january 2009 – issue 113 contents exemptions income … · - any repurchase or resale agreement,...

Integritax Issue 113 – January, 2009 ©SAICA, 2009 page 1

JANUARY 2009 – ISSUE 113

CONTENTS

EXEMPTIONS

1693. Sporting bodies

INCOME

1698. Recoupment of deductible expenditure

EMPLOYEES TAX

1694. Share incentive trusts

ANTI-AVOIDANCE

1699. Setback for SARS

CUSTOMS & EXCISE

1695. Seizure of goods

INTERNATIONAL TAX

1700. STC Ruling

VALUE-ADDED TAX

1696. Deregistration pitfalls

1697. Purpose – the golden rule

SARS NEWS

1701. Interpretation notes, media releases and

other documents

EXEMPTIONS

1693. Sporting bodies

Interpretation Note 46, released by SARS on 28 July 2008, deals with the broad principles in

interpreting the current legislation applicable to sporting bodies with specific reference to the

amalgamation of amateur and professional sporting bodies. Before its deletion, section 10(1)(cD) to

the Income Tax Act No 58 of 1962 (the Act) provided an exemption from income tax in respect of –

“the receipts and accruals of any amateur sporting association”.

The above provision was deleted with effect from 15 July 2001 with the introduction of a new tax

dispensation for exempt organisations. Under the new dispensation, a concept of a “public benefit

organisation” (PBO) conducting an approved “public benefit activity” (PBA) was introduced. Both

these terms are defined in section 30. The PBAs approved by the Minister of Finance are set out in

Part I of the Ninth Schedule to the Act.

Provided an amateur sporting organisation complied with the requirements and conditions of section

30 and conducted the approved PBA, the organisation could be approved as a PBO and was fully

exempt from income tax on its receipts and accruals. One of the requirements contained in section 30

was that an approved PBO was not permitted to engage in any trading or business activities.

As a result of the professional sport conducted by some national or provincial sporting organisations,

they no longer qualified as amateur sporting associations and thus failed to comply with the


requirements for approval as PBOs. This was because they did not conduct the approved PBO activities

and consequently their income was regarded as being derived from trading activities or a business

undertaking. Certain sporting bodies therefore separated their professional and amateur activities in

order for the amateur body to qualify as a PBO.

In 2006 the provisions relating to PBOs were amended to provide a partial taxation system for

approved PBOs conducting trading or business activities. This meant that PBOs were permitted to

retain their trading activities while being taxed on their trading income without losing their tax-exempt

status.

The separation of a sporting body into two separate entities proved to be to the disadvantage of certain

sporting bodies and consequently the 2007 Budget Review proposed measures to be introduced to

assist in the re-integration of the separate sporting entities, so that expenditure incurred by the

professional body to develop amateur sport can be deducted.

The re-integration process presents a number of tax problems, for example, the transfer of assets will

trigger a capital gain, VAT and transfer duty as well as the recoupment of capital allowances.

Interpretation Note 46 illustrates, in broad principles, the tax relief measures that are available in order

to alleviate some of these tax problems. The relief is available to reintegration transactions concluded

on or before 31 December 2009.

BDO Spencer Steward

IT Act: s 30, Ninth Schedule

Interpretation Note No. 46

EMPLOYEES TAX

1694. Share incentive trusts

Share Incentive Trusts (“SIT”) have been used for many years as vehicles to implement employee

share incentive schemes. From a commercial point of view, and more specifically in the case of

private companies, specified company divisions or fund managers, a SIT makes an excellent tool

for holding shares on behalf of employees, which is the reason why they have been so popular.

However, the undesirable tax consequences introduced by section 8C of the Income Tax Act, 1962

(“the ITA”), including the recent proposed amendments to this section, have caused SITs to become

unattractive, with the result that it is predicted that tax advisors will in future in all probability

choose to revert to more conventional share option schemes. As is explained in this article, with

careful planning and drafting it is still possible for businesses to use SITs as a mechanism for

employment share schemes without having to face all of the consequences of section 8C.

How does the structure work?

