Vendor beware: capital gains tax on instalment sales

By Ben Strauss, Director in Cliffe Dekker Hofmeyr's Tax and Corporate and Commercial practices

Taxpayers should take great care when selling assets where the price is paid in instalments as the transaction may trigger some tricky capital gains tax (CGT) consequences.

Consider the case of New Adventure Shelf 122 (Pty) Ltd vs The Commissioner of the South African Revenue Service (7007/2015) [2016] ZAWCHC 9 (17 February 2016). In this case the taxpayer acquired immovable property in 1999. In the taxpayer’s 2007 tax year it sold and transferred the property to a third party for a profit. The buyer had to pay the price of the property in instalments over more than one tax year.

The taxpayer accounted for CGT on the entire purchase price in its 2007 tax return. The South African Revenue Service (SARS) assessed it accordingly.

However, in its 2012 tax year the taxpayer and the buyer agreed to cancel the sale agreement as the buyer could not proceed with the intended development of the property. Under the cancellation agreement the buyer would transfer the property back into the name of the taxpayer, and the taxpayer would keep the amounts already paid by the buyer. The amount kept by the taxpayer was significantly less than the initial price.

Put simply, the taxpayer disputed the 2007 assessment as the sale was cancelled and, accordingly, no CGT was payable.

The taxpayer and SARS agreed that the 2007 assessment was correct. However, the taxpayer contended that SARS had to amend the assessment on the ground that the proceeds on the disposal of the property had been reduced in 2007 as a result of the cancellation of the sale agreement in 2012; in other words that SARS had to change the amount of CGT due in the 2007 tax year.

The court held that the original assessment could not be altered, and that the taxpayer had to account for the full CGT in the 2007 tax year.

The court case was based on legislation that has since been changed. The position, however, remains the same and can be summarised simply as follows:

• CGT is triggered on the disposal of an asset.
• A taxpayer must account for CGT on the difference between the proceeds on the disposal of the asset, and the base cost of the asset.
• The proceeds from the disposal of an asset are equal to the amount received by or accrued to the taxpayer.
• Where during the current tax year the taxpayer becomes entitled to any amount which is payable in a subsequent tax year, the full amount must be treated as having accrued to the taxpayer in the current tax year. A taxpayer is considered to be entitled to an amount if the entitlement is unconditional. For instance, in the New Adventure case, while the second instalment of the price was only due in a tax year after the sale and transfer of the property, the full price had accrued to the taxpayer in the 2007 tax year as the taxpayer had become unconditionally entitled to the amount.
• To the extent that the taxpayer does not have an unconditional entitlement to the proceeds in the current tax year, the taxpayer must account for CGT in the tax year during which the proceeds actually accrue. However, a capital loss realised by a taxpayer in the year of disposal must be carried forward and deducted in the year that the proceeds do accrue, subject to certain rules relating to the determination of capital losses. For instance a taxpayer sells immovable property to a purchaser for R2 million in tax year one. Of the price R500,000 is only payable in tax year two if the purchaser is successful in rezoning the property. The taxpayer will account for CGT on R1,5 million in tax year one only and will account for CGT on R500,000 in tax year two if the condition of rezoning is fulfilled. Conceivably, the parties in the New Adventure case could have made the payment of the second installment contingent on the purchaser being successful with the development, in which case the taxpayer would only have had to account for the part of the price actually received during the 2007 tax year.
• If a person during a tax year disposes of an asset for consideration that cannot be quantified in full during that tax year, then so much of the consideration as cannot be quantified is deemed not to have accrued to the person in that tax year. If and when the amount becomes quantifiable during a later tax year, it is deemed to have accrued to the person from the disposal in that year. For example a taxpayer agrees to sell shares in a company to the purchaser for a price of R1 million in tax year one. The parties agree that the purchaser will pay an additional amount determined as a percentage of the net profits of the company in tax year two. The taxpayer would need to account for CGT on the amount of R1 million in tax year one, and the ‘earn-out’ amount (if any) in tax year two.
• A similar special rule applies when a person sells equity shares and more than 25% of the price is payable in subsequent tax years.

But what happens where (as in the New Adventure case):

• a taxpayer sold an asset for a price which accrues unconditionally on disposal, but which is payable in instalments over two or more tax years;
• the sale agreement is cancelled in a later tax year due to, say, the default of the purchaser; and
• the purchaser must return the asset to the taxpayer?

In that case, the taxpayer must account for CGT on the full proceeds in the year of disposal of the asset. In the tax year in which the agreement is cancelled, to the extent that the taxpayer suffers a loss in that the full price is less than the value of the property, the taxpayer will suffer a CGT loss. (The purchaser must account for CGT on the value of the property transferred back to the taxpayer.)
Notably, however, the taxpayer will only be able to off-set that capital loss against other capital losses in the same or future years. In other words, the taxpayer would have paid CGT on the full sale price in the year of disposal but may not be able to recover the loss unless and until the taxpayer realises other capital gains.

What is apparent from the above is that a taxpayer must obtain professional tax advice and plan carefully before concluding an agreement for the sale of an asset where the price is paid in instalments over more than one tax year.