Taxation of capital distributions to change yet again

March 1st, 2012
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By Barry Ger

Since 1 October 2001 the sale of shares in a company held as capital assets may attract capital gains tax (CGT) if the proceeds from those shares exceed their ‘base cost’ (ie, generally what was actually paid for them). Canny shareholders will know, however, that it is possible to ‘squeeze’ value out of a share without actually selling it in one of two ways –

  • declaring dividends out of the accumulated profits and reserves of the company; or
  • by returning the original share capital of a company to the shareholders (a so-called ‘capital distribution’).

The former method has never overly concerned the South African Revenue Service (SARS) because dividends are subject to tax in the form of secondary tax on companies (or, as of 1 April 2012, dividend withholding tax). The question that has befuddled SARS, however, has been how to tax the latter.

Originally capital distributions were only to be subject to CGT on disposal of the share – the law required an adjustment to the proceeds or the base cost by the amount of capital distributions the shareholders had received during the time that they held the shares so that a larger capital gain would arise on disposal. SARS, however, realised that many shareholders were delaying share disposals just to avoid this tax. So, as from 1 October 2007, the tax law was changed so that each capital distribution would represent a part-disposal of the share, compelling the shareholder to immediately calculate a capital gain or loss on the date the distribution was made. Long-time readers will recall that this was discussed in 2008 (March) DR 43. The CGT on part-disposals prior to 1 October 2007 was to be paid on 1 July 2011. This requirement was, however, delayed.

As from 1 April 2012, as a result of amendments set out in the Taxation Laws Amendment Act 24 of 2011, the taxation of capital distributions will change once again and it seems that these changes may generally benefit shareholders. This article seeks to explore these amendments, as well as the underlying reasons that motivated them.

As a starting point, and to appreciate how wide ranging the changes are, it would be useful to examine in more detail the current regime under which capital distributions are taxed.

The current regime

As noted above, each capital distribution made by a company to its shareholders currently triggers a deemed ‘part-disposal’ of shares for CGT purposes. The capital gain that this ‘part-disposal’ generates will be taxable immediately.

For calculation purposes, the proceeds are represented by the amount of the capital distribution itself, and the base cost of the ‘part of the shares disposed of’ will be a portion of the base cost of the actual shares. The portion of the base cost that is allocated to the ‘part disposed of’ will depend on the ratio between the amounts of the capital distribution to the total value of the share on the date of the capital distribution. The base cost of the shares will thereafter diminish by the portion of the base cost that is used to calculate the capital gain or loss.

To illustrate, let us take a share that is acquired for R 60 in 2008 that has a value of R 100 in January 2012. If a shareholder receives a capital distribution of R 10 during January 2012, the shareholder will be considered to have disposed of part of the share.

As the capital distribution represents 10% of the current value of the share, 10% of the expenditure incurred in respect of the shares will be deemed to be the base cost of the part that is treated as having been disposed of. In this example that base cost would be R 6 (ie, 10% of R 60).

The shareholder accordingly has a capital gain of R 4 arising from the capital distribution of R 10 (ie, R 10 of deemed proceeds less R 6 of the deemed base cost). Furthermore, the base cost of the shares would decline by R 6 from R 60 to R 54.

Reasons for the change

Why, it may be asked, is the above regime to change?

It would appear that the motivation was concern that the current rules resulted in overtaxation of taxpayers.

The explanatory memorandum that accompanied the Amendment Act acknowledges that the part-disposal treatment of capital distributions has the unintended result that shareholders are also taxed on companies’ undistributed profits instead of just the capital distribution. Conceptually, this is double taxation because undistributed profits are taxed already as dividends.

The reason for this anomaly lies in the fact that the formula that calculates the capital gain uses the current market value of a share to determine the portion of a share’s base cost that is offset against the capital distribution. As the market value of a share is affected by both share capital and undistributed profits, the net effect is that only a portion of the base cost is allowed as an offset when the full base cost associated with the underlying share should be available.

Consequently, the Amendment Act has revised the rules so that the capital distribution will be allocated against the full base cost of the shares.

The new regime

In terms of the proposed amendments to the Act, from 1 April 2012 a return of capital or capital distribution will no longer result in a ‘part-disposal’ of a share. Instead, a capital distribution will merely have the effect of reducing the base cost of the share. A capital gain can still arise, however, to the extent that the base cost of a share is reduced to a point beyond zero. In other words, the excess of the capital distribution over the base cost becomes the taxable capital gain.

