Deductions
1567. Ring-fencing of losses
October 2007 – Issue 98

Section 20A was made effective from 1 March 2004. Assessed losses prior to that date applied against trading income will not be counted for inclusion in the various tests i.e. losses in three years of assessment out of five or losses in six years of assessment out of ten.

As the 2007 tax year recently came to an end, the first count of losses in three years can be made.

When the legislation was first introduced by Act 45 of 2003, the preamble to section 20A(2) read as follows:

(2) Subsection (1) applies where the taxable income of a person for a year of assessment (before taking into account the set-off of any assessed losses incurred in carrying on any trade during that year and the balance of assessed loss carried forward from the preceding year) equals or exceeds the amount at which the maximum marginal rate of tax chargeable in respect of the taxable income of individuals becomes applicable, and where—

The effect of the wording was that the taxpayer’s taxable income had to be determined, combining all trades but excluding assessed losses brought forward and losses for that year from any trade. Only if the taxable income exceeded the amount on which the maximum marginal rate of tax was chargeable would the section be of effect.

Clearly this wording was flawed as calculating the taxable income merely excluding the assessed losses could have resulted in inflated retirement annuity contribution deduction (as section 11(n) requires losses to first be taken into account) but could also have resulted in a decreased medical deduction (as taxable income prior to the medical deduction would have been higher).

An amendment was necessary and the Revenue Laws Amendment Act No. 31 of 2005 amended the preamble to section 20A(2) as follows:

(2) Subsection (1) applies where the sum of the taxable income of a person for a year of assessment ([before taking into account the set-off of] determined without having regard to the other provisions of this section) and any assessed [losses incurred in carrying on any trade during that year] loss and [the] balance of assessed loss [carried forward from the preceding year)] which were set off in terms of section 20 in determining that taxable income, equals or exceeds the amount at which the maximum marginal rate of tax chargeable in respect of the taxable income of individuals becomes applicable, and where-

Clearly, the intention behind the amendment would leave the taxpayer determining taxable income, taking into account any and all assessed losses from all trades and correctly determining deductions and subsequently add back the assessed losses to the taxable income to determine whether the taxpayer would be left with a notional taxable income at which the maximum marginal rate would apply.

However, the amendment left the provision reading as follows:

(2) Subsection (1) applies where the sum of the taxable income of a person for a year of assessment (determined without having regard to the other provisions of this section) and any assessed loss and balance of assessed loss which were set off in terms of section 20 in determining that taxable income, equals or exceeds the amount at which the maximum marginal rate of tax chargeable in respect of the taxable income of individuals becomes applicable, and where-

The section in its current form raises two issues. First, the section is open to being misread (and hence applied incorrectly) and, secondly, the SARS Guide on Ring Fencing of Assessed Losses misrepresents the legislation in its current form, reflecting rather the original flawed legislation.

Potential misinterpretation

The section could be read to mean that the taxpayer must, ignoring section 20A, determine his taxable income, taking into account all assessed losses brought forward and any current year losses and this sum must exceed the amount on which the maximum marginal rate of tax would apply. Naturally by combining taxable profit from all trades with all current and balance of assessed losses means that most taxpayers intended to be caught in the ring-fencing will escape (unless their profitable trades after accounting for all losses still exceeds the amount on which the maximum marginal rate of tax would apply).

The use of the phrase "the sum of the taxable income of a person for a year of assessment […] and any assessed loss and balance of assessed loss which were set off in terms of section 20 in determining that taxable income" can be read mathematically as follows (since adding a negative number results in the number being subtracted from the total):

Sum of:

Whereas if the section read: "the taxable income of a person for a year of assessment […] adding back any assessed loss and balance of assessed loss which were set off in terms of section 20 in determining that taxable income" would provide the intended result, illustrated as follows:

Sum of:

The SARS Guide

The current SARS guide "Ring Fencing of Assessed Losses states that the ring-fencing of a trade loss can only occur when the pre-requisites in subsection (2) are present. As soon as these circumstances are present, the loss will be subject to potential ring-fencing. These circumstances are the following -

·      the taxable income, before deducting assessed losses, for the year of assessment in question must be equal to, or exceed the amount at which the maximum marginal rate of tax chargeable for individuals becomes payable;
and either one of the following requirements is met -

·      the taxpayer has, during a period of five years ending on the last day of that year of assessment, incurred an assessed loss in at least three years of assessment [section 20A(2)(a)];
or

·      the trade in respect of which an assessed loss was incurred falls within the suspect trades listed in section 20A (2)(b).

This extract still reflects the original flawed legislation and implies that SARS is unaware of the change. SARS should ensure that it amends the law to correctly reflect the intended application of the law to prevent tax practitioner and taxpayer headaches.

It is submitted that the language used in the section should be amended otherwise SARS should expect multiple objections based on the current wording.

This dual understanding of the application of section 20A in the 2007 year of assessment is perhaps a disaster waiting to happen.

University of Cape Town

IT Act:S 20A