Effective date
Section 20A was inserted into the Act by section 36(1) of the Revenue Laws Amendment Act 45 of 2003 with effect from 1 March, 2004 and is applicable in respect of any year of assessment commencing on or after that date.
Impact on general deduction formula
Section 20A does not replace the purpose or the function of section 11(a) read with section 23(g). Thus an assessed loss from a trade could be disallowed in whole under section 11(a) read with section 23(g) if the activity carried on by the taxpayer is not a bona fide trade, and in such event section 20A will have no role to play. Section 20A comes into operation when assessed losses from a trade were allowed in earlier years of assessment. It is therefore applied after the application of sections 11(a) and 23(g) and provides a structure for determining whether or not a trade loss should be set off against other income, thereby reducing taxable income. Apart from specific circumstances, which will be dealt with later, a “ring-fenced” loss is not “lost” or “disallowed”; but merely carried forward to the next year of assessment and is available for set-off against any income derived from that specific trade in that year.
Applicable to natural persons only
The ring-fencing provisions only apply to an assessed loss from a trade carried on by a taxpayer who is a natural person. Natural persons trading in a partnership are thus included. Assessed losses incurred by companies, close corporations and trusts are not subject to the section 20A ring-fencing provisions. An individual who carries on a registered micro business contemplated in the Sixth Schedule to the Act will not generate an assessed loss from that micro business because all its receipts and accruals are exempt from tax under section 10(1)(zJ) and any deductions will accordingly be prohibited under section 23(f).
The four steps to ring-fencing
Section 20A contains four steps which determine whether an assessed loss can be ring-fenced. These are as follows:
Step 1 [section 20A(2)] – The maximum marginal rate of tax requirement
Step 2 [section 20A(2)(a) and (b)] – The “three-out-of-five-years” requirement or alternatively, the “listed suspect trade” requirement
Step 3 [section 20A(3)] – The “facts and circumstances” test (the escape clause)
Step 4 [section 20A(4)] – The “six-out-of-ten-years” requirement (the “catch all” provision)
Steps 1 and 2 are pre-requisites to potential ring-fencing.
Step 3 is an escape clause. In other words, an assessed loss that qualified for potential ring-fencing under steps 1 and 2 can escape ring-fencing under step 3.
Step 4 is a “catch all” provision that applies even if a taxpayer has escaped ring-fencing under step 3. It does, however, not apply to farming operations.
Step 1 – The “maximum marginal rate” requirement – Section 20A(2)
Under this step it is first necessary to adjust taxable income by adding back any assessed
loss and balance of assessed loss carried forward from the previous year of assessment.
If the amount so determined falls within the highest tax bracket for individuals, the taxpayer will have met the first step in the potential ring-fencing process.
Conversely, if the adjusted taxable income is below the level at which the maximum marginal rate of tax becomes payable, the assessed loss may not be ring-fenced, regardless of the number of years in which losses have been incurred and the the nature of the trade being carried on. In such event there is thus no need to proceed to steps 2 to 4.
The levels of taxable income above which the maximum marginal rate of tax becomes
payable are as follows:
Table 1 – Maximum marginal rate thresholds
| Year of assessment ending on the
last day of February |
Taxable income above which the maximum marginal rate of tax applies |
|---|---|
| 2005 | 270 000 |
| 2006 | 300 000 |
| 2007 | 400 000 |
| 2008 | 450 000 |
| 2009 | 490 000 |
| 2010 | 525 000 |
| 2011 | 552 000 |
Section 20A(2) makes no reference to either a “secondary” or “primary” trade or to “active” or “passive” income. The amount arrived at after adding back the assessed loss to taxable income can thus arise from any source. No distinction is made, for example, between a rental loss incurred by a person in receipt of pension and interest income or a rental loss incurred by either a person who is in full-time employment or a person conducting another trade as a sole proprietor.
