By Erich Bell, Senior Tax Consultant at BDO South Africa.
SARS issued a draft interpretation note (DIN) in September 2015 on the tax implications of the assumption of contingent liabilities where a business is sold as a going concern. This article sheds some light on the assumption of contingent liabilities which specifically formed part of the purchase price relating to the acquisition of the business as a going concern.1
A purchaser can settle the purchase price for the acquisition of a business as a going concern by employing a combination of: cash consideration, assuming the seller’s debts, assuming the seller’s contingent liabilities, loan funding, or share issues.
The DIN clarifies that a business disposed of as a going concern consists of individual assets and that the seller and the purchaser must allocate the purchase price to these assets using the same ratio. If the purchase price consists of a combination of cash and assumption of contingent liabilities, these elements will have to be allocated to the assets transferred in terms of the sale. Consider the following example:
A sells a manufacturing concern to B for R100 as a going concern. A and B agree that the R100 will be settled through a cash payment of R70 and the assumption by B of A’s bonus provision of R30. The bonus provision would only become payable to employees still in the employment of B after 2 months from date of transfer as a going concern. The assets transferred consist of premises of R60, machinery of R30 and trading stock of R10.
A and B would have to allocate the R100 to the assets transferred, which can be done in a manner they deem fit as long as it reflects the substance. Assume that R60 cash is allocated to premises and R10 to machinery, and that the R20 bonus provision is allocated to machinery and R10 to trading stock. The purchase price would then be allocated as follows:
|Selling price||Cash||Bonus provision|
1 The tax implications would differ where a purchaser assumes some of the seller’s contingent liabilities without it forming part of the purchase price.
The DIN defines a contingent liability as ‘an obligation whose existence will only be confirmed by the occurrence or non-occurrence of one or more uncertain future events and, if confirmed, will result in expenditure being incurred to settle the confirmed obligation’. The DIN draws a clear distinction between ’embedded obligations’, which constitute contingent obligations linked to a particular asset that reduces the value of the asset and which must be transferred with the asset under law, and ‘free-standing contingent obligations’, which constitute separately identifiable contingent liabilities not linked to and that do not affect the value of a particular asset. Free-standing contingent liabilities are most commonly encountered as employee provisions such as bonus and post-retirement medical aid provisions. An example of an embedded obligation is mining rehabilitation obligations associated with mining rights.
The DIN sets out the income tax implications for the seller and the purchaser on the assumption of the free-standing contingent liabilities by the purchaser and on the subsequent realisation thereof by the purchaser.
It is firmly established in our law that an ‘amount’ for ‘gross income’ and proceeds purposes (for CGT purposes) does not only include cash but also the value of property or the value of any other in kind benefit received by the taxpayer. The assumption by the purchaser of the seller’s free-standing contingent liabilities would benefit the seller as the seller would no longer be required to settle these liabilities if and when they become unconditional. The value of free-standing contingent liabilities must be determined and included in the seller’s gross income if they were allocated to an asset that is income in nature. Alternatively, the value would constitute proceeds for CGT purposes if the liabilities were allocated to an asset that is capital in nature. The DIN takes the view that the benefit amount is equal to the face value of the free-standing contingent liability.
From the above example, for CGT purposes, (i) the full cash payment of R60 would constitute proceeds for the seller for the disposal of the premises; and (ii) the R20 of the face value of the bonus provision plus the R10 cash payment would constitute proceeds for the seller on disposal of the machinery. R10 of the face value of the bonus provision allocated to the trading stock would have to be included in the seller’s gross income as trading stock is income in nature.
The seller must ‘actually incur’ an amount for it to qualify as a deduction. The courts have generally held that there must be a definite and absolute liability, or rather, a conditional legal obligation on a person to incur an amount for it to qualify as expenditure ‘actually incurred’ and be deductible. Provisions for anticipated expenditure would not qualify for a deduction. As the free-standing contingent liabilities are conditional at the date of transfer, the seller would not be deemed to have ‘actually incurred’ the free-standing contingent liabilities and would not qualify for a deduction, irrespective of whether the purchase price is reduced as a result of such transfer. The seller would also not be entitled to a deduction when the free-standing contingent liabilities subsequently realise in the purchaser’s hands, as the purchaser would then be the person who actually incurred the expenditure relating to the free-standing contingent liabilities and who should be entitled to the deduction (if applicable). From the example the seller would not be entitled to deduct the R30 bonus provision transferred to the purchaser.
The purchaser would not be entitled to a deduction of the value of the free-standing contingent liabilities assumed on the date of transfer of the going concern as the purchaser would not have actually incurred any expenditure with regard to the liabilities at such time (being conditional on events following date of transfer). The purchaser would only be entitled to claim a deduction of the liabilities when they realise and are actually incurred. Upon realisation of the free-standing contingent liabilities, the purchaser would need to investigate to which assets acquired in terms of the sales agreement the face value of the free-standing contingent liabilities were allocated. This determination is required as it considers the purpose for which the purchaser assumed the contingent liabilities and the nature of the expenditure resulting from the realisation of the free-standing contingent liabilities. The DIN clarifies that the expenditure resulting from the realisation of the free-standing contingent liabilities would follow the nature of the asset to which it was apportioned in terms of the purchase agreement. Therefore, when determining the deductibility of the expenditure resulting from the realisation of the free-standing contingent liabilities, the income or capital nature of the expense should not be considered, but instead the nature of the asset to which it was apportioned is relevant.
From the example above, the free-standing contingent liability is a bonus provision of R30 which would be deductible under normal circumstances upon realisation, being income in nature. In terms of the purchase price allocation, R20 of the bonus provision was apportioned to machinery which constituted capital assets, whilst R10 was allocated to trading stock which constituted revenue assets. Under the methodology applied in the DIN, the R20 bonus provision apportioned to the machinery would follow the capital nature of the machinery and would have to be capitalised to the cost of the machinery. This capitalised cost would qualify for a capital allowance over a number of years. The remaining R10 of the bonus provision apportioned to the trading stock would follow the income nature of the trading stock and would qualify for a full deduction on realisation.
This article summarises some of the main principles in the DIN relating to the transfer of contingent liabilities on disposal of a business as a going concern. These complexities should be considered in such transactions to manage any adverse tax implications.
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