Capital gains tax on reduction of interest rate

The South African Revenue Service (SARS) recently published a ruling dealing with the question as to whether the cancellation and extinguishment of a right to claim interest on a shareholder loan will trigger a capital gains tax (CGT) liability (Binding P

CGT arises when a person disposes of an asset. The term 'disposal' is defined widely in the Eighth Schedule to the Income Tax Act, No 58 of 1962 (Schedule). In particular, in terms of paragraph 11(1)(b) the "forfeiture, termination, redemption, cancellation, surrender, discharge, relinquishment, release, waiver, renunciation, expiry or abandonment of an asset" constitutes a disposal for CGT purposes.

The facts of the ruling were the following: A Ltd (A) bought 74% of the shares in B (Pty) Ltd (B). A and B were not connected parties before the share purchase. In other words, they were acting at arm's length.

B owed about R4 billion to a financier in terms of an interest-bearing loan claim. As part of the share purchase, A also acquired that claim for a price of about R1 billion. B continued to owe A the full amount of R4 billion. However, B was not in a position to service the interest on the claim.

A proposed that the claim be split in two: A would continue to charge interest on the R1 billion portion of the claim. A would however stop charging interest on the R3 billion balance of the claim.

First, SARS ruled that as A and B were not connected persons before A acquired the shares in B, the price of R1 billion represented an arm's length price. Now, it is not immediately apparent why a ruling was necessary in respect of this aspect. In terms of paragraph 38 of the Schedule (which SARS referred to in its ruling), if a person disposes of an asset to another person who is a connected person in relation that person for a consideration that is below an arm's length price, then the proceeds of the disposal are, for CGT purposes, deemed to be the market value of the asset. However, in circumstances of the ruling, A did not acquire the claim from B. Accordingly, the provisions of paragraph 38 of the Schedule would not have been applicable, even if A and B were connected persons in relation to each other before the sale transaction.

Second, SARS ruled that the cancellation and extinction of A's right to interest did not trigger CGT for A. While it was appropriate for the taxpayers in this case to have applied for a ruling for the sake of certainty in the light of the big amount of money involved, it is in my view not apparent that the reduction of the rate of interest of a loan is a disposal for CGT purposes.

SARS is of the view that the cancellation of a contract as such is a disposal for CGT purposes (see, for example, SARS's Comprehensive Guide to Capital Gains Tax (issue 4) at page 287). However, consider the case where a bank agrees with a debtor to reduce the rate of interest from 8% per year to 7% per year. In my view, it would be anomalous to suggest that the bank has, in principle, made a disposal for CGT purposes because it has 'cancelled' or 'relinquished' the right to some interest. On the strength of the decision in Income Tax Case No 1859 74 SATC 213, I would suggest that a creditor who reduces the rate of interest is not making a disposal to any person, and accordingly no CGT should arise – even if the creditor reduces the rate to nil.

However, even if the reduction of the rate of interest by a creditor is a disposal for CGT purposes, practically the disposal ought to have no negative CGT consequences as the creditor would be receiving no proceeds. In terms of paragraph 35(1)(a) of the Schedule the proceeds on disposal of an asset include "the amount by which any debt owed by that person has been reduced or discharged." However, that provision would not apply where the rate of interest has been reduced prior to the interest accruing because there is no debt owing which has been reduced or discharged. In fact, if the reduction of the rate of interest is a disposal for CGT purposes, the creditor could even argue that he has realised a capital loss!

What the ruling does show is that both taxpayers and SARS are still grappling with the issue relating to the extent to which the cancellation or variation of an agreement gives rise to CGT.