The clogged-loss rule
Paragraph 39 of the Eighth Schedule to the Act is a capital gains tax (CGT) anti-avoidance provision which requires a capital loss to be treated as a “clogged loss” where a person disposes of an asset to a connected person and incurs a capital loss. The clogged-loss rule comes into play when determining the disposer’s aggregate capital gain or aggregate capital loss and requires that the loss be entirely disregarded. In this way, the capital loss is ring-fenced and may be set off only against capital gains arising from disposals to the same connected person.
Restrictions in the rules
The clogged-loss rule restricts the deduction of capital losses if the asset in question is disposed of to a person who was a connected person in relation to the disposer of the asset immediately prior to the disposal, or if the asset is disposed of to a person which, immediately after the disposal of the asset, is a member of the same ‘group of companies’ as the disposer or is a trust with a company beneficiary that is a member of the same group of companies as the disposer.
The ring-fencing restrictions are extended so that the capital losses, in addition to only being permissibly deducted from capital gains arising from disposals of assets to the same connected person, may only be deducted from the arising capital gains during the same or a subsequent year of assessment.
The timing of the disposal is governed by a further restriction, in that the disregarded capital loss may be deducted only if the other person to whom the subsequent disposals are made, is still a connected person in relation to the disposer at the time when the disposer makes the disposals.
The relevance of ring-fencing
The provisions of paragraph 39 become relevant where, for example, a shareholder disposes of an asset to his company, which is a connected person, and incurs a capital loss. In this situation, the capital loss may not be brought into account when determining the shareholder’s aggregate capital gains or losses for the year of assessment in which the transaction took place and, instead, the disregarded capital loss may only be deducted against capital gains made from the shareholder’s disposal to his company during the same or subsequent years of assessments, provided that the company is still a connected person to the shareholder at the time of any subsequent disposals.
Confusion in the clogging
Paragraph 39 is only applicable where an asset has been “disposed” of “to” a person. Taxpayers have often been confused by this aspect of paragraph 39, as many situations give rise to an asset having been disposed of “to” no one in particular. The South African Revenue Service’s (SARS) 6th Issue of its Comprehensive Guide to Capital Gains Tax demonstrates that “disposing to” no one is a common scenario which occurs, for example, in the scrapping or extinction of an asset or when an asset is deemed to be disposed of and the deeming provision does not specify an acquirer.
The difficulty that arises where there is no transfer to a connected person of an asset or of the rights encapsulated by the asset was brought to the Tax Court’s consideration in the 2012 Income Tax Case No. 1859 (IT 1859). The court in this instance had to consider the applicability of paragraph 39 where Company A purchased redeemable preference shares in Company B (within the same group of companies from various third-party banks), shortly following which Company B redeemed the shares and Company A incurred a resultant capital loss on the redemption. In this way, the court needed to determine whether the redemption of shares constituted a “disposal to”. The court identified the difficulty herein as, whilst the wording of paragraph 39 clearly covers transactions such as sales or the transfer of assets and shares from the disposer to a connected person, the legislation is not clear where there is no transfer of the asset.
According to the courts - meaning of disposal
IT 1859 was a landmark case for the interpretation of “disposal” in terms of paragraph 39. As part of its considerations, the court relied on the “canons of construction” to conclude that the use of the preposition “to” in paragraph 39(1) cannot be ignored. It was therefore held that, while the redemption of shares constituted a “disposal” as defined in paragraph 11 of the Eighth Schedule to the Act, the redemption was not a “disposal to any other person” as envisaged in paragraph 39. The court reasoned that the redemption of shares results in the extinction and not the transfer of the rights embodied in the shares to the redeeming company.
A precedent has since been set that the redemption of shares is not subject to paragraph 39 because the shares contemplated herein have not been disposed of as set out in the provisions. The court demonstrated that a literal interpretation of the legislation must be utilised, and relied on the meaning of the word “to” in the Concise Oxford Dictionary to decide that “the disposal of the asset must thus be ‘in the direction of’, or ‘so as to reach’ the connected person”.
The draft TLAB has directly addressed the discrepancies ensuing from the IT 1859 decision by specifically setting out that, for the purposes of disregarding capital losses in terms of paragraph 39, where a company redeems its shares, the holder of those shares must be treated as having disposed of them to that company. As such, though the literal interpretation of paragraph 39 will still have to be managed due to the impact of IT 1859, the draft TLAB has clarified the position in respect of redemption of shares.