Tax and the thoroughbred racing industry
THE following items might be of interest to racehorse owners and breeders.
New ring fencing legislation came into effect from 1 March 2004.
The horseracing industry – in a pleasing display of unity – made submissions to both SARS and Treasury in an attempt to communicate the economic impact of the new legislation and the serious negative consequences realistically expected by our industry. Those submissions, made on behalf of horseracing by Basil Thomas and his legal colleague Ivor Evans had positive results. Horseracing was removed from the list of “Suspect Trades”.
Here are some suggestions for ways that owners and part-time breeders can alleviate the adverse effects of the legislation. NOTE: This overview was first published a few years ago and Thomas reports that the legislation is now in its mature phase.
By Basil Thomas
WE HAD considerable success in our negotiations with SARS and Treasury that culminated in our representations to the Parliamentary Portfolio Committee. Being removed from the Suspect Trades list was a major victory. But the problem has certainly not gone away. We still fall squarely under the scrutiny of Section 20A Subsection (2) (a).
Section 20A Subsection (2) (a) reads “….that person has, during the five-year period ending on the last day of that year of assessment, incurred an assessed loss in at least three years of assessment in carrying on the trade (the “Secondary Trade”) contemplated in subsection (1)…”
In other words, we still fall under what is known as the “three-out-of-five-year-rule”.
The legislation does provide an “escape route” in Section 20A Subsection (3). The subsection concerned is a little lengthy to repeat here, but I would urge all owners and part-time breeders to make themselves familiar with the contents thereof.
Essentially, the Ring Fencing MAY not apply to losses “where that trade constitutes a business in respect of which there is a reasonable prospect of deriving taxable income (other than taxable capital gain) within a reasonable period having special regard to…”
It then goes on to detail a number of activities and applications that the taxpayer would be required to demonstrate exist.
Therefore, it is very important to look at every possible means to avoid ANY loss year being categorised as a loss year under the three-out-of-five-year rule. That approach should apply from Year One. For example, it may be that over the next seven years, five of those years (including year seven) reflect losses. However, if one is able to satisfy the Commissioner that two of the loss years should not apply for reasons explained, then in fact the ring fencing will be deferred until year seven.
Our objective should be to defer the impact of the legislation or avoid it completely.
How do we go about doing this? Firstly, make yourself familiar with the contents of Section 20A Subsection (3). Secondly, conduct your affairs (in particular, your accounting records) with the “escape route” in mind.
We have been continuing our interactions and negotiations with SARS and have received assurances that our submissions will be taken into account – and have been promised the opportunity to review and comment on the draft before publication.
Our submissions attempt to explain some of the unique circumstances and events applicable to the horse racing industry that should be taken into account in determining whether a loss year should fall under the umbrella of Section 20A Subsection (2) (a) (The three-out-of-five-year rule). Although lengthy, it may serve a good purpose to share some extracts from those submissions.
This will give a stimulus to how we should be thinking and how we should be maintaining our accounting records. We should be doing all that is possible to exclude from the application of Section 20A all those factors and events that have “prevented” a profit from being realised.
These submissions have not been accepted or endorsed by SARS at this stage. They may be rejected in part or in totality.
FACTORS TO BE TAKEN INTO ACCOUNT WHEN ASSESSING LOSSES INCURRED BY RACE HORSE OWNERS AND PART-TIME RACE HORSE BREEDERS
1. Wear-and-Tear Allowances
Without a doubt, the most important submission that we wish to make in this regard is:
1.1 Racehorses, stallions and mares do not have a common value – far from it.
1.2 It is true that a number of them, through their achievements on the racetrack or at stud, have the potential to earn considerable revenue for their owners and in certain cases their value will exceed their original cost.
1.3 However, generally speaking these animals are unlikely to achieve a material recoupment on sale or disposal at the end of their careers. In this regard they differ significantly from other livestock.
1.4 The owner in selection takes great care and without doubt, PROFIT is the main objective. However, the capabilities and realisation of potential will only be determined by the passage of time.
1.5 It is an inescapable and established reality that in many cases it is only the application of the Wear-and-Tear Allowances that brings about the Net Loss situation. Here follows the conundrum. The W&T Allowances accurately portray the depreciating value of the majority of horses and should therefore be appropriately applied from an accounting point of view. Yet, the pursuit of profit unquestionably exists and in many cases, a cash profit (excluding W&T) results.
1.6 We respectfully submit that in terms of the discretion available under subsection (3) it would be reasonable to apply the following:
1.6.1 If in any loss year, but for the deduction of the Wear-and-Tear Allowances, a profit would have resulted – then such year shall NOT be considered a loss year in terms of Sect 20A Subsection 2(a).
