n Business Tax and Company Law Quarterly - Early termination of contracts : the tax implications

Volume 7, Issue 4
  • ISSN : 2219-1585


It is a reality of everyday commercial life that parties agree bilaterally to terminate contractual arrangements prior to their stipulated termination dates. In most circumstances, the party wishing to withdraw from the arrangement is required to pay an amount of compensation to the counter-party. The payment of this compensation and the agreement by the counter-party to surrender certain of its rights trigger tax implications. This article explores the income tax, capital gains tax (CGT) and value-added tax (VAT) implications that may arise in consequence of the early termination of a contractual arrangement. As regards the income tax implications, the issue is whether the compensation will constitute a receipt of a capital or revenue nature in the hands of the counter-party. While a number of tests have been adopted over the years, the test most often applied is whether the compensation fills the hole of therecipient's profits or assets, the former being revenue in nature and the latter capital in nature. The payment of the compensation by the party wishing to withdraw from the contractual arrangement may be deductible depending on whether it can be said that the payment (expenditure) is closely related to the party's income-earning operations. The author ventures that the debate regarding whether expenditure incurred in avoiding expenditure (i.e getting-out of an onerous arrangement) can be said to have been incurred in the production of the party's income is now moot the expenditure cannot be disallowed on that basis.Should the receipt of the compensation by the counter-party constitute a receipt of a capital nature, the issue arises as to whether the compensation can be said to constitute 'proceeds' for the 'disposal' of an 'asset' by the counter-party.The view of SARS is that the personal rights held by the counter-party under the contractual arrangement constitute an 'asset' for CGT purposes and a disposal of such 'asset' takes place when the right is surrendered in exchange for payment of the compensation. It is difficult to identify any base cost of such 'asset'. The surrender of a right (the personal rights held by the counter-party under the contractual arrangement) constitutes the supply of services by the counter-party and the counter-party will be required to account for VAT in respect of the compensation received.

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