When a Hobby Becomes Taxing
When a Hobby Becomes Taxing
By Doria Cucciolillo, Assistant Manager
The first iteration of the 2025 National Budget documents, presented by the Minister of Finance on 19 February 2025, contained certain measures designed to broaden the tax base and improve the administration around tax collection, to raise additional revenue. When broadening a tax base, the aim is to increase the level of economic activity and number of entities that are subject to tax, which should result in a higher tax liabilities and collections. In an income tax context this can be done, amongst other things, by eliminating or limiting the income exempt from normal tax or the deductions permitted in determining taxable income.
An area that seems to have come under increasing scrutiny, is the extent to which taxpayers are permitted to utilise assessed losses in determining the taxable income that is subject to income tax. For years of assessment ending on or after 31 March 2023, a limitation was imposed on the extent that a company can set off an assessed loss carried forward from a previous year of assessment in determining its current year’s taxable income. The set off of such a carried forward assessed loss may not exceed the higher of R1 million or 80% of the taxable income (as determined before the application of such set-off) for that year of assessment. As this limitation was introduced to facilitate a reduction in the corporate tax rate from 28% to 27%, taxpayers other than companies, such as individuals and trusts, were shielded from this limitation and may still fully set off the balance of an assessed loss carried forward from a previous year of assessment in determining the current year’s taxable income.
In relation to the set off of assessed losses, individuals should be mindful of the assessed loss ring-fencing provisions of section 20A of the Income Tax Act. In determining the taxable income derived by an individual from carrying on a trade or a non-trade activity, any assessed loss incurred by that person during the same year of assessment in carrying on any other trade may generally be set off against the income from that trade. There are certain exceptions to this rule which, for example, prevent a person from setting off an assessed loss incurred in a foreign trade against income from a South African source or setting off any assessed loss incurred against income from a retirement fund lump sum benefit, retirement fund lump sum withdrawal benefit or severance benefit.
An individual who earns taxable income from carrying on a trade (such as a business or employment) or a non-trade activity may attempt to reduce or avoid paying normal tax by disguising an activity carried on for private or domestic purposes (i.e. a hobby) as a trade and setting off any assessed losses incurred in that artificial trade against his or her taxable income from other sources that would have otherwise been taxed. This treatment is particularly inappropriate as section 23(b) prohibits a deduction for private or domestic expenses.
Mainly to prevent these schemes, the current form of section 20A was introduced into the Act with effect from 1 March 2004. This provision prohibits certain individuals from setting of an assessed loss incurred during a year of assessment in carrying on a “suspect” trade from any income derived during the same year of assessment from any other trade or non-trade activity. Such a ring-fenced assessed loss can only be set off against income derived from that same suspect trade in a future year of assessment or amounts derived from the disposal of assets used in the trade after cessation of the trade. A suspect trade represents either a trade in which the natural person incurred an assessed loss (as determined before considering any balance of assessed loss carried forward) in at least three out of the five years of assessment ending on the last day of the current year of assessment or, regardless of the number of years in which an assessed loss was incurred, a trade that falls within the ambit of the specific suspect trade categories listed in section 20A(2)(b). There are 9 categories of suspect trades for which an assessed loss could potentially be ring-fenced. The trades are: sport practiced by the individual or any relative, dealing in collectibles by the individual or any relative, renting residential accommodation (or vehicles, aircraft or boats as defined in the Eighth Schedule to the Act) which is not used at least 80% by persons other than that person’s relatives for at least half of the year of assessment, animal showing by the individual or any relative, farming or animal breeding not carried on on a full-time basis, performing or creative arts practised by the individual or any relative, gambling or betting practiced by the individual or any relative and dealing in cryptocurrencies.
Interestingly, as is clear from the above list, the section 20A ring-fencing provisions could apply to an assessed loss incurred in respect of carrying on certain activities listed as a suspect trade even if a relative of an individual, rather than the individual him- or herself, performs the suspect trade activity. This could be the case if, for example, a person and his or her spouse jointly carries on a trade, with the one spouse practising a sport for reward and the other spouse financing the activities and attending to administrative matters and participating in the earnings on an agreed percentage basis. The income from the trade will accrue to each spouse in the agreed income-sharing proportions for income tax purposes, provided that these proportions reflect a reasonable reflection of the respective contributions of each spouse to the trade. If an assessed loss is incurred in this trade, each spouse will share in that assessed loss in the agreed income-sharing proportions. However, assessed losses incurred from such trade by either spouse would fall within the ambit of the list of suspect trades and potentially be subject to ring-fencing.
Despite a trade falling within the ambit of the aforementioned ‘three-out-of-five year’ loss rule or suspect trade category, a natural person may still qualify to set off an assessed loss incurred from carrying on the trade against income from other trade or non-trade activities, provided that such trade constitutes a business in respect of which there is a reasonable prospect of deriving taxable income (other than a taxable capital gain) within a reasonable period taking into account specific facts and circumstances prescribed in the Income Tax Act. The concession under this ‘facts and circumstances’ test is, however, not applicable in respect of a trade (other than farming) if the person has incurred an assessed loss in carrying on that trade (as determined before considering any balance of assessed loss carried forward) in at least six out of the ten years of assessment ending on the last day of the current year of assessment.
Importantly, the assessed loss ring-fencing provisions presently only apply to an individual that is subject to income tax at the maximum marginal rate. Thus, in determining if the assessed loss from a suspect trade is potentially ring-fenced, the first step is to determine if the person’s taxable income for the year of assessment in question (as determined before taking into account any assessed loss incurred from any trade in the current year and/or any balance of assessed loss carried forward from a previous year of assessment) is equal to or exceeds the threshold at which normal tax at the maximum rate becomes payable. For the 2026 year of assessment this would be the case if the person’s taxable income, before the set off of any assessed loss or balance of assessed loss carried forward, is R1 817 001 or more. When it was first enacted, the rationale for confining the assessed loss ring-fencing provisions to individuals earning in the highest band of taxable income was the presumption that such individuals would have greater means of disguising a hobby as a trade.
In the 2025 National Budget, as presented on 21 May 2025, National Treasury noted that the section 20A ring-fencing provisions still enable those falling below the maximum marginal normal tax rate to erode the tax base by continuously offsetting losses from certain suspect trades against other sources of income. In particular, it noted that the fiscus suffers substantial losses through refunds of prepaid taxes constituting employees’ tax, which often occurs due to individuals setting of assessed losses from suspect trades against taxable income derived from employment. To close this loophole, National Treasury proposed reviewing and amending the current threshold at which the assessed loss ring-fencing provisions are applied.
It is anticipated that National Treasury will thus propose lowering the taxable income threshold at which section 20A applies. Individuals who earn the types of income referred to above, regardless of their level of taxable income, should therefore keep themselves apprised of developments later in the year. In this regard, the Draft Taxation Laws Amendment Bill is likely to be released for public comment around the beginning of July and the final version of the Bill is likely to be tabled around the end of October.