1.6.2 If in any loss year, after ignoring the deduction of the Wear-and-Tear Allowances, a loss still results – then such year SHALL be considered a loss year in terms of Sect 20A Subsection 2(a) - unless the taxpayer is able to satisfy SARS that other legitimate facts and circumstances exist to prevent such determination.
2. Cumulative Profit/Loss
Notwithstanding the provisions of Subsection 3(a), we respectfully submit that the cumulative profit/loss is relevant. For example:
2.1 Tax year 2005 – loss R5000; Tax year 2006 – profit R50000; Tax year 2007 – loss R15000; Tax year 2008 – loss R R12000.
2.2 In terms of subsection 3(a), ring fencing is applied in 2008 (third loss year).
2.3 However, cumulative PROFIT is R18000.
2.4 The following would be appropriate:
If at the time that a third loss year (within a five-year period) has occurred, a cumulative profit exists for the same period, then the ring fencing under subsection 2(a) will not be applied.
3. Two-year-olds
3.1 Most frequently, horses are purchased as yearlings.
3.2 The standard birth date for horses in the Southern Hemisphere is 1 August (ie all horses become a year older on 1 August regardless of their actual date of birth). The obvious result is a variation in the development and maturity of all horses
3.3 Horses are not allowed to race until they are two. In practise, races for two-year-olds are only programmed from January. Accordingly, there is every likelihood that in the tax year ended 28 February, a two-year-old will be either unraced or will have only raced once or twice at the most.
3.4 Taking into account the costs incurred in maintaining and training the horse from date of purchase to 28 February of the year when the horse has turned two, it is simply impossible (or at best, extremely rare) for a profit on that particular animal to be achieved.
3.5 Accordingly, we respectfully submit that the trading losses incurred in the first two years of a horse’s life should be disregarded.
4. Mares
4.1 The covering season for mares is seasonal and limited.
4.2 A mare that is not impregnated in this period has no prospect of earning a profit. The same consequence applies to mares which “slip”, miscarry or abort in the year of assessment.
4.3 We ask that the trading losses of mares that have not produced a foal in the year of assessment should appropriately be disregarded.
5. Exceptional/Unusual Events or Circumstances
Exceptional or unusual circumstances that may apply in this industry include the following:
5.1 Severe and/or protracted illness preventing the ability to race and earn income;
5.2 Exceptional veterinary expenses relating to 5.1 above;
5.3 Equine flu on a regional or national basis. This has occurred on two occasions in the recent past – resulting in the cancellation of the racing programme and the quarantining of horses;
5.4 Exceptional weather conditions resulting in the curtailment of the racing programme and the consequent limitation of income earning opportunities. (As a guideline, a horse should participate in at least six races per year to have a reasonable prospect of recording a trading profit).
Accordingly, we would recommend that the following factors be taken into account when assessing losses:
5.a Whether, having regard for sickness or injury suffered by a racehorse which prevents it from racing less then six times in the year of assessment, losses incurred in respect of that year should be disregarded.
5.b Whether having regard for extraordinary circumstances including without limitation, generalised disease or weather, which prevent a racehorse from running so that it is denied an opportunity to earn an income, losses incurred by that racehorse for the duration of the extraordinary circumstances should be disregarded.
5.c Whether for reasons beyond the taxpayer's control, his racehorse has been prevented from running in at least six events in any year of assessment.
5.d Whether, having regard for any generalised disease, a part‑time racehorse breeder has been impeded in his business, for example but without limitation, through being unable to mate racehorses or to sell racehorses or to export racehorses, a loss in any year in any relevant five-year period should be disregarded.
5.e Whether any loss sustained in any relevant year of assessment by any racehorse owner or part‑time racehorse breeder is too small, having regard for the scope of the business operation in question.
The above will give some idea of our thinking and our approach. The bottom line is: why has a loss year resulted? What factors, events and circumstances can we highlight to convince SARS that, but for their occurrence, a profit would likely have been achieved, or will likely be achieved in the foreseeable future? I strongly recommend that owners and part-time breeders should get into that mindset right now and not wait for 2007 or the third “loss year”.
As our interactions and negotiations with SARS continue, we will keep you informed of progress.
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RINGFENCING OF SECONDARY TRADES
Basil Thomas posed a few questions to the Commissioner for the South African Revenue Service. Here is J Pietersen’s response.
Our meeting dated 26 February 2007, as well as previous discussions and correspondence refer.
Below are my comments on the specific issues raised by you on behalf of race horse owners and part time race horse breeders.
1. Question: Will section 20A(3) of the Income Tax Act (the Act) be considered in the first year of a trade being carried on?