Typically, a SIT would be used when an employer company (“the company”) would like some of

its shares to be acquired for the benefit of certain of its existing and future employees. The intention

is that these employees are allowed to share in the profits of the company, but at the same time

placing a restriction on them to take ownership of and trade in the shares.

To achieve this aim a warehousing arrangement is implemented in terms of which a SIT is

established to acquire the shares in the company. As employees generally do not have sufficient

funds to fund the acquisition of the shares, the SIT may require third party funding to acquire the


shares. Such funding could be in the form of a loan, but because the interest on the loan is not a tax

deductible expense, it is generally more efficient to raise capital through preference share funding

provided by a bank. Since the SIT cannot issue preference shares, a special purpose company

(“SPV”) is formed to issue preference shares to the bank. The SPV would then advance the capital

to the SIT in exchange for a vested right to the income and profits of the SIT, expressed as a

number of units. The reason why the vested right is extended to the profits is to ensure that if the

income from the shares is insufficient for the SPV to pay dividends to the bank, the SIT can sell

some of the shares to generate profits, which will be distributed to the SIT.

Once the SIT has obtained the funding from the bank and acquired the shares in the employer or

affiliated company, it appoints the employees as beneficiaries and, instead of giving them rights to

the underlying shares, the trust deed allocates to them an immediate vested right in the income and

gains of the SIT, which is also expressed as units. If the SIT requires additional funding to acquire

the shares, it may request a financial contribution by the beneficiaries before units are allocated. It

is important to note that the unit is not a real asset, but its function is merely to act as a tool to

establish the nature and quantity of the vested rights which have been allocated to the beneficiary,

so as to allow such beneficiary to participate in the income and gains of the SIT. The units of the

employees would rank behind the units of the SPV, which means the employees will only obtain

vested rights to the income and gains once the SPV has settled its liability to the bank.

To incentivise employees to remain in the employ of the company, the units are made subject to a

restriction in terms of which an employee is not entitled to sell, cede, transfer, lend or otherwise

alienate or dispose of or enter into any contract to dispose of his/her unit before the expiry of a

specified lock-in period. The lock-in period is generally the date on which the shares in the

company are disposed of by the SIT or the date on which the SIT is wound up, whichever is the

earlier.

As explained more fully below, the key characteristic of the SIT is that the underlying shares in the

company are held by the SIT without any restriction, and because the beneficiaries do not have any

vested rights in the underlying capital or assets of the SIT (i.e. the shares in the company), the

trustees are empowered to dispose of the shares at their sole discretion. Until the shares are so

disposed of, the voting rights attached to the shares are exercised by the trustees of the SIT for the

benefit of the beneficiaries.

Operation of section 8C Since 26 October 2004, the tax consequences of equity based incentives for employees and

directors are governed by section 8C of the ITA. Initially, section 8C applied only to any person

who acquired an equity instrument by virtue of his or her employment or office of director. This

application was extended in 2005 and now also includes any person who acquires an equity

instrument from any person by arrangement with his or her employer.

For purposes of section 8C, an ‘equity instrument’ is a share or part thereof in the equity share

capital of a company or a member's interest in a close corporation. Specifically included in the

definition of an equity instrument are:

� an option to acquire such a share, part of a share or a member's interest; and

� any other financial instrument that is convertible to a share, part of a share or a member's

interest. A ‘financial instrument’, in turn, is widely defined in section 1 of the ITA to include:

- a loan, advance, debt, stock, bond, debenture, bill, share, promissory note, banker's

acceptance, negotiable certificate of deposit, deposit with a financial institution, a


participatory interest in a portfolio of a collective investment scheme, or a similar

instrument;

- any repurchase or resale agreement, forward purchase arrangement, forward sale

arrangement, futures contract, option contract or swap contract;

- any other contractual right or obligation the value of which is determined directly or

indirectly with reference to a debt security or equity, any commodity as quoted on an

exchange or a rate index or a specified index.

The effect of section 8C is that if the equity instrument generates a gain, the taxpayer is required to

include such gain in his income for the tax year in which the instrument vests in him. This means

that the gain will be subject to income tax at the taxpayer’s marginal income tax rate. If the equity

instrument generates a loss, the taxpayer is required to deduct that loss from his income for the tax

year in which the equity instrument vests in him.

