The tax implications of assuming contingent liabilities as part of a sale of business present uncertainties for both sellers and purchasers. The South African Revenue Service issued Interpretation Note 94 during December 2016 to provide guidance in this regard. The approach set out in this note require taxpayers to pay careful attention to, amongst other, the classification of contingent liabilities assumed, values attached and allocation of these items as purchase consideration as these factors have a significant effect.
The tax treatment of contingent liabilities assumed by a purchaser when acquiring a business as a going concern has been an area of uncertainty for a number of years following the Ackermans v C:SARS case in 2010 and legislation proposed in this regard by the National Treasury during 2011 that was ultimately not implemented. The proposals were withdrawn on the basis that the matter could be resolved by issuing an interpretation note. The long awaited interpretation note (Interpretation Note 94 (IN94)) was published on 19 December 2016.
Scope of the interpretation note
The focus of IN94 is limited to the tax treatment of contingent liabilities assumed as part of transferring a business as a going concern.
The first consideration highlighted in the IN is to establish the nature of the contingent liability and to ensure that the item considered is in fact a contingent liability that may result in expenditure being incurred upon settlement, as opposed to an accounting provision.
The IN distinguishes between two types of contingent liabilities namely embedded contingent liabilities, which is inextricably linked to asset and therefore reflected in the value of the asset, and a free-standing contingent liability. This distinction is of critical importance as the tax treatment of the assumption of the categories of contingent liability differs significantly, as discussed below.
Guidance on the tax effect
In the case of an embedded contingent liability, the effect of the contingent liability inextricably linked to an asset will be reflected in a depleted value of that asset to be taken into account as proceeds in respect of the transfer of the asset by the seller and as the acquisition cost of the purchaser.
In the case of a free-standing contingent liability, the essence of the guidance provided by IN94 is:
- The seller must value the benefit of being relieved of this contingent liability. This value constitutes proceeds for capital gains tax or income, depending on the nature of the asset of which the purchase price is being settled by assumption of the contingent liability. This has an immediate tax impact for the seller.
- The contingent liability is not realised and no expenditure is incurred by reason of the fact that the seller accepted a lower cash consideration for the business. Consequently, the seller is not entitled to a deduction.
- The assumption of a contingent liability does not give rise to expenditure for the purchaser - this only happens when the contingent liability crystallises into an actual obligation. At that point , the purchaser may deduct the expenditure. This deduction must however be considered in light of the fact that the purchaser incurred the expenditure to acquire an asset rather than for the original underlying cause that initially give rise to the contingent liability.
This treatment may result in differences between the amount and timing of the effect in the hands of the purchaser and seller. Scenarios would exist where neither of the parties are entitled to the deduction when a contingent liability that arose during operations eventually realises into expenditure.
The IN also deals with transactions where roll-over relief applies. The approach suggested results in an outcome where the purchaser effectively steps into the shoes of the seller when the contingent liability realises. In such a case, the mismatch concerns noted above are avoided.
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.