Had a contract terminated?
14 May 2009

The compensation might not be taxable according to a recent court ruling...

An hotelier, a close corporation, had managed to secure a lucrative contract with a South African company in terms of which it undertook to provide accommodation over a period of approximately two years to successive intakes of non-resident students from the Middle East who were undergoing training in this country. Immediately following the September 11 2001 attacks in the United States of America, and midway through the contract period, the students left and no further intakes were received. The hotelier negotiated settlement for the premature termination of the contract with the South African principal and received a sum as compensation. A substantial portion of the compensation was applied towards the repair and replacement of premises and contents that had been damaged during the period of occupancy by the students.

The hotelier had claimed that the amount received as compensation was a capital receipt. SARS had assessed the amount to tax as a receipt of revenue. The Tax Court and the High Court had, in successive appeals ruled against the hotelier which then appealed to the Supreme Court of Appeal (Fourie Beleggings v C:SARS( 168/082) 009 ZASCA 37 (31 March 2009)).

The hotelier's case was founded on the basis that the contract was an asset of the business and that the amount that was received in compensation was a payment for the loss or "sterilisation" of an income-earning asset and therefore should be regarded as a receipt of a capital nature. Three decisions in the South African courts were relied upon in support of this assertion.

The Supreme Court of Appeal accepted that, in certain cases, an amount paid as compensation for the loss of a contract may be capital in nature, but hastened to add that, in the matters relied upon by the hotelier the contracts had been used by the taxpayer for the purpose of generating income. The contracts in those cases had provided the taxpayers with the ability to derive income.

A distinction was drawn between a contract that is a means of producing income and a contract that is directed towards earning income. In the former case, termination of the contract would eliminate the source of the income, while in the latter case, on termination of the contract the source of the income would remain intact.
The Court held [ paragraph15]:

"ln the present case, the appellant traded as a hotelier before the contract and continued to do so, both once it had commenced and after it had been cancelled. The contract did not operate as a means by which the appellant generated business or through which it acquired business or obtained opportunities from which to earn income. lt 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. lt 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 [the SA principal] was concluded as part of its business of providing accommodation. lt was therefore a product of the appellant's income earning activities, not the means by which it earned income."

It was therefore held that the compensation received was of a revenue nature and that the assessment as such had been properly made.

This decision is a most useful addition to our tax law by virtue of the lucid explanation of the distinction between contracts that form part of the income-earning structure and contracts that are related to income-earning operations.

This article first appeared in PwC's Synopsis

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