Answer:No. Section 20A(1) of the Act requires that "subject to subsection (3), where the circumstances in subsection (2) apply ..." It follows that subsection (1) must be tested to the exclusion contained in subsection (3). Subsection (1) only comes into play if the circumstances in subsection (2) apply. These circumstances are:
- Assessed losses (see definition of section 20) have been incurred in 3 out of 5 years;
OR
- Suspect trades
Subsection (3) therefore needs consideration only if the circumstances under (2) apply. Subsection (3) is designed to exclude a trade from the ring fencing provisions if it is considered to be viable. It would be superfluous to measure a trade in the first year of operation against profitability if the "circumstances in subsection (2)" do not apply.
2. Question: Will the losses that a trade has incurred in three out of five years as envisaged by subsection (2)(a) be ring-fenced permanently?
Answer: No, the losses are not ring fenced permanently. Each 5 year period will be considered independently. Future losses will not be ring-fenced unless a third loss occurred in a (new) five-year period.
Example: ZX, an engineer, commences with a part-time activity in which he makes and installs steel gates and fences at private residences after hours and/or during weekends. This activity is not a listed suspect trade in subsection (2)(b) and is therefore subject to the 3 out of 5-year rule in terms of subsection (2)(a). Assume for the purposes of the example that the taxable income is subject to the maximum marginal rate of tax. The activities result in:-
Year Current Current Assessed
of year year loss
Assessment profit (R) loss (R) carried
forward
2005 12 300 No ring-fencing
2006 11 800 No ring-fencing
2007 14 200 No ring-fencing
2008 500 No ring-fencing
2009 20 000 20 000 Third loss in 5 years
2010 15 000 5 000 R20 000 - R15000
2011 11 000 5 000
1. No ring-fencing - second loss in a five-year period (s29A(2)2. Assessed loss carried forward s29A(5)
2012 9 000 14 000 Third loss in 5 years
3. Question: How will the fact that a profit was made in one year in a five year cycle, influence the application of the "facts and circumstances" test in the following loss years?
Answer: The "facts and circumstances" test consist of a set of factors to which special regard must be given and is an objective test. Whether there is a reasonable prospect of deriving taxable income within a reasonable period will be determined taking into account the facts and circumstances of the specific trade, in this instance, the horse racing industry. The "facts and circumstances" test list a set of factors to which special regard must be given, these factors tend to take the commercial realities into account, concentrating on the fact that there is no abnormal factors or conditions present. A profit year is a factor that will be taken into account, but will not be a decisive factor in evaluating all the facts and circumstances.
4. Question: What factors will be taken into account when assessing losses incurred by race horse owners and part-time horse breeders?
Answer: All the factors listed in section 20A(3) will be taken into account. A single factor will not be viewed in isolation in determining whether the trade constitutes a business with a prospect of deriving a taxable income, it will be viewed in combination with all relevant factors. The fact that there is or may be a reasonable prospect to generate taxable income within a reasonable period, does not give rise to a particular loss being disregarded. A loss year is a loss year the purposes of section 20A(2)(a) and will remain as such. The application of section 20A(3) becomes a factor when a third loss has occurred in a five-year period.
- A loss attributable to a specific timing difference created by the difference between wear and tear/depreciation for accounting and tax purposes may be an indication that there is a reasonable expectation that taxable income will be derived within a reasonable period.
- Losses attributable to yearlings and two-year-olds will not be detrimental to a race horse owners, provided all the requirements of the "facts and circumstances" are met.
- It is accepted that mares that have not produced a foal in the year of assessment will have an impact on the business and may result in a loss year. These are however factors that should be evaluated over a reasonable period and not only in the specific year of assessment. Factors of this nature would generally be built into business models that are based on a profit motive. No factor can stand on its own but should be evaluated in conjunction with all the other underlying factors that will have an influence on the prospects of deriving taxable income from the business.
- It is accepted that exceptional/unusual events or circumstance, for example equine flu, weather conditions, veterinary expenses, etc. will have an impact on the business and may be the result of losses in a specific year or years of assessment. The reason for the loss will be taken into account, but in evaluating the ability to derive taxable income one should have regard to the nature of the business and not have fanciful expectations of profitability or take every potential risk that would not normally be considered as prudent, into account. The test is one of reasonableness, i.e. factors that one can reasonably expect to prevail.
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(The following is published with the kind consent of Moneyweb from its Tax Breaks newsletter)
By Dr Philip Theunissen
NOT ALL incomes are taxable. Some forms of income are usually taxable, while others are only taxable in specific cases. There are also permissible deductions that can be made, and some forms of income are tax free. There’s a basic formula according to which the taxpayer can determine his or her taxable income for a specific time period.
