By Pieter van der Zwan
Difficult economic times may invariably lead to some debts becoming irrecoverable. The irrevocability of a debt has tax consequences for both the lender and borrower. These tax implications become more complex if the debt was denominated in a foreign currency. The South African Revenue Service (SARS) recently issued a draft interpretation note that deals with gains or losses on foreign exchange transactions (draft IN). Amongst others, this draft IN provides some insight into SARS’ views on the treatment of exchange differences on debts that are not recoverable.
The perspective of the lender
A lender would essentially be entitled to deduct losses in respect irrecoverable debts in terms of three provisions, other than section 24I. These are:
- trading losses suffered as a result of bad debts by money-lenders (s 11(a)), or
- debts arising from amounts that constituted income may qualify for an allowance when doubtful (s 11(j)) or a deduction when it becomes bad (s 11(i)).
Where any of these provisions allow for a deduction or allowance in respect of a loss on a debt, the draft IN states that the loss should be determined in the foreign currency of the debt and translated to ZAR at the spot rate. The result is an automatic reversal of unrealised exchange gains or losses previously taken into account on the bad portion of the debt.
The same logic should however also be applied where a foreign denominated debt that became bad does not qualify for a deduction or allowance. The exchange differences previously taken into account do not qualify for the deduction or allowance as the respective provisions apply to the underlying transaction that gave rise to the debt, as opposed to the exchange differences on it. This means that where a foreign denominated loan that did not arise from a transaction that gave rise to income by a person who does not carry on a money-lending business becomes bad, the lender cannot reverse the effect of unrealised exchange differences on the debt as it is not entitled to a deduction for the bad debt itself. For years of assessment ending on or after 1 January 2017, a specific provision (s 24I(4)) has been introduced to allow for unrealised exchange gains to be deducted when the underlying debt becomes bad, but also for exchange losses to be recouped, if no other deduction under s 11 applies.
The perspective of the borrower
Specific rules that deal with reductions of debt exist. The definition of the reduction amount, which may trigger recoupments or have capital gains tax implications, contains no specific guidance in relation to foreign denominated debts. SARS’ view is that the reduction amount should be determined in the foreign currency of the debt and then translated to ZAR at the spot rate.
The draft IN suggests that this has the effect that the borrower who benefits from a reduction would need to recoup unrealised exchange losses previously taken into account on the reduced debt (under s 8(4)(a) as opposed to s 19). No mechanism exists to reverse the effect of unrealised exchange gains previously taken into account for tax purposes on the reduced debt.
This recoupment introduces a cost that potentially distressed borrowers should be bear in mind when dealing with arrangements that have the effect of reducing debts.