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ALERTAUGUST 2014

TAXIN THIS ISSUE

RULING ON LEASEHOLD

IMPROVEMENTS

SECURITIES TRANSFER TAX AND “EARNOUT”

PROVISIONS

RULING ON LEASEHOLD IMPROVEMENTS

The South African Revenue Service (SARS) released binding private ruling 177 (Ruling) on 31 July 2014. The Ruling concerned a lease and a sub-lease and SARS was asked to rule on the income tax consequences for, inter alia, the landlord in circumstances where there is an obligation on the sub-lessee to make improvements to the land.

The proposed transaction was briefly as follows:

■■ A lessor would lease its land to a lessee;

■■ The term of the lease would be 99 years (renewable);

■■ The lease agreement would permit the lessee to effect improvements on the land at the lessee’s cost, but placed no obligation on the lessee to do so;

■■ The lease would however specify the type of improvements to be effected, and the time periods in which such improvements need to be completed, should the lessee decide to effect improvements;

■■ The lessee would pay the lessor a monthly rental based on the development costs of any improvements effected;

■■ The lessee would sub-let the land to a sub-lessee concurrently with the main lease;

■■ The term of the sublease would be 99 years (renewable);

■■ The sub-lease agreement would oblige the sub-lessee t o effect improvements on the land; and

■■ The sub-lessee’s rental would be based on the development costs of the improvements effected, which would increase after a period of time.

Applicable principles

Generally, and in terms of paragraph (h) of the definition of 'gross income' in s1 of the Income Tax Act, No 58 of 1962 (Act), where a right to have improvements effected on land or buildings accrues to a landlord in terms of a lease in any year or period, the landlord has to include in its gross income either:

■■ the amount stipulated in the agreement as the value of the improvements or the amount to be expended on the improvements; or

■■ if no amount is stipulated, the fair and reasonable value of the improvements.

Even though such a right would ordinarily constitute a capital accrual for the landlord, the Act specifically provides for bringing it into account as gross income for the landlord so as to prevent parties from disguising or converting rentals (which are usually revenue in nature) as capital accruals in the form of improvements to land or buildings being leased.

Technically, the relevant amounts must be included in the landlord’s gross income in the tax year that the right to the improvements accrues (which is usually when the agreement is entered into), but SARS has previously postponed the inclusion until such time as

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the improvements have been completed, even though this is not legally correct.

Where a lessee incurs expenditure in respect of effecting improvements on land under a lease, such expenditure would ordinarily not qualify for deduction under s11(a) of the Act because it constitutes capital expenditure. However, s11(g) of the Act provides for an allowance to be claimed by a lessee for expenditure actually incurred in respect of effecting improvements to land or buildings where it is obliged to do so under the lease, subject to various limitations.

Also, because a landlord may be required to include a substantial amount in its gross income under paragraph (h) of the definition of 'gross income' at the commencement of the lease, even though the landlord might only benefit (if at all) from the improvements when the lease terminates, relief is provided to the landlord in the form of an allowance in terms of s11(h) of the Act.

Essentially, s11(h) of the Act provides that a lessor may claim as an allowance an amount that “the Commissioner may deem reasonable, having regard to any special circumstances of the case” as well as having regard to the period over which the lessee may claim a deduction under s11(g) of the Act, subject to certain limitations.

SARS usually allows an amount equal to the difference between the value that the lessor has to include in its gross income and the present value of the improvements at that time. If that amount is allowed against the amount included by the lessor in its gross income, then the lessor would effectively only be taxed on the present value of the improvements, which amount reflects more accurately the value of the right that accrues to the lessor at the time of commencement of the lease.

