Written by: Max Azer
What is it?:
Section 42 of the Income Tax Act, No. 58 of 1962 provides a corporate relief (deferral) mechanism commonly referred to as an asset for-share transaction.
In substance, this entails a transaction where a person (natural person, trust or company) disposes of his assets to a South African tax resident company in exchange for equity shares in that company on a tax neutral basis (i.e. no immediate income tax or capital gains tax consequences).
How does it work? (requirements):
The following requirements (in brief) must be met:
- A person must dispose of an asset to a resident company and the market value of that asset must exceed its original cost (the base cost or the cost incurred in terms of section 11(a) or 22(1) or 22(2)).
- At the close of the day on which the assets are disposed of to the company, the person disposing of such assets must hold a qualifying interest (More than or equal to 10% of voting rights or equity shares in the company)
- The assets must retain its nature i.e. where the person/disposer of the asset held it as trading stock, the company is deemed to have acquired it as trading stock, conversely the same applies to where the assets was held as capital assets.
It is important to note that the person is no better or worse off from a value perspective since they merely replaced the value of the asset(s) transferred with shares of an equivalent value in the company to which they transferred the asset.
What are the benefits? (who is best suited for):
A person can transfer assets to a South African tax resident company without immediate income tax or capital gains tax consequences. The tax is deferred to when the company acquiring the assets will dispose of them in the future.
The company which acquires the assets, will be deemed to have stepped into the shoes of the person disposing of the assets, i.e. the base cost of the asset for the company acquiring the assets is equal to the original base cost at which the seller/disposer acquired the assets. Thereby no gain is realised, but the gain is deferred to when the company will sell the assets in future.
Where the disposer did not hold the assets as capital assets but perhaps trading stock, the acquirer/local company would then be deemed to have incurred the same amounts as the disposer incurred in terms of section 11(a) or 22(1) or 22(2).
A natural person can simplify their Estate Administration by transferring multiple assets in their own hands into a company, in exchange for one asset, namely the shares issued by the company. When an individual passes away, they are deemed to sell all their assets, so if such a person passes away, they will only dispose of one asset, instead of the multiple assets held before the asset for share transaction.
An asset for share transaction may also make sense when an investment portfolio is held by a natural person or a trust. When the shareholder is a natural person or a trust, the dividend declaring entity is required to withhold dividend withholding tax at 20%. If, following, an asset for share transaction, a share portfolio is now held by a South African tax resident company, an exemption may be claimed from the dividend withholding tax of 20%, thereby saving this tax over the time of the investment.
Certain conditions, known as claw-backs, could potentially void the benefits of a Section 42 transaction and leave the person with income tax or capital gains tax payable, as if the asset for share transaction did not happen, they are:
- If the seller receives consideration other than shares in the company.
- If the seller disposes of the shares within 18 months, they may be liable for taxes on any gains.
- If the seller ceases to hold a qualifying interest (at least 10%) in the company within 18 months, they may be subject to taxes on the shares.
- If the company disposes of acquired assets within 18 months, there may be tax implications depending on the type of asset.
These conditions aim to ensure that Section 42 transactions are used as intended and not for the avoidance of tax.
A section 42 asset-for-share transaction can be a useful tool in organising or reorganizing your personal or group tax affairs. If you have any questions about Section 42 Asset for Share transactions, please send us a mail to tax@finleys.co.za for the attention of Anrich Marais and Maxwell Azer.
Disclaimer: This article is intended for educational purposes and should not be used as tax advice, without consulting a tax practitioner on the facts specific to your case.