Early termination of contracts : the tax implications

• Jurisdiction: South Africa
• Date: 01 December 2016
• Published date: 01 December 2016
• DOI: 10.10520/EJC198524
• Pages: 13-24
• Published By: Siber Ink
• Author: Des Kruger

13

© SIBER INK

Early Termination of

Contracts:

THE TAX IMPLICATIONS

DES KRUGER*

ABSTRACT

It is a reality of everyday commercial life that parties agree bilaterally to termi-

nate contractual arrangements prior to their stipulated termination dates. In

most circumstances, the party wishing to withdraw from the arrangement

is required to pay an amount of compensation to the counterparty. The

payment of this compensation and the agreement by the counterparty to

surrender certain of its rights trigger tax implications. This article explores

the income tax, capital gains tax (CGT) and value-added tax (VAT) implica-

tions that may arise in consequence of the early termination of a contractual

arrangement.

As regards the income tax implications, the issue is whether the compen-

sation will constitute a receipt of a capital or revenue nature in the hands of

the counterparty. While a number of tests have been adopted over the years,

the test most often applied is whether the compensation fills the hole of the

recipient’s profits or assets, the former being revenue in nature and the latter

capital in nature. The payment of the compensation by the party wishing to

withdraw from the contractual arrangement may be deductible depending

on whether it can be said that the payment (expenditure) is closely related to

the party’s income-earning operations. The author ventures that the debate

regarding whether expenditure incurred in avoiding expenditure (i e getting

out of an onerous arrangement) can be said to have been incurred in the

production of the party’s income is now moot — the expenditure cannot be

disallowed on that basis.

Should the receipt of the compensation by the counterparty constitute a

receipt of a capital nature, the issue arises as to whether the compensation

can be said to constitute ‘proceeds’ for the ‘disposal’ of an ‘asset’ by the coun-

terparty. The view of SARS is that the personal rights held by the counterparty

under the contractual arrangement constitute an ‘asset’ for CGT purposes

and a disposal of such ‘asset’ takes place when the right is surrendered in

exchange for payment of the compensation. It is difficult to identify any base

cost of such ‘asset’.

The surrender of a right (the personal rights held by the counterparty

under the contractual arrangement) constitutes the supply of services by the

counterparty and the counterparty will be required to account for VAT in

respect of the compensation received.

Introduction

Parties prematurely terminate contractual arrangements for many varied

reasons, very often for commercial purposes. However, the contractual

* Consultant, Webber Wentzel Attorneys.