Example 1 – Maximum marginal rate pre-requisite
Facts:
B, an individual under the age of 65, disclosed the following information in his 2010 return of income:
| R | |
|---|---|
| Employment income | 575 000 |
| Allowable deductions (Pension fund contributions) | (43 125) |
| Interest received | 25 000 |
| Capital gain before annual exclusion | 31 500 |
| The capital gain was made on the disposal of a fixed property.) | |
| Letting of property – Assessed loss incurred during 2010 year of assessment | (21 000) |
| (suspect trade) | |
| Balance of assessed loss brought forward from 2009 | (15 000) |
| For the 2010 year of assessment the maximum marginal rate is 40% on taxable income exceeding R525 000. | |
| Result | |
| R | |
| Taxable income from employment (R575 000 – R43 125) | 531 875 |
| Taxable interest (R25 000 – R21 000 exemption) | 4 000 |
| Taxable capital gain (R31 500 – R17 500 annual exclusion) x 25%* | 3 500 |
| Letting of property – assessed loss** | (21 000) |
| Balance of assessed loss brought forward from 2009** | (15 000) |
| Taxable | 503 375 |
| Add back: Assessed loss from letting of property | 21 000 |
| Add back: Balance of assessed loss brought forward from 2009 | 15 000 |
| Taxable income after adding back assessed losses [section 20A(2)] | 539 375 |
Notes:
R539 375 represents the taxable income after adding back the assessed loss incurred from letting of property during the 2010 year of assessment (R21 000) and the balance of assessed loss brought forward from the previous year of assessment (R15 000). This amount is used to determine whether the “maximum marginal rate” pre-requisite in section 20A(2) has been met. Since R539 375 exceeds R525 000 (the maximum marginal rate threshold), the taxpayer has met the first pre-requisite for potential ring-fencing.
* The taxable capital gain of R3 500 is included in taxable income under section 26A. (25% of the capital gain after first deducting the annual exclusion is included in taxable income under section 26A.)
** The assessed loss arising from letting of fixed property for the current year, and balance of assessed loss brought forward from the previous year of assessment are added to taxable income to determine the “sum of taxable income” referred to in section 20A(2).
Step 2 – Potential ring-fencing pre-requisites
Under step 2, a taxpayer will be subject to potential ring-fencing if either section 20A(2)(a) [the “three-out-of-five-years” pre-requisite] or section 20A(2)(b) [the suspect trade requirement] applies.
The “three-out-of-five-years” pre-requisite [section 20A(2)(a)]
Under section 20A(2)(a) an assessed loss will be subject to potential ring-fencing if assessed losses have been incurred in at least three out of the last five years of assessment.
The five year period includes the current and four previous years of assessment.
The “three-out-of-five-years” pre-requisite applies to a trade, that is not listed as a suspect trade in section 20A(2)(b).
A taxpayer who incurs assessed losses in the first three years of assessment in which the trade is carried on will be subject to potential ring-fencing in the third year, since even if profits are derived in years four and five the requirements of the pre-requisite will have been met. In other words, it is unnecessary to wait for five years before applying the provision. On the other hand, a profit made in any year of assessment delays potential ring-fencing.
Under section 20A(9) assessed losses incurred on or before 29 February 2004 are not taken into account. Thus the first year after the introduction of section 20A in which an assessed loss from a trade can be subject to potential ring-fencing is 2007, assuming that assessed losses were also incurred in the 2005 and 2006 years of assessment.
The “three-out-of-five-years” pre-requisite only triggers potential ring-fencing in the current year of assessment in which the requirements are met. Assessed losses allowed against other income in earlier years thus remain unaffected and the assessments for those years will not be revised as a result of a taxpayer being subject to ring-fencing in future years of assessment.
Example 2 – “Three-out-of-five-years” pre-requisite: Assessed losses incurred before the 2005 year of assessment
Facts:
On 1 March 2002 X, an individual, commenced carrying on a trade that is not listed as a suspect trade under section 20A(1)(b). The trade produced assessed losses in each of the 2003 to 2007 years of assessment. After adding back these assessed losses X’s taxable income was above the threshold at which the maximum marginal rate of tax becomes payable.
Result:
X has met the maximum marginal rate requirement in each year, thus satisfying the first requirement for potential ring-fencing.
Under section 20A(9) the assessed losses incurred in the 2003 and 2004 years of assessment must be disregarded for the purposes of applying the “three-out-of-five-years” pre-requisite. The assessed losses will therefore only become subject to potential ring-fencing in the 2007 year of assessment.
