16 February 2001

National Treasury’s Outline Of Major Policy Issues Contained Within
The Proposed Capital Gains Tax Legislation (Final Edition)

Dear Madame Chair and Members of the Portfolio Committee on Finance,

Thank you for affording National Treasury and SARS with the opportunity to provide continued input into the hearings process for the proposed capital gains tax legislation. National Treasury and SARS have been fully incorporating the written submissions and oral comments provided by the public. As previously discussed, SARS is compiling a lengthy table of responses to each of these comments. The revised draft of the legislation is also being adjusted. National Treasury and SARS are grateful to the Portfolio Committee and the public for their assistance.

The purpose of this memorandum is to inform your committee of the major policy issues contained within the proposed legislation. As you are aware, SARS also prepared a separate memorandum addressing the major administrative and technical issues. Neither memorandum reiterates our policy rationale for proposing the capital gains tax. In this regard, ample supporting evidence has already been submitted to the Portfolio Committee at the hearings along with corroborating international expert testimony, all of which support the notion that taxation of capital gains is a necessary pre-requisite for a comprehensive income tax base.


This memorandum first discusses two relevant major policy issues omitted from the proposed legislation (i.e., rules for distinguishing between capital gains and ordinary income, as well as comprehensive rules for company restructurings). This memorandum then addresses selective major policy issues within the proposed legislation.

Before turning to the detail, it is extremely important to note that any policy concerns addressed within this memorandum are undergoing thorough and continued quantitative/qualitative analysis. Possible rate adjustments and exclusion levels remain a continuing subject of consideration. Hence, it cannot be construed that the discussion contained herein represents hardened positions. The following discussion should accordingly be viewed as an exploration of options before the Committee.

I. MAJOR POLICY ISSUES OMITTED FROM THE LEGISLATION
The proposed capital gains legislation does not presently contain any guidance with respect to two major policy issues. First, the proposed legislation fails to provide guidance for distinguishing between capital gain versus ordinary income. As a result, the capital versus ordinary distinction continues to depend on judicial case law. Second, the proposed legislation fails to contain comprehensive rules addressing company restructurings, such as formations, acquisitive reorganisations (e.g., mergers and amalgamations), unbundlings, as well as intragroup sales and rationalisations. The company restructuring rules contained within the proposed legislation currently address only limited situations.

National Treasury is currently examining these issues as legislative items for the upcoming year. National Treasury believes the importance of these issues may warrant further study and/or a separate deliberative process for Parliament and the public.

A. The Capital Versus Ordinary Distinction
1. Nature of the Problem
In terms of tax policy, most of the theory supporting the capital gains tax suggests that capital gains should be taxed at equal levels as ordinary income. As discussed by National Treasury over the course of the hearings, all forms of profit should be taxed equally in terms of equity and market efficiency. Indeed, the historical review provided by Professor Rick Krever and others indicates that the distinction between capital gains and ordinary income represents an artificial relic of feudal trust law. This distinction does not stem from rationale economic theory.

Nevertheless, even though capital gains represent economic profits to the same extent as ordinary income, National Treasury chose not to tax capital gains at full ordinary rates. National Treasury was concerned that a sudden change from the historic rate of zero to a full inclusion rate may be too drastic, thereby causing potential economic disruption. National Treasury was also concerned that full taxation of capital gains could conceivably create a potential "lock-in effect" (i.e., taxpayers would have an undue incentive to hold assets rather than face tax on sale). National Treasury believed the proposed 15 per cent rate for corporations and the maximum 10.5 per cent rate for individuals was sufficiently low to prevent any undue lock-in effect. Although National Treasury is deeply skeptical of such arguments, the low inclusion rate also arguably represents a concession to those who believe that capital gains tax relief is necessary because the sale of long-term assets may carry a disproportionate share of inflationary gains and because capital gains may have a bunching effect (i.e., a uniquely large accumulation of income that pushes a taxpayer into a "one-time" higher tax bracket).

However, the proposed low inclusion rate comes at a cost. Incentive (albeit reduced) still exists for taxpayers to artificially convert ordinary income into capital gain. While case law exists for drawing a distinction, case law creates great uncertainty because the case law distinction focuses on taxpayer intent, which involves heavily subjective facts and circumstances criteria. Under this intent test, taxpayers who purchase and hold assets with the intent to sell are fully taxed while taxpayers who purchase and hold assets for other reasons are deemed to have capital gain. Besides its inherent uncertainty, the test lacks any meaningful economic rationale, thereby promoting conversion without economic consequence.

