The South African Revenue Service (SARS) recently released its discussion paper (Discussion Paper) on the tax implications of the assumption of contingent liabilities in the context of a sale of business as a going concern and where the assumption of the contingent liabilities is in part settlement of the purchase price of the assets.
Whereas the purchase price can generally be settled by, for example, a cash payment, the assumption of unconditional liabilities, loan account, or the issue of shares, the Discussion Paper specifically deals with the assumption of contingent liabilities.
A contingent liability is a conditional liability that will only become unconditional should an uncertain future event occur or not occur.A further distinction should be drawn between embedded liabilities and free-standing liabilities.
An embedded liability inherently depresses the value of the business asset sold and its assumption by the purchaser does not constitute consideration. For example, the potential obligation to upgrade a building in order to comply with health and safety legislation could be seen as an embedded liability that reduces the value of the asset.
A free-standing liability is a separately identifiable contingent liability that does not affect the market value of the asset but the assumption thereof by the purchaser constitutes consideration for the asset(s) bought. Common examples include employees leave pay, bonuses, post-retirement medical aid contributions, and warranties on which claims may arise.
The Discussion Paper focuses only on the tax consequences in respect of the assumption of free-standing contingent liabilities.
In order to accurately determine the tax consequences for the seller and the purchaser, it is important that the purchase consideration be properly allocated. A value should be attached to each asset, the unconditional liabilities and the contingent liabilities. It is not a requirement that these values be recorded in the sale agreement (but it is recommended). According to the Discussion Paper, the tax treatment should be the same irrespective of whether the sale agreement reflects a net purchase price, or lists assets, liabilities and contingent liabilities separately with a value allocated to each item. However, if no allocation is stipulated (or a fictitious allocation is made), it is anticipated that SARS will make an allocation based on the available information, which allocation could be contrary to the intention of the parties.
According to the Discussion Paper, the tax consequences involve the following:
The assumption of a free-standing contingent liability by the purchaser constitutes consideration in respect of the sale of the assets. Accordingly, the value attached to the assumption of the contingent liabilities must be taken into account in determining the income, proceeds or any recoupments in the hands of the seller in respect of the assets sold.
Since a contingent liability cannot be seen as expenditure actually incurred, the seller will not be entitled to any deduction.
SARS does however warn that the parties could, for example, agree that the seller separately pays the purchaser to take over the contingent liabilities, and that the assumption of the contingent liabilities does not then constitute consideration for the business assets. Such an alternative transaction could have different tax consequences even though it may have the same economic effect. In this regard it is submitted that parties should word their agreements carefully and with due appreciation for the consequences.
At the date of sale, the purchaser will not incur any expenditure in respect of the assumption of the contingent liabilities, whether for purposes of claiming deductions or determining the base cost of an asset. This is so because the liability has not yet become unconditional.
Only once the contingent liability becomes unconditional will the purchaser incur expenditure. The Discussion Paper notes that the expenditure that the purchaser incurs at that point in time will relate to the particular asset for which the assumption of the contingent liability constituted consideration. It is not the character of the contingent liability that determines the availability of a deduction, but the asset for which the assumption of the contingent liability constituted consideration.
It is therefore vital that the parties clearly indicate to which asset(s) the assumption of the contingent liability relates, and how the value is allocated.
SARS has invited taxpayers to submit comments by 31 March 2014. The Discussion Paper notes that SARS will consider issuing interpretation notes once comments have been received.
Author: Heinrich Louw (DLA Cliff Dekker Hofmeyer)