing allowable trade loss. Accordingly, the provisions of section 20A are applied after the provisions of section 11(a) and 23(g). Section 20A merely ring-fences an otherwise allowable trade loss.
When does section 20A apply?Ring-fencing can only be applied if the taxpayer is a natural person whose taxable income (before the deduction of any assessed losses) is subject to the maximum marginal rate of tax and he/she either had an assessed loss in at least three out of the last five tax years or the assessed loss arises from one of the suspect trades listed in section 20A(2)(b).
The three-out-of-five year ruleIn arriving at the three-out-of-five year rule (or the six-out-of-ten year rule – see below), losses incurred in tax years ended on or before 29 February 2004 cannot be taken into account. Accordingly, assuming that losses are incurred in three consecutive tax years, a loss is subject to potential ring-fencing in terms of the three out-of-five year rule only as from the 2007 tax year, and then only once the facts and circumstances test has been applied (see below) and the taxpayer is not able to show that the trade constitutes a business in respect of which there is a reasonable prospect of deriving taxable income within a reasonable period of time. The losses which were allowed as a deduction against other income in the 2005 and 2006 tax years will, however, not be affected by the ring-fencing of the loss in the 2007 tax year.
A profit made in a particular tax year will also delay the potential ring-fencing of losses from that specific trade in terms of the three-out-of-five year rule. For example, if losses are made in the 2005,
2006 and 2008 tax years, but a profit is made in the 2007 tax year, the potential ring-fencing is delayed until 2008.
Suspect tradesOn the other hand, the listed suspect trades are subject to potential ring-fencing from the 2005 tax year if that trade does not satisfy the facts and circumstances test. The suspect trades listed in section 20A(2)(b) are -
· Sporting activities; · Dealing in collectibles; · Rental of residential accommodation (unless at least 80% of the accommodation is used for at least half the year by non-relatives of the taxpayer); · Rental of vehicles, aircraft or boats (unless at least 80% of these assets are used for at least half the year by non-relatives of the taxpayer); · Showing animals in competitions; · Farming or animal breeding unless the person carries on these activities on a full-time basis; · Any form of performing or creative arts; and · Gambling or betting.SARS has given some clear guidelines as to what it considers to be "full-time" in relation to farming or animal breeding. The guide states that subsection (2)(b) does not only refer to the fact that the activities should be conducted on a full-time basis, but specifically indicates that that person (i.e. the taxpayer) should carry on the activities on a full-time basis. Accordingly, per SARS’ interpretation, the wording appears to exclude any other person who may, for example, be managing the taxpayer’s farming or animal breeding activities on his/her behalf. SARS considers that carrying on farming or animal breeding on a full-time basis would, for the purposes of section 20A, appear to indicate that these activities should take up most or all of the taxpayer’s normal working hours. Should this not be the case, the farming/animal breeding activities will be viewed as a suspect trade.
What remains important, however, is that the facts and circumstances test (the escape clause) is available to all trades, and the fact that the farming or animal breeding activities are conducted on a part-time, as opposed to a full-time, basis is not a deciding factor in considering whether the trade constitutes a business with a reasonable prospect of deriving taxable income within a reasonable period. A bona fide farming activity will, therefore, not cease to be bona fide merely because it is conducted on a part-time basis.
Facts and circumstances test (escape clause)In relation to the facts and circumstances test contained in section 20A(3), SARS refers to it as "an objective test", given that the factors taken into account do not include the taxpayer’s intention. In our view, it is instead a test in terms of which certain objective yardsticks are taken into account in arriving at the subjective conclusion of what constitutes a "reasonable prospect" of deriving taxable income within a "reasonable period of time". Given that there are no definitions of these terms, it is considered that an element of subjectivity in evaluating the facts and circumstances must come into play, since what constitutes a reasonable prospect/period for one trade may not be so for another.
In commenting on the various facts and circumstances set out in section 20A(3), SARS places some emphasis on the fact that the trade must be carried on in a commercial manner, and sets out the following useful table:
Trade carried on in a commercial manner Trade not carried on in a commercial mannerThe taxpayer has a business plan
No planning, of any nature, neither prior to nor after commencing with the activity
The main purpose is making a profit
Profit is not the main purpose
Taxpayer seeks the best prices or commercial markets for services or products
The activity is conducted on a casual basis. Sales/services to acquaintances and family
The size and scale of the activity is sufficient for the specific trade and exceeds any personal needs by far
The size and scale of the activity is not sufficient to render the activity profitable and satisfies the taxpayer’s personal needs only
The activity is organised and records of all transactions are kept
The activity is not organised and records of transactions are not kept
There is repetition and regularity of activities
Transactions are irregular and isolated
Six-out-of-ten year ruleIn terms of the six-out-of-ten year rule contained in section 20A(4), a person is no longer able to rely on the facts and circumstances test (the escape clause) where losses from a suspect trade (but excluding farming) have been incurred in six out of ten years. Accordingly, should losses arise continuously from the 2005 tax year, the 2010 tax year will be considered to be the sixth tax year in which the loss is ring-fenced, notwithstanding that ring-fencing was avoided in the previous five tax years by applying the facts and circumstances test.
Multiple activities deemed to be a single tradeIn terms of section 20A(7), for purposes of the ring-fencing provisions, all of a taxpayer’s farming activities are deemed to constitute a single trade. The section is, however, silent with regard to the treatment of other activities, and SARS’ view is that, whether or not more than one related activity (other than farming) can in fact be regarded as a single trade will depend entirely on the facts of the specific case. For example, SARS would view the letting of five apartments in an apartment block to be a single trade, but the occasional letting of a number of properties purchased as holiday homes could constitute separate trades and the income and expenditure of each would then need to be considered separately.
Other amounts to be included as "income" from the tradeSARS has indicated that it will view recoupments and amounts derived from the disposal of assets on cessation of a trade (up to the original cost price) as income derived from the carrying on of that trade in permitting the set-off of ring-fenced losses against those amounts. Amounts in excess of the original cost price are not regarded as income but are subject to capital gains tax.
Certain administrative issuesSARS also sets out certain guidelines on reporting requirements relating to section 20A, the care which needs to be taken in relation to the payment of provisional tax where a loss may be ring-fenced and the obtaining of tax directives.
A flowchart for the application of the ring-fencing provisions is also set out in the guide, and we reproduce this flowchart in its entirety below. With the exception of farming on a part-time basis which is inadequately catered for in the flowchart, we consider this to be a useful checklist for determining whether the provisions of section 20A are applicable.
Editorial comment: It should be noted that certain changes to section 20A are currently being proposed.
Deloitte