To illustrate, let us once again take the example of the share that is acquired for R 60 in 2008, which still has a value of R100 in May 2012. If its shareholder receives a capital distribution of R 10 during May 2012, the base cost of the share will drop from R 60 to R 50. No capital gain will arise as the base cost still exceeds zero.

This is a better result than the previous regime, which resulted in a capital gain of R 4.

This sounds simple enough, but the calculation becomes somewhat complicated when dealing with shares acquired before 1 October 2001.

If the share was acquired prior to 1 October 2001 the revised rules prescribe a new method for determining the base cost of that share for purposes of the calculation of the capital gain.

In terms of this new method, the shareholder will be treated as having disposed of that share at the date the capital distribution is made for an amount equal to the market value of the share at that time and as having immediately reacquired that share at deemed expenditure equal to that market value. Any capital gain that would have been determined had the share been disposed of at market value at that time should be deducted from this deemed expenditure and any capital loss that would have been determined had the share been disposed of at market value at the time should be added to this deemed expenditure. This will then be the new base cost of the share.

To the extent then that the amount of the capital distribution exceeds this new base cost of the share, which has been determined in the aforementioned manner, the excess will be treated as a capital gain in the hands of the shareholder.

To illustrate this, let us return once more to the example of the share acquired in 2008 for R 60, but let us adjust the example so that the share is acquired in 1998 with a market value of R 60 on 1 October 2001 (ie, the valuation date value of the share).

On receipt of a capital distribution of R 10 during May 2012, the base cost of the shares will be determined by deeming them sold and reacquired for their current market value (ie, R 100) and deducting the capital gain of R 40 that would have arisen had they been actually sold (R 100 less the valuation date value of R 60). The base cost for purposes of the capital distribution calculation will therefore be R 60.

As the capital distribution of R 10 does not exceed the newly determined base cost of R 60, no capital gain will arise as the base cost still exceeds zero.

The base cost of the shares will, however, drop from R 60 to R 50.

It may be noted that the new calculation method gives a very different result for shareholders than that which occurs under the current regime. Instead of a capital gain or loss automatically arising on receipt of the capital distribution, only the base cost of the shares is reduced and only if this reduction exceeds the value of the base cost will a capital gain arise.

Beware April Fools’ Day

While the new provisions may seem positive for shareholders (unless you are a shareholder who would have benefited from an immediate capital loss), they have an unfortunate sting to them. Shareholders who still hold shares in companies from which they received capital distributions between 1 October 2001 and 1 October 2007 (ie, untaxed capital distributions) may face a nasty shock on 1 April 2012.

On that date, these shareholders will be deemed to have received all those untaxed capital distributions and a calculation will need to be done to determine if they result in a capital gain using the methods of calculation set out above. Long-time readers will recall that this liability was meant to arise on 1 July 2011 but, with the change in the capital distribution taxation regime, the date has been postponed to 1 April 2012.

Criticism and a last word

The new regime does not come without some criticism.

The new rules, although simpler to administer than the current part-disposal regime, are still very complex. Many shareholders will find the calculation of the tax difficult, especially capital distributions that are made in respect of shares acquired before 1 October 2001. A valuation of shares will be required and a market valuation is not easily or cheaply obtained, especially in the case of private companies. Shareholders may have to fork out more cash for costly valuations in addition to the CGT they will ultimately have to pay.

Secondly, a case for an exemption from the tax can be made in the case of corporate groups where capital distributions are made between group companies. Omission of such an exemption appears out of step with several other provisions in the Income Tax Act 58 of 1962 that provide for corporate relief or deferral from taxes where transactions occur between companies within a defined group of companies.

Lastly, the 1 April 2012 tax burden will not win SARS the hearts of many shareholders. The imposition of the tax liability is redolent of retrospective legislation. Shareholders who lack the cash flow to pay this tax may be forced to sell their shares. While they would have been paid cash when the capital distribution was made, they may not have kept it for the tax payment.

Despite these criticisms, the new dispensation regarding capital distributions appears set to stay. Companies may once again need to consider seeking advice from their tax advisers before returning value to their shareholders in this way.

Barry Ger BBusSc LLB BCom (Hons) (Taxation) (UCT) is a tax consultant in Cape Town.

This article was first published in De Rebus in 2012 (March) DR 49.