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South Africa - Tax impact of warranty clauses
South Africa - Tax impact of warranty clauses
Tax impacts of warranty clauses in South Africa.
Does the seller grant warranties or indemnities to the purchaser when acquiring a company?
It is not unusual for a seller of the shares in a company to be required in the Share Purchase Agreement to provide certain warranties and/or indemnities to the purchaser, however these are dependent on the particular facts and terms negotiated by the parties.
Does the tax treatment of the warranty depend on its legal classification (e.g. indemnity vs. reduction in the purchase price vs. others)?
Yes, the tax implications of an indemnity payment are different from the tax implications of an adjustment to the purchase price. The tax implications of an indemnity will depend on the underlying risk being mitigated against (i.e. an indemnity in respect of a loss of trading profits or trading stock will have different tax implications to an indemnity in respect of a loss of a capital asset).
If the warranty results in an adjustment of the purchase price, again the tax implications may differ at the level of the vendor and acquirer depending on whether the sale was done on a revenue account or capital account.
Is classification of the contractual warranties as a price reduction clause or an indemnity clause relevant in your jurisdiction?
Yes, the classification is important as the tax implications for the seller and the acquirer are attendant upon the classification.
Are mixed clauses included in the SPA (for instance, a warranty drafted partially as a price-reduction clause for the portion corresponding to the purchase price and as an indemnity clause for the amount exceeding the purchase price)?
Mixed clauses are seldom used.
Is the classification usually mentioned in the SPA?
Yes, the classification is usually mentioned in the SPA.
Are there criteria to distinguish between a price reduction clause and an indemnity clause? Could you briefly describe these criteria?
An indemnity is an obligation by a person (indemnitor) to provide compensation for a particular loss suffered by another person (indemnitee). An indemnity is accordingly a promise to reimburse the buyer in respect of a particular type of liability, should it arise.
An indemnity is distinct from a warranty in that:
- an indemnity guarantees compensation equal to the amount of loss that is subject to the indemnity, while a warranty only guarantees compensation for the reduction in value of the acquired asset due to the warranted fact being untrue (and the beneficiary must prove such reduction in value);
- warranties require the beneficiary to mitigate its losses, while indemnities do not;
- warranties do not cover problems known to the beneficiary at the time the warranty is given, while indemnities do.
A price reduction clause is typically linked to a warranty.
What is the most common type of warranty in your jurisdiction?
A warranty is a contractual assurance from a seller to a buyer. The nature of the transaction dictates the nature of warranties required, which can range from warranties relating to ownership of assets, regulatory filings being up to date, financial warranties and the like. Warranties are commonly subject to a series of negotiated limitations on liability, such as limiting the warranty to a limited time period, or maximum exposure etc.
Is a tax warranty usually provided by way of a separate warranty agreement (different from the SPA)?
Typically, the tax warranties are included in an annexure to the SPA.
Is it usual / a market practice to negotiate after-tax settlements, i.e. to reduce the price adjustment to a net payment (i.e. indemnity minus the tax effect of the deduction for the acquirer or target) or to guarantee full indemnification (i.e. gross-up payment to guarantee a net indemnity)?
No it is not a market practice in South Africa.
Acquirer
| Corporate Income Tax | Personal Income Tax | |
| Price reduction clause | There is a reduction in the cost base of the asset acquired. Consequently, future capital gains or taxable income will be increased. | There is a reduction in the cost base of the asset acquired. Consequently, future capital gains or taxable income will be increased. |
| Indemnification clause | The tax treatment depends on the risk that is being mitigated against and whether the pay-out fills a “profit” hole or “capital” hole of the acquirer.* | The tax treatment depends on the risk that is being mitigated against and whether the pay-out fills a “profit” hole or “capital” hole of the acquirer.* |
Vendor
| Corporate Income Tax | Personal Income Tax | |
| Price reduction clause | The tax treatment will depend on whether the sale was done on a revenue account or capital account:
|
The tax treatment will depend on whether the sale was done on a revenue account or capital account:
|
| Indemnification clause | The deductibility will depend first and foremost on what the payment relates to. If the payment relates to a specific asset category (such as trading stock) then arguably the payment could be income tax-deductible. | The deductibility will depend first and foremost on what the payment relates to. If the payment relates to a specific asset category (such as trading stock) then arguably the payment could be income tax-deductible. |
Target
| Price reduction clause | N/A** |
| Indemnification clause | N/A |
* For example, an indemnification against all taxes being paid, if paid out, would potentially be gross income for the acquirer and fully taxable at corporate income tax rates. On the other hand, an indemnification payment for the loss of a capital asset could be capital in nature and taxed at (the lower) CGT rates.
**Non-available
Mohammed Jada - KPMG, South Africa
Head of Corporate Tax
Tel: (+)27 (0)82 719 5531
Mohammed.Jada@kpmg.co.za
Jenna Mason – KPMG in, South Africa
Senior Manager, M&A Tax
Tel : (+)27 (0)63 682 1387
Jenna.Mason@kpmg.co.za
Heather Ashe - KPMG, South Africa
Associate Director, Corporate Law Advisory
Tel: (+)27 (0)82 719 5892
Heather.Ashe@kpmg.co.za