Ruling

With reference to the proposed transaction, SARS ruled that:

■■ the lessor should include in its gross income the 'fair and reasonable value' of the improvements effected by the sub-lessee (in accordance with paragraph (h) of the definition of 'gross income');

■■ the lessor may claim an allowance in terms of s11(h) of the Act “…determined by using the present value of the actual development cost arising from the performance of the sub-lessee’s obligations under the sub-lease, discounted at the rate of 6 per cent of the 99-year period…”;

■■ The sub-lessee may claim an allowance under s11(g) of the Act in respect of the expenditure that it will incur, over a 25 year period; and

■■ If the sub-lease terminates pre-maturely and before the sub-lessee could claim all its allowances of the 25 year period under s11(g), it may claim the entire unredeemed balance in terms of s11(g)(vii).

Comments

The Ruling is significant because it applies paragraph (h) of the definition of 'gross income' to a landlord in circumstances where no right to have improvements effected accrues to that landlord in terms of the lease agreement – the right to have improvements effected accrues to the lessee in terms of the sub-lease agreement.

It therefore appears that SARS was willing to impute the terms of the sub-lease agreement on the lessor under the main lease.

The Ruling is not clear as to when the lessor should include the relevant amounts in its gross income ie the year the contract is concluded or the year the improvements are completed. As stated, the correct legal position is that the lessor must include the amounts in the year that the right accrues and not only in the year that the improvements are completed. It may however be very difficult to determine the 'fair and reasonable value' of the improvements at the time that the right accrues, depending on how specific the agreements are.

The Ruling also states that the lessor may claim an allowance in terms of s11(h) of the Act determined with reference to the present value of the 'actual development cost', as opposed to the 'fair and reasonable value' of the improvements that was included in the lessor’s gross income. The 'actual development cost' could actually be higher or lower than the 'fair and reasonable value' of the improvements and this could have an impact on the net amount that the lessor would effectively be taxed on.

An obvious concern here is also that the 'actual development cost' would only be known once the developments have taken place and the improvements have been effected. It is thus not clear whether the Ruling implies that the lessor should claim the allowance at the time of completion of the improvements.

It should also be noted that the Ruling makes it clear that the time period over which a lessee may claim an allowance under s11(g) of the Act (in this case 25

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years), is not necessarily the same period over which amounts are discounted for purposes of s11(h) of the Act (in this case 99 years).

Interestingly, the Ruling does not mention any of the Value-added Tax consequences that could arise as a result of the supplies made by the parties.

Heinrich Louw

Often parties to a sale of shares agreement agree to an 'earnout' or 'agterskot' clause: a provision that part of the price will be paid in future if certain conditions are met. For example, the parties may agree that, while the seller must transfer ownership of all the shares to the purchaser at the time of the sale, the purchaser will pay a part of the purchase price only if the company reaches specified financial targets in future.

The further payment could be a fixed or variable amount. For example, B could buy A's shares for R100, while B undertakes to pay A an additional R50 if the profit after tax of the company is at least R30 over the following year. Alternatively, B could undertake to increase the price of R100 by a percentage determined with reference to the amount of the profit after tax.

Securities Transfer Tax (STT) is usually levied in respect of a sale of shares transaction. However, where a sale of shares is subject to an 'earnout' provision, the issue arises as to how the amount of the STT is calculated, specifically in the context of unlisted companies.

Section 2(1) of the Securities Transfer Tax Act, No 25 of 2007 (STT Act) provides that STT is levied in respect of every transfer of any security issued by local companies at a rate of 0,25% of the taxable amount of the security as determined in terms of the STT Act.

For purposes of the STT Act, the term 'security' includes a share in a company and any member's interest in a close corporation.

The term 'transfer' is defined widely in the STT Act and includes a sale, assignment or cession, or disposal in any other manner of a security.

In terms of s6(1) of the STT Act the taxable amount in respect of every transfer of an unlisted security is, in the case of an ordinary transfer (that is, otherwise than as a result of a cancellation or redemption of the share):

n the amount or market value of the consideration given; or

n where no consideration is given or the consideration given is less than the market value of that security, the market value of that security.

