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The tax consequences of cancelling a contract

17 November 2015   (0 Comments)
Posted by: Author: Denny Da Silva
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Author: Denny da Silva (Webber Wentzel)

"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.”

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.

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This article first appeared on the November/December 2015 edition on Tax Talk. 


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