The tax liability on the part of the taxpayer arises on the date that the equity instrument vests in the

taxpayer. This enables the tax authorities to tax as much of the growth in the value of the equity

instrument as possible. After the equity instrument has vested in the taxpayer, any further growth

in the value of the equity instrument may be subject to Capital Gains Tax (“CGT”), which is levied

at a lower rate than income tax.

Traditionally the vesting by the SIT of the units in the employees circumvented the application of

section 8C and allowed the growth in value of the units to be subject to CGT. This was because:

-the units did not constitute shares or part thereof in a company, nor did they entitle the

beneficiaries to acquire shares or part thereof in a company; and

-although the units may constitute a “financial instrument” as defined in section 1 of the ITA, the

governing trust deed does not allow the beneficiaries to convert their units into shares or members’

interests as required by section 8C.

In terms of the draft Revenue Laws Amendment Act, 2008, which was released for comment in

August 2008, it is proposed that from 21 October 2008 the definition of an equity instrument be

extended to specifically include any contractual right or obligation the value of which is determined

directly or indirectly with reference to a debt security or equity. This amendment has a significant

impact on the use of units in the SIT model as the value of the vested rights of the beneficiaries are,

in almost all circumstances, determined with reference to the underlying shares held by the SIT.

Accordingly, because of the proposed amendment any units issued from 21 October 2008 by a SIT

would constitute equity instruments for purposes of section 8C, with the result that any gains

realised when such units vest will be subject to income tax.

At first glance it looks as if the days of the SIT are finally numbered however, considering the

operation of the SIT it is recognized that the proposed amendment may, in fact, provide more

clarity to the tax position of the units. This is because in the past, even when it could be argued

that the units were not subject to the provisions of section 8C, the units would have remained

subject to the provisions of the Seventh Schedule of the ITA or paragraph (c) of the definition of

“gross income”, both of which could have resulted in a tax liability if the beneficiaries acquired the

units for less than their market value. Having the units now specifically included in section 8C has

the effect that they become excluded from the application of the Seventh Schedule of the ITA or

paragraph (c) of the definition of “gross income”, with the result that their taxation is entirely

governed by the provisions of section 8C.


It is important to note that in terms of section 8C the tax event will only take place when the units

vest. The timing of the vesting of an equity instrument, and therefore the taxpayer’s tax liability,

depends on whether the equity instrument is a restricted equity instrument or an unrestricted equity

instrument. Section 8C provides that an unrestricted equity instrument is one which is not a

restricted equity instrument, and that an equity instrument will constitute a restricted equity

instrument if, inter alia: -

- it is subject to any restriction (other than a restriction imposed by legislation) that prevents the

taxpayer from freely disposing of that equity instrument at market value;

- it is subject to any restriction that could result in the taxpayer forfeiting ownership or the right

to acquire ownership of that equity instrument otherwise than at market value, or being

penalized financially in any other manner for not complying with the terms of the agreement for

the acquisition of that equity instrument;

- if any person has retained the right to impose a restriction on the disposal of that equity

instrument;

- if the employer, associated institution in relation to the employer or other person by

arrangement with the employer has at the time of acquisition by the taxpayer of the equity

instrument undertaken to:

� cancel the transaction under which that taxpayer acquired the equity instrument; or

� repurchase that equity instrument from that taxpayer at a price exceeding its market

value on the date of repurchase;

if there is a decline in the value of the equity instrument after that acquisition;

- which is not deliverable to the taxpayer until the happening of an event, whether fixed or

contingent, other than the requirement to pay the consideration in respect of the acquisition of

that equity instrument.

An unrestricted equity instrument vests on the date on which it is acquired by the taxpayer, while a

restricted equity instrument vests on the earlier of the following dates:

- the date on which all the restrictions which result in it being a restricted equity instrument cease

to have effect;

- immediately before a taxpayer disposes of the restricted equity instrument;

- immediately after an equity instrument which is an option terminates (otherwise than by the

exercise or conversion of that equity instrument); or

- immediately before the taxpayer dies, if all the restrictions relating to that equity instrument are

or may be lifted on or after death.

