By Jean-Louis Nel, Director – Tax
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Section 42 of the Income Tax Act (“ITA”) permits a person (“Transferor”) to transfer an asset to a company (“Transferee”) in return for equity shares. Ordinarily, section 42 allows for the transaction to be implemented on a tax neutral basis, where there will be no capital gain tax (“CGT”) as a result.
The position is somewhat different where the market value of the asset transferred to the Transferee exceeds the market value of the shares issued to the Transferor. Section 24BA(3)(a) of the ITA deems the differential between the market value of the asset and the market value of the shares to be a capital gain in respect of the disposal of the shares by the Transferee, to the extent that the exclusions of section 24BA(4) of the ITA do not apply. Therefore, the Transferee shall be liable to account for CGT on the differential However, there is some form of postponed relief for the Transferee in terms of Section 40CA of the ITA, which allows for a step-up in the base cost of the asset acquired.
Section 40CA provides that where a Transferee acquires an asset in exchange for shares issued by the Transferee, the Transferee is deemed to have actually incurred an amount of expenditure to acquire the asset which is equal to the sum of:
- The market value of the shares immediately after the acquisition; plus
- Any deemed capital gain determined in terms of Section 24BA(3)(a) of the ITA.
In principle, this means that the Transferee’s capital gain upon eventual disposal will effectively be reduced. It is important to note, however, that the Transferee steps into the shoes of the Transferor with respect to the asset, in terms of section 42(3)(a)(ii) of the ITA.
Thus, where an allowance asset is transferred, the Transferee will only be entitled to the same allowances of the Transferor. In other words, the allowances permitted will not be determined with reference to the increased based cost by operation of section 40CA of the ITA but rather the expenditure incurred (base cost) by the Transferor.
The workings of these provisions serve to indicate that a transaction under section 42 of the ITA may not be as rudimentary as it appears. The value of the shares and the asset in question must always be considered, particularly where the Transferor acquires less than 100% of the shares in the company.