Section 42 of the Income Tax Act often features in restructuring discussions or proposals. When considering transactions or restructurings involving section 42 of the Income Tax, it is important to understand the provision’s boundaries. In other words, when it may not apply or when tax implications arise despite its relief. This article discusses some boundaries.

Deferral, not exemption

Section 42 was not intended to provide a tax exemption on the realisation of economic value. It defers certain tax implications while a taxpayer retains an interest in the asset (through the company’s equity shares) until that value is realised. This is why, for example, consideration in the form of a loan does not qualify. Similarly, a fixed-value or non-participating share that is not an equity share does not qualify for the relief. These considerations convert the transferor’s economic interest in the asset into something other than an ownership interest. They do not preserve the same type of interest as an equity share interest. (If the consideration consists partly of equity shares and partly of other consideration, section 42(4) restricts the relief to the equity share component).

Section 42 sometimes applies to the introduction of a South African holding company into a shareholding structure. Dividends paid by a South African company to such a holding company are exempt from both dividends tax and income tax. When the holding company disinvests from the investee company whose shares it acquired through an asset-for-share transaction, it is necessary to carefully assess whether the initial transaction satisfies all the requirements of section 42 and also be aware of the anti-dividend stripping rules in section 22B and paragraph 43A of the Eighth Schedule to the Income Tax Act.

Transfers of value to another person

The corporate rules are not intended to relieve the transfer of value to another person without tax consequences. The premise underlying the provisions is that the person ultimately retains the economic interest in the asset. Consistent with that premise, section 41(2) specifically states that the corporate rules do not override several provisions of the Income Tax Act, many of them anti-avoidance measures. This includes the value shifting rules in the Eighth Schedule to the Income Tax Act. These rules apply to arrangements that involve, amongst others, changes in the rights or entitlements to interests in a company (typically through shareholding) where the value of one person’s shareholding decreases while a connected person acquires an interest in that company, or the value of a connected person’s interest increases.

The corporate rules also do not override the anti-value mismatch rules in section 24BA of the Income Tax Act. This puts beyond doubt the position that these rules do not provide relief for the tax implications of value shifts. This provision applies to transactions where a company acquires an asset and issues its own shares to the transferor as consideration. This is the same type of transaction that section 42 may apply to. Section 24BA comes into play if the consideration (shares issued), before taking into account any other transaction, operation, scheme, agreement or understanding that directly or indirectly affects the consideration, differs from what would have applied had the transation been between independent persons dealing at arm’s length. Section 24BA deems a capital gain or dividend to arise, depending on the direction of the value mismatch. 

Donations tax also remains unaffected. This was arguably intentional seeing that the corporate rules not meant to provide relief to the tax implications of a value transfer to another person. Under section 58, a disposal of an asset for consideration that the Commissioner does not regard as adequate gives rise to a deemed donation. The deemed donation may attract donations tax.

Take-home message

In complex transactions involving section 42, it is critical to:

(a) establish the full details and economic effects of the transaction,

(b) identify all provisions of the Income Tax Act that may apply, and

(c) carefully assess their interrelated implications.

You can listen to more on this topic in Episode 81 of my podcast, Tax Break, at the link below: