The tax implications of amounts incurred in respect of rental contract cancellations

Abstract

The purpose of this study was to examine whether penalties payments made by the lessor's to the lessee's, in respect of early termination of commercial lease agreements can be deductible in terms of the provisions of the Income Tax Act (58/1962). The research object was determined by critically analysing the relevant provisions of the ITA (58/1962) with reference to case law and applicable academic commentary. A critical evaluation of the legal aspects of a lease agreement was done to determine the specific rights attached to a commercial lease agreement. The validity of early termination penalties was furthermore questioned against the requirements of the Consumer Protection Act 68 of 2008 (hereafter referred to as the CPA (68/2008)). CPA (68/2008) did confirm the validity of penalties for the early termination of lease agreements, but added that the penalty should be reasonable, taking into account the circumstances surrounding the contract, and thus imposing a limitation on the quantum of the penalty, but not imposing any limitation on the calculation method The research was limited to three contractual relationships which were tested against section 11(a). The first scenario dealt with early termination by a lessor for own use of the property: <ul>- Although such termination payments would qualify as expenses or losses actually incurred, it was found that because the terminating lessor's purpose is to use the property for its own trading activities, such a termination payment will not qualify as it is not incurred in the production of income (ITC 819 (1955:71)).</ul> <ul>- In applying the capital tests it revealed such occurrences will be 'once off' happenings that could classify the termination to be capital in nature. However, when applying the 'enduring benefit' test, it was questionable whether such a benefit actually gets created. The determining factor was the purpose for which the termination was incurred (New States Areas Ltd v CIR (1946:170)). The purpose revealed that the taxpayer's motive was not to create an asset for future benefits but in plain words just to make use of the said property for its own trading activities.</ul> The second scenario applicable was when a lessee terminates a lease agreement prematurely: <ul>- Terminations from a lessee's perspective were also found to be expenses or losses actually incurred, on cancellation of a burdensome contract before termination date. In this instance, the amount was also found to be incurred in the normal course of business, by motivating that the termination was to minimise expenditure and to enhance company profits (ITC 1600 (1995:137)).</ul> <ul>- The 'enduring benefit' created when a lessee terminates an onerous rental contract prematurely, was said to be the avoidance of paying excessive rent for the remainder of the contract (Cornelissen, 2010). However, an in depth review of the true nature of the transaction revealed that the purpose of the termination was the monthly rental saving (New States Areas Ltd v CIR (1946:170)), and not the creation of a future benefit, which will be capital in nature. At face value the 'once and for all' test revealed that terminations from a lessee escaping a burdensome rental contract will be capital in nature. In Stone case supra (1974:129)), the court stated that losses should be classified at the hand of what was lost; if the loss was floating capital then the loss will be non-capital expenditure. The legal nature of lease termination payments revealed that the quantum is in essence future rent payable (Shrank&Yim, 2009), which proved that a termination payment from a lessee was in true nature floating or non-capital expenditure.</ul> The final scenario dealt with head and subleases and discussed early terminations by a lessor, whose business is leasing: <ul>- It was concluded that both delimitations as per the third scenario would constitute expenses or losses actually incurred. As for the 'in the production of income' requirement; ITC 1267 (1977:151), confirmed that when a lessor was in the business of renting out property, any termination payments in relation to cancellations of such leases would qualify as being made in the production of income, as long as the taxpayer does not cease its trading activities.