Example. Facts. Taxpayer X purchases shares for R100 and sells those shares for R150 two years later.

Result. If Taxpayer X purchases and holds those shares for the dividend stream, the sale of those shares creates capital gain. If Taxpayer X purchases and holds those same shares for resale, the sale produces ordinary income.

As illustrated from the above example, Taxpayer X can receive two different tax results, even though no economic difference exists between the two circumstances outlined. Taxpayer X can receive different tax treatment even though Taxpayer X holds the shares for the same two-year period. Moreover, the actual dividend yield on the shares seemingly bears little weight on the analysis. Many taxpayers currently hold and sell common shares with dividend yields as low as 2-3 per cent, claiming capital gains when they sell. This widespread position seemingly goes unchallenged. Financial institutions similarly claim that a large portion of their financial instrument sales amount to capital gain rather than ordinary income.

In many instances, the current taxpayer intent test has become mostly taxpayer elective. Taxpayers, such as financial institutions, have even greater flexibility under this test because of their sophisticated legal support. The facts and circumstances nature of the test ultimately leaves SARS auditors with a difficult search for variable facts ultimately controlled by the taxpayer.

2. Potential Resolution
The capital gains versus ordinary income distinction should possibly be re-examined in the coming months as the capital gains tax legislation goes into effect. National Treasury is currently studying a number of options in this regard. For instance, the law could be modified with a series of per se rules before resort to the current facts and circumstances test.

These per se rules could come in a variety of forms. Sales occurring within a 1-year period could be given per se ordinary gain treatment because the speed of the sale makes the gain akin to ordinary business and wage income, which similarly arises annually (also the inflationary arguments for relief disappear when capital assets are subject to quick turnover). Many countries, such as the United States, have these forms of short-term gain rules. Conversely, per se capital gain treatment could apply for properties held for more than 5-years. This concept stems from current section 9B, which implicitly assumes that long-held properties are more susceptible to the lock-in effect produced by heavy taxes on sale and are more likely to reflect inflationary gain. Query, however, whether a per se 5-year rule would create a lock-in effect of its own.

To the extent the facts and circumstances test would continue to apply, the test could be adjusted legislatively. The facts and circumstances test could attain a more rationale economic focus. For instance, if one believes that inventory business gains should continue to be taxed as ordinary income, any sale gains akin to inventory should be taxed along the same lines. Under this view, financial institutions engaged in the purchase and sale of financial instruments would have ordinary income with respect to all sales, not just with respect to specific instruments. This treatment would apply even if the holding of a particular instrument was allegedly for a dividend or interest yield.

B. Company Restructurings
1. Nature of the Problem
The capital gains tax has an inherent wide-ranging effect. Capital gains tax legislation not only applies to outright cash sales but also to "property-for-property" swaps. Taxation of these "property-for-property" swaps includes company share-for-share exchanges as well as other company restructurings. Many countries provide tax exemptions for these exchanges, believing these exemptions facilitate business transactions necessary for economic growth.

* * * *
Typical exemptions focus on company formations, which create the limited liability necessary for business start-ups. Without special relief, taxpayers forming a company would trigger taxable gains because these taxpayers are technically surrendering property-for-shares in the new company. Other exemptions involve share-for-share exchanges, mergers, or unbundlings on listed markets. These realignments among listed companies maximise market efficiencies on an industry-wide basis. However, taxation of these events in shareholder hands is perceived unfair because many of the shareholders involved have no actual say over the realignment and receive no actual cash (i.e., simply surrendering shares in one company for shares in another).

* * * *
Other exemptions focus on intragroup transactions. The South African tax system generally imposes tax on a company-by-company basis, even if all the companies involved are part of a single group with a 100 per cent controlling company acting as the parent. Sales between members of the group create a taxable event, even though all group members economically represent divisions of a single enterprise. Capital gains tax legislation exacerbates this problem because most intragroup sales are of a capital gain/loss character. Many jurisdictions accordingly provide intragroup exemptions so groups can freely conduct internal realignment.

Exemptions for intragroup restructuring also alleviate the "problem of cascading." The "problem of cascading" stems from the capital gains tax when that tax is combined with the classical corporate tax model employed by South Africa. This problem exists because any increase in value to company assets increases the value of company shares (and hence share gains). In the case of a group structure, this value increase has a multiplier effect.

