12 May 2017 by Tax and Exchange Control Alert

Tax consequences of waiver of contractual rights

Capital gains tax (CGT) is levied on the disposal of an asset. The terms “disposal” and “asset” are defined widely in the Eighth Schedule to the Income Tax Act, No 58 of 1962 (Act). The term “disposal” includes “the forfeiture, termination, redemption, cancellation, surrender, discharge, relinquishment, release, waiver, renunciation, expiry or abandonment of an asset” (see paragraph 11(1)(b) of the Eighth Schedule to the Act (Eighth Schedule)).

Paragraph 38 of the Eighth Schedule applies when a person disposes of an asset by way of a donation, or to a person who is a connected person in relation to the person disposing of the asset for a consideration that is below an arm’s length price.  In such a case, the asset is deemed to have been disposed of for a market-related consideration.

The reduction of a debt for inadequate consideration can give rise to either income tax (under s19 of the Act), or to CGT (under paragraph 12A of the Eighth Schedule) in the hands of a creditor. The tax depends on the way that the debtor applied the debt funding.

Donations tax is levied on the value of property disposed of under a donation. The term “donation” includes “any gratuitous waiver or renunciation of a right” (s55 of the Act – emphasis added).

The provisions above were the subject of Binding Private Ruling 273 (Ruling) issued by the South African Revenue Service (SARS) on 2 May 2017.  The facts were as follows: two companies (Co A and Co B) were both wholly-owned subsidiaries of another company. Co A had the right to receive from Co B “an annual quantity of produce” determined under a prescribed formula. Co A unilaterally waived the right against Co B.

Unfortunately, the further details of the arrangement between the parties and circumstances surrounding the waiver of the right are not set out in the Ruling.  

Notably, it is not clear how Co A could unilaterally waive its right. Presumably, if Co A had a right it would have arisen under some contractual arrangement with Co B. If so, Co A would not have had the power to waive the right; the right would have had to have been terminated by mutual agreement between the parties. If that was the case, there would have been no question of a donation or disposal of the asset by waiver for tax purposes.

Nevertheless, SARS ruled that the waiver did not give rise to donations tax. Assuming that there had been a unilateral waiver of the right, it is unclear why donations tax was at issue in the Ruling at all.  As noted above, for a disposal to amount to a donation, there must be an element of gratuity. It is doubtful that the element of gratuity would have been present in the context of what appears to have been a commercial transaction. Nevertheless, it is encouraging to see that SARS continues to rule that commercial transactions in the ordinary course do not give rise to donations tax (see also, for example, Binding Private Ruling 252 dated 10 October 2016 and Binding Private Ruling 253 dated 19 October 2016).

Co A and Co B were “connected persons” in relation to each other. However, SARS nevertheless ruled that the waiver of the right for no consideration did not trigger paragraph 38 of the Eighth Schedule.  Again, it is not clear why that provision was at issue. The provision applies if there is a disposal to a person. If the right was simply waived, could it be said that there was a disposal of the right to Co B? (See, for example, Income Tax Case No 1859 74 SATC 213.)

SARS also ruled that neither s19 of the Act, nor paragraph 12A of the Eighth Schedule applied to the waiver. Those provisions apply where a debt owed is waived. It is not clear that the obligation to provide the produce annually actually was a debt owed at the time of the waiver.

Finally, as to value-added tax, SARS ruled that the waiver of the right to the produce for no consideration did not trigger the application of s10(4) of the Value-Added Tax Act, No 89 of 1991 to deem the value of the supply of the service to be at open market value.

Taxpayers should welcome the Ruling. But, unfortunately, as the Ruling does not set out the facts in detail, and as the Ruling does not set out SARS’s reasoning, taxpayers should take care in similar transactions.

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