Taxpayers and their advisors employ section 42 of the Income Tax Act in various types of transactions. When encountering this provision, it is important to understand its mechanics but also its broader context. In this article, I discuss the some of the background to section 42, the context in which it applies, and the relief afforded.

Transaction

Section 42 applies to an asset-for-share transaction. In broad terms, this involves a transaction where a person disposes of an asset to a resident company. As consideration that company issues equity shares to the person. A key requirement of the definition is that the person (transeror of the asset) must hold a qualifying interest in the company at the end of the day of the disposal. There are a few permutations as to what constitutes a qualifying interest. The element with arguably the lowest threshold is a holding of at least 10 percent of the equity shares and at least 10 percent of the voting rights in the company. (There is an exception to the qualifying interest requirement. The exception applies where the person does not hold a qualifying interest, but is in the full-time employment of a. service company.)

Relief

Some of the key relief mechanisms in section 42 applies are the following:

(1) The person is deemed to have disposed of the asset to the company at its tax cost. Therefore, no taxable gain arises for the person transferring the asset.

(2) The company is deemed to have acquired the asset with the same tax attributes as the person. This means the acquisition date, the asset’s use characteristics and the cost all roll over to the company.

(3) The person is deemed to have acquired the shares in the company with the same tax attributes as the asset.

(4) If the asset is an allowance asset, no recoupment arises for person who transfers the asset. The company steps into the shoes of the person for the remaining allowances and for any recoupment of allowances in future. If the company sells the asset, it recoups not only the allowances it claimed but also those the person claimed before the transfer.

The effect of the above is that at the time of the asset-for-share transaction there is no immediate tax consequence. The provision is, however, not an exemption. Because the tax characteristics carry forward into the company, the relief provided is a deferral until a realisation event happens.

Broader context

Section 42 forms part of the corporate rules in the Income Tax Act. It is one of six corporate rules introduced around 2001 after capital gains tax (CGT) came in effect. The explanatory memoranda published by the National Treasury at the time explain the broader purpose of these rules. CGT can be an impediment to restructuring pose an obstacle for taxpayers who want to set up their businesses in the most efficient way. The rules exist to allow certain restructurings without tax standing in the way.

If you examine the design of the rules more closely, you will note that they all involve moving assets while the same persons ultimately retain the economic interest in those assets in some form. For example, section 45 allows assets to be moved between group companies, implying that the same controlling group company retains its interest in the asset. Similarly, section 46 deals with unbundling, where a person who holds shares indirectly through another company can come to hold both sets of shares directly. The common thread than run through the corporate rules is that the same persons continue to hold an economic interest in the same assets after the transaction.

Section 42 fits this same pattern. The person held the asset before the transaction. They exchange it for shares in a company that now holds the asset. The person, however, still holds the an economic interest in the asset, but now indirectly through the shares in the company. The qualifying interest requirement provides the threshold for that shareholding. (This relief also comes at a cost. In episode 8 of my podcast, Tax Break, I discussed how gains are duplicated when using section 42.)

Example

An asset-for-share transaction that I often encounter is where a person who holds shares in an operating company (OpCo) transfers those shares to a wholly-owned holding company (HoldCo). The asset transferred is the OpCo shares and HoldCo issues all its equity shares to the person as consideration. This transaction often fits neatly into the requirements of section 42.

The structure is attractive because dividends flowing from OpCo to HoldCo do not immediately attract dividends tax. This is due to the exemption from dividends tax for dividends that flow from one South African resident company to another. If a R10 million surplus arises in OpCo, it can be moved to HoldCo as R10 million available for investment. A similar distribution to the beneficial owners (assuming they are not South African companies) would have left them with R8 million after 20 percent dividends tax. In principle, this allows for a larger investment base.

However, one should be cautious and ideally model the effect of the structure out fully: assume HoldCo invests the R10 million and over time, with compounding, the investment grows to R100 million. The full R100 million will be subject to dividends tax when it is eventially distributed to HoldCo’s beneficial owners. This means that the introduction of HoldCo deferred the immediate dividends tax, but brought all of the future growth into the dividends tax net, at the rate when it is eventually distributed. When considering HoldCo’s balance sheet, it is, therefore, important to bear the impact of this dividends tax in mind.

In conclusion

Section 42 is a deferral mechanism for a transaction in which a person swaps an asset for equity shares in a company, and the person retains an economic interest in the asset through that shareholding. I discuss this type of transaction in episode 80 of my podcast, Tax Break. You can listen at the link below: