STC Sept 2006 - STC on liquidation dividend when assets were not revalued

Secondary Tax on Companies
1444. STC on liquidation distributions
September 2006 – Issue 85

Introduction

There is much confusion regarding the amount of a liquidation distribution that is subject to secondary tax on companies (STC). This confusion arises largely as a result of the complex wording of the dividend definition in section 1 of the Income Tax Act No. 58 of 1962 (the Act) and the STC exemptions contained in section 64B(5) of the Act. Furthermore, there has been much debate about whether the determination of the market value of assets at 1 October 2001 (the implementation date of capital gains tax (CGT)) was necessary for STC purposes, even if the market value was never intended to be used by the taxpayer for CGT purposes. This article examines the STC exemption that applies to liquidation distributions of capital profits and explores the controversy surrounding the question of whether the valuation of assets at 1 October 2001 is a prerequisite for the purpose of the STC exemption.

STC exemption

Section 64B(5)(c)(ii) exempts from STC certain capital profits distributed to shareholders in the course or in anticipation of the liquidation, deregistration or winding up of a company (referred to in this article as "liquidation distributions"). The application of this exemption depends on when the asset whose disposal gave rise to the capital profit was acquired and disposed of. Three situations are envisaged:

§ A liquidation distribution out of capital profits arising from disposals of assets prior to 1 October 2001 will be fully exempt from STC in terms of this provision.

§ There is no STC exemption for a liquidation distribution out of capital profits arising from assets acquired and disposed of on or after 1 October 2001.

§ In the case of a liquidation distribution out of capital profits arising from disposals of assets that were acquired prior to 1 October 2001 and disposed of on or after that date, the STC exemption applies only to the pre-1 October 2001 portion of the capital profit. The exemption is not available for "the amount of profit determined as if that asset had been acquired on 1 October 2001 for a cost equal to the market value of that asset on that date". In other words, the total capital profit that forms part of a liquidation distribution must be pro-rated and the portion of the profit relating to the period before 1 October 2001 is exempt from STC. It is important to note, however, that this pro-rating only applies if the market value of the asset was "determined in the manner contemplated in paragraph 29 of the Eighth Schedule".

The words "determined in the manner contemplated in paragraph 29 of the Eighth Schedule" have been the subject of much controversy over the last few years, particularly in view of the deadline imposed by paragraph 29(4) for the valuation of assets. To properly understand the significance of the phrase, it is necessary to consider the evolution of section 64B(5)(c) over the last few years.

A brief history

Prior to the introduction of CGT, the section 64B(5)(c) exemption applied to liquidation distributions of any "profits of a capital nature". In the Revenue Laws Amendment Act No. 74 of 2002, the provision was substantially overhauled and sub-paragraph (ii) was inserted, providing that the exemption would apply to a -

"distribution of profits of a capital nature (other than capital profits attributable to the disposal of any asset on or after 1 October 2001 which capital profits must, in the case of an asset acquired before that date, be limited to the amount of profit determined as if that asset had been acquired on 1 October 2001 for a cost equal to the market value of that asset on that date as contemplated in paragraph 29 of the Eighth Schedule)". (Emphasis added.) (Amendment effective for dividends declared on or after 1 January 2003.)

The reason for this amendment was stated in the Explanatory Memorandum to the Revenue Laws Amendment Bill, 2002 as follows:

"As was announced by the Minister of Finance in the Budget Review this year, the capital profits distributed on liquidation will be included in a "dividend".

In giving effect to this proposal, the definition of ‘dividend’ in section 1 is being amended to include certain capital profits distributed upon liquidation. It is, however, proposed that STC should only be imposed in respect of dividends declared on or after 1 January 2003 from capital profits in anticipation of liquidation or deregistration, which was attributable to the period on or after 1 October 2001. The proportion of capital profits subject to STC will, therefore, in respect of the disposal of a capital asset on or after 1 October 2001, in respect of an asset which was acquired before that date, be limited to an amount of profit which would have been determined on the disposal of that asset as if that asset had been acquired on 1 October 2001 at market value."

In the Revenue Laws Amendment Act No. 45 of 2003 the highlighted part of this sub-paragraph was amended by deleting the word "as" and inserting the words "determined in the manner" so that the provision thereafter referred to "the market value of that asset on that date determined in the manner contemplated in paragraph 29 of the Eighth Schedule". At the time, the significance of this amendment went almost unnoticed, although the Explanatory Memorandum to the Revenue Laws Amendment Bill, 2003 stated the following:

"As part of the quid pro quo for the extension of the deadline for the preparation of valuations for CGT purposes, the proposal makes it clear that the deadline will also apply to valuations for the purposes of the exemption of the distribution of capital profits from STC."

The deadline referred to in this statement is that contained in paragraph 29(4) of the Eighth Schedule which provides that -

"… a person may only adopt or determine the market value as the valuation date of that asset if … that person has valued that asset within two years after valuation date …".

This deadline for submission of valuations was extended from 30 September 2003 to 30 September 2004 in terms of Government Notice No. 207 in Government Gazette 26026 of 20 February 2004.

It is interesting that the Explanatory Memorandum refers to this imposition of a time restriction on the date by which a market value must be determined for STC purposes as a "quid pro quo for the extension of the deadline". The question that arises is whether there was any mention of such a quid pro quo at the time that the extension to the valuation deadline date was granted?

The notice in Government Gazette 26026 stated the following:

"By virtue of the power vested in me by paragraph 29(8) of the Eighth Schedule to the Income Tax Act, 1962 (Act No. 58 of 1962), I, Trevor Andrew Manuel, Minister of Finance, hereby extend the period for valuation of assets contemplated in paragraph 29(4)(a) of the Eighth Schedule to the Income Tax Act, 1962, to 30 September 2004."

