The tax consequences of cancelling a contract
17 November 2015
Posted by: Author: Denny Da Silva
Author: Denny da Silva (Webber Wentzel)
a contract is entered into and cancelled in the same year of assessment,
certain adjustment rules are applied with the intention of effectively putting
the taxpayers in a neutral tax position, as if they never entered into the
The cancellation of a contract and subsequent return
of the asset sold will have capital gains tax ("CGT") consequences for
both parties in terms of the provisions of the Eighth Schedule to the Income
Tax Act No. 58 of 1962 ("Eighth Schedule") – both at the time that
the asset is disposed of by the seller to the purchaser (i.e. the original
disposal) and when the contract is cancelled and the asset is returned by the
purchaser to the seller. One also needs to consider whether the contract was
cancelled in the same year of assessment in which the contract was entered into
or if that contract was cancelled in the subsequent year of assessment, as this
will impact the attendant tax consequences.
When a contract is entered into
and cancelled in the same year of assessment, certain adjustment rules are
applied with the intention of effectively putting the taxpayers in a neutral
tax position, as if they never entered into the transaction.
When a contract is cancelled in a
subsequent year of assessment, the amount of any capital gain incurred by the
original owner (i.e. the person who disposes of the asset to the purchaser
under the contract which has been cancelled) in the year of disposal should
give rise to a capital loss in the year of cancellation.
However, National Treasury has
identified certain anomalies which do not result in a tax neutral cancellation
or which result in a step-up in the base cost of assets without actually having
paid or given up any economic benefit/value.
For example, assume that in year
1 Company A sells shares having a base cost of R1 000 to Company B (a
sister company which is a connected person as defined in section 1 in relation
to Company A) for R10 000 (being the market value of the shares) on loan
account. During the same year of assessment Company A and Company B agree to
cancel the contract and Company B returns the shares (which still have a market
value of R10 000) to Company A and is relieved of having to settle the
loan account of R10 000.
The original disposal by Company
A results in a capital gain of R9 000 (being the difference between the
base cost of R1 000 and the proceeds of R10 000). Company A has also
acquired a new asset, being the claim against Company B and which has a base
cost of R10 000, in exchange for the disposal of the shares which have a
market value of R10 000. However, if the proceeds on the disposal of the
shares to Company B are reduced by the R10 000 (being the amount owing by
Company B in terms of the loan account and which is no longer payable by
Company B), then Company A is left with a capital loss of R1 000 as it
will be deemed to have received proceeds of nil and there is currently no
adjustment rule to reduce its base cost to nil. Furthermore Company A will get
a step-up in the base cost of the shares to R10 000, as there is no
provision that restores Company A's base cost to R1 000, and Company A is
deemed to acquire the shares at market value (i.e. R10 000).
We can take the above example
once again but assume that the contract is cancelled in year two and that the
shares still have a market value of R10 000. In this instance, the
provisions of the Eighth Schedule have the effect that Company A would have a
capital loss of R10 000, being the amount that it is no longer entitled to
as a result of the cancellation of the contract. There is also no provision
that restores Company A's base cost to R1 000, so it would get a step-up
in the base cost of the shares to R10 000.
To address the abovementioned
anomalies, National Treasury proposes the following:
- When a contract is entered into and cancelled in the same year of
assessment, these two events (i.e. entering into the contract and then
cancelling it) will not be regarded as a disposal of the asset concerned
for the original owner. No capital gain/ loss calculation will therefore
be required by the original owner, thus ensuring that the base cost of the
asset in the hands of the original owner remains the same as it was prior
to entering into the contract. Using the example above, the intention is
that Company A's base cost in the shares remains restored to R1 000,
as the transaction between Company A and Company B is ignored (i.e. as if
it never happened).
- It is proposed that if a contract is cancelled in a subsequent year
of assessment to which it was entered into, that certain amendments are
made to the Eighth Schedule to ensure a more equitable outcome of the
cancellation of the contract. In essence, the proposal is to either
include a capital gain or loss (as the case may be) in the current year of
assessment, which is equal to the capital gain or loss (as the case may
be) that was realised in the year that the asset was disposed of under the
original contract. Using the example above, the intention is that Company
A would have a capital loss of R9 000 in year two when the contract
is cancelled (being equal to the capital gain that Company A realised when
the shares were disposed of).
- The base cost of the asset reacquired by the original owner will be
equal to the sum of the asset's base cost at the time of entering into the
contract, and any subsequent expenditure incurred by the new owner as
allowed under paragraph 20 of the Eighth Schedule.
The proposed amendments will come
into operation on January 1 2016, and will apply to disposals made during any
year of assessment commencing on or after that date.
Please click here to take the quiz.
This article first appeared on the November/December 2015 edition on Tax Talk.