Hidden Capital Gains Tax

Companies busy with or anticipating their own liquidation, deregistration or winding up need to be aware that they could trigger an early capital gains tax (CGT) liability for their shareholders, with the attendant cashflow implications this would entail.

Such a situation could arise if the company intends to take advantage of the secondary tax on companies (STC) exemption which is available in terms of section 64B(5)(c) of the Income Tax Act. Currently, a company can avail itself of this exemption on the distribution of pre 31 March 1993 revenue profits and pre 1 October 2001 capital profits. However, this possibility will fall away when the new dividend withholding tax regime – expected in the latter part of 2010 – becomes effective, but in the meantime shareholders must take note that an STC-exempt distribution could give rise to a CGT liability in their hands. An exposition of recent changes to our tax legislation will show how this could happen.

For CGT purposes, any distribution by a company that does not constitute a dividend – for example a return of share capital or share premium to shareholders – and any dividend that qualifies for the STC exemption already mentioned, constitutes a so-called “capital distribution.”

The South African Revenue Service (SARS) has now decreed that, after 1 October 2007, any capital distribution received by or accrued to a shareholder triggers a deemed part-disposal of that share on the date of the receipt or accrual of the capital distribution. A shareholder will thus have to determine a capital gain or loss on this deemed part-disposal even though he or she still owns the particular shares. In effect, this is a mechanism whereby SARS can collect taxes on any capital “gain” made by the shareholder over the period that the share has been held, instead of having to wait - for what could be decades – until the share is disposed of.

With respect to the period before 1 October 2007, companies were previously allowed to distribute their share capital to shareholders – as a reduction in capital – without triggering either STC or CGT. In the case of STC this was because such a capital distribution is specifically excluded from the definition of a dividend, and in the case of CGT because any capital distribution was only required to be added to the proceeds realised when the shares were eventually disposed of, with CGT then levied at the point of disposal.

As a result of retroactive changes made to the Income Tax Act, this situation no longer applies. If any capital distribution is made between 1 October 2001 and 1 October 2007, and the shares in respect of which the distribution were made are still owned by the shareholder on 1 July 2011, SARS will deem there to have been a part-disposal of those shares. A deemed capital gain or loss will accordingly have to be determined, and shareholders may be required to pay CGT on shares not yet disposed of. Holders of listed and unlisted shares will be affected, and even more complex rules will apply to shareholders who have elected to use the weighted average method of valuing their listed shares.

The unfortunate consequence of all this is that: should a company or its shareholders be considering its liquidation, deregistration or winding-up in order to utilise the section 64B(5)(c) exemption, the potential CGT implications, which may result in an unexpected cashflow demand should also be considered and shareholders (holding shares in companies where liquidation, deregistration or winding-up is not envisaged) who received capital distributions between 1 October 2001 and 1 October 2007 should prepare in the near future to make a contribution to SARS which they probably had not anticipated making.