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.
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.
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
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.
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