New rules for cancellation of contracts

New rules for cancellation of contracts

• 28 July 2015
• Corporate Tax
• Denny da Silva and Elandre Brandt

Important:

This article is based on tax law for the tax year ending 28 February 2016.

Authors: Denny da Silva and Elandre Brandt (Webber Wentzel)

The cancellation of a contract is regarded as a disposal for capital gains tax purposes (as governed by the provisions of the Eighth Schedule to the Income Tax Act) and will have tax implications for both parties - both at the time of the original disposal and when the contract is cancelled. One also needs to consider whether the contract was cancelled in the same year of assessment in which the contract was entered into or if that contract was cancelled in the subsequent year of assessment, as this will impact the attendant tax consequences.

When a contract is entered into and cancelled in the same year of assessment certain adjustment rules are applied with the intention to effectively put the taxpayers in a neutral tax position, as if they never entered into the transaction.

When a contract is cancelled in a subsequent year of assessment, the amount of any capital gain incurred by the original owner in the year of disposal should be give rise to a capital loss in the year of cancellation.

However, National Treasury has identified certain anomalies which do not result in a tax neutral cancellation or which result in a step-up in base cost of assets.

To address the abovementioned anomalies, National Treasury proposes the following:

• When a contract is entered into and cancelled in the same year of assessment, these two events (ie entering into the contract and then cancelling it) will not be regarded as a disposal in the hands of the original owner. No capital gain/ loss calculation will therefore be required by the original owner, thus ensuring that the base cost of the asset in the hands of the original owner remains the same as it was prior to entering into the contract.
• It is proposed that if a contract is cancelled in a subsequent year of assessment to which it was entered into, that certain amendments are made to the Eighth Schedule to ensure a more equitable outcome of the cancellation of the contract. In essence, the proposal is to either include a capital gain or loss (as they case may be) in the current year of assessment which is equal to the capital gain or loss (as the case may be) realised in the year that the asset was disposed of under the original contract.
• The base cost of the asset reacquired by the original owner will be equal to the sum of the asset's base cost at the time of entering into the contract and any subsequent expenditure incurred by the new owner as allowed under paragraph 20 of the Eighth Schedule. The proposed amendments will come into operation on 1 January 2016 and will apply to disposals made during any year of assessment commencing on or after that date.

This article first appeared on webberwentzel.com

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