Securities transfer tax and "earnout" provisions

sharesAuthor: Ben Strauss (Cliffe Dekker Hofmeyr)

Often parties to a sale of shares agreement agree toan ‘earnout’ or ‘agterskot’ clause: a provision that partof the price will be paid in future if certain conditionsare met. For example, the parties may agree that,while the seller must transfer ownership of all theshares to the purchaser at the time of the sale, thepurchaser will pay a part of the purchase price onlyif the company reaches specified financial targets infuture.

The further payment could be a fixed or variableamount. For example, B could buy A’s shares forR100, while B undertakes to pay A an additional R50 if the profit after tax of the company is atleast R30 over the following year. Alternatively, Bcould undertake to increase the price of R100 by apercentage determined with reference to the amountof the profit after tax.

Securities Transfer Tax (STT) is usually levied in respectof a sale of shares transaction. However, where asale of shares is subject to an ‘earnout’ provision,the issue arises as to how the amount of the STTis calculated, specifically in the context of unlistedcompanies.

Section 2(1) of the Securities Transfer Tax Act, No25 of 2007 (STT Act) provides that STT is levied inrespect of every transfer of any security issued by localcompanies at a rate of 0,25% of the taxable amountof the security as determined in terms of the STT Act.

For purposes of the STT Act, the term ‘security’ includesa share in a company and any member’s interest in aclose corporation.

The term ‘transfer’ is defined widely in the STT Act andincludes a sale, assignment or cession, or disposal inany other manner of a security.

In terms of s6(1) of the STT Act the taxable amountin respect of every transfer of an unlisted security is,in the case of an ordinary transfer (that is, otherwisethan as a result of a cancellation or redemption of theshare):

  • the amount or market value of the considerationgiven; or
  • where no consideration is given or theconsideration given is less than the market valueof that security, the market value ofthat security.

S3(1)(c) of the Securities Transfer Tax AdministrationAct, No 26 of 2007 (STT Administration Act) statesthat STT which becomes payable during a month’in respect of any transfer’ of an unlisted security,must be paid to the South African Revenue Service(SARS) within two months from the end of that month,otherwise SARS may impose interest and penalties.

In the case of an earnout transaction, STT couldconceivably be imposed the following ways:

  1. STT could be imposed at the time of the salebut only on the amount that accrues at that time(R100 in our example above), as this amount isknown; and the contingent payment could bedisregarded entirely. However, STT is levied ‘inrespect of a transfer’. Arguably, this could meanthat the intention is that STT must not only belevied ‘on transfer’ of shares but at any time whenconsideration accrues in respect of the transfer.
  2. STT could be levied at the time of the sale on the full consideration, that is, on the sum of theinitial consideration (R100 in the example above)and the contingent consideration (R50 in the firstalternative in the example above). If it transpiresthat the contingent portion of the considerationdoes not becomes payable, the taxpayer couldapply for a refund in terms of s4 of the STTAdministration Act. However, this would not bepossible in the case where the contingent amountwas a variable amount (as is the case in thesecond alternative in the example above).
  3. The person liable for the STT and SARS couldadopt a wait-and-see approach. In other words,STT would not be imposed at the time of the salebut would be imposed only at the time whenthe full consideration is known, that is, when itbecomes certain that the contingent amount will bepaid, and what the amount is.
  4. The person liable for STT could attempt to placea present value on the contingent portion of theconsideration, taking into account the probabilitythat it would become payable. The person couldthen add that amount to the fixed portion of theconsideration to determine the taxable amount,and pay STT on the total.

While, in the case of an earnout arrangement, it is notcertain at the time of the sale that the earnout amountwill become payable and/or what the amount willbe, it is certain that the seller does, at the time of thesale, acquire at least a contingent right to receive theearnout amount.

In the case ofWH Lategan v Commissioner for InlandRevenue 2SATC 16, and in the context of incometax, a taxpayer sold wine for a certain price, partof which was due in the current tax year, and thebalance due in the following tax year(s). The courtstated that:

“So far as a debt was concerned which was payablein the future and not in the year of assessment, itmight be difficult to hold that the cash amount ofthe debt had accrued to the taxpayer in the year ofassessment. He had not become entitled to a right toclaim payment of the debt in the year of assessmentbut he had acquired a right to claim payment ofthe debt in future. This right had vested in him, hadaccrued to him in the year of assessment and it wasa valuable right which he could turn into money if hewished to do so”

The statement of the court quoted above may also beapplicable in determining the amount of STT in the
case of an earnout arrangement. At the time of thesale, a right to the earnout amount vests in the seller,and it is a valuable right which could be turned intomoney, even though it is a contingent right.

In this regard, the United Kingdom (UK) Court ofAppeal case ofL M Tenancies 1 plc v IRC[1998]STC 326 is instructive. The case involved thedetermination of an amount of stamp duty due inrespect of a lease. Under the lease, the rent and apremium were determinable in accordance with aformula which was linked to variables that could onlybe determined in future.

The court held that the words “the amount of value ofthe consideration [payable] for the sale” in relevant UKlegislation (very similar to the words used in the STTAct) “include amounts or value payable in the futureand amounts or value payable immediately or in thefuture whether unconditionally or contingently.”

Naturally, it may be difficult to place a value on theright to the contingent earnout amount and it may wellbe that in many cases the value will be nil. It shouldalso be remembered that the burden of proving theright amount would rest on the person paying the STT.

It is submitted that, in the light of the tenets of taxationthat taxes should be certain and should be collectedat the time and in the manner that is most appropriatefor the taxpayer, it is likely that South African courtswould take the same approach as that taken in theLMTenanciescase.

In our view, the relevant legislation should beamended to make it clear how STT should belevied in the case of earnout arrangements. In themeantime, parties to such transactions should consider approaching SARS for a ruling.