National Treasury’s Summary Outline of Major Policy Changes With Respect toThe Proposed Capital Gains Tax Legislation
March 9, 2001
National Treasury and SARS issued the first version of the capital gains tax (the "CGT") on December 12, 2000. This draft was subject to public comment as well as extensive hearings before the Portfolio Committee on Finance. National Treasury and SARS recently issued a revised draft of the legislation on March 2, 2001, which takes into account these comments and hearings.
Provided below is a summary outline of the major policy changes contained within the legislation. Part I addresses policy changes prompted by the hearings on February 16th, and Part II address other policy changes. SARS is concurrently issuing an extensive list of responses to all the public comments received and will separately address all technical/administrative concerns.
PART I:
POLICY CHANGES PROMPTED BY THE FEBRUARY 16TH HEARINGS
A. Deemed Sale on Death The CGT treats death as a deemed sale of all the deceased’s assets at fair market value. This deemed sale treatment underpins the CGT. Without this deemed sale on death, taxpayers would have an unduly strong incentive to hold assets rather than sell before death (a critical concern identified by the IMF).
1.Proposed $50,000 Exclusion on Death: Concerns were raised that the CGT may adversely impact the middle and lower classes on death, which would run counter to the exclusion for the Estate Duty. In order to accommodate these concerns, the current CGT draft increases the annual R10,000 exclusion to R50,000 on death. This increase reflects the fact that death creates a forced sale of all taxpayer assets; whereas living taxpayers can maximise the $10,000 exclusion by spreading gains over multiple years. 2.Reduction in Estate Duty/Donations Tax: In order to eliminate the perceived double tax on death (the simultaneous imposition of the CGT and the Estate Duty/Donations Tax), the Estate Duty and Donations Tax are being reduced to 20 per cent as was announced in the Budget. The reduction in the Estate Duty/Donations Tax is intended to match the government’s expected revenue gain from the CGT on death.
3. Proposed Delay Where the CGT Exceeds More Than 50 Per Cent of the Net Value of the Estate: As stated in the February 16th hearings, situations may arise where the CGT exceeds the net value of a taxpayer’s estate on death. These situations exist when the estate contains high levels of untaxed gain along with high levels of corresponding debt. Example. Facts. Taxpayer dies owning an estate with property having a R1 million value and a R200,000 cost base. The estate owes R950,000 in debt to various banks. Result. If the CGT fully applies on death, the CGT will outweigh the net value of the estate. The total tax will equal R84,000 (R800,000 gain x the 10.5 per cent rate), whereas the net estate has only a R50,000 net value.
As a matter of tax theory, the total CGT just described merely represents the proper amount of tax owed on gains deferred during life. Situations in which high levels of gain are accompanied with high levels of debt are also fairly uncommon. Other regimes that impose CGT on death, such as the Canadian income tax, provide no relief for this circumstance. Moreover, in terms of business practice, banks which lend to taxpayers with such high levels of debt frequently require death-insurance coverage, and estates with this coverage will receive tax-free insurance proceeds to remedy the high level of debt.
Nevertheless, despite the above, the revised CGT draft attempts to mitigate the circumstances just described on the grounds that taxes by themselves should not unilaterally bankrupt taxpayers. The revised CGT draft contains relief via a delayed collection mechanism. Under this delayed collection mechanism, taxpayers can defer payment of the CGT to the extent the CGT exceeds 50 percent of the net value of the deceased’s estate. This deferral is allowed for a maximum three year period and is subject to an interest charge.
B. The CGT on Charitable Donation Under the initial CGT draft, the CGT fully applied when a taxpayer donated property to a charity unless that charity was a qualifying section 18A organisation and the donation was deductible (i.e., was no more than 5 per cent of the taxpayer’s taxable income or R1,000, whichever was higher). Although this initial method of taxation was correct as a matter of tax theory (i.e., a sale of an asset followed by a cash donation should create the same result as an outright donation), taxation of charitable donations under the CGT was thought to be a step backwards for public benefit organisations because donations could previously be made tax-free. Under the revised CGT draft, the CGT does not apply to charitable donations made to any public benefit organisation described under section 30, even if those donations are not deductible. This expanded exemption should exempt most donations on death (where the bulk of charitable donations occur as a practical matter).
C. The Home Sale Exclusion As currently drafted, an exclusion exists for home sales that effectively exempts up to R1 million of capital gains. This R1 million exclusion ensures that the home sale exclusion does not become a wholesale relief mechanism for mansions and home estates of similar magnitude.