The gain to be included in the income of the taxpayer is calculated by subtracting from the market

value of the equity instrument at the time that it vests in the taxpayer, the sum of any consideration

paid by the taxpayer in respect of the equity instrument. As the beneficiaries are restricted from

disposing of their units until the day when the trust terminates, it is unlikely that the units would

have any value at this date with the result that no tax liability would arise in the hands of the

beneficiaries in terms of section 8C.

The tax position of the unit holders

During the term of the trust, the beneficiaries have a vested right to the income and capital gains of

the trust. Because there is no provision in section 8C which provides that any income or capital

gains received by or accrued to the beneficiary will be subject to section 8C, the normal tax

principles of trusts would apply.


In terms of section 25B of the ITA, a vesting trust is transparent for income tax purposes, which

means that income derived by a trust for the benefit of a beneficiary with a vested right to such

income is deemed to have accrued directly to the beneficiary. Similarly, any deduction or

allowance which may be claimed in respect of such income may be claimed by the relevant

beneficiary.

In terms of paragraph 80 of the Eighth Schedule to the ITA, the same flow-through principle

applies when a beneficiary has a vested right to capital gains (as opposed to the underlying asset of

the trust). In terms of paragraph 80(2), where a capital gain arises in a trust in a year of assessment

during which a trust beneficiary has a vested interest (or acquires a vested interest) in that capital

gain but not in the asset, the disposal of which gives rise to the capital gain, the whole or that

portion of the capital gain so vested must be taken into account for the purposes of calculating the

capital gain or loss of the beneficiary in whom the gain vests. This attribution only applies to

capital gains, as capital losses remain trapped in the trust. The effect of paragraph 80(2) is that

when the trust disposes of its underlying assets (i.e. the shares), the gain realised by the trust upon

such disposal will vest in the beneficiaries and will be taxed in their hands at their applicable CGT

rate.

Section 8C(5)(b)

It is important to note that the units may still be taxable in the hands of the beneficiaries by virtue of

section 8C(5)(b) of the ITA. As the application of section 8C(5)(b) could eradicate the potential

advantages of the structure, it is imperative that drafters of the trust deed of the SIT always ensure

that:

- the beneficiaries do not obtain any vested right in the underlying assets (capital) of the SIT;

- no restrictions are placed on the ability of the trustees of the SIT to deal with the shares; and

- the SIT pays an amount equivalent to the market value of the shares on the date it takes

possession thereof.

Edward Nathan Sonnenbergs

IT Act: s 1 “gross income” par (c), s 8C, 8C(5)(b), s 25B, Seventh Schedule, and par 80 of the

Eighth Schedule

Editorial comment: It needs to be noted that the Revenue Laws Amendment Bill 2008 has now

become an Act with effect from 8 January 2009.


CUSTOMS & EXCISE

1695. Seizure of goods

It is notorious that, world-wide, there is large-scale pirate manufacture and sale of consumer goods

that are protected by copyright and trademark legislation.

There are many unscrupulous business people who are happy to let someone else bear the cost of

developing and marketing a successful product, and who then hijack the profits by flooding the

market with cheap imitations.

Predictably, the holders of intellectual property rights are prepared to outlay large sums to take

legal action to protect their products. This often necessitates litigation in many countries of the

world.

Crocs litigation

The latest flurry in the South African courts, in this regard, has centered on the internationally well-

known Crocs range of casual footwear, which retails for R500 a pair and upward.

The decision of the Cape High Court in Pick ’n Pay Retailers (Pty) Ltd v CSARS, The

Commissioner for Customs and Excise, Crocs Inc, and the Magistrate, Cape Town (case

13354/2007; judgment given on 6 May 2008, not yet reported) concerned the importation into

South Africa from China of some 20 000 pairs of beach sandals, and the legal proceedings taken by

a copyright holder to prevent these products entering the local market on the grounds that they were

counterfeit copies.

In the Gauteng High Court, Crocs’ copyright claims also featured in an appeal against a seizure

order in the matter of Moresport (Pty) Ltd v Commissioner for the South African Revenue Service

(case 36853/2006, judgment given on 27 March 2008; not yet reported).

