The Income Tax Implications Of Debt Write-Offs
Where a creditor and a debtor enter into an arrangement whereby debt is cancelled or waived, such an arrangement is a concession or compromise as defined in the Income Tax Act. A concession or compromise is a debt benefit which carries income tax consequences.
The term debt is defined in the Income Tax Act as “ any amount that is owed by a person in respect of – (a) expenditure incurred by that person; or (b) a loan, advance or credit that was used directly or indirectly, to fund any expenditure incurred by that person, but does not include a tax debt as defined in section 1 of the Tax Administration Act;”
The income tax consequences for the debtor in relation to such a transaction will depend on the purpose for which the debt was used. If the debt was used to fund a capital asset, on which no allowance/s can be claimed e.g. land, then paragraph 12A of the Eighth Schedule of the Income Tax Act is applicable.
If the asset is still on hand at the time the debt benefit arise, the base cost of the relevant asset must be reduced by the debt benefit amount. The debt benefit amount will be the amount cancelled or waived.
With effect from 1 January 2019, if a debt is cancelled or waived in respect of a capital asset that was disposed of in a year of assessment, before the year of assessment in which the loan is cancelled or waived, then the income tax consequences for the debtor will be determined as follows:
The capital gain or loss previously calculated on the asset, should be recalculated as if the debt benefit and any other debt benefits occurred prior to the disposal of the asset.
The recalculated capital gain or loss is then compared to the original capital gain or loss and the difference between the two will be taxed as a capital gain in the year of assessment in which the debt benefit arises.
If the debt was used to fund a capital asset on which allowances are claimable and that asset was not disposed of in the year of assessment prior to the year in which the debt benefit arose, then the base cost of the asset is reduced by the amount of the debt benefit. Once the base cost of the asset has been reduced to nil and the debt benefit amount has not been exhausted, the excess amount will be taxed as a recoupment.
With effect from 1 January 2019, in the case where the allowance asset was disposed of in a prior year of assessment and the debt benefit occurs in a different year of assessment as the disposal, then the total debt benefit amount is calculated as follows:
The recoupment that was previously calculated on the disposal of the allowance asset is recalculated as if the debt benefit was taken into account on recoupment of the asset
The recalculated recoupment is compared to the original recoupment calculated on disposal of the allowance asset and is taxed as a recoupment.
If the disposal resulted in any capital gain or loss, in addition to the recoupment then the calculation discussed above in relation to capital gains or losses will be applicable.