1. Commitment to Review the R1 Million Cap Along With Other Numerical Caps: While the R1 million cap is reasonable in the current environment, some concern was expressed that the R1 million cap will devalue over time. The revised CGT draft does not address this concern, but the Explanatory Memorandum contains a commitment by the National Treasury and SARS to adjust the cap upwards to cover anticipated inflation (revenue availability permitting). This adjustment will include a review of other caps contained in the Income Tax Act. The revised CGT draft does not contain an automatic adjustment upward for inflation because no automatic adjustment of this kind exists elsewhere, even for marginal rates.
2. Trusts: Many taxpayers hold their homes through companies or in trust. The prior CGT draft allowed taxpayers to withdraw their homes from companies without triggering the CGT so taxpayers could avail themselves of the R1 million home sale exclusion upon subsequent sale. This withdrawal was allowed for a transitional period. The revised CGT draft extends this transitional relief to trusts.
D. Connected Party Losses The revised CGT draft retains the same prohibition against connected party losses as contained within the initial CGT draft. Under this prohibition, taxpayers can only deduct losses on disposals to connected parties to the extent those losses are matched by connected party gains. The connected party loss rule ensures that taxpayers cannot annually generate losses by disposing of assets within the same economic group. The problem with the initial CGT draft, however, was that the definition of "connected party" was to broad, including all relatives "within the third degree of sanguinity." The revised draft narrows the definition for this anti-loss rule to more immediate family members, such as parents and siblings.
E. Company Restructurings and Intragroup Relief The CGT legislation has significant consequences for company restructurings and intragroup transfers. Company restructurings technically trigger various forms of property-for-property transfers (such as share-for-share swaps) that lie at the heart of the CGT. Intragroup transfers also have significant CGT impact because intragroup movements within corporate members of the same group are now CGT events that previously occurred tax-free.
1. Delayed Action: The revised CGT draft does not contain rules for company restructuring or intragroup relief. These forms of relief will be addressed separately over the coming months before the CGT goes into effect on October 1, 2001. It was believed that the delay would provide National Treasury and SARS with sufficient time to issue more comprehensive relief not only with respect to the CGT but also with respect to other taxes as well.
2. New Comprehensive Company Distribution Rules: Although the revised CGT draft does not contain comprehensive restructuring relief, the revised CGT draft does contain comprehensive company distribution rules that will serve as the foundation for future restructuring relief. These rules are located within Part IX.
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All company distribution of assets (other than shares in that company or options thereto) will trigger a CGT event. For example, if a company distributes a land to its shareholders and that land has a R100 market value and a R20 cost base, the company making the distribution will have R80 of gain. This CGT impact is the natural outcome of the classical corporate tax model employed by South Africa – an outright distribution of an asset should have the same impact as a sale of that asset followed by the distribution of cash proceeds. This CGT impact will apply regardless of whether the distribution qualifies as a dividend, redemption, or liquidation.
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All shareholders receiving a non-share distribution must reduce the base cost in their shares to the extent the distribution comes out of share capital or share premium. Although these distributions continue to be tax-free as under prior law, these distributions now create increased gain upon eventual disposal of the underlying shares. For example, assume a shareholder owns a share with a R100 value and a R30 base cost. Also assume the shareholder receives a cash distribution of R50, R20 of which constitutes dividends and the remainder of which constitutes a return of share capital. Under these circumstances, the shareholder receives the full distribution tax-free (although the dividend potentially subjects the distributing company to the Secondary Tax on Companies), but the distribution reduces the shareholder’s base cost in the share by R30 down to zero. If the shareholder then sells the share for its market value of R100, the shareholder will have R100 of capital gain rather than R70 of capital gain.
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The liquidation provisions contain timing rules for determining when liquidating distributions generate capital gain or loss for shareholders. These timing rules are needed because non-liquidating distributions generate adjustment only to the base cost of shares as outlined above, whereas liquidating distributions crystallise shareholder gain or loss. The liquidation rules also allow for some intragroup relief when a liquidating distribution qualifies as a intragroup dividend exempt from the Secondary Tax on Companies.
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.If a company distributes its own shares, the share distribution is tax-free. This tax-free treatment applies regardless of whether the newly issued shares are part of a scrip share distribution or part of a substitution where previously held shares are surrendered in exchange. If shares are distributed without substitution, the new shares have a zero base cost. If shares are distributed in substitution, the new shares assume the base cost of the previously held shares substituted in exchange.
F. The Capital Versus Ordinary Distinction
Both the initial and revised CGT drafts do not contain any rules for distinguishing capital gains versus ordinary revenue. This distinction remains largely an issue of case law, which relies on taxpayer intent (i.e., taxpayers are subject to ordinary rates only if they purchased an asset with the primary intent to sell). Although items of a capital nature are now taxable, the distinction remains important because ordinary revenue sales retain the full brunt of taxation whereas capital gain sales are partially exempt.