S3(1)(c) of the Securities Transfer Tax Administration Act, No 26 of 2007 (STT Administration Act) states that STT which becomes payable during a month 'in respect of any transfer' of an unlisted security, must be paid to the South African Revenue Service (SARS) within two months from the end of that month, otherwise SARS may impose interest and penalties.

In the case of an earnout transaction, STT could conceivably be imposed the following ways:

1. STT could be imposed at the time of the sale but only on the amount that accrues at that time (R100 in our example above), as this amount is known; and the contingent payment could be disregarded entirely. However, STT is levied 'in respect of a transfer'. Arguably, this could mean that the intention is that STT must not only be levied 'on transfer' of shares but at any time when consideration accrues in respect of the transfer.

2. STT could be levied at the time of the sale on the full consideration, that is, on the sum of the initial consideration (R100 in the example above) and the contingent consideration (R50 in the first alternative in the example above). If it transpires that the contingent portion of the consideration does not becomes payable, the taxpayer could apply for a refund in terms of s4 of the STT Administration Act. However, this would not be possible in the case where the contingent amount was a variable amount (as is the case in the second alternative in the example above).

3. The person liable for the STT and SARS could adopt a wait-and-see approach. In other words, STT would not be imposed at the time of the sale but would be imposed only at the time when the full consideration is known, that is, when it becomes certain that the contingent amount will be paid, and what the amount is.

SECURITIES TRANSFER TAX AND “EARNOUT” PROVISIONS

4 | Tax Alert 8 August 2014

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4. The person liable for STT could attempt to place a present value on the contingent portion of the consideration, taking into account the probability that it would become payable. The person could then add that amount to the fixed portion of the consideration to determine the taxable amount, and pay STT on the total.

While, in the case of an earnout arrangement, it is not certain at the time of the sale that the earnout amount will become payable and/or what the amount will be, it is certain that the seller does, at the time of the sale, acquire at least a contingent right to receive the earnout amount.

In the case of WH Lategan v Commissioner for Inland Revenue 2 SATC 16, and in the context of income tax, a taxpayer sold wine for a certain price, part of which was due in the current tax year, and the balance due in the following tax year(s). The court stated that:

"So far as a debt was concerned which was payable in the future and not in the year of assessment, it might be difficult to hold that the cash amount of the debt had accrued to the taxpayer in the year of assessment. He had not become entitled to a right to claim payment of the debt in the year of assessment but he had acquired a right to claim payment of the debt in future. This right had vested in him, had accrued to him in the year of assessment and it was a valuable right which he could turn into money if he wished to do so"

The statement of the court quoted above may also be applicable in determining the amount of STT in the case of an earnout arrangement. At the time of the sale, a right to the earnout amount vests in the seller, and it is a valuable right which could be turned into money, even though it is a contingent right.

In this regard, the United Kingdom (UK) Court of Appeal case of L M Tenancies 1 plc v IRC [1998] STC 326 is instructive. The case involved the determination of an amount of stamp duty due in respect of a lease. Under the lease, the rent and a premium were determinable in accordance with a formula which was linked to variables that could only be determined in future.

The court held that the words "the amount of value of the consideration [payable] for the sale" in relevant UK legislation (very similar to the words used in the STT Act) "include amounts or value payable in the future and amounts or value payable immediately or in the future whether unconditionally or contingently."

Naturally, it may be difficult to place a value on the right to the contingent earnout amount and it may well be that in many cases the value will be nil. It should also be remembered that the burden of proving the right amount would rest on the person paying the STT.

It is submitted that, in the light of the tenets of taxation that taxes should be certain and should be collected at the time and in the manner that is most appropriate for the taxpayer, it is likely that South African courts would take the same approach as that taken in the LM Tenancies case.

In our view, the relevant legislation should be amended to make it clear how STT should be levied in the case of earnout arrangements. In the meantime, parties to such transactions should consider approaching SARS for a ruling.

Ben Strauss

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