</ul> <ul>- The capital tests first of all revealed that when a lessor of sub-lessor is in the business of leasing properties, lease terminations would be deemed part of such a trade. Such a regular or recurring expense would thus fall outside the ambit of the 'once and for all' test (New States Areas Ltd v CIR (1946:410)). Applying the 'enduring benefit' test it was revealed that the benefit that could be created will be subject to the landlord being able to lease the property at an improved tariff. The result of dissecting the true nature of the transaction serves as support for the findings in the 'once and for all' test, as the clear purpose of termination was income producing in nature (New States Areas Ltd v CIR (1946:170)).</ul> The aforementioned confirmed that the main challenge for all the contract relationships would be whether the amount was incurred in the production of income. The deciding factor was determined to be the closeness of the link between the expense or loss incurred in respect of the taxpayer's trade (CIR v Standard Bank of SA Ltd 1985 (4) SA 485 (A) 47 SATC 179:198). The requirement to determine whether an early termination payment was not capital in nature furthermore revealed that, although certain rights and obligations did qualify as an asset within the sphere of the Eighth Schedule, instances exist commercially where a specific transaction could be dual in nature. Although it was confirmed that there was no halfway house between capital and revenue, it was proven that a specific transaction could be dual in purpose. The focus in dissecting such a cost was, however, rested on the purpose and intent for which the taxpayer incurred the specific cost (CIR v Standard Bank of SA Ltd (1985:196)). To explain such instances, the example of lease terminations linked to the acquisition of the same or similar property was used. It was proved that if a taxpayer can dissect a termination and acquisition payment into its separate classes, the difference in lieu of the fair market value of the asset being acquired, was in fact a termination cost that may be revenue in nature. It was noted in Nemojim (Pty) Ltd case supra (1983:266), that expenditure could be apportioned according to different types of income. The apportionment between capital and revenue was however only allowed at the hand of Guardian Assurance Holdings (SA) Ltd case supra (1976:113). Although lease termination payments are generally accepted as being capital in nature, it was proved that the taxpayer could in certain circumstances be allowed a deduction against taxable income in terms of section 11(a) ITA (58/1962). Each case would however have to be determined on its own merit. In concluding the research, it was found that the prohibition section 23(g) would apply when a taxpayer ceases its trading totally. This reason was supported by the fact that such termination payment would constitute non-trade expenditure. The second scenario applicable was determined to be when a taxpayer terminated a lease prematurely to make use of the property for its own trading activities (ITC 819 (1955:71)). AFRIKAANS : Die doel van die navorsing was om te bepaal of vroee kansellasie betalings tussen huurders en verhuurders met betrekking tot kommersiele huurkontrakte aftrekbaar sal wees in terme van die bepalings van die Inkomstebelastingwet (58/1962). Die navorsingsdoelstelling is vasgestel deur die relevante bepalings van die Inkomstebelastingwet (58/1962) met verwysing na hofsake en gepaste akademiese kommentaar in ag te neem. 'n Kritiese evaluasie van die wetlike aspekte van 'n huurkontrak is gedoen om die tipe regte te identifiseer wat gepaardgaan met 'n kommersiele huurkontrak, asook om die geldigheid van vroee kansellasie ten opsigte van die Wet op Verbruikersbeskerming (68/2008)(“CPA”) te bevestig. Die CPA (68/2008) het die geldigheid van vroee kansellasie betalings bevestig en geklassifiseer as vergoeding vir die kontrakbreuk gepleeg. Die vereiste is egter dat die betaling 'n direkte verband moet hê ten opsigte van die skade gely deur die niekontrakbreukende party. Die aftrekbaarheid van die vroee kansellasie betalings moes voldoen aan die vereistes van artikel 11(a), en is voortaan getoets aan die hand van drie toepaslike gevalle vir die studie. Die eerste geval geidentifiseer is die kansellasie van 'n verhuurder om die eiendom vir eie gebruik te benut: <ul>- Daar is bepaal dat alhoewel die betaling sal kwalifiseer as 'n uitgawe of verlies werklik aangegaan, die rede om die eiendom te gebruik vir eie besigheidsdoeleindes, veroorsaak dat die bedrag nie aangegaan is in die produksie van inkomste nie. Hierdie stelling is vasgestel aan die hand van die uitspraak in ITC 819 (1955) 21 SATC 71(C).