Clearly, there was no mention of any quid pro quo in this notice.

The 2003 Explanatory Memorandum indicates that it was the intention of the legislators to only allow the STC exemption on liquidation distributions of post-1 October 2001 capital profits if the market value of the underlying asset was determined by the extended deadline date of 30 September 2004 but this was not publicized at the time that the amendment was made.

SAICA’s submission to the Portfolio Committee on Finance (PCoF) on the draft Revenue Laws Amendment Bill, 2003 included the following statement:

"The insertion of the words "determined in the manner" seem to indicate, as per the Draft Explanatory Memorandum, that the period within which the valuation was required to be done for capital gains tax ("CGT") purposes also applies equally for the STC exclusion.

In our view, this objective is not achieved merely by the addition of the above words as subparagraph 29(4) of the Eighth Schedule to the Income Tax Act merely states that the requirement to value the asset within 3 years (after the recent extension in terms of subparagraph 29(8)) applies for the purposes of paragraph 26(1)(a) and 27(3) of the Eighth Schedule to the Income Tax Act.

We believe that paragraph 29(4) also requires to be amended to make reference to subsection (5)(c)(ii) of section 64B of the Income Tax Act."

The response from SARS and National Treasury in the document entitled "Responses to representations by organizations and individuals to the meetings of the PCoF and SCoF on the Revenue Laws Amendment Bill, 2003 (the Bill)", dated 24 November 2003 was as follows:

"This statement is correct. The deadline of 30 September 2004 for the valuation of assets also applies to valuations for the purposes of the exemption in respect of the distribution of capital profits from STC."

The further amendments suggested by SAICA, which would have assisted in clarifying that the deadline referred to in paragraph 29(4) was relevant also for the purposes of section 64B(5)(c)(ii) were, however not made.

The current problem

With the passage of time, it now transpires that many companies did not have the value of their assets at 1 October 2001 determined by the deadline date of 30 September 2004 because the directors and advisors were under the impression that they were not compelled to value their assets. This decision was based on the fact that the intention of the legislators when CGT was introduced was that taxpayers had three alternative methods for determining the base cost of their assets for CGT purposes: that is, market value, the time-apportionment basis or 20% of market value. However, although this choice is available for the purpose of determining the base cost of an asset for CGT purposes, no such choice exists for STC purposes. Indeed, the failure to determine the market value of the asset could prove costly as such companies will not qualify for the partial exemption of capital profits included in a liquidation distribution, with the result that the STC liability arising on the liquidation, deregistration or winding up of a company will be substantially higher than was initially envisaged.

This result is due to the interplay between section 64B(5)(c)(ii) and paragraph 29 of the Eighth Schedule and SARS’ interpretation of these provisions, which is stated in their recently-issued Draft Comprehensive Guide to STC as follows:

"The intention in adding these words was to make it clear that paragraph 29(4) of the Eighth Schedule had to be complied with …

SARS regards the entire capital profit as being subject to STC where a taxpayer has failed to complete a valuation by 30 September 2004."

In other words, if the 1 October 2001 market value of an asset was not determined by the deadline date of 30 September 2004, then the pro-rating of the capital profit does not apply. The result is that the whole capital profit forming the part of a liquidation distribution of such capital profits will be subject to STC, including the portion relating to the pre 1 October 2001 period.

It is unfortunate that the need to comply with paragraph 29, and particularly paragraph 29(4) of the Eighth Schedule, for STC purposes was not properly clarified and the real implications communicated to taxpayers when section 64B(5)(c) was amended in 2003. The failure to properly address the implications of the amendment has resulted in considerable confusion in the ensuing years.

SAICA representations

During this time, SAICA has raised the problem with SARS and National Treasury numerous times in written submissions and in meetings, as set out below:

Submissions:

§ Submission to SARS dated 11 June 2004

§ SARS’ response dated 16 July 2004

§ Second submission to SARS dated 21 October 2004

§ SARS’ response dated 9 December 2004

§ SAICA’s submission on the Revenue Laws Amendment Bill, 2005 dated 17 October 2005

§ SAICA’s submission to the Portfolio Committee on Finance on the 2006 Budget Speech dated 6 March 2006

All of the above correspondence is available on SAICA’s website (under Services to members/ SAICA’s Tax Page/ SAICA submissions).

The matter has been discussed at the following meetings:

§ Meetings between SAICA and National Treasury

o 15 July 2004

o 6 October 2005

o 27 March 2006

§ Meeting between SAICA and SARS Law Administration 11 November 2005.

The responses from SARS and National Treasury have generally been a reiteration of what was stated in the 2003 Explanatory Memorandum.

Conclusion

It is clear that SARS’ view is that the market value of assets at 1 October 2001 must have been determined by 30 September 2004 in order for the section 64B(5)(c)(ii) exemption to apply. Although SAICA will continue to petition this matter with both SARS and National Treasury, directors and advisors should be aware of the provisions of section 64B(5)(c)(ii) and SARS’ current interpretation thereof before proceeding with the liquidation, deregistration or winding up of a company.

South African Institute of Chartered Accountants

IT Act:S 64B(5) 64B(5)(c)(ii),

IT Act:8th Schedule par 29, par 29(4)

Revenue Laws Amendment Act No. 74 of 2002

Revenue Laws Amendment Act No. 45 of 2003

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Secondary Tax on Companies 1444. STC on liquidation distributions September 2006 – Issue 85