The sale and purchase of a business as a going concern is a common commercial occurrence.
Typically, a sale and purchase agreement provides for the delegation of liabilities, including contingent liabilities, of the seller to the purchaser, while in some circumstances these liabilities remain with and fall to be discharged by the seller. In South Africa, when liabilities are delegated to the purchaser, the question arises as to whether the seller or the purchaser is entitled to claim a tax deduction in respect of the discharge of the contingent liability.
No deduction allowed
In A Co. Limited and Another v Commissioner for the South African Revenue Service, the seller argued that it had realized a loss upon the delegation of contingent liabilities to the purchaser which should be deductible in terms of section 11(a) of the Income Tax Act. The loss arose on the basis that the seller would, instead of receiving payment for the full value of all the assets, only be entitled to an amount equal to the value of the assets less an amount equal to the liabilities delegated. The Tax Court held that the seller was not entitled to a deduction in respect of the alleged loss on the basis that the requirements of section 11(a) of the act had not been met.
Tax Manager
Edward Nathan Sonnenbergs
In an appeal against the decision, in Ackermans Limited v The Commissioner for the South African Revenue Service, the Supreme Court of Appeal again found in favour of the Revenue Service.
As the seller is not entitled to a deduction, the question arises as to whether a deduction is available to the purchaser as and when it incurs expenditure in respect of the contingent liabilities it has assumed. A reference to the deductibility of payments made by the purchaser can be found in the Ackermans case, where Cloete JA stated that:
“It was submitted on behalf of the respondent (Ackermans and Pep SA) that unless the three contingent liabilities were allowed as a deduction in the hands of Ackermans, an anomaly would arise as they would never be deductible. The argument is without foundation. There would be no bar to Pepkor deducting the liabilities as and when they became unconditional, as counsel representing the Commissioner rightly conceded.”
Despite these views, there is technical uncertainty in this regard. As a result of submissions made to the national treasury by ENS and other interested parties, the tax treatment of contingent liabilities delegated as part of a sale of business agreement is now specifically addressed in the Draft Taxation Laws Amendment Bill, 2011.
Proposals
The draft bill proposes that where contingent liabilities are delegated as part of the sale of a business as a going concern, the seller will be entitled to a deduction in respect of those contingent liabilities. This is achieved as follows:
• the definition of gross income will be amended to provide that the partial or full relief from any liability constitutes gross income. In particular, the fair market value of the liability will be included in the gross income of the seller; and
• it is proposed that a new section 11F will be introduced whereby the seller will be deemed to have incurred expenditure in the production of income equal to the fair market value of the contingent liability which the seller has been relieved of, provided a number of requirements are met. In particular, the contingent liability must relate to the business undertaking disposed of and the consideration payable by the purchaser must have been determined by the seller and the purchaser after taking into account the assumption of the contingent liability by the purchaser. Furthermore, the seller must be carrying on a trade (which may not be the case if the entire business of the seller was disposed of).
Example
The above is best illustrated by way of an example.
As part of a sale of a business undertaking as a going concern, the seller sells trading stock with a cost of R400 to the purchaser. The purchaser also assumes a provision for future warranties in respect of the trading stock of R120 (which represents the fair market value of the contingent liability) and the parties agree that a cash consideration of R280 is payable to the seller in respect of the trading stock.
In accordance with the proposals, R400 will be included in the seller’s gross income and the seller will be deemed to have incurred expenditure of R120. Accordingly, only R280 will be included in the income of the seller.
With regard to the purchaser, a new section 24CA is proposed which states that the fair market value of the contingent liability must be included in the income of the purchaser for the year of assessment during which the disposal is made. Furthermore, the purchaser will be allowed to claim a deduction in respect of any expenditure which the purchaser is likely to incur in a future year of assessment in relation to the contingent liability assumed. The amount which is allowed as a deduction in one year of assessment must be included in income in the succeeding year of assessment.
During the year of assessment in which the business undertaking is acquired, the purchaser will include R120 in its income but will also claim a section 24CA allowance of R120. The effect on the tax computation is, therefore, nil.
If during the subsequent year of assessment the purchaser incurs expenditure of R40 in respect of warranties, he will add back R120 as the opening balance of the provision and deduct R80 as the closing balance. This adjustment to the tax computation will cancel out the R40 debited to the income statement of the purchaser in respect of the expenditure incurred. As such, no deduction is available to the purchaser in respect of the expenditure incurred.
Annalie la Grange is a manager in the tax department at Edward Nathan Sonnenbergs
Johannesburg
150 West Street
Sandton
Johannesburg
South Africa
2196
Tel: +27 11 269 7600
Fax: +27 11 269 7899
E-mail: info@ens.co.za
