Tax treatment of assessed losses
The Income Tax Act provides that in determining the taxable income of a company from carrying on any trade, the company can set off any assessed loss against the income so derived. As a result, the company's tax liability is reduced.
A company will be considered to have an assessed loss during the year of assessment if its allowable deductions exceed its income for that year. It will be entitled to carry forward its assessed loss for set off against future taxable income, provided that it continues to trade. If it ceases trading, the assessed loss will be lost.
Below certain issues are highlighted which a company needs to be aware of when considering the tax treatment of assessed losses.
When will a company be carrying on a trade? The term trade is quite widely defined in the Income Tax Act and includes the letting of property. Although the definition of trade does not spell it out as such, it is to be noted that "to trade" constitutes more than just an intention to trade. For example, the mere intention to let property does not constitute carrying on trade.
When does trade commence?
At what point will a company be considered to have started trading? For example, if a company conducts certain feasibility studies to assess the viability of a venture, will the feasibility studies constitute the carrying on of a trade? Unfortunately, there is very little guidance to be found in our law on this point. It has however been held by our courts that:
"It is clearly correct that a venture must be viewed as a whole and that it may straddle more than one tax year; there is, however, a vast difference between the mere laying of plans for respondent's future, on the one hand, and the commencement of preparatory activities for a future venture, on the other, and at least some activity is required. The mere laying of plans cannot constitute the carrying on of a trade as envisaged in section 1 of the Income Tax Act in the absence of some positive act aimed at promoting the said plans."
As stated above, in determining the taxable income of a company from carrying on any trade, the company can set off any assessed loss against the income so derived.
What does "income" mean in this context? Is it income as defined in the Income Tax Act, being gross income less exempt income, or is it something else? From our case law, it would appear that it is not income in its defined sense but rather income taxable but for the set-off of the assessed loss. This means that a set-off can only arise if there would otherwise have been taxable income. This is a startling view and it is recognised by the South African Revenue Service that to apply the law in this manner would lead to iniquitous results. The practice therefore is that the assessed loss will not be forfeited as long as the company continues to earn at least some income from trading.
Trading outside the Republic
If a company is carrying on both a local and foreign trade, it is not allowed to set off any assessed loss from its foreign trade against income from its local trade.
Companies are allowed to deduct expenses incurred before the commencement of trade from income earned once they start trading. However, if a company generates an assessed loss as a result of deducting these so-called pre-trade expenses, the assessed loss is ring fenced and cannot be set off against income from any other trade. This restriction constitutes an exception to the normal rule, which allows an assessed loss to be set off against income from any other trade of the company.
Pre-trade expenses from a specific trade may only be deducted from the income from that trade after deducting any other amounts which are allowable as a deduction (from that trade) in terms of any other provision of the Income Tax Act. This means that an assessed loss from any other trade must be deducted from the income of a specific trade before taking into account any pre-trade expenses relating to that specific trade. This is illustrated in the example below.
Assume that company X has two trades (trade A & B). Trade A generates taxable income of R100 before deducting pre trade expenses of R50.Trade B generates an assessed loss of R100 and has no pre trade expenses. Company X must set off the assessed loss from trade B against the taxable income of trade A of R100 before deducting the pre trade expenses of R50. In this example the pre-trade of R50 will therefore be carried forward.
Within a South African group of companies, it is possible, by using certain tax rules, that a group company can transfer its assets to another group company in a tax neutral manner. This recognises that, although each company within the group is a separate company, in reality the group as a whole is a one economic unit. Thus, when companies within the same group transfer assets between one another in terms of the corporate rules, the transferor and transferee are treated as one and the same person and as a result, income tax and CGT rollover relief is provided.
However, no relief is provided for the transfer of assessed losses within a group context. For example, group company A has an assessed loss and group company B has taxable income: A is not permitted to transfer its loss to B in order to reduce the Group's effective tax burden. This appears to contradict the view that the group as a whole is viewed as a one economic unit. In fact, SARS can undo any intra-group transaction which it views to be concluded for the sole or main purpose of using the assessed loss to reduce the group's tax burden - indeed an anomalous outcome.
*Pitsi Rammutla is a senior consultant at Deloitte