LEX Ltd is a company that is incorporated in South Africa and is listed on the JSE Securities Exchange. LEX Ltd holds all of the issued share capital of RK (Pty) Ltd and of ART (Pty) Ltd and has done so since the dates of their incorporation.
All three companies are incorporated in South Africa as well as effectively managed in South Africa and are regarded as residents for South African taxation purposes. The companies are all involved in the motor manufacturing industry.
The three companies all have a 31 December financial year end and the pro-forma balance sheets of RK (Pty) Ltd and ART (Pty) Ltd for the financial year ended 31 December 2004 are summarised below:
ART (PTY) LTD
BALANCE SHEET AS AT 31 DECEMBER 2004
Note R million
ASSETS
Non-current assets 5 500
Loan due from fellow subsidiary
Fixed assets
1 0
5 500
Current assets 6 650
Accounts receivable
Inventories
Cash
2 500
1 750
2 400
Total assets 12 150
EQUITY AND LIABILITIES
Capital 7 305
Issued capital
Retained income
1 100
6 205
Current liabilities
Accounts payable 4 845
Total equity and liabilities 12 150
Note
1 The loan amounts to R125 million and comprises a capital element of R100 million and accrued interest of R25 million. The loan has been impaired as a result of the financial position of RK (Pty) Ltd. The impairment led the company to claim the R25 million as a bad debt deduction in terms of section 11(i) of the Income Tax Act in its year of assessment ended 31 December 2004.
The loan was originally advanced during the financial year ended 31 December 2002 and was funded out of surplus cash.
5
RK (PTY) LTD
BALANCE SHEET AS AT 31 DECEMBER 2004
Note R million
ASSETS
Non-current assets
Fixed assets
400
Current assets 910
Accounts receivable
Inventories
375
535
Total assets 1 310
EQUITY AND LIABILITIES
Capital 125
Issued capital
Retained deficit
Loan from fellow subsidiary
2
100
(100)
125
Current liabilities 1 185
Accounts payable
Bank overdraft
1 025
160
Total equity and liabilities 1 310
Notes
1 The company is in an assessed loss position for the year of assessment ended 31 December 2004 and is expected to have accumulated an assessed loss amounting to R55 million at the end of the year of assessment ending 31 December 2005.
2 RK (Pty) Ltd used the funds received from ART (Pty) Ltd to fund the acquisition of land and buildings that it utilised for purposes of its trade. Tax allowances have not been claimed on the buildings so acquired as they do not qualify for allowances in terms of the Income Tax Act. The R25 million interest expenditure incurred on the loan has however been claimed as a deduction in terms of section 11(a) of the Income Tax Act.
The financial director of LEX Ltd has proposed that ART (Pty) Ltd waive its right to recover the R125 million loan due from RK (Pty) Ltd. He envisages that the transaction would be concluded in April 2005. The purpose of the transaction would be to strengthen the balance sheet of RK (Pty) Ltd as the company has not been performing to expectations and is experiencing severe cash flow problems.
REQUIRED
Prepare a memorandum setting out, with full supporting reasons and reference to relevant provisions of the Income Tax Act, the potential taxation consequences arising from the proposed transaction from the perspectives of both ART (Pty) Ltd and RK (Pty) Ltd.
The memorandum should address any consequences with regard to normal tax, capital gains tax (CGT), donations tax and secondary tax on companies (STC) of the proposed transaction.