As companies try to keep up in a changing business environment and the pressure to change, reorganise or rationalise increases, the need to pay or be paid lump sum amounts to compensate for the fact that the terms of a contract or arrangement have changed, or been cancelled, also increases.
So, if you suddenly find yourself in the situation where you receive or need to pay such an amount, what will the tax consequences be?
Let's look at some examples:
* You or your company or close corporation (CC) own a commercial property which is leased to various tenants for office purposes.
A new housing development is being built in the area and you see the potential for your property to earn greater rental income if it were leased for retail purposes in terms of long term leases.
To free up the property to lease it to the new tenants you have to pay the existing tenants a cancellation fee;
* You own a farm on which you grow grapes which you sell to the local co-op to make wine. The government wants to use some of your land for strategic purposes for one year, and your current crop will be destroyed. The government pays you a compensatory lump sum; and
* You are an investment manager with a number of management contracts in terms of which you have to carry out management functions over the contracted periods. One of your clients prematurely cancels its contract with you and pays you a lump sum in compensation.
The list of possible scenarios is endless. The rules are, however, fairly straight forward, although not always easy to apply.
An amount received to compensate for the sterilisation or removal of an income earning asset will be capital in nature, and therefore not taxable. This is because it has been received to compensate you for the loss of part of your income earning structure. Similarly, if you make a payment to enhance your income earning structure, it will be capital in nature and not tax deductible.
If you receive an amount to compensate you for the loss of certain profits, but your income earning structure remains intact, the receipt will merely be filling a "hole" in your profits and will be taxable. Similarly, if you pay an amount which may be part of your regular recurring income-earning expenses, it will be tax deductible.
Applying these rules to the scenarios set out above results in the following tax consequences.
The lease cancellation payment is capital, ie not taxable in the lessee's hands since the cancellation damages form part of the structure of the lessee's business. It may also not be deductible in your hands, since it is paid to increase the future income- earning potential of your building.
Since it is only one crop that has been destroyed, the payment by the government to compensate you for the destroyed grapes would fill a "hole" in your profits and the amount would be taxable. Had the vines themselves been destroyed, the compensation would have been received for the destruction of a capital asset and would, therefore, not be taxable.
Whether the receipt for the premature cancellation of the management contract would be capital (not taxable) or revenue (taxable) would depend largely on the contract.
Assuming it was a substantial long term contract, it may be necessary for to you to downsize your business because of the cancellation. A fee would be paid to compensate you for the loss of part of your income earning structure, as opposed to only filling a "hole" in your profits. It would be capital and not taxable.
The decision as to the nature of a receipt or payment for damages or compensation is not always cut and dried. It's important to know the rules, but equally important to seek advice if you're not sure.