PAYMENT OF PURCHASE
5.2 Different Types of Payments
5.2.2 Payment in the Issuing of Shares
This method of payment can work if the person who is selling an asset to a company is a director of the company. One has to examine the advantages and disadvantages from both the seller and the company's side and, the end result before deciding whether to go this route.
In this case the director would have the company issue redeemable preference shares, to the same value of the asset he is selling to the company at a nominal rate per share. Ideally the shares should have a coupon value at the rate equivalent to the going interest rate. There are advantages from both the seller's point of view and the company's point of view.
From the seller's standpoint he has a greater amount of shares in the business, giving him that much more voting power. He has redeemable preference shares with a coupon rate at a stated value, he now escapes having to charge interest as if he was a creditor of the company which would be taxable in his hands. Should there be a cash flow problem and he does not get paid out in a particular year, this is not then income which would have been accrued to him thus making it taxable even though he had not received it.
The advantages of this type of transaction from the company's side, it can be seen that if there is a cash flow problem, it does not have to meet the repayments of a loan that would have been needed to finance this purchase.
Should there be an inadequate cash flow in a year there would be no declaration of a dividend. The only other advantage to the company would be the fact that this transaction would strengthen the balance sheet by having less liabilities and a greater share capital.
Conversely, there are a higher number of disadvantages for the seller than the company. Let's look at this transaction from the company's standpoint first of all. The biggest disadvantage to the company is that it is unable to deduct from its income the issuing of the shares and the payment of the dividends.
Taken from the director's side, he would have to forgo the right of being a creditor to the company and, should problems arise, it would be to his disadvantage. Section 8E of The Income Tax Act refers to:
''Dividends on certain shares deemed to be interest in relation to the recipientthereof. "
The interpretation of this section is, any dividends paid on redeemable preference shares, which are redeemed within three years of issue, will then
constitute interest in the recipients hands thus making them taxable. As already mentioned, dividends may only be paid out of profits and should there not be profits for a few years the director's capital is tied up without any returns.
In conclusion, on the payment of issuing shares, one has to examine all the above mentioned advantages and disadvantages, but the final decision would most probably be made on other aspects. Aspects such as the financial situation of the business, the willingness of the director to have his capital tied up for some years without reward. Other aspects which could influence the decision to go this route could be the tax situations of either the company or the director or both, to name a few reasons that could influence the decisions.
5.2.3 Annuity Type Payments An annuity is defined as :
"annuity
n - a sum of money payable annually; an investment insuring fixed annual payments. Annuitant, n one who receives an annuity."(Anon., 1995 Cassell pocket English Dictonary)
As( Kruger D, et al 2003) states:
" The courts have/ from time to time/ attempted to isolate and describe the qualities ofan annuity. Thus:
• There must be an annual payment though each annual payment could be divided into weekly or monthly instalments;
• The payments must be repetitive/ recurring from year to year, for at least some period of time;
• The recipient must have a right to receive the amounts, that is to sey; a legally enforceable right"
The above definitions are not precise enough for one to be able to safely use the annuity type of receipt on the sale of an asset or going concern. Further to this, there are many sections in The Income Tax Act which do not smile favourably on annuity type receipts.
In drawing up a purchase and sale agreement the purchaser is unable to raise finance or alternatively it is decided between the purchaser and the seller that the purchaser will pay the asset / going concern off over a period of time. Careful attention should be exercised when defining payments.
Monthly/annual payments can be defined as both an annuity and as instalment payments.
For example, should it not be stated that the asset/going concern is being sold for a fixed amount, payable over a fixed period. But rather that the purchaser will be paying an amount on an annual/monthly basis over an indefinite period, this could most definitely be construed as an annuity. In order to prevent this type of thing happening it should be stated in the contract that the purchaser will be paying a fixed amount over a fixed period for the asset/going concern. This can include interest and or finance charges as well.
What has been described above is from one extreme to another. There is a huge grey area between these two poles and it is this area that has caused many problems over the years. One of the cases where this problem can be seen in is ITC 713 (1950 17 SATC 337). In this case a taxpayer owned a manufacturing business which he sold for the sum of fifty pounds per month payable for the rest of his life.
The issue that the courts had to contend with was, this fifty pounds per month for life was it of a capital nature or was it revenue. The Commissioner contended it was revenue and taxed him accordingly. In his summing up of the case Lucas Jstated:
"The contention advanced on behalf of the appellant is that the fifty pounds per month for life which he is to receive is a capital amount and not income in terms of the Act There is no fixed amount determined as purchase price.
It might be fifty pounds, the first payment or it might go on for twenty years... The agreement is quite clear that on death of the appellant the payments by the purchaser will fall away completely. This in my viel-'Y, is entirely different from the position where a fixed amount has been agreed upon and then provision made for such payments in instalments"
So one can go on mentioning the various cases which either decided whether annuity payments were of a capital payment on the asset/going concern.
The problem here is, if the payment is considered to be an annuity payment, both the purchaser and the seller lose on the deal. The seller from the point that this income is now considered to be revenue in his hands and taxed accordingly and not as a capital gain an taxed on a lower rate, and the purchaser will not be allowed to deduct this payment as an expense, it will still remain a capital payment from his side.
The test that can be applied here is:
• Does the payment in instalments reduce a debt over a period of time? or
• Are the instalments merely a contractual agreement payable indefinitely?
In summing up it can be seen how important it is for the architect of a contract to be precise should a payment in instalments be considered as one of the options of payment. He must leave no reason for doubt in anybody's mind as to what the payments are for and how they are to be paid and over what time they are to be paid.