During December 2013, SARS released a draft discussion paper in which it set out its application of the relevant tax law, in relation to the tax treatment of the purchaser and seller, with regard to the assumption of contingent liabilities as part settlement of the purchase price of assets acquired as part of a going concern.
SARS states that the document was prepared in light of recent judgments delivered by local and foreign courts as well as numerous requests for clarity regarding the income tax treatment, of both the seller and the purchaser, in respect of the assumption of contingent liabilities as part settlement of the purchase price of assets disposed of and acquired.
A particular point of interest in the discussion document is the fact that SARS distinguishes between, what it calls, ‘embedded’ and ‘free-standing’ contingent liabilities. This distinction appears to be based on the judgment delivered by the Supreme Court of Canada in the matter of Daishowa-Marubeni International Ltd v Canada 2013 SCC 29 in which the court distinguished between:
- a contingent liability which, in its view, is a future cost which depresses the value of the asset (i.e. embedded contingent liability); and
- an obligation which is a distinct existing liability which does not impact the market value of the asset (i.e. a free-standing contingent liability).
Although the Discussion Document only considers the tax treatment of the seller and purchaser with regard to the assumption of ‘free-standing contingent liabilities’, SARS does state that it “accepts that a distinction must be drawn between an embedded statutory obligation that depresses the value of an asset and a separately identifiable contingent liability”. In SARS’ view an ‘embedded contingent liability’ is so inextricably linked to the asset that should the asset be transferred the contingent liability will have an impact on the market value of the asset and the assumption of the contingent liability by the purchaser will not qualify as consideration given by the purchaser.
The application of the principles enunciated in Daishowa-Marubeni International Ltd v Canada could potentially have far reaching consequences in the South African mining sector to the extent that it is applied to the transfer of mining rights and the assumption of the corresponding rehabilitation liability by the purchaser. In Daishowa-Marubeni International Ltd v Canada the court had to determine the tax treatment of the seller in respect of a right to harvest timber (i.e. forest tenure) which it had disposed and whether or not the value of the reforestation liability assumed by the purchaser, which attached to that forest tenure, should be included in the seller’s ‘proceeds of disposition’.
The court found the reforestation obligations attaching to a forest tenure are not a distinct existing debt, the assumption of which would form part of the sales price of the forest tenure. Instead the SCC was of the view that the reforestation obligations are a future cost embedded in the forest tenure which serves to depress the value of the forest tenure (at paragraph 29). In its view, a forest tenure with a reforestation obligation attaching to it is more akin to a property in need of repair. The assumption by the purchaser of the cost of repairs would not form part of the sales price for the property but would in fact depress the value of the property and as such would not form part of the seller’s proceeds of disposition.
As with the reforestation liability which attached to the forest tenure, a rehabilitation liability attaches to each mining right issued in South Africa with the effect that the Department of Mineral Resources (“DMR”) will not transfer such a mining right unless the corresponding rehabilitation liability is also transferred to and assumed by the purchaser. A direct application of the decision in Daishowa-Marubeni International Ltd v Canada will result in the market value of the mining right decreasing and the assumption of the rehabilitation liability not constituting consideration given by the purchaser. From the purchaser’s perspective this will affect the amount of capital expenditure the purchaser will incur and as such will affect the amount of capital expenditure it will be able to deduct in terms of section 15(a) read with section 36(7) of the Income Tax Act 58 of 1962 (“the Act”), in determining its taxable income from mining activities.
However, the Act makes specific provision for the allocation of cost and as such the amount of expenditure incurred in the situation where mining assets are disposed of. In this regard section 37 of the Act makes provision for the manner in which the capital expenditure incurred by the purchaser, upon acquisition of mining property, should be determined.
The basis upon which the application of section 37 is premised is the effective valuation of the mining assets and property by the Director-General of the DMR. The effective valuation serves to determine the value of the capital assets acquired by the purchaser on the effective date of the transaction. This value, as determined by the Director-General of the DMR, is deemed to be the amount of expenditure incurred by the purchaser in acquiring each of the respective mining assets and as such is deductible in determining the purchaser’s taxable income from mining.
Should the values attributed to the respective assets by the Director-General of the DMR, in its effective valuation, exceed the consideration given by the purchaser in acquiring the assets, the deemed cost and deemed capital expenditure incurred by the purchaser is to be determined by apportioning the consideration given by the purchaser for each asset, to hold the same ratio to the total consideration given by the purchaser as the effective value of that asset, as per the effective valuation, holds to the total effective valuation of all the assets acquired.
From the above it is clear that the meaning of the term ‘consideration given’ is of vital importance with regard to the interpretation and application of section 37 of the Act. The amounts included and the amounts excluded from the meaning of the term will have a substantial impact on the amount of capital expenditure the purchaser will be deemed to have incurred upon acquisition of the assets.
The direct application of the judgment in Daishowa-Marubeni International Ltd v Canada to the transfer of mining rights and the corresponding rehabilitation liability in South Africa will undoubtedly impact the application of section 37 as the ‘consideration given’ by the purchaser will, according to SARS, not include the value of any rehabilitation liabilities assumed by the purchaser.
The Act currently does not make provision for the separate treatment of contingent liabilities in the form of ‘embedded liabilities’ and ‘free-standing liabilities’ nor are these concepts currently recognised in South African tax law. It must thus be determined if these concepts are in fact applicable in South African tax law and if so what the impact thereof is in respect of the transfer of mining rights and the corresponding rehabilitation liability as well as the consideration that the purchaser gives in return for the assets it acquires.