According to this formula, the permissible expenses are deducted from the total income earned for a specific time period. This brings the taxpayer first to his or her gross income, then to income and then to the taxable income or calculated loss.
According to this basic definition, a person’s total income was taxed, which implied that losses from one of his or her businesses could be offset against the profits of his or her other businesses.
In this way, part time farmers who continuously expanded their operations were able to build up a farming loss that could be deducted from their other forms of income. This resulted in many medical doctors, attorneys, accountants, marketing agents and other professionals using farming operations to create assessed losses.
By definition, costs and losses incurred for the generation of income for a given tax period are allowed, provided they were incurred by a South African citizen via a practice of a non-capital nature.
The Receiver, however, finds it problematic that not all "activities" are approached with the right bona fides. For this reason, the new legislation aims to curb this particular tax benefit of professionals; such part-time activities are now classified as suspect activities.
The result is that the losses incurred through these activities can only be offset against the profits from the same activities, and not against the profits of other activities. The losses of the suspect activities are thus curbed and separately accumulated until these activities start showing profits. At this point, the loss can be applied against taxable income, but it may under no circumstances be deducted from the taxpayer’s main practice.
GENERAL APPLICATION
Several circumstances must be present before ring fencing can apply. Firstly, the taxpayer must be a natural person whose taxable income is subject to the maximum marginal rate before taking any assessed losses into account. If this is the case, then either:
1) There must have been assessed losses from the secondary activities in at least three of the past five years, or
2) The secondary activities must be one of the designated group, which for convenience may be described as "suspect activities" (see below).
If either of these conditions is present, then, unless there is a "reasonable prospect" (see below) of deriving taxable income within a reasonable period from the secondary trade, losses from it are ring fenced and may only be set off against future income from that secondary trade.
This regulation will become effective from the 2004/2005 tax year, and losses before then will not be taken into account. If an activity has once been declared suspect, its status can also not be changed, and it will be considered as such for the remainder of the taxpayer’s lifespan.
Despite the three-losses-in-five-years test, there is a further category in which certain activities are declared suspect beforehand. Where these activities are concerned, taxpayers will find that they won’t be able to apply losses as deductions against profits from other activities, and this is already so for the current tax year (2004/2005). These activities include the following:
· Sport
· Trade in collectors’ items
· Leasing living units, except in cases where at least 80 percent of the unit is occupied by a person who is not a family member of the taxpayer
· Leasing of vehicles, aircraft and boats, except in cases where at least 80 percent of the asset is used by a person who is not a family member of the tax-payer
· Showing of animals in competitions
· Farming or breeding of animals other than on a full-time basis
· Performing arts such as acting, singing, painting, photography, pottery etc
· Gambling and betting.
The owners of racing horses are specifically excluded from these activities. The Portfolio Committee on Finance was of the opinion that the horseracing industry is almost exclusively run by part-time owners and that the contribution this practice makes to the general economy justifies that such activities should not be declared suspect.
ESCAPE ROUTE
Despite the stipulations already discussed, there is an escape route taxpayers can follow so that their secondary activities are not declared suspect. For this escape plan the taxpayer will have to provide proof that his or her secondary practice is legal and has a good chance of becoming profitable in future.
The rule of thumb is that the secondary practice should rather display the characteristics of a "business" than a "hobby". There must then be fair expectations that the business will become profitable within a fair period of time, and the following acts and situations will be key:
- The relationship of losses to income. If the taxpayer has a small gross income but accompanying large losses, it points to a risk for the Receiver, and it will be declared suspect.
- Advertising and marketing. A typical business that shows losses at first will advertise and market with the aim to attract profits at a later stage. In comparison, a hobby is seldom advertised or marketed with the aim of building a client base.
- Running of a business. The characteristic will be that the activities surrounding it will be indicative of a business, and the following factors will be taken into account:
· The number of full-time employees
· The position of the business (business site versus a cottage in the garden)
· The number and value of equipment used
· The amount of time the taxpayer spends on the business
· The ratio of the number of years showing losses versus the number of years showing profit
· The future business plan of the practice
· The availability of the business’ assets for passing time of entertainment.
The escape route cannot be used in cases where the secondary practice has suffered six losses during the past 10 years. If this is the case, the secondary practice doesn’t pass the test and will be classified as suspect.
The supporting argument is that a person who has the intention to run a profitable business will not persist if it is continuously showing a loss. In comparison, a person who practices a hobby will persist with it even against a loss. Losses that were incurred up until 29 February 2004 will not be brought into consideration for this aim
