As a result of the court decisions, neither the seller nor the buyer are eligible to claim provisions as a tax deduction: a patently inequitable situation.
Only legislative intervention could have resolved the sorry state of confusion into which these cases had thrown the law.
Believe it or not, the tax gods appear to have heard this plea and in proposed legislation (which at the time of writing is only in draft form), our revenue authorities prescribe comprehensively the tax treatment of contingent liabilities upon the sale of a business.
This article will explore the proposed legislation as well as the extent to which sellers and purchasers of businesses, as well their advisors, may derive clarity from it.
As a starting point however, it is necessary to explain once again, to the uninitiated, exactly what a provision is.
From a legal perspective, 'provisions' generally relate to contingent liabilities, ie liabilities that will arise upon the happening of a future event. For tax purposes, they represent amounts that a taxpayer has not yet 'actually incurred' and are not yet tax-deductible against income. In the normal course, the event occurs, the liabilities materialise, the provision becomes a determined expense and the taxpayer can claim a deduction in respect thereof.
Examples of such provisions or contingent liabilities include employee bonuses (ie only arising if an employee remains with the company until the date the bonus becomes due), warranty claims (ie only arising if a product becomes defective), post-retirement medical aid commitments and environmental claims. They are to be distinguished from fixed liabilities, ie liabilities that have already arisen and are owing to creditors.
The problem with these provisions arises when taxpayers sell their businesses as going concerns before the liabilities materialise.
Although it is a matter of negotiation, usually one of two scenarios develops:
- either the seller obtains the full purchase price in cash for the sale of the business but remains responsible for the payment of all liabilities including contingent ones; or
- the purchaser assumes some of the liabilities (both fixed and contingent) and reduces the purchase price by the amount of the liabilities assumed.
In the first scenario, the position is clear: The seller will pay tax on the gain that arises on the sale of his business and will claim a deduction in respect of the provisions when they materialise later.
The waters get muddied, however, in the second scenario.
Certainly the fixed liabilities assumed by the purchaser will form part of the seller’s proceeds upon sale of the business (and will therefore contribute to the seller’s capital or revenue gain). Effectively, fixed liabilities are treated the same as cash considerations. But what about the provisions?
Many tax advisors have, traditionally and until the 2009 Ackermans case, maintained the view that the sellers can claim a deduction in respect of these provisions when the business is sold and these liabilities are taken up by the purchaser against reduction of the cash consideration. That was in fact what the taxpayer (a seller of a business) in that case argued. Unfortunately, this view did not succeed in the Supreme Court of Appeal. In contentious decisions which were subject to substantial criticism by tax commentators, judges in both the lower and appeal courts held that the seller’s claim did not meet the requirements of the general deduction formula and victory went to the South African Revenue Service.
The case did not resolve all matters, however. In particular, it was not clear whether the purchaser could claim the deduction. Although obiter dicta in the Appeal Court case suggested it could, many contend that the purchaser may not claim a deduction in these circumstances. They would argue that the liabilities in such an instance were incurred by the purchaser as part of the cost price paid in order to acquire the business, which is a capital asset, hence the 'expenditure' incurred by the purchaser would be capital in nature. This is supported in foreign case law (such as the New Zealand case, Commissioner of Inland Revenue v New Zealand Forest Research Institute Ltd  STC 522).
Unfortunately, this would mean that neither purchaser nor seller can claim deductions for provisions assumed upon sale. Obviously the effect of this interpretation would be that purchasers would not take up provisions when a business is sold but this is not always commercially possible. Often once a business is sold, the seller may no longer want to have to worry about meeting liabilities that materialise sometimes years or even decades later. Also they might not be in a position to do so, if the liability arises long after they have closed shop and/or have been wound up.
Recognising that the 'law is somewhat uncertain', in the words of the Explanatory Memorandum to the draft bill, the National Treasury Department has proposed legislation which seeks to 'remove this uncertainty'.
There are two proposals of significance.
Firstly, provisions assumed by a purchaser will be treated as consideration in the hands of the seller. Effectively, this means that all liabilities, contingent or fixed, taken up by a purchaser when buying a business, will be treated as consideration for both the seller and the purchaser.
Like fixed liabilities, they will be allocated to gross receipts or proceeds on sale, depending on whether trading stock or capital assets are sold. Unlike fixed liabilities however, they will be taken into account at market value as opposed to face value. This means that if it is likely that the liability will never arise, the value assigned to the provisions in the total consideration would be small.
An example would be useful here.
Let’s say Optimus Prime (Pty) Ltd ('Optimus') owns a motor vehicle dealership and decides to sell it to Megatron (Pty) Ltd ('Megatron') for R1 million. In terms of the sale agreement, Megatron has to take over warranties relating to the motor vehicles already sold. The warranties give rise to contingent liabilities in that they require Megatron to pay out customers upon the happening of an uncertain event, ie the sold motor vehicle becoming defective or transforming into a killer robot, whichever comes first. The contingent liabilities associated with these warranties are, of course, a provision and they have a value of R500 000. In terms of the proposed legislation, the value of the warranties assumed by Megatron will form part of the purchase price for the dealership in Optimus’s hands. Optimus has effectively sold its business for R1,5 million (R1 million in cash and R500 000 in provisions assumed by Megatron). To the extent that the business comprised cars, the purchase price will be revenue income and to the extent it comprised goodwill and capital assets, the purchase price will be a capital receipt in Optimus’s hands.
The second significant proposal is that the seller will now be entitled to claim the provision as a deduction for tax purposes when the business is sold, but the purchaser will be forbidden from making the same claim. Despite the findings of the judges in the Ackermans decision, the reduced cash consideration the seller receives on sale as a result of the purchaser assuming the provisions, will be regarded as a cost actually incurred by the seller in carrying on its trade. (The taxpayer in the Ackermans case must, no doubt, be peeved that the proposals basically put into effect the losing position that it championed in the tax courts!)
In the purchaser’s hands, the provisions will be included in its gross income but the purchaser will simultaneously be provided with an allowance equal to the amount included. The allowance will be added back and rolled forward every tax year but will reduce as payments in respect of the provisions materialise. Essentially, this is a very elaborate mechanism aimed at keeping the purchaser from ever claiming the same deduction as the seller.
Once again, this can best be illustrated with an example.
In the 2013 tax year when Optimus sells its business, Optimus can claim a deduction of R500 000, equalling the value of the warranties or provisions assumed by Megatron. Megatron, however, will include R500 000 in its income in respect of the provision it assumes. The inclusion is immediately set off though, against an allowance of R500 000 granted to Megatron. In the 2014 tax year, war breaks out between the Autobots and the Decepticons and many of the cars sold by Optimus to its customers transform into killer robots. In terms of the warranty agreement, Megatron pays out R100 000 to its customers (or their families). Although the R500 000 provision is added back to Megatron’s income that year, because Megatron paid R100 000 of the warranties in that year, Megatron can claim R100 000 as a deduction plus R400 000 for the remainder of the allowance rolled forward. In the 2015 year, only R400 000 of the allowance is added back. It can be seen then that the rollover and addback of the allowances has no effect on Megatron’s income – it neither reduces nor increases it.
In terms of the draft bill, the proposal outlined above will be effective for disposals of businesses from 1 January 2012.
It should be noted that that bill remains in draft form only and it could well be changed before the legislative process runs its course. Whatever the final form of the proposal however, it is comforting that our revenue authorities have decided to address the uncertainty surrounding this issue and have injected some clarity into the legal debate.