Example. Facts. Individual forms Company X with R20 of cash, which in turn forms Company Y with the same R20 of cash, followed by Company Y’s formation of Company Z with the same R20 of cash. Company Z then uses the cash to purchase land, and the land appreciates to a R100 value (which in turn increases the value in each of the companies).

Result. The potential R80 of capital gain with respect to the land multiplies through the group. The Company X, Y, and Z shares each separately have an R20 cost base along with a R100 value. Thus. if Company Z sells the land, Company Z has R80 of gain. If Company Y then sells Company Z, Company Y has R80 of gain. If Company X sells Company Y, Company X has R80 of gain. Lastly, if Individual sells Company X, Individual has R80 of gain. The net effect is four levels of gain stemming from a single asset.

A dual level of tax (from Individual’s sale of shares and a company sale of the land) is a typically accepted feature within a classical corporate tax model, such as that found in South Africa, because this dual level of tax is seen as the proper price of limited liability. However, potential multiple levels of tax from group structures are problematic because lower-tier subsidiaries are economically akin to divisions of a single enterprise. Many countries accordingly provide intragroup relief so that companies within a single group can freely transfer assets with one another or compress into a single company without triggering tax.

2. Potential Resolution
National Treasury is exploring various options for addressing the restructuring of companies. Restructuring relief is a vital part of any capital gains tax system, and indeed, of any income tax system as a whole. At issue is how best to come to grips with these issues given the current circumstances. National Treasury is committed to some form of action in this area.

The present draft contains limited restructuring relief provisions. Among other items, the current unbundling and rationalisation rules have been extended to include relief from the capital gains tax. The capital gains tax regime additionally has a separate tax-free incorporation rule that provides for the tax-free formation of smaller companies by individuals.

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One option is to provide further limited adjustments to the current proposed legislation. The rules as drafted could be expanded along with adjustment for other current relief provisions, such as section 24A (which allows tax-free share-for-share exchanges under the basic Income Tax Act). One area of immediate concern omitted from the present draft would be intragroup relief – a critical area given the regularity of intragroup asset transfers.

As a practical matter, restructuring relief (a unique aspect of the capital gains tax) can only be fully considered after the basic rubrics of the capital gains tax have fully been established. These rubrics are still being adjusted to reflect the comments received during the hearings and elsewhere. As a result, immediate relief would come at a probable price. Immediate relief would most likely come in narrow form as the best way to safeguard government against artificial revenue loss (potentially rife in this area). This relief could then be expanded as government becomes comfortable that any expansion will contain appropriate safeguards.

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A second option would be a wholesale re-examination of the company restructuring rules over the coming months as the capital gains legislation goes into effect. This option recognises that the introduction of the capital gains tax simply magnifies the inadequacies of the restructuring provisions under current law. In essence, delayed relief could mean expanded relief.

Under this wholesale re-examination, company restructurings could be part of one unified regime. This unified regime would contain combined relief from various taxes, such as the secondary tax on companies, in addition to the capital gains tax. These company restructuring rules would work in unison to provide full flexibility while safe guarding the government against artificial erosions caused by multi-stage restructurings. These rules would most likely apply to company formations, listed company restucturings, and intragroup transfers. This unified regime would also probably have to contain rules designed to prevent disguised receipts of cash or cash equivalents as well as rules to prevent the tax-free movement of accrued gains into foreign companies falling outside South African taxing jurisdiction.

II. MAJOR POLICY ISSUES WITHIN THE LEGISLATION
In its current form, the proposed capital gains legislation contains a number of policy issues. According to written submissions and the comments made before Parliament, National Treasury believes the following major policies issues are at stake:

(a) The Annual Exclusion,
(b) Combined Impact of the Estate Duty/Other Taxes,
(c) Capital Losses as an Offset,
(d) The Purchase and Sale of Assets With Foreign Currency,
(e) Expenses Relating to Capital Assets,
(f) The R1 Million Cap on the Home Sale Exclusion,
(g) Business Reinvestment Relief,
(h) Small Business/Retirement Relief,
(i) Deemed Sale on Charitable Donation,
(j) Deemed Sale on Expatriation, and
(k) Connected Party Losses.

