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Elephant trap

22 January 2009

Its not at all uncommon for organisations to purchase property to develop an office block or factory for their own use and then to have events (such as a dotcom bubble or a sub-prime crisis) overtake them, so that the original plans are put on hold. Its also common for those original plans eventually to be completely abandoned and for the organisation to decide that the office block etc should be erected elsewhere and that the original property should be developed and sold for profit.

Now, such a chain of events will usually result in part of the profit from the sale of the developed property being taxed at the normal corporate income tax rate of 28%, instead of the capital gains tax (CGT) rate of 14%. The reasons for this treatment flow from the basic rules of tax law and I don't propose to explain them here, other than to caution that the scale of the development is critical in determining whether any profit is taxed at the higher rate. Simply, if you sell the land undeveloped all the profit will be subject only to CGT, but if you develop to the extent of building (for example) mini-factories to maximise your profits, you trigger income tax. What I really want to highlight is a detailed rule which falls into the elephant trap category... i.e. something to be carefully observed from a distance and then dealt with appropriately! As an aside, much tax planning falls into the category of avoiding elephant traps in the tax law, rather than thinking of cunning devices to fool the taxman!

The point is this: when our hypothetical organisation purchased the land for development and use, it acquired it as a capital asset and established a CGT base cost for tax purposes. When it changed its intention to develop for profit, it transmuted the capital asset into a trading asset (stock) and triggered a CGT event in terms of the CGT rules. These rules say that you take the market value of the land at the time that change occurs, deduct the base cost (essentially the purchase price) and pay tax at the 14% rate on that 'profit'. The balance of the profit is taxed at the 28% rate. Now, this is both a good thing and a bad thing -- the good part is that before the CGT system arrived the entire profit on sale of the developed land would have been taxed at the higher income tax rate -- the bad part is that the CGT event will typically be triggered long before the property has been sold, so there may be no cash flow to pay the tax on assessment for that tax year. Additionally, most taxpayers would not be aware of this rule until the property had been sold and their accountant prepared their tax return for that year, which probably means that the CGT would be paid late and interest and penalty would be levied!

When does the CGT trigger get pulled in this scenario? Is it when the organisation 'changes its mind' and decides to develop for sale rather than for use (as I loosely suggested above)? Or is it when actual development starts, which might be months or years later? In my view its the later date (although the point has never been considered by our tax courts) -- the tax law looks at the time the organisation 'crosses the Rubicon' to actively being a developer and that is generally when physical development of the property commences. So, if you are in this kind of situation (and it also applies to individuals inheriting property and developing it), be aware that your celebratory 'breaking ground' ceremony could mask the sound of you falling into the elephant trap by not recognising the CGT event and paying the tax on time.
The University of Cape Town now offers a one day Property Tax workshop in Cape Town and Johannesburg, which is presented by David Clegg, property tax specialist. This workshop is ideal for accountants, attorneys, property investors and others wanting to learn about the complexities of income tax, capital gains tax, VAT and other property tax legislations. Please contact Christina at christina@getsmarter.co.za or on 021 683 3633 for more information.



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