It should come as little surprise that a faltering economy is often accompanied by an increase in litigation. Struggling companies see an increase in retrenchments and performance-based terminations. Construction projects collapse midstream, leading to litigation over which parties should bear the financial burden of incomplete work. There is an increase in regulatory prosecutions of statutory infringements, such as prohibited practices in terms of the Competition Act, 1989 (Act No. 89 of 1998) ("the Competition Act"). In this context it is noteworthy how often defendants neglect the matter of the tax treatment of settlement agreements. Plaintiffs who receive settlement payments are usually more concerned about the tax treatment of those settlement payments than defendants who pay these amounts.
Where the defendant is engaged in a business or trade there will be some kind of tax benefit available for making settlement payments and paying legal expenses. In a majority of these cases, the amount may, depending on the facts and circumstances surrounding that payment, be deductible for tax purposes as a normal business expense. However, there are cases where the settlement costs cannot be deducted as an expense but must be capitalized, in other words, the expenses must be added to the base cost (usually the purchase price) of the asset. At the extreme end of the deductibility/non-deductibility continuum one finds complete non-deductibility under section 23(o) of the Income Tax Act, Act 58 of 1962 ("the Act"). Even though tax concerns are less obvious for the defendant than the plaintiff who receives the settlement, the defendants should still bear in mind a few key rules.
rule 1: beware the capitalisation issue
Nearly all defendants want to make sure that they can deduct a payment as a business expense in accordance with the general deduction formula in section 11(a) of the Act. In business litigation this is usually not a problem, but it still requires careful consideration. Certain taxpayers have been hit hard by capitalisation rules, having to add the cost of a settlement or legal expenses to the base cost of the asset, with the result that they obtain no current tax deduction.
This issue is best understood if the concept of "base cost" is briefly sketched. A taxpayer's base cost of an asset is the value at which the taxpayer carries the asset on its tax balance sheet. An asset's base cost is initially its purchase price to the taxpayer. This initial base cost is subsequently increased by capital expenditures and decreased by capital allowances and other charges, becoming the taxpayer's adjusted base cost in the asset. The base cost may, therefore, vary over the period that the asset is held by the taxpayer. Upon the sale of the asset, the capital gain or loss for tax purposes is measured by the difference between the amount realised for the asset and its adjusted base cost. The base cost of the asset represents, in effect, the amount at which the base cost of the asset may be recovered free of tax through capital allowances and adjustments to gain or loss upon the disposal of the asset.
For instance, the cost of building a railway line constitutes capital expenditure. Such expenditure is not deductible as a business expense in the year in which it is built; instead it must be depreciated over its useful life and the amount of depreciation each year is all that is deductible that year. In this way, the cost is matched with revenue, which is a desired outcome of tax law. Litigation expenses designed to establish, maintain or defend a legal title to or right in an asset, i.e. the railway line, are added to the base cost of the asset and thus increase the amount of capital allowances that the owner of the asset can claim as a deduction from its income.
In contrast, business expenses incurred in day-to-day operations are deemed ordinary business expenses and are deductible from a business's taxable income in the year in which they are incurred. Thus, repairs to the railway line which preserve, but do not enhance the railway's value, can be expensed while improvements intended to increase the railway line's value have to be capitalised. By the same token, expenses incurred by a taxpayer to establish, maintain or defend a legal title or right in an asset will have to be capitalised by adding those expenses to the base cost of the asset.
rule 2: remember that fines and penalties for unlawful activities are not deductible
In the range of potential taxpayer difficulties, section 23(o) treatment is arguably even worse than capitalisation treatment since section 23(o) prevents any deduction The key, of course, is just what is considered a fine or penalty for unlawful activities within the scope of section 23(o). Most statutes create offences and corresponding penalties in order to force compliance with their provisions. A few examples of these include:
- paragraph 5(5) of the Fourth Schedule to the Act which applies to an employer that fails to deduct the correct amount of employees' tax;
- sections 75 and 104 of the Act under which the courts can impose criminal penalties; and
- practices prohibited by the Competition Act - under sections 4 to 9 of the Competition Act certain restrictive practices, as well as the abuse of a dominant position, are prohibited. Restrictive practices include –
- horizontal or vertical relationships between parties which prevent or lessen competition;
- restrictive horizontal practices, including price-fixing, market division between firms and collusive tendering; and
- minimum resale price maintenance.
On 26 February 2010, the South African Revenue Service (SARS) issued Interpretation Note No. 54 on section 23(o). Interpretation notes are intended to provide guidelines on SARS' interpretation and application of the provisions of tax legislation falling under the jurisdiction of SARS. Not all penalties result from an 'unlawful act' and will thus not be barred as a deduction by section 23(o). Fines and penalties referred to in section 23(o) must be distinguished from amounts payable as damages which may also qualify under the general deduction formula in section 11(a) and will not be denied under section 23(o). For instance, a party found liable of a practice prohibited by the Competition Act may be sued by a third party (referred to as an 'affected party' in the Competition Act) for damages. The deductibility of competition damages to such affected party is not prevented by section 23(o) since those damages would not be regarded as fines and penalties.
The equivalent provision in the US Tax Code to section 23(o) is section 162(f). One has to admire the creativity of the taxpayer in the Field Attorney Advice 20084301F issued by the United States' Internal Revenue Service in its attempt to avoid the characterisation of a fine or penalty. In Field Attorney Advice 20084301F, Electrotoy was a consumer products manager operating in States X, Y and Z. The respective States sued in Federal District Court accusing Electrotoy of price fixing. The States claimed Electrotoy's prices were anti-competitive. The three States sought injunctions, as well as civil penalties. Eventually the parties filed a consent decree and final judgment. In it, Electrotoy agreed to an injunction against dictating the price of its products and agreed to pay an amount to the three States. The money was to be earmarked for the use by the State Attorney-General for anti-trust enforcement, for a consumer protection fund, or any other function allowed under state law. Significantly, Electrotoy admitted no liability and claimed that the consent judgment could not be used in any proceedings to show its guilt. The Field Attorney Advice concluded that Electrotoy's payment to all three States to settle the anti-trust suits was not deductible under section 162(f). The Field Attorney Advice noted that the amount Electrotoy paid was below the maximum amount the law allowed for a penalty. The Field Attorney Advice found that this by itself was evidence that the entire payment Electrotoy made was a fine or penalty (despite the inclusion of the no admission of liability language in the consent order).
rule 3: beware the withholding issue
Probably the biggest tax exposure for defendants is the failure to withhold taxes. The tax treatment of settlement payments and trial / arbitration awards in employment related disputes is a complex area with many uncertainties. If it is an employment case and the amount paid to settle the matter constitutes "remuneration" (as that term is defined in the Fourth Schedule to the Act), then the liability for failing to withhold employees' tax can be serious. An employer that fails to withhold the required employees' tax is liable for that tax, as well as penalties and interest. Employers should at least apply the following four step test in determining the correct treatment of employment-related settlement payments:
- first, the employer should determine the character of the payment being made and the nature of the claim giving rise to the payment;
- second, the employer should determine whether the payment is taxable in the hands of the claimant;
- third, the employer should determine whether the payment is remuneration; and
- fourth, the employer should determine the appropriate tax reporting.
The range of payments which pass from employer to employee is so wide that it is beyond the scope of this article to analyse each of them. However, if the four step test is applied to these payments then it may lead to a more accurate tax characterisation and reporting outcome for the employer with the consequential elimination of withholding tax risk.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.