As stated in the February 16th hearings, the current case law distinction is wholly unsatisfactory. According to the Commissioner, the uncertain nature of this case law generates 1 in 5 litigated cases. The case law distinction also lacks any economic rationale. In order to remedy this problem, legislation will be issued before (October 1) that will improve and clarify the ordinary versus capital distinction.
PART II:
OTHER POLICY CHANGES
A. Time-Apportionment for Pre-Effective Date Assets The CGT will apply only to gains accruing after October 1. Taxpayers who eventually dispose of pre-effective date assets (i.e., assets held on October 1) must accordingly determine the October 1 value of those assets in order to limit their gains to the post-October 1 period. The initial and revised CGT drafts contain three methods for determining this October 1 value: (1) the market value method, (2) the 20 per cent proceeds method, and (3) the time-apportionment base cost method. At issue is the time-apportionment method.
The time-apportionment method determines post-October 1 gains by assuming that all gains accrue evenly over time. The purpose of this rule is to reduce the need for the appraised valuation of all pre-effective date assets. Example (1). Facts. Individual purchases an asset on October 1, 1997, for R10 and later sells that asset for R100 on October 1, 2009. Result. Of the total period in which the asset was held by Individual, 1/3rd can be attributed to the period before October 1 (i.e., 4 out of 12 years) and 2/3rds afterwards (8 out of 12 years). The time-apportionment method assumes 1/3rd of the gain accrued during the pre-October 1 period. The asset accordingly has a deemed October 1 value of R40 (i.e., the initial R10 cost plus 1/3rd of the R90 total gain), limiting total gain on sale to R60 (i.e., R100 proceeds minus the R40 October 1 deemed value). Although the time-apportionment rule can be simple in theory as illustrated above, complications arise when pre-effective date assets are subject to multiple base cost adjustments. These adjustments may come in various forms, such as improvements, depreciation, and share capital distributions. Multiple base cost adjustments require separate calculations because the gain/loss attributable to each adjustment must be distinguished from the gain/loss attributable to the initial acquisition. Example (2). Facts. Individual purchases machinery for R100 on October 1, 1999, and subsequently improves the machinery for an R20 cost on October 1, 2000. Individual sells the asset for R360 on October 1, 2004. Result. Both the initial and revised CGT drafts require the gain from the improvement to be separated from the gain on the underlying machinery.
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Step #1: The proceeds are allocated between the machinery and the improvement pro rata as follows: (a) R300 of proceeds to the machinery (i.e., R360 total proceeds x R100 machinery base cost/R120 total base cost), and (b) R60 of proceeds to the improvement (i.e., R360 total proceeds x R20 improvement cost/R120 total cost).
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Step #2: The machinery is deemed to have an October 1 value of R180 (R100 initial cost plus R80 of deemed pre-October 1 appreciation (i.e., 2/5ths of the total R200 appreciation)), leaving R120 of post-October 1 gain on the sale (i.e., R300 of proceeds less the R180 October 1 value).
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Step #3. The improvement is deemed to have an October 1 value of R30 (i.e., R20 initial cost plus R10 of deemed pre-October 1 appreciation (1/4th of the total R40 of appreciation)), leaving R30 of post-October 1 gain on the sale (i.e., R60 proceeds less the R30 October 1 value).
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In the end, Individual has R150 of capital gain (R120 plus R30).
As illustrated, subsequent adjustments add significant complexity to the time-apportionment calculation. These complications are intensified when items such as annual depreciation are taken into account. Still more problematic are share adjustments for controlled foreign entities which occur regularly for deemed income inclusions (i.e., deemed income resulting from passive or diversionary transactions (under section 9D) and for taxable foreign dividends (under section 9E).
The revised CGT draft does not resolve the complications resulting from any of these multiple adjustments. The revised CGT instead contains three options: (1) retain the multiple calculations in full, (2) eliminate these multiple calculations by assuming all adjustments occur upon initial acquisition, and (3) a combination of the two methods, such as applying multiple calculations except for financial instruments.
The simplest method is to utilise Option (2), which assumes that all subsequent adjustments occur upon initial acquisition. The problem with Option (2) is that this option artificially accelerates gain or loss into the pre-October 1 period. For instance, in the example above, if one assumes the improvement occurs on purchase for a total R120 initial cost, Individual is deemed to have an October 1 base cost of R216, thereby triggering R144 of gain on sale (R360 minus R216) rather than the R150 described above. At bottom is a question of tax purity versus rough justice simplicity.