A. The Annual Exclusion
The proposed legislation requires individuals and special trusts to annually disregard up to R10,000 of net capital gains or net capital losses. This annual exclusion is designed for administrative convenience, the purpose of which is to eliminate de minimis gains and losses from the system. This annual exclusion is especially important in the case of SITE system taxpayers who would otherwise file no returns.

Criticism has been directed towards two aspects of the annual exclusion. The public comments suggest the annual exclusion is too low. These criticisms further suggest the exclusion should not apply to capital losses. However, despite these comments to the contrary, the current approach continues to have significant justification.

(1) Level of the Annual Exclusion: The present R10,000 exclusion is designed mainly to relieve lower income groups from the system. In that vein, an exclusion for home sales and for the sale of personal-use assets was initially chosen in lieu of a higher exclusion for all assets. While a general higher exclusion seemingly promotes administration by removing more gains from the system, a higher exclusion may also have the opposite effect. As the exclusion grows in size, the system begins to take the same shape as the current system with taxpayers having an undue incentive to convert ordinary income into tax-free capital gains. Excluded gains are especially problematic in terms of enforcement because excluded gains often go wholly unreported. While the IMF has admittedly suggested an initial high level of exclusion to be decreased as administrative capacity increases, adjustment of the exclusion may create uncertainty with taxpayers arranging their affairs around the initial high exclusion level only to be disappointed as the exclusion is legislatively phased-out.
(2) Excluding Losses: National Treasury fails to understand the unfairness created with respect to the R10,000 exclusion for losses. This exclusion for losses exactly matches the exclusion for gains. The exclusion for losses similarly eliminates bookkeeping for small amounts, especially in the case of taxpayers on the SITE system who would otherwise file no returns.

B. Combined Impact of the Estate Duty/Other Taxes
Public comments have criticised the capital gains tax as duplicative of other taxes. For instance, death will now not only trigger the Estate Duty but also the capital gains tax. These critics accordingly suggest that only one tax instrument should apply per event – either by removing the other duties or by not applying the capital gains tax.

Despite the above comments to the contrary, the combined impact of the capital gains tax with other duties/taxes does not create the full double tax impact suggested. The current multiple system of taxation targets different forms of wealth. For instance, the capital gains tax is designed to tax accrued gains; whereas, the Estate Duty targets accumulated gross wealth.

Example. Facts. Taxpayer X owns a large tract of uninhabited land with a value of R5 million. Taxpayer X purchased the land in 1980 for R2 million. By the 2001 implementation date, the land is worth R4 million. Taxpayer X dies in 2005 when the land is worth R5 million.

Result. The Estate Duty falls on the full R5 million of accumulated wealth held on death. The capital gains tax falls on the R1 million accrued after the 2001 implementation date. Only the tax on the R1 million of gain is subject to potential double tax.

Faced with this double tax impact on accrued gains, one could either reduce the other duties/taxes or not apply the capital gain tax. The current draft leaves the capital gains tax in tact. According to the IMF report, failure to tax capital gains at death creates an enormous "lock-in" effect with taxpayers unduly holding assets until death to avoid the tax. The December draft instead leaned in favour of reducing the Estate Duty as the viable and practical alternative for granting relief.

The proposed legislation also contains other forms of double tax offsets. For instance, transfer duties and stamp duties paid upon purchase are added to the base cost of assets, thereby reducing capital gain on sale. For instance, if a taxpayer purchases land for R100 subject to a R10 transfer duty, the taxpayer will have a R110 cost base rather than a R100 cost base. In terms of the Estate Duty, taxpayers will exclude all capital gain taxes paid from their gross estates. The current version of the proposed legislation fails only to contain offsets for the combined effect of the capital gains tax and the Donations Duties. The revised version of the legislation will remedy this defect.

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One side-issue with respect to the Estate Duty is of additional note. In some cases, the capital gains tax on death could produce relatively harsh results if an estate contains significantly appreciated assets, all of which are subject to high levels of debt. These situations could potentially create a situation where the tax on death exceeds the deceased’s net value.

Example. Facts. Individual dies owning land with a R1 million gross value and related debt equal to R950,000. The land has a R200,000 cost base.

Result. Setting aside any special capital gain exclusions, Individual’s death will generate R800,000 of gain, which will be subject to tax at R84,000. This R84,000 amount exceeds the net R50,000 value of the estate.

