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Every contract has a tax consequence

When drafting a contract, ignoring tax will often be to your peril.

EVERY SINGLE contract in terms of which money or property changes hands has tax consequences for the parties involved.

These consequences have been plainly evident in cases where people bought their fixed property in a Close Corporation or private company, thinking that because they occupied the property personally, they would be entitled to claim a primary residence exemption of up to R1.5 million* on any profits made when this property was sold.

The expensive reality is that since the property is owned by the legal entity, and not by the occupants, no exemption is applicable, and Capital Gains Tax of 14%* of the profits would become payable.  A rudimentary understanding of the Eighth Schedule would have probably resulted in the deal being structured somewhat differently.

Another situation (cited in Income Tax Case 1702) deals with a lady who had been renting a property from the City of Cape Town for over 20 years, and faced the loss of her home as a result of the Council wishing to sell the property to developers.

She was given the right of first refusal to purchase the property, which was offered to her at a price that was well below market value.

Since she did not have the money to purchase this property, she entered into a scheme with a bank whereby they would grant her a loan to purchase the property, which would be repaid once she had sold the property to another person at market value.  Her intention was to use the profits to purchase a flat in a less-expensive area.

Along comes the long arm of SARS, who sought to tax her on the profit made.  What’s more, because of the intention to sell the property at a profit within such a short period of time, this profit was taxed as income, rather than as capital gains.

The taxpayer took her case to the Cape Special Tax Court, who found in favour of SARS.  Had she been aware of the possi-bility of being subjected to tax, she would have probably attempted to come to some other arrangement with the Council in order for her to secure alternative accommodation.

It is also be submitted that when the bank structured this deal, they did not consider the possible tax consequences thereof for their client.  People who draw up contracts of this nature need to consider many issues, such as the following:

  • Is the expenditure specified in the contract tax-deductible for the payer?
  • Is it taxable in the hands of the beneficiary or payee?
  • If the payment involved has tax implications, in what tax year is it deductible or taxable?
  • Most importantly, could the contract be drawn up in a different way that produces a more favourable tax result for some or all of those involved?

Another example where the tax implications of a contract are not thought out is well illustrated in Income Tax Case 11661 which came before the Durban Tax Court in May 2006.  A manufacturing and distribution company used a standard contract for the sale of its products.

The details of the contract provided that if the purchaser paid by the 25th of the month, he would receive a discount.

The taxpaying company prepared its annual income tax returns on the basis that gross income consisted of the discounted price, that is, a lower revenue figure after granting the discount.

SARS disagreed with this approach and issued an assessment where gross income was reflected as the full selling price, without the discount.  Obviously, this higher revenue figure would mean a greater tax liability for the manufacturer / distributor taxpayer.

The Tax Court ruled that, on a proper interpretation of the particular contract, SARS was correct in regarding the taxpayer’s gross income as the higher undiscounted selling price.

The discount itself would only be taken into account as a deduction when it is actually granted, thereby becoming an expense “actually incurred” in the production of income.  However, the gross income may not be reduced in anticipation of a future discount that is contingent on early settlement of the customer’s account.

A bit more time spent on the details of the contract could have avoided this situation.  Had the contract been drawn up in a slightly different way, by stipulating that the discounted lower figure was the official selling price, and that the price would increase by a stipulated percentage if not paid by the 25th of the month, the taxpayer’s gross income would have been the more favourable discounted figure.

A little more attention to the tax implications of the detailed contract terms could have ended in a better story for this taxpayer.

  • The primary residence exemption and effective rate of CGT stated in this article were those in force at the time the case was put before the court. The current primary residence exemption is R2 million, and the effective CGT rate for companies is 21.6%.

 

Steven Jones is a registered SARS tax practitioner, a practicing member of the South African Institute of Professional Accountants, and the editor of Personal Finance and Tax Breaks.

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