"Papa was a rolling stone.
Wherever he laid his hat was his home.
And when he died all he left us was alone."
You may recognise these lyrics from a song by "The Temptations". Fortunately, Papa didn't leave his son a loan. If this was the case, and Papa happened to be resident in South Africa, his son may have had a capital gains tax (CGT) liability on the death of his impecunious and itinerant father.
If a creditor reduces or discharges a debt for a consideration that is less than the amount of face value of the debt, then the debtor must account for CGT on the amount reduced or discharged (paragraph 12(5) of the Eighth Schedule to the Income Tax Act, 1962 (the Act)).
Often when people die they hold debts owing to them by their heirs. For example, where a mother may have lent an amount of money to her daughter to start a business, or a farmer may have sold his farm to his family trust on a loan account.
At the outset it is important to know that the debt is an asset in the estate of the deceased and the executor must accordingly account for the debt in the liquidation and distribution account. The debt also forms part of the estate for purposes of the calculation of estate duty.
From a CGT perspective, the manner in which a creditor deals in her will with a debt owed to her by an heir is of great importance as this may have calamitous consequences for the heir.
In ITC 1793 67 SATC 256, the testatrix had during her lifetime sold shares to a family trust on loan account. In her will she stated the following (my translation):
"I bequeath my estate as follows…Any amount which may be owing to me by [the trust] under the loan account, to [the trust]."
The High Court analysed the salient provisions of the Act and, in particular, the provisions of paragraph 12(5) of the Eighth Schedule to the Act. The Court held that the provisions do apply and that the trust was liable for CGT.
The High Court found that the drawing of the will and its coming into operation on the date of the death amounted to a discharge of the debt.
In an unreported decision of the Kimberley Tax Court (the Court), the facts were that the deceased had bequeathed the residue of her estate to a trust. At the time of her death, the trust owed the deceased an amount on loan account.
The South African Revenue Service (SARS) contended that, in terms of her will, the debt owed by the trust had been discharged for no consideration as contemplated in paragraph 12(5) of the Eighth Schedule to the Act.
The Court dismissed the contention and held that the loan account formed part of the residue of the deceased's estate. It was not her intention to bequeath the loan account as a legacy or dispose of the loan account for no consideration.
The Court then considered an interesting question, namely, whether the method employed by the executor in winding up the estate brought the award within the realm of paragraph 12(5) of the Eighth Schedule to the Act. The executor had not recovered the loan account from the trust but had simply awarded the loan account to the trust in the liquidation and distribution account.
The Court held that the determining factor is the intention of the creditor, and not the manner in which the estate is wound up.
Accordingly, the Court found that the loan account had not been reduced or discharged for no consideration and that the trust was not liable for CGT.
Some commentators have - in my opinion, rightly - criticised the decisions (see for instance Barry Ger's article in "De Rebus" No 488 July 2009 at page 45) while others have offered innovative suggestions for avoiding the problem (see for instance Leon Rood's article in "FinWeek" of 23 July 2009 at page 43).
My view is that testators who have loan accounts owing to them should say something along the following lines in their wills:
"I record that the Temptations Trust is indebted to me on loan account in the amount of R100,000.
I hereby direct that on my death my executor must demand repayment of the loan account from the Temptations Trust.
I hereby bequeath an amount of money equal to the amount owing to me under the loan account, to the Temptations Trust.
I hereby direct that my executor shall be entitled to apply set-off in relation to the amount due under the loan account and the amount under the bequest."
If this route is followed, on the death of the testator, the executor would need to show the loan account as an asset in the liquidation account, and show the bequest as an asset in the distribution account. However, no funds would flow as the executor would apply set-off.
Nevertheless, there would be no reduction or discharge of the loan account as it would have been settled in full.
As Leon Rood points out in his article (cited above), SARS is no doubt keeping its eyes open for schemes avoiding the CGT. But the methodology suggested above does not constitute avoidance and was in fact accepted by SARS in its submissions in the Kimberley Tax Court case.
Whatever the position, my advice is: Papas - and Mammas - don't leave your heirs a loan unless you've taken advice.
Director, Corporate and Commercial