B. Part-Sales of Identical Financial Instrument Portfolios
The revised CGT draft contains explicit rules for determining the gain or loss on the sale of a financial instrument when that instrument represents one of many identical instruments held by the taxpayer. Rules are needed in this area because the identical nature of financial instrument portfolios makes it difficult to determine which financial instrument is being sold. For instance, assume Individual owns 5 common shares in Company X. Also assume Individual purchases two of those shares for R120 on June 1, 2002 and the other three shares for R180 on December 10, 2002. If Individual then sells 1 share, which is the cost base in the share - R120, R180 or a combination of both?
The revised CGT draft provides explicit rules with great flexibility. Taxpayers can choose either: (a) the first in first out method, (b) the weighted average method, or (c) the specific identification method. In the example above, the 1 share sold would have a R120 base cost under the first in first out method, a R156 base cost under the weighted average method (i.e., the total base cost of all the shares divided by 5), and either a R120 or R180 base cost under the specific identification method. Taxpayers utilising a particular method with respect to identical financial instruments must use the same method for all such identical financial instruments.
Although the freedom to choose methods is generally taxpayer favourable, the Unit Trust, Wrap Fund, and LISP Fund Industries had information reporting concerns because they could not track multiple holders utilising different methods. The revised CGT draft accordingly eliminates this problem by requiring these industries to wholly rely on the weighted average method for information reporting purposes (their preferred method).
C. Personal Asset Companies
Under both the initial and revised CGT drafts, individuals cannot deduct losses from the sale of personal-use assets because losses of this kind most likely stem from personal consumption (a non-deductible item under any income tax system). The revised CGT draft contains anti-abuse rules that are designed to prevent taxpayers from disguising these losses through company schemes. Example. Facts. Individual owns all the shares of Company X. Company X was formed solely to purchase a car for Individual’s personal use. Company X received R100 on formation to purchase the car. Individual uses the Company X car for many years as planned with the car devaluing to R10. Individual then sells the Company X shares for R10. Result. Under the initial CGT draft, Individual could claim an R90 loss on the sale of the Company X shares, even though the loss on a direct sale of the car by Individual would have been disallowed.
The revised CGT draft prevents the above scheme by disallowing the loss on the sale of company shares to the extent the loss is attributable to the devaluation of personal-use assets. However, this rule does not apply if more than 50 per cent of the assets of a company consist of business assets.
D. Value Shifting Arrangements (Disguised Gifts of Closely Held Shares) The initial CGT draft mentioned that rules would be forthcoming to prevent value shifting arrangements. The revised CGT draft contains specific rules in this regard. Value shifting arrangements essentially involve disguised gifts of closely held shares. These arrangements typically arise when a closely held company issues shares at a price below market value as a disguised gift among family members. Example. Facts. Mother owns all 100 common shares of Company X with a total market value of R100,000. Company X issues 100 additional common shares to Son for R20,000 in cash. Company X is not subject to tax on the share issuance because a share issuance does not constitute a disposal under the CGT. Result. The issuance of 100 shares to Son for R20,000 constitutes a value shifting arrangement because all of Company X is worth R120,000 with Son receiving 50 per cent at only a R20,000 cost.
The value shifting arrangement above triggers tax for Mother because she is effectively donating shares to her son. Mother’s proceeds on the disposal amount to R40,000 because she had a R100,000 interest before the issuance and a R60,000 interest afterwards.
E. Financial Instrument Anti-Loss Rules Both the initial and revised CGT drafts contain rules to prevent taxpayers from generating capital losses without economic consequence. Two of the more notable rules involve pre-acquisition dividends and short-term disposals of identical instruments. A third rule involves straddle transactions, which was dropped from the revised CGT draft.
1. Pre-Acquisition Dividends: Both the initial and revised CGT drafts recognise that taxpayers may generate artificial losses by purchasing shares containing immediately expected dividends. Taxpayers involved in these schemes purchase these shares, receive dividends tax-free, and then sell the shares at a loss. Example. Facts. Individual purchases a listed share for R100. The share is expected to distribute dividends of R5 within a few days after the purchase date. Individual holds the share until receipt of the dividend and then sells the share within a few days later for R95 (i.e., the R100 value less the R5 dividend). Result. Individual is exempt from tax on the dividend. If no anti-avoidance rules applied, Individual would also generate a loss of R5 on the sale (i.e., the R95 value less the R100 cost base). However, Individual is in the same economic position as before - Individual both starts and ends with R100 of cash (the ending amount consisting of R5 of dividends and R95 of sale proceeds).
