New rules have been introduced into the Eighth Schedule of the Income Tax Act to deal with the capital gains tax implications arising on the cancellation of contracts. This would apply for example where an asset being an allowance or non-allowance which falls into the capital gains tax net is sold and the contact is subsequently cancelled.
The cancellation of any contract is regarded as a disposal for capital gains tax purposes as contemplated in the Eighth Schedule. The tax treatment of such cancellations depends on whether the contract was cancelled in the same year of assessment in which the contract was entered into or if that contract was cancelled in the subsequent year of assessment in which the contract was entered into.
SAME YEAR CANCELLATION
A new non-disposal rule applies in terms of paragraph 11(2)(o) of the Eighth Schedule. The disposal and subsequent cancellation of the contract is effectively treated as a non-disposal.
The effect is that there is no capital gains tax implications, that is, no capital gain/loss calculation is required. The original owner will retain the base cost. This new non-disposal rule applies in respect of disposals on or after 1 January 2016.
SUBSEQUENT YEAR CANCELLATION
A new paragraph 20(4) limits the base of the original owner to an amount equal to the base cost of that asset prior to entering into the relevant contract on the disposal of the asset that has subsequently been cancelled. Expenses incurred after entering into the contract will be taken into account in the base cost of the asset as allowed under paragraph 20 of the Eighth Schedule.
In addition, where the seller calculated a capital loss in the year of assessment that the contract of disposal was entered into, then the seller must now account for a capital gain that is equal to the capital loss previously accounted in the year that contract of disposal is cancelled, in accordance with the new paragraph 3(c) of the Eighth Schedule.
If, however, seller calculated a capital gain in the year of assessment, that the contract of disposal was entered into, then the seller must now account for a capital loss that is equal to the capital gain previously accounted in the year that contract of disposal is cancelled, in accordance with the new paragraph 4(c) of the Eighth Schedule.
The capital gain or loss previously accounted for is reversed and the seller is therefore effectively placed back in the position before the contract of disposal was entered into.
Paragraphs 3(c), 4(c) and 20(4) came into operation on 1 January 2016 and apply in respect of disposals made during any year of assessment commencing on or after that date.
The reason for the change was due to the anomaly relating to the base cost of the asset in the hands of the original owner that resulted when a contract was cancelled in either the current or subsequent year of assessment which could have been subject to abuse. The old rules resulted in a possible capital loss in the hands of the original owner (same year cancellations), and an unintended benefit of a step-up in base cost (subsequent year cancellations). This was noted as being especially prevalent between connected persons.
Donations, debt waivers, reduction or variation of the selling price will hold very different capital gains tax consequences.
Author: Muneer Hassan CA(SA) is a Tax Consultant and a Senior Lecturer in Taxation at UJ