Jumping fences: Section 20A of the Income Tax Act and ring-fenced losses

Jumping fences: Section 20A of the Income Tax Act and ring-fenced losses

• 18 February 2019
• Individuals Tax
• Louis Botha and Louise Kotze

Monday, 19 February 2018

Important:

This article is based on tax law for the tax year ending 28 February 2018.

Authors: Louis Botha and Louise Kotze (CDH)

In South Africa’s current challenging economic climate, the risk of suffering losses in business is higher than normal. From a tax perspective, persons are generally allowed to set off losses incurred in respect of one trade against the income derived from another trade, to reduce their tax liability. However, the extent to which taxpayers can do this is limited and in this regard taxpayers, specifically natural persons, should be aware of the provisions of s20A of the Income Tax Act, No 58 of 1962 (Act). In terms of s20A, losses incurred by natural persons in respect of certain trades will be ring-fenced under certain circumstances, meaning that such losses cannot be offset against income derived from other trades carried on by such natural persons. 

Rationale behind s20A

In terms of the Explanatory Memorandum on the Revenue Laws Amendment Bill, 2003 (Memorandum), s20A was introduced to curb the practice where natural persons pursued ventures that, for the most part, consisted of hobbies disguised as trades, referred to in the Memorandum as suspect trades. The Memorandum states that private consumption can be disguised as trade so that individuals, especially wealthier individuals, can set-off the expenditures from this trade against other income such as salaried or professional income. Section 20A addresses this by stating that losses incurred in respect of a trade will be ring-fenced under certain circumstances.

When a loss is ring-fenced, that loss may not be set off against the other income of the natural person in order to reduce his tax liability. The loss may only be set off against the future income derived from the trade to which the loss relates. It follows that any balance of assessed loss pursuant to conducting that trade may, in future, also only be set off against the income derived from that trade. 

When will section 20A apply to a loss?

Section 20A(2) sets out the requirements that, if met, will result in the relevant loss being ring fenced. 

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This article first appeared on cliffedekkerhofmeyr.com.

FAQs

1. What does Section 20A of the Income Tax Act cover?

Section 20A deals with ring-fencing of assessed losses from certain trades. It prevents taxpayers from using repeated losses from specific activities to reduce their taxable income from other sources, especially when SARS suspects the trade is more of a hobby than a profit-making venture.

2. What is a ring-fenced loss in South African tax law?

A ring-fenced loss is a tax loss that is restricted to a specific trade and cannot be offset against other income. Instead, the loss is carried forward and only applied against future income from the same trade.

3. When does SARS apply Section 20A to ring-fence losses?

SARS applies Section 20A when a taxpayer incurs losses from a trade for three out of five years, or if the trade falls within the list of suspect trades outlined in the Act, such as farming, dealing in collectables, or animal showing.

4. What are examples of trades subject to ring-fencing rules?

Examples include farming with game or exotic animals, rental of residential property, sport activities, creative arts, or other hobby-like ventures where the likelihood of ongoing losses is high.

5. Can ring-fenced losses ever be used against other taxable income?

Yes, if the taxpayer can prove that the trade is conducted with a realistic prospect of making a taxable profit, SARS may allow the losses to be set off against other income. Otherwise, they remain ring-fenced.

6. How long can a ring-fenced loss be carried forward?

A ring-fenced loss can be carried forward indefinitely but can only be used to offset income generated from the same trade in future years.

7. Why did SARS introduce Section 20A?

Section 20A was introduced to prevent abuse of tax deductions by individuals who claim persistent losses from non-commercial activities or hobbies to reduce their overall tax liability.

8. How can taxpayers avoid ring-fencing of losses?

Taxpayers should ensure their activities are conducted in a commercial, businesslike manner, with evidence of intention and potential to generate taxable profits. Keeping strong records, business plans, and proof of efforts to make a profit is essential.

9. What happens if a trade becomes profitable after years of losses?

Once a trade shows profitability, the ring-fenced losses from prior years can be set off against the future income from that trade, reducing taxable income in those years.

10. Should individuals with ring-fenced losses consult a tax professional?

Yes. Because Section 20A rules are complex and subjective, consulting a tax practitioner or advisor helps ensure compliance with SARS requirements and prevents unnecessary disputes or penalties.

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