South Africa’s Section 42 for Normal People

When normal people hear the phrase “a section 42 asset-for-share-transaction” the reaction is usually one of shallow breathing, panic and the urge to run away or stick forks in one’s eyes. Well today we explain this infamous and very useful section in simple language to see if we can calm the nerves. Section 42 of the South African (“SA”) Income Tax Act is a provision that deals with the tax consequences of exchanging one asset for another within a group scenario, in effect, an asset is exchanged for shares.

It is actually a very helpful provision because it delays the dreaded capital gains tax consequences (“CGT”) when you sell assets within a group. However, keep in mind that the South African Revenue Service (“SARS”) will not let you off the hook completely since the CGT will become payable at some stage, but as long as you stay within the rules, this tax event is postponed until the group decides to sell the asset or shares outside of the group.

Example

Let’s look at a real-life scenario: Farmer Brown has owned his farm for 15 years. He bought it from his neighbour for R2 million, and it has increased in value over the years and is now worth R10 million (lucky fish!). Farmer Brown has three sons and after his death he wants to leave the farm to all three of them, but because of the prohibition of the subdivision of agricultural land rules, it is an administrative nightmare to subdivide his farm to give each son a third.

Therefore, Farmer Brown sets up the Brown Family Trust and makes his three sons the beneficiaries of this discretionary trust. The Brown Family Trust incorporates a company of which it is the 100% shareholder.

Farmer Brown uses section 42 to transfer his farm into the name of the company, in exchange for 10% of the equity shares in the company. The benefits of using section 42 include that for tax purposes, the company is deemed to receive the farm at the original base cost of R2 million, and to have held the farm for the last 15 years.

Farmer Brown on the other hand is deemed to have received the 10% equity shares in the company for a base cost of R2 million, 15 years ago. Farmer Brown now updates his last will and testament and leaves his newly acquired 10% shares to the Brown Family Trust on his death. The end-result is that the beneficiaries of the Brown Family Trust will be the ultimate beneficial owners of the farm, and the transfer did not result in any tax costs immediately.

A key aspect to remember is that SARS will get its CGT when Farmer Brown dies, on the growth of the shares from the base cost of R2 million, to the market value of the shares on farmer Brown’s death.

There are certain requirements for the section 42 transaction to work, for instance farmer Brown needs to own at least 10% of the equity shares in the company by close of business on the day of the transaction, neither the farm nor the shares held by farmer Brown may be transferred within a year and a half, and certain other anti-avoidance provisions. However, the benefits are really great as Farmer Brown disposed of his farm at market value and received shares that are also worth the market value of the farm (R10 million).

The one downside is that if the company sells the farm (obviously after a year and a half to comply with the anti-avoidance provisions mentioned above), it will pay CGT on the full gain, since the date that the farm was acquired by Farmer Brown, being the sales price minus the base cost of R2million.

The same applies to the shares held by Farmer Brown. But thinking about it, if CGT was paid by Farmer Brown in the absence of the section 42 benefits, and again when the company sold years later, the gain would have worked out to be the same. Or even if the farm was kept by Farmer Brown and sold at the later date, the farm would have gained the same value.

So, in effect section 42 acts as a tax delaying mechanism. SARS will get its pound of flesh eventually; it just does not have to be right now while Farmer Brown is doing his estate planning.

Conclusion

The above explanation is very simple and there are many more anti-avoidance provisions and certain other tax provisions that could play a role in the treatment of the section 42 transaction, but for a normal person, we hope that this explanation drives away the panic brought on by hearing the term “section 42”. It remains essential to comply with the various requirements and seek professional advice when using this section. We can help with this.

PS. this newsletter forms part of our series on explaining complex tax concepts (transfer pricing and controlled foreign companies) to normal people.