While consideration must be given to this circumstance, it should be noted that this circumstance seems relatively unusual (both the inherent gain and the debt must be large in relation to gross assets). Second, the capital gains tax on death merely places an individual in the same tax position as if the individual had sold all of his or her assets before death. Admittedly, this tax on death is seemingly unfair because individuals do not have the power to control the time of death versus the time of sale, but it should be remembered that a deceased individual receives the benefit of deferral by postponing the tax on gain throughout his or life. That said, care should be taken to ensure that the tax system does not result in situations that can bankrupt taxpayers. One possible mechanism of relief may be a special spreading of the capital gains tax on death over a 5-year period with an interest charge for the delayed payment.

C. Capital Losses as an Offset
Some criticism has been directed toward the proposed legislation’s limited allowance of capital loss offsets. Under the legislation as currently proposed, capital losses can offset only capital gains, not ordinary income. Public comment contends this limitation is unfair to taxpayers who may never receive capital gains after having undergone a capital loss.

Despite the above comment to the contrary, the present limitation on capital losses is not unreasonable. First, capital losses cannot be used as a full offset against ordinary income because capital items are subject to only partial taxation whereas ordinary items are subject to taxation in full. Any proposed use of capital losses as a full offset against ordinary income would create opportunity for arbitrage.

Example. Facts. Corporation X earns R100 of ordinary inventory income subject to tax at 30 per cent. Corporation X purchases two offsetting positions in the same share of an unrelated company – a long position and a short position. If the share increases in value by R100, the long position increases by R100 but the short position decreases by R100. Conversely, if the share decreases in value by R100, the long position decreases by R100 but the short position increases by R100.

Result. If capital losses can act as a full offset against capital gains, Corporation X can use its simultaneous purchases of long and short positions as mechanism to reduce its tax rate from 30 per cent to 15 per cent. Both simultaneous purchases create an inherent R100 capital gain and R100 capital loss. Corporation X would then use the capital loss to offset the ordinary income, leaving R100 of capital gain taxable at 15 per cent. The simultaneous purchases are of no economic consequence to Corporation X because both positions economically offset one another.

Admittedly, the above arbitrage could be reduced without preventing capital losses as an offset against ordinary income. One could utilise an ordering system so that all capital losses are first netted against capital gains before being netted against ordinary income. Second, capital losses could be netted with a conversion ratio. For instance, in the case of companies, R2 of capital loss could act as an offset against only R1 of ordinary income because capital gains are taxed at 15 per cent, whereas ordinary income is taxed at 30 per cent.

These approaches are ultimately problematic because capital gain items generally contain one important distinction from ordinary income items – taxpayer control of timing. Taxpayers generally have much greater practical control over the disposal of capital assets than the creation of ordinary income – the latter of which recur annually. As a result, taxpayers often have the practical power to accelerate capital losses while deferring capital gains. In view of this power, the limitation on losses acts as an anti-tax shelter limitation to ensure the proposed capital gain tax system does not undermine the revenue yield from the ordinary tax base. This proposed limitation is consistent with other international tax systems, which similarly prevent the use of capital losses as an offset against ordinary income.

D. The Purchase and Sale of Assets With Foreign Currency
Public comment has criticised the proposed legislation for its system of foreign currency conversion. Under the system as proposed, taxpayers who purchase assets with foreign currency must utilise a cost base equal to the currency conversion value at the time of purchase. On sale, they must convert the sale proceeds at a currency conversion value at time of sale. Critics contend this system of taxation is unfair because the resulting gain will mainly stem from the devalued Rand.

Example. Facts. Taxpayer X purchases land with $100 in U.S. currency when the Rand is traded at R6 per U.S. dollar. Taxpayer X later sells the same land for $100 in U.S. currency when the Rand is traded at R8 per U.S. dollar.

Result. Under the legislation as proposed, Taxpayer X has a R600 cost base in the land (R6 x $100) with a selling price of R800 (R8 x $100). The net result is R200 of taxable gain.

Critics are admittedly correct that taxpayers who purchase and sell assets through other currencies are subject to tax on Rand devaluations. The capital gains tax system, like the ordinary income tax system, measures gains in terms of the Rand. This means that all gains and income, including nominal gains from inflation and Rand fluctuations, are fully taxed. Inflation and Rand fluctuations not only impact gain on assets purchased with foreign currency, but also domestically purchased assets. Thus, the best answer is probably not to provide relief for specific transactions but to raise marginal rates across the board, or more importantly, to address the economic issues impacting inflation and the Rand. Specific relief for assets purchased in foreign currency would simply provide taxpayers with an incentive to invest in assets acquired through foreign currency over domestically acquired assets.

