Three strikes, you’re out
Revenue takes its cutters to ring-fencing
FIVE TAX YEARS have now elapsed since the South African Revenue Service introduced its ring-fencing provisions, and the taxman is wasting no time in sending assessments to taxpayers engaged in loss-making secondary trades, particularly those it considers “suspect”, says Bernard Sacks, tax partner at tax, audit and advisory firm Mazars Moores Rowland.
Ring-fencing provisions were introduced into SA’s Income Tax Act with effect from the 2005 tax year. It ring-fences assessed losses of individuals in the highest tax bracket in certain circumstances. Those provisions were introduced in order to prevent the perceived abuse by taxpayers reducing their taxable income by claiming losses from hobbies disguised as secondary trades, such as farming.
To provide affected individuals with a better understanding of what ring-fencing is, and also to enable them to determine how and to what extent the provisions may affect their personal income tax liability, Revenue published a guide on its website that sets out how it interprets the legislation and provides some practical examples and responses to frequently asked questions.
In dealing with the issue of what constitutes ring-fencing, Revenue refers to it as “an anti-avoidance measure, in terms of which the expenditure incurred in conducting a trade is limited to the income from that specific trade. Any excess expenditure (loss) is then carried forward and is set off against any income derived from that trade in a subsequent year of assessment”.
The ring-fencing provisions are applicable to natural persons only. It therefore includes natural persons trading in a partnership. Assessed losses incurred by companies, close corporations and trusts aren’t subject to those ring-fencing provisions.
“As a general rule losses from one trade can be set off against profits in another, unless that trade makes a loss three years out of five or is considered ‘suspect’ by Revenue,” says Sacks.
Suspect trades include any sport practised by the taxpayer or a relative; dealings in collectibles; animal showing; any form of performing or creative arts; any form of gambling or betting; and the rental of residential accommodation, vehicles, aircraft or boats as defined in the Income Tax Act (unless at least 80% of the residential accommodation, vehicles, aircraft or boats are used by persons who aren’t relatives of that person for at least half of the year of assessment).
If the operation makes a loss three years out of five, Revenue will ring-fence the third year’s loss and only allow it to be set off against taxable income from that specific trade. It will not set it off against the taxpayer’s income from other trades.
Sacks says the onus is on the taxpayer to object to an assessment from Revenue ringfencing a loss. The legislation allows for ringfencing to be waived if the taxpayer can show the enterprise has a “reasonable prospect” of making a profit within a reasonable time period. “However, if the trade is considered ‘suspect’ and losses have been incurred in six years out of 10, the reasonable prospect rule can’t apply to the benefit of the taxpayer.” The exception to that rule is farming.
In making a “reasonable prospect” case, Revenue would want to see proof of things such as the gross income from the trade, the nature of the business, the level of activity carried on, business plans, details of employees, unexpected events giving rise to losses and details of advertising, promotion and selling expenses.
“In other words, Revenue wants to see whether the trade is carried on in a commercial manner,” says Sacks. Where an assessment that ring-fences an assessed loss is issued to a person, that person has a right to object to the relevant assessment if he isn’t satisfied with the decision made by Revenue.
If the objection is disallowed or partially disallowed that person has the right to lodge an appeal against such disallowance or partial disallowance. Information regarding the objection and appeal procedures is available on Revenue’s website under “dispute resolution” or can be obtained from any Revenue branch office.
Onus on taxpayer to object to an assessment. Bernard Sacks