Income vs capital

Save yourself tax hassles by ensuring that a clear distinction is made between ‘income’ and ‘capital’ in any agreement you sign with other parties.

Income vs capital
- Advertisement -

A South African taxpayer that had held the South African distribution rights to a well-known whisky since the 1970s lost those rights. This almost resulted in the bankruptcy of the taxpayer. However, it then received a large lump sum consideration as compensation for the early termination of the distribution agreement. SARS sought to tax this money as income and also sought to enforce a VAT output in respect of the lump sum.

READ:Clarity on VAT and foreign companies

The taxpayer objected to the classification of the lump sum as ‘income’ – on which tax would be payable – and also to the treatment of the money as attracting output VAT. The taxpayer contended that the amount paid to it by its overseas distribution rights holder was ‘capital’, not ‘income’. Capital is, of course, not taxable. The Tax Court held that the
lump sum be included as income, but the Supreme Court of Appeal held that the taxpayer had lost a valuable asset upon termination of the distribution agreement.

Sterilisation of an asset

One of the judicial tests used by the court was the investigation of the sterilisation of an asset. Because the whisky distribution agreement was so useful in bringing clients to the retailers serviced by the taxpayer, the removal of that
whisky brand materially affected the business. It was thus a capital asset that brought income to the taxpayer.

- Advertisement -

As the termination agreement made no reference to loss of profits, the compensation was thus held by the Supreme Court of Appeal to be capital in nature. Regarding the contention of SARS that VAT was payable upon the transaction, the Tax
Court had held that VAT was payable in terms of Section 11 of the VAT Act, as termination was in favour of an offshore provider of rights.

In favour of non-resident
The Supreme Court of Appeal examined the findings of the Tax Court and found that the surrender of a right is a service as contemplated in the VAT Act. It also found that such a service had been rendered in favour of a non-resident. Simply put, it held that in order for VAT to apply, the services would have had to be rendered directly in connection with moveable property in South Africa.

But, in this case, the surrender of the distribution rights was not a supply rendered directly in connection with moveable property in South Africa, because the site of the right is where the debtor resides – in this case outside South Africa.

The need for clarity
The importance in this case is the emphasis on the correct application of the tests for ‘capital’ and ‘income’ classification. And I believe that, when an agreement of this nature is drafted, great care must be taken to ensure that a clear interpretation of the parties’ intentions can be made.

Peter O’Halloran is head of tax at BDO, Gaborone. Phone him on 00267 390 2779.