One troublesome aspect in this area is the current tax treatment of controlled foreign entities ("CFEs") (i.e., South African controlled foreign companies). For purposes of administrative simplicity, last year’s residence legislation opted to follow common international practice by allowing CFE gain or loss to be determined wholly under foreign currency without separate purchase and sale translation. This foreign currency mechanism for CFEs effectively eliminates all Rand devaluation gains within the CFE. Thus, taxpayers can simply plan around the proposed legislation’s treatment of the Rand currency issue by holding assets through CFEs.

E. Expenses Relating to Capital Assets
Under current law, taxpayers cannot deduct interest or other expenses attendant with capital assets to the extent those assets fail to generate ordinary income. Current law prevents taxpayers from deducting these expenses because the underlying assets otherwise fail to produce income (in other words, the tax system does not intend to artificially promote investments that simultaneously generate deductible loss with tax-free income). The public comments have rightly pointed out that adjustment of current law should perhaps be made with the introduction of capital gains.

Example. Facts. Taxpayer X purchases rental apartments for R100. Taxpayer X purchases the apartments with cash down plus assumed debt. Taxpayer X pays R12 of interest annually on the debt. Taxpayer X intends to lease the apartments but unexpectedly finds a purchaser who wishes to purchase the apartments for R200. Taxpayer X never leases the apartments as anticipated.

Result. Under current law, Taxpayer X cannot deduct the interest on the debt because the apartments are a capital asset, the gain on which is exempt from tax until the introduction of the capital gains tax.

Interest and other expenses relating to non-income producing capital assets probably should be added to the cost base of those assets (unless those assets are held for personal use) because all the subsequent capital gain sale is no longer exempt from tax. Thus, in the above example, the R12 of interest should be added to the original R112 cost base of the land (thereby reducing the gain on subsequent sale). This adjustment should additionally apply to company shares held as capital assets but special adjustments will have to made to take into account the fact that shares produce exempt dividend income for the holder. As stated at the hearings on February 13^th, SARS is considering utilising a formula whereby all expenses related to capital gain shares will provide an upward cost base adjustment equal to 2/3rds of the actual expense.

F. The R1 Million Cap on the Home Sale Exclusion
One issue of heavy comment contained in the proposed legislation is the R1 million cap on the home sale exclusion. Under this cap, only R1 million of gain on the sale of a home is excluded. Thus, if a taxpayer sells a home and generates R1.1 million of profit, R1 million of the gain is excluded; the remaining R0.1 million would be taxable at capital gain rates.

National Treasury believes the R1 million cap on the home sale exclusion represents an appropriate method for ensuring the exclusion does not apply to the sale of mansions and large land estates. The home sale exclusion is mainly intended as a middle-class relief measure so taxpayers of common means can reinvest their home sale proceeds into a larger or better home without compromise to tax concerns. Taxpayers who have gains in excess of this amount are likely to have sufficient cash from other sources to pay any tax on sale without compromise to their future lifestyles.

The R1 million cap probably should exclude most home sale gains, except for the mansions and large land estates described, because evidence suggests that most taxpayers sell their homes every seven years. It is the rare taxpayer who would exceed this level of gain on sale. One admitted problem with the cap is that the value of the cap will decrease with inflation and should be adjusted accordingly. The Portfolio Committee has rightfully pointed out that the Income Tax Act contains a number of caps, which also need adjustment. This issue is still under study.

G. Business Reinvestment Relief
The proposed legislation contains relief from the capital gains tax when a taxpayers sells certain business assets at gain to the extent that taxpayer replaces those assets with new business assets. Business assets eligible for this relief mainly include machinery and other tangible assets eligible for a capital allowance. This relief does not apply to buildings or real estate.

The purpose of this relief provision is to ensure that taxpayers who hold depreciating business assets can sell those assets and fully reinvest their proceeds into new business assets needed to maintain their business. Any tax on sale in these instances would prevent full reinvestment. Under the specifics of the provision, taxpayers can spread the sale gain over a 5-year period. It is anticipated this sale gain will be completely eliminated by the depreciation resulting from the newly purchased asset because most machinery-type assets have a 5-year cost allowance period. The net result is to prevent any cash-flow short fall caused by the capital gains tax on sale.