Example 3 – “Three-out-of-five-years” pre-requisite: Losses in three consecutive years of assessment
Facts:
On 1 June 2007 Z, an engineer, commenced making and installing steel gates and fences at private residences after hours and on weekends.
For the 2008, 2009 and 2010 years of assessment the amount arrived at after adding back to taxable income any assessed loss and balance of assessed loss exceeds the amount at which the maximum marginal rate of tax becomes payable.
The activities result in the following assessed losses: 2008: R12 300; 2009: R11 800 and 2010: R14 200.
Result:
Z has met the maximum marginal rate requirement in each year, thus satisfying the first requirement for potential ring-fencing.
The manufacture and installation of gates and fences is not a suspect trade listed in section 20A(2)(b) and the taxpayer is therefore subject to the “three-out-of-five years” pre-requisite in section 20A(2)(a).
Z has incurred assessed losses in three consecutive years of assessment commencing in the 2008 year of assessment. The “three-out-of-five years” pre-requisite is therefore met in the 2010 year of assessment. The assessed loss of R14 200 incurred in that year is therefore subject to potential ring-fencing.
Example 4 – “Three-out-of-five-years” pre-requisite: Counting of assessed losses in years in which the “maximum marginal rate of tax” pre-requisite does not apply
Facts:
On 1 March 2007 an individual commenced carrying on a trade that is not listed as a suspect trade under section 20A(1)(b). The trade produced assessed losses as follows: 2008: (R80 000); 2009: (R100 000); 2010: (R120 000); 2011: (R140 000). After adding back the assessed losses the taxpayer derived taxable income as follows: 2008: R180 000; 2009: R200 000; 2010: R400 000 and 2011: R560 000.
The taxable income above which the maximum marginal rate of tax applies is as follows: 2008: R450 000; 2009: R490 000; 2010: R525 000; and 2011: R552 000.
Result:
After adding back the assessed loss incurred in each year, the taxpayer’s taxable income for 2008, 2009 and 2010 fell under the level at which the maximum marginal rate of tax became payable. Thus, although the taxpayer met the “three-out-of-five-years” pre-requisite in 2010, the assessed loss for 2010 could not be ring-fenced because the first pre-requisite (the maximum marginal rate of tax pre-requisite) was not met in that year.
In the 2011 year of assessment the taxable income after adding back the assessed loss for that year exceeded the level at which the maximum marginal rate of tax becomes payable. The “three-out-of-five-years” pre-requisite has been met in 2011, since assessed losses were incurred in 2009, 2010 and 2011. The assessed losses in 2009 and 2010 are counted for the purposes of the pre-requisite notwithstanding that the taxpayer’s taxable income was below the level at which the maximum marginal rate of tax is payable in those years. However, only the 2011 assessed loss will be subject to potential ring-fencing.
Example 5 – “Three-out-of-five-years” pre-requisite: Delay of potential ring-fencing as a result of deriving a profit in a year of assessment
Facts:
B is employed on a full-time basis by a bank and has a part-time lawn-mowing business which is not a listed suspect trade. The lawn-mowing business produced the following results: 2005: (R7 000); 2006: (R5 000); 2007: R12 000; 2008: (R4 000); 2009: R5 000 and 2010: (R6 000).
After adding back the assessed losses from the business, B’s taxable income meets the maximum marginal rate of tax requirement in each year of assessment.
Result:
B has met the maximum marginal rate requirement in each year, thus satisfying the first requirement for potential ring-fencing.
Since a listed suspect trade is not being carried on, B is subject to the “three-out-of-five-years” pre-requisite under section 20A(2)(a), being the second requirement for potential ring-fencing.
The assessed losses incurred in 2005 and 2006 are not subject to ring-fencing as it is too soon to apply the “three-out-of-five-years” rule. The profit of R12 000 derived in 2007 has the effect of delaying potential ring-fencing by one year. In 2008 B meets the “three-out-of-five-years” pre-requisite, having incurred assessed losses in 2005, 2006 and 2008 (that is, in three out of four years). The 2008 assessed loss of R4 000 is carried forward and set off against the 2009 profit of R5 000. The assessed loss of R6 000 incurred in 2010 is also subject to ring-fencing because assessed losses have been incurred in three out of five years (2006, 2008 and 2010).
