The Impact of Capital Gains Tax (CGT)

Since Capital Gains Tax (CGT) came into effect on 1st October 2001, taxpayers have woken up to a dark side of a complicated tax force whereby the disposal of assets by means of a sale, donation or expropriation, including emigration, death and a waiver of a debt may give rise to a CGT liability.

No contract (or variation of a contract), no business deal, no corporate reconstruction, no sale of investments, no waiver or reconstruction of a debt and no formation or variation of a trust should be entered into without a careful appraisal of the CGT consequences.

Potential franchisees may have considered the benefits of buying a franchise including the ability to invest surplus capital funds into a business that will increase sales and profits; save time in market development; use other people’s money and thus improving return on investment. After a period of time, an individual could then dispose of the business interest or sell the business as a going concern for a handsome price and gear the returns into other investments. Sounds like paradise, until SARS demands for a share of the pie.

Paragraph 57(1) of the Income Tax Act provides relief to small business persons who, instead of providing for their retirement, have reinvested their resources into their businesses. For the purpose of the paragraph, a “small business” means a business of which the market value of all its assets at the date of selling the asset, or interest in the business, does not exceed R5 million.

In establishing whether the business qualifies, one needs to consider the market value of all the assets, regardless of their nature and also regardless of the liabilities of the business. To qualify for this exclusion, a person’s TOTAL small business interests must not have a market value asset base of more than R5 million. The exemption amounts to R500 000 which means that amounts of up to this amount will be free of CGT when a small business is disposed of.

Selling of a small business can happen in the following legal entities or business forms:

1. Sole trader: In the case of a sole proprietor, a business might mean a “taxi business” or an ‘accounting firm’ or a “farming business” separate from all assets of the sole proprietor, for instance, a primary residence, household furniture, or an investment in unit trusts.

2. Partnership: This involves the disposal of an interest in each of the active business assets of a business, qualifying as a small business, owned by a partnership, upon that natural person’s withdrawal from that partnership to the extent his or her interest in that partnership

3. Company or Close Corporation (CC): This involves the disposal of an entire direct interest in a company or close corporation which consists of at least 10% of the equity of the company or CC, to the extent that the interest relates to active business assets of the company which must qualify as a small business.

 

The exclusion from CGT relates to the disposal of an “active business asset” which means an asset used or held wholly or exclusively for business purposes. It excludes a financial instrument or any asset held in the course of carrying on business mainly to derive any income in the form of any annuity, rental income, a foreign exchange gain or royalty or any income of a similar nature. The intention is to exclude assets generating a “passive” type of income and to rather target active business assets.

To qualify for the exemption the following conditions must be present:

  • The interest in the business must have been held for at least 5 years;
  • The person was substantially involved in the business, and
  • The person must realize all capital gains within a period of 24 months commencing on the date of the first disposal, and
  • The person must be at least 55; or
  • The disposal is due to ill-health, other infirmity or death.

 

Consider the following case study as an example…

On attaining the age of 55 in 2010, Elias wishes to retire. He operates a fleet of taxis in the Gauteng area as a sole proprietor and has done so for the past eight years. He remains actively involved in the operations of this business although he does not do any driving himself.

The original cost of these taxis amounted to R1 million. Elias owes nothing on these vehicles and they have been fully depreciated for tax purposes. He found a buyer for his business who takes it over “lock, stock and barrel” for R1.2 million in February of that particular year.

Elias is also substantially involved in a franchised fast food outlet in Balfour with a business partner, Fanie. They incorporated a close corporation and a company six years ago. The market value of this franchise business amounts to R2 million. A liability amounting to R750 000 in respect of a Franchise Start Up Loan facility granted by ABSA is still outstanding. The only other asset owned by the close corporation is a 100% shareholding in the company. The company’s only asset is the building, which is let to the close corporation for a market-related rental. The market value of these shares amounts to R1 750 000. Elias and Fanie each hold a 50% interest in the close corporation. Fanie purchases Elias’s interest in the close corporation upon his retirement for R1 800 000, 15 months after the disposal of his taxi business. The member’s interest originally cost each party R100 000.

Taxi business

 

Selling priceR1 200 000
RecoupmentR1 000 000
ProceedsR200 000
Base costNil
Original costR1 000 000
DepreciationR1 000 000
Capital gainR200 000

 

Franchise Fast Food:

Active business assets to total assets
(R2 m / (R2 m + R1,75 m)) = 53,33%

Proceeds attributable to active business assets
(R1,8 m x 53,33%) = R960 000

Base cost attributable to active business assets
(R100 000 x 53,33%) = R53 333

Capital gain attributable to active business assets = R906 667

 

Commentary

Elias is involved in two businesses, both qualifying as ‘small businesses’. He has attained the age of 55, has owned or held an interest in the active assets for more than five years, and has been substantially involved in the operations of both businesses. He may therefore disregard up to R500 000 of the capital gains realized provided that the disposals occur within a period of two years, which they do. Elias may therefore disregard the capital gain of R200 000 realized in the year that he disposed of his taxi business.

The following year he has no qualifying capital gains, but in the year after that he may disregard R300 000 (R500 000 – R200 000) of the qualifying capital gain realized upon the disposal of his interest in the close corporation. Notice that in this particular year his total capital gain amounts to R1 700 000 (R1 800 000 – R100 000, being the original interest). After deducting the R300 000 that may be disregarded, the balance of R1 400 000 will be subject to CGT.

It’s clear that CGT has an impact on business decisions for both franchisees and franchisors. Be sure to investigate all options and exemptions available before selling your business assets. This article was prepared by Maria Machial of Marican Asset Management.