Resolutive conditions are widely used in the drafting of contracts but the tax consequences associated with such conditions are often not considered by the contracting parties.
If a contract contains a resolutive condition, the continuance of such a contract is made dependent upon the happening of an uncertain future event. However, there is no postponement or suspension of the contract and all rights and obligations come into existence immediately upon conclusion of an agreement between the parties. Such a date will be regarded as the date of disposal, as is envisaged in paragraph 13 of the Eighth Schedule to the Income Tax Act, 58 of 1962 ("the Eighth Schedule"). Accordingly, if the parties dispose of an asset, they will have to account for any capital gains tax that flows from the contract on such a date.
However, if the resolutive condition is subsequently fulfilled, the agreement will terminate immediately with retrospective effect. In such an instance, the legal position is the same as if the contract was never entered into and all rights and obligations that resulted from the contract will cease to exist. As a result, the contracting parties are lawfully required to be restored to the position they were in, prior to the conclusion of the agreement (that is, the status quo ante).
The tax treatment on termination will differ from the normal legal treatment, because tax is an annual event and cannot be dealt with retrospectively. In order to establish how the parties will be restored to their precontractual position, a distinction needs to be made between whether the resolutive condition was fulfilled in the year the contract was concluded or in a subsequent year of assessment.
If the conclusion of the contract and the fulfilment of the resolutive condition fall within the same year of assessment, the proceeds received from the disposal and the base cost of the asset must be reduced by any amounts received as a result of the termination of the contract in terms of paragraphs 35(3)(c) and 20(3)(b) of the Eighth Schedule. Effectively, this will result in the proceeds and the base cost of the asset being reduced to nil and the parties are restored to their precontractual position.
However, if the termination of the contract takes place in a subsequent year of assessment, the capital gain that was accounted for on the date the contract was concluded, will be treated as a capital loss under paragraphs 3(b)(ii) and 4(b)(i)(aa) of the Eighth Schedule. In terms of these provisions the repayment of proceeds will be treated as a capital loss, whilst the reversal of the claim of the base cost will be treated as a capital gain in the year of termination.
In order to illustrate this, assume that Mr A entered into a contract on15 February (year 1), with Company B in terms of which Mr. A disposes of an asset for R6 million (the original cost of acquiring the asset was R2 million). The contract stipulates that the purchase price must be settled within three months (year 2). Company B fails to pay within the prescribed period, which results in the resolutive condition being fulfilled and the termination of the contract.
Mr. A will have to account for capital gain tax on the R4 million gain realised in year 1 and the base cost of the asset in Company B's hands will be R6 million. In year 2, Mr. A will realise a capital gain of R2 million (reversal of base cost accounted for in year 1) and a capital loss of R6 million (reversal of proceeds accounted for in year 1).The net result for Mr. A in year 2 is an aggregate capital loss of R4 million. Company B's cost of acquisition of the asset is reduced under paragraph 20(3)(b) of the Eighth Schedule by R6 million and will neither realise a capital gain nor a capital loss.
In light of the above, taxpayers need to be mindful that the fulfilment of a resolutive condition in a succeeding year of assessment, can have adverse cash flow implications which need to be carefully considered when concluding an agreement. It would be preferable, from a tax point of view, if the conditions are suspensive in nature. This is on the basis that the tax consequences of a contract are deferred until the suspensive conditions are fulfilled.