The assessments for the 2005 and 2006 years of assessment will not be amended to disallow the assessed losses that were set off in those years in calculating taxable income.
The “suspect trade” pre-requisite [section 20A(2)(b)]
Under the alternative to the “three-out-of-five-years” pre-requisite in step 2, an assessed loss that arises from any one of the eight suspect trades listed in section 20A(2)(b) will be subject to automatic potential ring-fencing.
Thus the first year of assessment in which an assessed loss from a suspect trade could be subject to potential ring-fencing is the 2005 year of assessment.
Each of the eight suspect trades contains either a qualifier or disqualifier indicating the circumstances in which that trade will be regarded as a suspect trade.
The trades comprising any sport, collectibles, animal showing, performing or creative arts and gambling or betting will be suspect if practised by the taxpayer or any relative of the taxpayer. Relatives of a taxpayer are included in order to address the situation in which that taxpayer conducts an activity in partnership with a relative.
Rental of residential accommodation, vehicles, aircraft or boats comprise a suspect trade unless 80% of the asset is used by persons who are not relatives of that person for at least half of the year of assessment.
Farming or animal breeding is a suspect trade unless such activities (including activities of a similar nature) are carried out on a full-time basis.
A trade that is excluded as a suspect trade will be subject to the “three-out-of-five-years” pre-requisite.
a) Any sport practised by the taxpayer or any relative of the taxpayer
Sporting activities in this category include any form of sport such as athletics, cricket, golf, rugby, soccer, water sports such as yachting, boat racing, water-skiing, scuba diving, country sports such as hunting and fishing. This category relates to sporting activities, which are physically practised by the taxpayer personally or by any relative of that taxpayer. The sport of racehorse ownership is, however, excluded as it is not usually physically carried on by the taxpayer or a relative of the taxpayer. The activity conducted by a racehorse owner will be subject to the “three-out-of-five-years” pre-requisite.
b) Dealing in collectibles by the taxpayer or any relative of the taxpayer
This category includes the dealing in art, antiques, cars, coins, militaria, notes, wine, stamps or any other object of interest to a collector.
c) Rental of residential accommodation
This category includes holiday homes, bed-and-breakfast establishments, guesthouses, dwelling houses or any other similar residential abode. An assessed loss arising from the rental of residential accommodation will arise from a suspect trade, unless
a t least 80% of the residential accommodation is used by persons who are not relatives in relation to that taxpayer; and
the accommodation is used by persons who are not relatives of the taxpayer for at least half of the year of assessment.
In order to be excluded as a suspect trade both the above requirements must be met.
The exclusion from the first bullet point could apply to the letting of 80% or more of a taxpayer’s main residence to non-relatives.
The reference to “for at least half of the year of assessment” can either be a continuous period of at least six months or other periods which in total are equal to at least six months.
The letting of 100% of residential accommodation to persons who are not relatives meets the “80% of the residential accommodation” exclusion. But to be excluded as a suspect trade, the property must also be occupied for at least six months, by persons who are not relatives of the taxpayer. The letting of a holiday home, which is used by the taxpayer or any relative of the taxpayer which is also let during the year of assessment on an occasional basis, for example, during peak seasons for less than six months, will therefore comprise a suspect trade.
Example 7 – Letting of residential accommodation
Facts:
During the 2010 year of assessment, B, for the first time let two rooms within her main home on a bed-and-breakfast basis. Each bedroom has its own en-suite bathroom. The total area of the house (including garages and outbuildings) is 420 square metres, while the area, which is let, is 120 square metres. The rooms were let to persons who are not relatives to B for a total of 300 days during the year of assessment. B incurred an assessed loss from this activity.
Result:
The area let to non-relatives, expressed as a percentage of the total area of the house, is 28.57% (120/420 x 100).