Example. Facts. Corporation X owns depreciable machinery with a cost base of R20 and a value of R130. Corporation X initially purchased the machinery for R100 but has taken a capital allowance of R80, reducing the cost base down to the current R20. Corporation X sells the machinery for R130 and purchases new machinery for R130. Both the new and old machinery are eligible for a 5-year capital allowance.

Result. Besides the required recoupment of the prior capital allowance, Corporation X has R30 of capital gain. This gain can be spread over a 5-year period, meaning that Corporation X will have R6 of capital gain per year. Corporation X will also be eligible to deduct a capital allowance of R26 per year (R130 divided by 5) for the new machinery, which is deductible against ordinary rates. The capital gain on sale deferred over the 5-year period should accordingly create no cash flow problems for reinvestment because the capital allowance for the new machinery will more than offset the deferred gain.

Public criticism of this proposed reinvestment relief falls along two lines. First, critics contend the type of assets eligible for relief should be widened to include buildings and other real estate property. Second, critics contend the rule should instead provide for tax-free treatment upon sale with a downward adjustment in the cost base for the new asset received to the extent any gain is deferred (i.e., the above R30 of capital gain on sale would be ignored with the cost base in the new machinery reduced by the same R30).

Despite the above comments, the current relief regime should be sufficient. Buildings and other real estate property were excluded because relief for properties of this kind historically promote tax-shelter-type industries. The current relief regime promotes investment in hardcore capital needed for economic growth rather than investment in office space.

With respect to a tax-free rollover, this mechanism is problematic because rollovers of this kind require long-term administrative tracking of new replacement assets. The current regime provides taxpayers with a 5-year spread as long as they purchase a replacement business asset; once purchased, no new tracking is required. The 5-year spread is also more generous to taxpayers than a rollover because this system triggers capital gain along with increased matching ordinary deductions for the capital allowance on the new machinery. A rollover rule would remove the capital gain along with the increased capital allowance.

H. Small Business/Retirement Relief
The proposed legislation contains small business relief in addition to the business reinvestment relief just described. Under this small business/retirement relief, taxpayers who are age 55 or more (plus taxpayers suffering disability) can sell their small business interests without capital gains tax. The purpose of this rule is to assist small business owners who have devoted their lives and proceeds exclusively to the growth of their businesses. Taxpayers of this kind often fail to have significant retirement savings – having only accumulated capital from their efforts devoted to the small businesses which they created.

Public comment has focused on the nature of the small business exception. Many of these comments contend the current small business exception is too limited because the exception applies only to businesses with a total gross value of no more than R5 million. These comments suggest the exemption be expanded to include R5 million per small business holder. For instance, if a business had two owners, each holder would be eligible for the exception as long as each owner holds no more than a R5 million interest (for a R10 million total business value). The problem with this option is that the proposed exemption is mainly intended for a narrow set of business owners who probably lack other resources. Multiple small equity holders of larger businesses most likely have other forms of retirement savings provided to all owners of the business.

Public comment has also focused on a lifetime exclusion similar to the one formerly used in Canada. Under this exclusion, taxpayers age 55 or older could exclude up to R500,000 of gain over their remaining lifetimes. This proposal offers the benefit of neutrality among investments held by older persons. Although intriguing, this proposal is problematic on several grounds. First, this form of large exclusion would create an enormous lock-in effect with taxpayers artificially holding assets until age 55 (much like the exclusion on death rejected by the IMF report). Second, the exclusion moves way beyond the original intent of the proposed targeted relief, which was to promote small business investment – a critical element needed to further stimulate the economy. Third, a life-time exclusion creates difficult tracking problems because the exclusion would apply to SITE system taxpayer who may file returns only sporadically.

I. Deemed Sale on Charitable Donation
Public comment has focused on the deemed sale of assets triggered upon charitable donation. Under this proposed rule, all charitable donations will trigger a deemed gain or loss unless those donations are made to a qualifying public benefit organisation and the donations are deductible under section 18A of the Income Tax Act (e.g., individuals are limited to charitable deductions equal to the greater of R1,000 or 5 per cent of their incomes). Public comment has suggested that the exemption be expanded.

Example. Facts. Taxpayer X donates land to a charitable organisation. The land has a R100 value and a R20 cost base.

