Provide a legal advice on the matter

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Reference no: EM13491506

You are a tax consultant. The following information has been presented to you:

Midlands (Pty) Ltd ('Midlands'), a resident company, owns a hotel in the Kwazulu-Natal Midlands Meander area. Midlands had a contract with a resident company called Nashen Ltd ('Nashen') to provide accommodation and meals for a period of six months for students from a country which does not have a double tax agreement with South Africa. Nashen had a contract to train the students.

During September 2009, after staying at the hotel for only two months, the students left the hotel without giving any reasons for their departure. They had caused extensive damage to the hotel rooms they had occupied. Midlands sought legal advice on the matter and, based on that advice, threatened to sue Nashen unless it settled a claim for damages of R4 million.

The claim consisted of the following:

• R600 000 for meals and accommodation for the remaining four months of the contract;
• R1 400 000 to effect repairs to the hotel rooms; and
• R2 million for loss of goodwill which Midlands suffered as a result of the events which led to the claim.

On 15 November 2009 the parties agreed to settle the matter out of court.

Nashen paid Midlands R2 million and Midlands undertook to abandon any rights it may have had for the damages and any pending or contemplated court action against Nashen. The parties agreed that the R2 million represented 50% of each of the three items in the claim.
Midlands incurred legal expenses of R30 000 in respect of this matter, which it settled during December 2009.
Midlands is not a small business corporation as defined.
In the completion of the tax return (IT14) of the company for its 2010 year of assessment ended 28 February 2010, the accountant of Midlands adjusted its accounting net income that included the R2 million received for damages and R30 000 legal expenses paid, as follows:
R
R
Net income
5 000 000
Less: Loss of goodwill received (a capital receipt)
(1 000 000)
4 000 000
Add: Legal expenses of a capital nature (50% of R30 000)
15 000
Add: Taxable capital gain
Proceeds for loss of goodwill
1 000 000
Less: Base cost - legal expenses of a capital nature
(15 000)
Capital gain
985 000
Include 50% in taxable income
492 500
Taxable income
4 507 500
However, The South African Revenue Service (SARS) queried the above treatment and stated that it was treating the full R2 million damages received as being of a revenue nature and thus taxable, but that it would allow the legal expenses in full in terms of section 11(c).
7
The 2010 assessment which SARS accordingly issued on 15 February 2011 reflected taxable income of R5 million.

The company's 2009 year of assessment reflected assessed taxable income of R3 250 000. This assessment was issued on 31 January 2010.

Midlands's 2008 assessment dated 30 May 2009 reflected taxable income of R2 400 000.

The company based its second provisional tax payment for 2010 on an estimated taxable income of R3 800 000.

The taxable income for the 2008 and 2009 years of assessment does not include any taxable capital gains. The company did not dispute the 2008 and 2009 assessments.

Reference no: EM13491506

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