Both the initial and revised CGT drafts eliminate the above avoidance technique in different ways. The initial draft required all shareholders to reduce the base cost in their shares by the R5 dividend, thereby preventing the R5 loss. This rule had two problems. First, this rule was administratively problematic because this rule required taxpayers to reduce their base cost for all dividends stemming from pre-acquisition earnings, thereby requiring shareholders to track all dividends to determine whether their dividends had a pre-acquisition element. Second, the reduction in value caused by most dividends is only temporary. Share values eventually rebound once subsequent dividends are expected or may rebound due to other events.
The revised CGT draft recognises the above defects of the initial CGT draft. Under the revised draft, shareholders will be denied losses only to the extent they hold a share for a period of no more than 91 days and only to the extent these losses are offset by dividends received within the same period. Long-term shareholdings are no longer of concern unless these shareholdings involve extraordinary dividends (i.e., dividends that exceeds 15 percent of sale proceeds), in which case a holding period of more than 2 years is required to fall outside the anti-avoidance rule. Under the revised CGTdraft, the revised pre-acquisition dividend rule should no longer be an issue of concern for most shareholders.
2. Short-Term Disposals of Financial Instruments: Both the initial and revised CGT drafts recognise that taxpayers can sell and repurchase equivalent assets at a capital loss without having any economic loss. These short-term sales and repurchases typically occur with respect to financial instruments. Example. Facts. Individual owns 1 common share of Company X on a listed exchange. Individual purchased the share for R100. On June 10, the share is worth R70, but Individual expects the share to eventually rebound in value. In order to generate a capital loss, Individual sells the share on June 10 and repurchases an identical common share for R70 the next day. Result. If no anti-avoidance rules existed, Individual could generate R30 of loss and still maintain the same effective economic position with respect to the share.
Both the initial and revised CGT drafts address the above concern by denying losses when taxpayers conduct sales and repurchases in the above short-term manner. However, the revised CGT draft is more narrowly tailored. The initial draft applied to the sale and reacquisition of all "the same or similar assets." The revised draft applies only to financial instruments because only financial instruments are sufficiently fungible to facilitate transactions of this kind. In addition, the revised rule applies only to situations involving "a financial instrument of the same kind and of the same or equivalent quantity or quality."
3. Straddle (i.e., Year End Loss) Transactions: The initial CGT draft contained a third anti-loss rule for straddle transactions. This rule delayed year-end losses if those losses were followed by subsequent gains occurring shortly into the new year. The initial rule was designed to prevent taxpayers from engaging in year-end transactions solely to generate losses as means for reducing expected year-end taxes. The revised CGT draft drops this anti-loss rule because the year-end losses targeted under the initial draft had no economic relation to the subsequent gains. Also no reason existed for discriminating against losses merely because those losses occurred toward year-end.
F. Pre-Effective Date Intangibles
Prior to the introduction of the CGT, many taxpayers artificially used the sale of intangibles as a mechanism to reduce tax. Many of these schemes involved the sale of intangibles along with other business assets. The main essence of this scheme was to artificially shift value from hardcore business assets to the intangibles. This shift was tax-free to the seller because intangible gains were of a tax-free capital nature, and the purchaser could previously receive a capital allowance from the intangible at a self-determined rate. Example. Facts. Taxpayer owns a business with machinery having an initial cost of R1,000, which was previously subject to a capital allowance of R900. Taxpayer also contends that the business requires significant know-how, which is formalised in a memorandum shortly before sale. Taxpayer sells the business for R1,100. Assume the parties claim R100 of the sale is attributable to the machinery and the other R1,000 is attributable to the intangible. Result. If the parties were allowed to claim that the business assets were worth only R100 and the intangibles were worth R1,000, both parties benefited under old law. The seller recognised gain of a tax-free capital nature, thereby avoiding recoupment on the machinery. The purchaser would claim a short-term write-off of the know-how on the stated basis that the know-how was of limited duration.
Prior law eliminated much of this practice either by preventing taxpayers from a claiming a capital allowance on their intangibles or by extending the useful life of their intangibles over a very long period. However, many of these pre-valuation date intangibles still have an artificially inflated base cost that can now potentially be used as a capital loss.
Both the initial and revised CGT drafts recognise that many pre-effective date intangibles contain an artificially inflated base cost. As a result, both drafts eliminate losses stemming from these pre-effective date intangibles. However, the revised draft is more narrowly targeted. Under the revised CGT draft, this anti-loss rule applies only when the intangible is acquired from connected parties or is part of an overall business acquisition.