4 July 2009 by

A new test to determine whether a receipt is of a capital nature?

At first blush one would not have thought that the facts of Fourie Beleggings v CSARS would cause a dispute that went all the way to the Supreme Court of Appeal in order to determine the tax consequences of a compensation payment. The facts were relatively simple. The taxpayer was an hotelier which conducted business at the Elgro Hotel in Potchefstroom. In particular, it entered into an agreement with a division of Denel (Proprietary) Limited in terms of which it provided accommodation for people referred to as "students".

In terms of the reported case these students appeared to have been members of the military forces of the United Arab Emirates who received training in South Africa. The taxpayer had to make special arrangements to meet the dietary needs of the students as well as a number of their special needs. Pursuant to the so-called "9/11" attack upon the World Trade Centre in New York in September 2001, the students packed up and left and it became apparent that they would not return.

In the light of this unforeseen development, Denel repudiated its contract with the taxpayer. Many of the rooms had been left in state of considerable disrepair as the students amongst others kept pets in their rooms and they also smoked hookahs (hubbly-bubbly pipes) that had burnt carpets, bedding and curtains. Ultimately the taxpayer accepted an amount of approximately R1,3 million in settlement of all claims it might have had arising from the early termination of the contract. The question arose as to whether such payment was of a capital or revenue nature.

Generally, the compensation payment would have been in respect of the loss of profit that was suffered by the taxpayer through an early termination of the lease agreement. Such receipt would clearly have been of a revenue nature. In other words, if a lump sum is paid in lieu of, and as compensation for, the balance of rent due for the period stipulated, it would more often than not be of a revenue nature.

However, it was argued on behalf of the taxpayer that the lease agreement itself amounted to an asset that formed part of its income producing structure. In other words, it was not argued that the property or the hotel form part of the income earning producing structure, but that the lease itself constituted the income producing structure. In other words, should this be the case, any amount paid for the loss or sterilisation thereof would be of a capital nature.

It was accepted by Leach AJA that an amount paid to a taxpayer as compensation for the cancellation of a trading contract may in certain circumstances be of a capital nature. However, in these cases the contract (or the rights and obligations flowing therefrom) should be used by the taxpayer for the purpose of generating income.

A fundamental distinction was drawn by the court between a contract which is a means of producing income and a contract directed by its performance towards making a profit. In the particular circumstances, the taxpayer traded as an hotelier before the entering into of the lease agreement and continued to do so after the cancellation thereof. It was therefore held that the lease agreement did not operate as a means by which the taxpayer generated business or through means of which it acquired business or obtained opportunities from which to earn income.

It was said: "it was merely a memorial of business the appellant had concluded, in which the number of persons it had agreed to accommodate, when that would take place and the rate that would be charged, were recorded. It may be that the appellant stood to earn a great deal from the contract which was to form the major source of its income during the period it lasted but that, and its anticipated duration of more than two years, did not transform it into part of the appellant's income producing structure. That structure was made up of its lease of the hotel and the use to which the hotel was put. The contract the appellant agreed with Naschem was concluded as part of its business of providing accommodation. It was therefore a product of the appellant's income earning activities, not the means by which it earned income".

It follows that one should therefore be very careful to identify the income earning structure of a taxpayer. A contract can potentially be part of the income earning structure. However, if a contract is concluded on the basis that it is not the means through which business is acquired or opportunities are obtained, compensation in respect of the cancellation thereof may potentially be of a revenue nature.

Emil Brincker

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