The tax trap behind assumed liabilities?
13 October 2025
The so-called corporate restructure rules which include the roll-over relief provisions are contained in sections 41 – 47 of the Income Tax Act 58 of 1962 (“the Act”).
In practice, one of the most commonly used of these provisions is the aptly named asset-for-share transaction in section 42.
The basic premise of an asset-for-share transaction is fairly straightforward. A person (individual, trust or company) (“the Seller”) transfers (disposes of) an asset (in most instances with an inherent capital gains tax liability, assuming the asset is held on capital account) to a company (“the Purchaser”) in exchange for equity shares in the Purchaser, with the transfer/disposal executed on a tax neutral basis and the tax event delayed until a future disposal outside of the roll-over relief provisions.
By implementing the transaction in terms of section 42, this transfer/disposal can be executed on a tax neutral basis.
As a result of the mechanics of section 42, the Seller is deemed (irrespective of the market value of the asset disposed of)1 to have sold the asset to the Purchaser at its base cost, resulting, effectively, in a tax neutral transfer of the asset (i.e. no taxable differentials). The Purchaser inherits the historical low base cost of the asset, and the Seller vests a base cost for the equity shares issued to it equal to the base cost of the asset transferred. The (deferred) capital gain in respect of the asset will only be triggered once the Purchaser disposes of the asset for consideration exceeding the rolled-over base cost (assuming said transaction occurs outside any of the roll-over relief provisions).
So far, so good. However, in certain instances, so-called qualifying debt can also be assumed by the Purchaser as part and parcel of the asset-for-share transaction. This article will focus on the inherent tax risks associated with such a transaction, and in particular on the anti-avoidance provision contained in section 42(8).
Debt-related anti-avoidance provisions
Section 42(8)2, in its current guise, provides as follows:3
- Where the Seller disposes of any asset which secures any debt to a company in terms of an asset-for-share transaction, and
- that debt was incurred by the Seller;
- more than 18 months before the disposal; or
- within a period of 18 months before the disposal and that debt was incurred by the Seller at the same time as that asset was acquired; and
- the Purchaser assumes that debt (i.e. the debt which secures the asset) as part and parcel of the section 42 transaction;
- the Seller must, upon the disposal of any equity share acquired by it in the Purchaser (in terms of the original section 42 transaction i.e. an equity share issued to it by the Purchaser) and notwithstanding the fact that the person may be liable as surety for the payment of the debt;
- treat so much of the face value of that debt as relates to the equity share, where the equity shares are held as a capital asset, as a return of capital in respect of that equity share that accrues to that person (i.e. the Seller) immediately before the disposal by that person of that equity share.
The reason for section 42(8) is quite apparent i.e. it is to prevent a loss to the fiscus through an artificial capital loss being created on fully geared assets. This flows from the base cost allocated to assets acquired with debt funding. The concept and practical application of section 42(8) is best explained by way of a simple example.
| Example 1 |
Person A borrows R10 million from a bank. Person A uses the bank funding to acquire a capital asset for R10 million (i.e. a fully geared asset). The asset appreciates in value to R15 million. Assume that the outstanding loan is still R10 million at this stage. Person A incorporates a company (“Company A”) and disposes of the asset to Company A in terms of section 42. Company A settles the purchase price by assuming the qualifying debt and issuing equity shares to Person A. As a result of the application of section 42, Person A’s base cost for the equity shares issued to him in Company A is R10 million (i.e. equal to the base cost of the asset transferred). However, the market value of the equity shares held by him in Company A is only R5 million (i.e. R15 million asset less the R10 million loan). Person A subsequently disposes of the equity shares in Company A for an amount equal to their value i.e. R5 million. In terms of general principles, Person A realises a capital loss of R5 million (i.e. R5 million proceeds minus R10 million base cost). However, section 42(8) would apply and lead to the following tax consequences. Immediately prior to the disposal by Person A of the Company A equity shares, the face value of the debt that relates to said equity shares (i.e. R 10 million) is treated as a return of capital in respect of those equity shares. Practically speaking, in terms of paragraph 76B(2) of the Eighth Schedule, the return of capital would reduce the base cost of the equity shares in the hands of Person A to nil. Person A would now have a capital gain of R5 million (i.e. R5 million proceeds minus Rnil base cost). One cannot fault the commercial outcome as a result of section 42(8) applying in this instance i.e. Person A is taxed on the subsequent growth in value of the asset acquired. The purpose of this article is to consider the impact of section 42(8) in instances where the assumed debt has, after the section 42 transaction, been settled in full. Depending on the interpretation of the phrase “treat so much of the face value of that debt as relates to the equity share” section 42(8) could, ostensibly, lead to an additional tax burden. Again, this concept is best explained by way of an example. |
| Example 2 |
The facts are similar to Example 1. However, in this example, at the time the disposal of the equity shares occurs, the debt assumed (as part and parcel of the original section 42 transaction) has been settled in full by Company A. In Example 1, at the time of disposal, Company A had an asset of R15 million and debt of R10 million (market value of the equity shares are R5 million). In terms of Example 2, however, Company A has an asset of R15 million and debt of nil. Therefore, commercially speaking, the settlement of the debt by Company A (in the period subsequent to it acquiring same as part and parcel of the section 42 transaction) should mean an increase in the market value of the equity shares held in Company A. In this example, the market value of the equity shares will have grown to R15 million. The disposal will be for R15 million. The interpretational issue at the core of this article relates to the time that one considers “the face value of that debt”, i.e. is it at the point in time of the original section 42 transaction, or at the point in time immediately before the disposal transaction? Put differently, does the fact that the qualifying debt assumed no longer exists at the time of disposal of the equity shares still lead thereto that the application of section 42(8) would wipe out the base cost? The tax consequences will be materially different, dependant on the interpretation applied. Scenario 1 – The face value of the debt at the time of the original section 42 transaction Proceeds of R15 million Base cost of R10 million Section 42(8) applies and wipes out the base cost (return of capital) i.e. one interprets the “face value of that debt” to mean the value at the point in time of the original section 42 transaction. CGT on R15 million Scenario 2 – The face value of the debt at the time of the subsequent disposal Proceeds of R15 million Base cost of R10 million Section 42(8) applies, however, as the debt has been settled in full there is no reduction of the base cost. In this scenario, one interprets the “face value of that debt” to mean the value at the point in time of the subsequent disposal. With there being no debt at this point in time, there is no reduction in the base cost. CGT on R5 million Eliminating the effect of the asset for share transaction, commercially the Seller acquired an asset for R10 million and sold it for R15 million making a capital gain of R5 million, which equates to the interpretation afforded under scenario 2. If, however one adopts the interpretation as outlined in scenario 1, the capital gain equates to R15 million which gives rise to a tax liability on a fictitious gain of the settled debt of R10 million. In such a situation, there is every incentive for the shareholder of the company not to have the debt settled by the company. |
Concluding remarks
If, for now, one assumes that the reference to the “face value of that debt” refers to the debt incurred at the time of the original section 42 transaction (notwithstanding the fact that the debt has been settled in full in the interim, which, commercially speaking, should increase the market value of the equity shares) this may result in an unexpected and unrealistic capital gain. It would be helpful to obtain clarity from SARS on this aspect.
For now, taxpayers (and their advisors) should tread carefully when implementing a section 42 transaction where qualifying debt is also assumed as part and parcel of the transaction.
Authors:
Etienne Louw, Director
Mike Teuchert, Partner
Want to know more?
