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The severe restrictions imposed throughout the pandemic and the recent damage done due to various instances of looting have led to the issue of onerous contracts raised once more. These contracts are defined as an agreement wherein the costs of meeting the contractual obligation exceed the expected economic benefits.

Understanding onerous contracts

Contracts have the capacity to be onerous from their onset or become so once circumstances change, such as when expected costs of honouring the contract increase or when economic benefits therefrom decrease. Due to the current turbulence in South Africa’s economic climate, onerous contracts have become increasingly common, especially for SMMEs.

Many businesses face cancellation costs for lease agreements that exceed the total rental payments for the remainder of the agreement. As a result, the penalty clause within these contracts presents an onerous contract as it is more cost-effective for the business to continue fulfilling its contractual obligations – despite not being able to afford to do so. Navigating the responsibilities of these contracts can be a demanding process without the relevant industry knowledge, which makes approaching your audit firm essential.
The taxpayer dilemma: Capital or revenue?

Onerous contracts have left taxpayers facing a dilemma of how the nature of these payments should be considered. The general rule is that payments made to discharge a liability used to aid the creation of recurring, tax-deductible revenue should be considered revenue in nature. It is a similar result for businesses who terminate a contract to reduce operating costs. However, when a business has made a lump sum payment for contract termination due to liquidation, the amount should be regarded as capital and not receive a tax deduction.

The main factors to consider when determining the nature of these payments are:

  • The intention of the payment
  • The impact of the payment of the business
  • The obligations of the payment
Contractual obligations and their influence on tax deductions

It is crucial for business owners and tax professionals to understand contractual obligations and their possible implications to avoid the contract becoming onerous. Businesses that find themselves in such a position are advised to negotiate with their service providers for an alternative arrangement to suit both parties. This could include restricting payment plans, implementing a payment holiday or modifying the agreement.

In negotiations pertaining to payment holidays, taxpayers will still be able to claim their rental payment as a deduction as the amount is still accrued despite its deference. Likewise, restructured payments can be treated as an agreement adjustment and are still deductible. Modified agreements, however, are treated as brand new obligations, and the relevant deductions will be re-evaluated and based on the revised contract. Under no circumstances will repayments of a capital nature be considered deductible.

Operating expenses incurred in your lease agreement can be deducted when due rather than when rental payments are made. As a result, arrangements made with respect to your rental obligations will not impact the management operating expenses.

If you require the assistance of a professional audit firm to facilitate the understanding of your contractual obligations and avoid the implications of onerous contracts, trust in the team at MMS Group. Contact us for more information. 

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