Result. If the donation is made to a charitable organisation that is a qualifying public benefit organisation and the donation is deductible under section 18A, no capital gains tax applies. If the donation falls outside these confines, the donation generates R80 of capital gain.

The proposed legislation creates a deemed sale as a matter of tax neutrality. A taxpayer who sells and donates land (thereby triggering gain/loss) should arguably be in the same position as a taxpayer who makes a direct donation. This proposed aspect of the legislation represents a policy decision of slow expansion with respect to public benefit organisations in order to ensure that tax relief promotes genuine charitable causes. Wholesale tax relief in this area may be problematic because tax systems, such as the United States, which have opted for wholesale relief have found this relief quickly becomes rife with tax avoidance.

On the other hand, this issue is still under review. Until the capital gains tax, taxpayers could at least donate properties tax-free to charities, even if those donations did not yield present deductions. A change in this regard may move the effort to promote charitable organisations one step back. Moreover, no abuse concerns may exist where an asset is donated tax-free if that donation also fails to generate any deduction.

J. Deemed Sale Upon Expatriation
The proposed legislation contains a deemed sale rule upon individual expatriation. Under this rule, an expatriating individual will be subject to tax upon surrendering his or her South African residence as if the individual sold all of his or her assets at fair market value. Public comment has criticised this proposal because many expatriating individuals cannot expatriate all their assets under the current system of exchange controls.

Taxation upon departure is consistent with a larger concept within the proposed legislation, which limits capital gains and losses to those accrued within South Africa. Under this regime, entering residents are generally taxed only on their post-entry gains and departing residents are generally subject to tax only on their pre-departure gains. The deemed tax on departure represents a last point for collecting capital gains taxes because South Africa does not tax capital gains earned by foreign residents (under its own law and by virtue of double tax treaties). Thus, failure to tax capital gains on departure would mean that further opportunities for taxing capital gains would be lost.

Example. Facts. South African Individual owns shares with a R100 value and a R20 cost base. South African Individual emigrates, thereby losing his or her residency status.

Result. As a general rule, South African Individual is subject to tax on share gains generated before departure. Any share gains generated after departure are no longer subject to South African tax. In order to ensure that the R80 of gain accrued with South African Individual is taxed, South African Individual is taxed on the gain at departure under the proposed deemed disposition rules.

One downside of this deemed sale regime upon departure, like all other deemed sales upon departure, is the fact that the deemed sale leaves the taxpayer subject to tax without receiving any actual cash proceeds. This taxation may seem especially harsh if a departing individual cannot withdraw his or her funds because of the exchange control legislation. In this circumstance, all one could suggest is that the departing individual pay his or her taxes out of proceeds required to remain behind.

K. Connected Party Losses
Public comment has criticised the proposed legislation with respect to its treatment of connected party losses. The proposed legislation provides that all loss sales between connected parties can only be deducted against connected party gains. Public comment argues this limitation is excessive because many connected party sales occur at arm’s length.

Despite these comments to the contrary, the proposed connected party loss rule is an important feature of the capital gains tax and is typically found in most capital gain taxes utilised throughout the world. The problem is not a question of arm’s length prices. Instead, the problem is a question of connected parties acting as a single economic unit.

Example. Facts. Taxpayer X owns Gain Asset A and Loss Asset B. Gain Asset A has a value of R100 with a cost base of R20. Loss Asset B has a value of R20 with a cost base of R100. Taxpayer X wants to trigger the loss but not the gain. Taxpayer X accordingly forms a wholly owned company and sells Asset B to that company for its true value of R20.

Result. Without a connected party loss rule, Taxpayer X could trigger the full R80 loss on Asset B, even though Taxpayer X retains full economic control of that asset through ownership of the company. The connected party loss rule denies the loss unless Taxpayer X has connected party gains.

As shown above, failure to prevent connected party losses means the capital gain tax would leave taxpayers in the best of both worlds. Taxpayers can defer gains by holding gain assets for the long-term while accelerating tax losses. This accelerated tax loss is problematic because the transfer occurs within the same economic unit. Indeed, many of the anti-loss rules throughout the proposed legislation are designed to prevent similar arrangements that facilitate tax-losses without economic consequence.

However, the scope of the proposed connected party loss rule may have to be reviewed. The definition of connected party may be too broad for this purpose, encompassing arrangements that fall outside a viable single economic unit.