</ul> <ul>- Die ondersoek of die kansellasie betaling kapitaal van aard sal wees, het onthul dat die rede waarvoor die kansellasie gedoen was van uiterste belang is soos vasgestel in New States Areas Ltd v CIR, 1946 (AD) 610 (14 SATC 155:170). Dit is bevestig dat die verhuurder se motief nie was om 'n toekomstige voordeel te skep nie, maar om die eiendom vir sy eie bedryfdoeleindes te benut.</ul> Tweedens is wanneer 'n huurder 'n kommersiele huurkontrak kanselleer voor vervaldatum: <ul>- In hierdie geval is gevind dat die betaling aangegaan is in die normale gang van die huurder se besigheid, omdat die motief was om die uitgawes te minimaliseer en dus profyt te vermeerder soos vasgestel in ITC 1600 (1995) 58 (SATC 131:137).</ul> <ul>- Daar is verder bepaal dat die toekomstige voordeel die maandelikse besparing van oordadige huurpaaimente vir die restant van die huurkontrak is (Cornelissen, 2010). Verdere analise het egter bewys dat die kern van die transaksie nie die skepping van 'n bate was nie, maar 'n kostebepsaring wat inkomste van aard is (New States Areas Ltd v CIR (1946:170)).</ul> Die finale geval geidentifiseer is in verband met verhuurders of sub-verhuurders wat in die bedryf van eiendomsverhurings is: <ul> - Die duidelike paradigma skuif na 'n bedrag aangegaan in die produksie van inkomste is hier waargeneem, wat eie is aan die tipe bedryf. Beide gevalle kwalifiseer as aangegaan in die produksie van inkomste soos bepaal in ITC 1267 (1977) 39 SATC 146:150, solank die verhuurder of sub-verhuurder nie totaal sy bedryfsaktiwiteite staak nie.</ul> <ul>- Dit is verder bevestig dat vroee kansellasie uitgawes of verliese as gereelde uitgawes vir 'n verhuurder geklassifiseer sal word. Die kapitale toets van "eens en vir altyd" sal dus sulke betalings diskwalifiseer van kapitaal van aard (New States Areas Ltd v CIR (1945) 13 SATC 400:410), wat die betaling dus as inkomste van aard klassifiseer.</ul> Die voorafgenoemde bevestig dat die hoofuitdaging in al drie gevalle is welke die bedrag aangegaan is in die produksie van inkomste. Die bepalende faktor is bevestig as die nabyheid van die verhouding tussen die uitgawe of verlies aangegaan, vergelyk met die belastingbetaler se bedryf (CIR v Standard Bank of SA Ltd. 1985 (4) SA 485 (A) 47 SATC 179:198). Alhoewel daar nie 'n halfweghuis tussen kapitaal en inkomste is nie, is dit bevestig dat gevalle kommersieel bestaan waar vervroegde kansellasie betalings tweevoudig van aard kan wees. Sulke tweevoudige betalings sal dus ontleed moet word aan die hand van die ware doel en intensie waarvoor die belastingbetaler die koste aangegaan het (Standard Bank of SA Ltd case supra (1985:198)). Huurkansellasies wat gepaardgaan met die aankoop van dieselfde of soortgelyke eiendom kan as voorbeeld dien. In sulke gevalle kan die surplus tussen die markwaarde van die eiendom wat aangeskaf word, en die fisiese betaling slegs geallokeer word aan die vervroedge terminasie koste wat inkomste van aard is. Indien die onus wat by die belastingbetaler rus, voldoende bewys kan word sal die betaling geallokeer word volgens sy tweevoudige aard (SIR v Guardian Assurance Holdings (SA) Ltd 1976 (4) SA 522 (A) (38 SATC 111:125)). Alhoewel huur kansellasie betalings algemeen as kapitaal van aard beskou word, is dit bewys dat in sommige gevalle die betaling wel sal kwalifiseer as 'n aftrekking in terme van artikel 11(a) van die ITA (58/1962). Elke geval sal egter bepaal word op eie meriete, deur spesifieke analise van die transaksie en sy omliggende omstandighede. Ter afsluiting is gevind dat die prohibisie artikel 23(g), eerstens toegepas sal word indien die belastingbetaler totaal stop om handel te dryf, en tweedens wanneer die verhuurder die kansellerende party is met die doel om die eiendom vir eie gebruik te benut (ITC 819 supra (1955:71)).