The distinction between amounts received of a capital nature as opposed to a revenue (or income) nature is essential for income tax purposes. Non-capital amounts received, such as from the disposal of trading stock, are subject to tax at a higher effective rate compared to capital profits.
The primary intention with which an asset is acquired is generally conclusive as to the nature of the receipt arising from the realisation of a capital asset unless other factors intervene which show that it was sold in pursuance of a profit-making scheme. It is not uncommon though, that a person’s intention in regard to how they hold an asset, changes from when the asset was acquired, for whichever reason. Such a change in intention could result in unintended tax consequences.
Firstly, for capital gains tax (CGT) purposes, a change in intention to hold assets as trading stock will result in a deemed disposal of the assets on the date immediately before such a change in intention occurs. Such disposal will be deemed to take place at the market value of the assets at that time. The effect of this is that, even though there has been no actual disposal, the difference between base cost and market value of the assets concerned will be subject to CGT.Should the deemed disposal result in a capital gain, it could result in cash flow constraints since there are no actual cash proceeds from which to fund the tax liability which arises.
The second consequence is that the person will be treated as having immediately reacquired the asset at the same market value at which the deemed disposal occurred. After that, for income tax purposes, the cost of the trading stock is deemed to be the market value so that only the profit realised above that value will be subject to normal income tax. Any profit arising on a sale of the assets will therefore only be subject to income tax to the extent that the value of that asset has increased over and above the market value thereof when it became trading stock.
When the opposite occurs (i.e. assets that were previously held as trading stock, but are now to be held as capital assets), a person is treated as having disposed of the asset for an amount which included in that person’s income under the provisions dealing with trading stock, and immediately reacquired that asset for a cost equal to that amount. This cost is treated as an amount of expenditure actually incurred and paid for future CGT purposes.
The amount to be taken into account under the trading stock provisions depends on what the change in use entails:
- Private or domestic use or consumption: Cost, less any provision for obsolescence. If the cost price cannot be readily determined, use the market value; or
- Assets which cease to be held as trading stock: Market value
Apart from the income tax consequences, there could also be value-added tax and transfer duty consequences when there is a change in intention to how assets are held. It is advisable that when such an event occurs, the necessary professional assistance is obtained to manage potential pitfalls.