Since the first element has not been met, the rental activity is a suspect trade for the 2010 year of assessment. Even though the second element has been met, the activity will still be a suspect trade for the 2010 year of assessment because both requirements for exclusion have not been met.
d)Rental of vehicles, aircraft or boats
An assessed loss incurred by a taxpayer in respect of the rental of these movable assets may be subject to potential ring-fencing if less than 80% of the assets are leased for at least half of the year of assessment, by persons who are not relatives of the taxpayer. The calculation of 80% will, as in the case of the rental of residential accommodation, be relevant when any of the assets in this category are subject to private use by the taxpayer or any relatives. As in the case of residential accommodation, the requirements relating to 80% of the use of the assets, by persons who are not relatives, and for at least half of the year of assessment, must both be met before the trade will qualify for exclusion as a suspect trade.
e) Animal showing by the taxpayer or any relative of the taxpayer
This category relates to the showing of animals in competitions and includes the showing of animals such as horses, cattle, dogs and cats. Animal showing activities may form part of farming or animal breeding, if a taxpayer conducts those activities and the progeny is shown, for example, at agricultural shows or other animal shows as part of the farming or animal-breeding activities. In other words, the animal-showing activities must not be conducted by the taxpayer as a separate business and must be merely incidental to farming or animal breeding. The latter activities are dealt with in item (f) below.
f) Farming or animal-breeding, unless the person carries on farming, animal breeding or activities of a similar nature on a full-time basis
The meaning of the term “full-time” is not described in either section 1 or section 20A and will be discussed below.
g)
Any form of performing or creative arts practised by the taxpayer or a relative of the taxpayer
This includes, for example, acting, dancing, filmmaking, singing, photography, writing, pottery, painting, jewellery making, metal works, sculpturing, carpentry, architecture and music. This category requires the specific art to be practised by the taxpayer or any relative of the taxpayer and will therefore exclude the investment by a taxpayer, for example, in a commercial film, without being involved in the actual making of such film. For more information on the taxation of film owners, refer to the Guide on the Taxation of Film Owners on the SARS website.
h) Gambling or betting practised by the taxpayer or any relative of the taxpayer
This category includes card playing, gambling at a casino on a regular basis, lottery purchases and sports betting. Winnings in respect of systematic and regular betting transactions by a taxpayer who is also a racehorse owner may, in certain instances, be regarded as part of the income arising from the racing activities of the taxpayer. This includes betting on the owner’s horses and on the horses of others. The inclusion in gross income of winnings by racehorse owners under certain circumstances is based on their special knowledge and close connection to trainers, jockeys and other owners.
Gambling or betting does not include dealing in securities on securities exchanges such as the JSE. These activities fall into the “three-out-of-five-years” pre-requisite.
The ordinary meaning of “full-time”
Section 20A does not define the term “full-time”. Unless a statutory provision indicates otherwise, the meaning of words or phrases must be given their ordinary dictionary meaning having regard to the content and purpose of the specific provision. This section is aimed at ring-fencing sustained assessed losses in respect of certain activities which are carried on in addition to a taxpayer’s other income-generating activities. The meaning to be attached to the term “full-time” should therefore advance the purpose of the legislator in enacting the section. The reference to “that person” refers to the taxpayer, and the section indicates that, unless the taxpayer carries on farming or animal breeding on a full-time basis, the taxpayer’s activities will fall within the suspect trade category.
According to the New Shorter Oxford English Dictionary the term “full-time” is defined as
“the total normal working hours: occupying or using all one’s working time.”
Collins English Dictionary describes full-time as meaning
“for all of the normal working week, a full-time job”.
A taxpayer will thus be carrying on farming or animal breeding on a full-time basis if these activities take up most or all of the taxpayer’s normal working hours. Consequently SARS will regard farming or animal breeding activities which do not take up most or all of the taxpayer’s normal working hours, as activities which fall within the list of suspect trades under section 20A(2)(b).
Section 20A(2)(b) specifically indicates that that person should carry on the activities on a full-time basis. The words “that person” are a direct reference to the taxpayer and exclude any other person who may be managing the taxpayer’s farming or animal breeding activities on that taxpayer’s behalf.
A bona fide farming activity will not cease to be bona fide merely because the taxpayer conducts the activity on a part-time basis. The activity may still escape ring-fencing if there is a reasonable prospect of deriving taxable income within a reasonable period [section 20A(3)].
While all other trades listed as suspect trades in section 20A(2)(b) are subject to automatic ring-fencing when assessed losses have been incurred in six out of ten-years, farming on a full-time basis is excluded from this provision [section 20A(4)].
SA Tax Guide 