[FAQ] The tax treatment of a loan owing to a connected person during liquidation

[FAQ] The tax treatment of a loan owing to a connected person during liquidation

• 25 February 2021
• Individuals Tax
• Peter Surtees

Background

A company has an outstanding loan owing to a connected person(an individual). The company is in the process of closing down. The loan will have to be written off. The loan funded losses and the company has assessed losses.

Should the loan write-off be treated as a recoupment on which income tax will be payable even if the connected person does not claim a capital loss?

Answer

The Income Tax Act

You are referring to section 19 of the Income Tax Act but paragraph 12A of the Eighth Schedule to the Act should also be considered. Either or both of the provisions may apply.

To the extent that the loan was used for deductible expenditure, it is a debt as defined in both section 19(1) and paragraph 12A(1) “expenditure incurred by that person [being the debtor] or a loan, advance or credit that was used, directly or indirectly, to fund any expenditure incurred by that person”.

Section 19 applies where, in terms of subsection (2)(b), “the amount of that debt is owed by that person in respect of or was used by that person to fund, directly or indirectly, any expenditure in respect of which a deduction or allowance was granted in terms of this Act”. In other words, section 19 applies to the extent that the company used the loan to incur deductible expenditure. This means that you have to analyse the use of the loan and, to the extent that it funded deductible expenditure, there is a taxable recoupment. The company will have to set off against the assessed loss the expenditure recouped as a result of the debt being written off. If the recoupment exceeds the assessed loss, the excess is taxable. If not, the remainder of the assessed loss is lost to the company.

Paragraph 12A applies where, in terms of subparagraph (2)(b), “the amount of that debt is owed by that person in respect of or was used by that person to fund, directly or indirectly, any expenditure, other than expenditure other than expenditure in respect of trading stock in respect of which a deduction or allowance was granted in terms of this Act”. At first blush, the amount of the loan used for capital purposes is a capital gain (other than any capital allowances claimed, which would be covered by section 19(2)(b). However, subparagraph (5)(e) provides that the capital gain provision will not apply where the debtor “is a company, where-

1. that debt is reduced in the course, or in anticipation, of the liquidation, winding up, deregistration or final termination of the existence of the company; and
2. the person to whom the debt is owed is a connected person in relation to that company”.

As for the creditor, paragraph 39 provides that the creditor, being a connected person in relation to the debtor, must disregard the capital loss incurred. This will apply to the entire loss, regardless of the use to which the company put the loan.

Therefore, you will have to analyse the uses to which the company put the loan into revenue and capital expenditure respectively and treat the revenue portion according to section 19(2)(b) and the capital portion according to paragraph 12A(2)(b).

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