Background

Crocs Inc, an American company that holds copyright and trademark in Crocs shoes, is engaged in

a world-wide battle against the unauthorised copying and sale of its copyrighted line of footwear by

unscrupulous manufacturers worldwide, particularly in China.

Crocs had instructed its South African attorneys to apply to the then Commissioner: SARS in terms

of section 15 of the Counterfeit Goods Act for the seizure and detention of all imported goods

suspected of being counterfeit copies of Crocs shoes.

Pick ’n Pay dispute

A customs officer, acting in terms of section 3(4) and section 4(1) of the Customs and Excise Act

No 91 of 1964, issued a detention notice in terms of section 113A(1), and provided a copy to Crocs

Inc (section 3(4) has now been deleted from the Act). The latter’s attorney thereafter provided the

SARS officer with an affidavit attesting that, having studied the items in question, he had

concluded that the goods were indeed counterfeit.

Consequent upon these events, SARS and the Commissioner for Customs and Excise applied to a

Cape Town magistrate in chambers, and on an ex parte basis (that is to say, without notice to Pick

’n Pay, who were consequently not represented at the hearing) in terms of section 6(1) of the

Counterfeit Goods Act for a warrant to be issued for the seizure, removal, detention and collection

of the goods in question. The magistrate granted the application and issued the warrant.


Pick ’n Pay immediately made urgent application to the Cape High Court for an order that the

warrant be set aside, that the detention, seizure and removal of the 20 000 pairs of shoes be

declared wrongful, and that they immediately be released to Pick ‘n Pay and declared not to be

counterfeit.

Application to set aside warrant

Pick ’n Pay sought to have the warrant for the seizure and detention of the goods set aside on the

grounds that it was improper for the warrant to have been applied for and granted ex parte, in other

words, without Pick ’n Pay’s being represented when application for the order was made to the

Magistrate.

In this regard, the court pointed out that a warrant for the seizure of goods in terms of the Customs

and Excise Act is less invasive than an order that the goods be forfeited. The purpose of a seizure

order is simply to preclude the goods from entering the marketplace pending a determination, under

a separate section of the Act, as to whether they are counterfeit. The court concluded that, properly

interpreted, the Customs and Excise Act does not require that application for a warrant for seizure

needs to be made in open court, rather than in chambers. The impairment of Pick ’n Pay’s rights,

consequential upon such a warrant would be of limited duration, pending a further application in

which the full merits of the case would be aired and resolved.

The short-term impairment of Pick ’n Pay’s rights had to be weighed against the immediate and

irreversible harm to the interests of the copyright holder if the goods were released into the

marketplace, and were later found to be counterfeit.

The court therefore concluded that the Customs and Excise Act did not require Pick ’n Pay to be

represented at the hearing when the warrant was applied for. A further ground on which Pick ’n Pay

sought to have the warrant for detention and seizure of the goods set aside was that Crocs Inc had

failed to act in the utmost good faith and make full disclosure of all material facts to the court

which heard the ex parte application for the warrant.

However, the court held that there had been no failure to make full disclosure to the court; Crocs

Inc had informed the court of Pick ’n Pay’s wish to be granted a hearing, but Pick ’n Pay had no

right to a hearing, and the magistrate had acted properly in exercising her discretion to decide the

matter on an ex parte basis.

Moresport dispute

In July 2006, Moresport (Pty) Ltd, a South African company carrying on business as an importer

and distributor of footwear, had imported some 5 000 pairs of shoes into South Africa, having

purchased them from a company in Vancouver. These shoes were detained by the customs and

excise division of SARS on suspicion of being counterfeit reproductions of the well-known Crocs

brand of shoes, the copyright in which was held by Crocs Inc, an entity incorporated in the USA.

Over the next couple of months, correspondence ensued between Crocs Inc and Moresport (Pty)

Ltd, in which Crocs stated that they were holders of the copyright in Crocs shoes, and that the shoes

imported into South Africa by Moresport were unauthorised reproductions whose importation by

Moresport amounted to dealing in counterfeit goods in terms of South Africa’s Counterfeit Goods

Act No. 37 of 1997.

In this correspondence, Crocs demanded that Moresport hand over all the imported shoes for

destruction and give a written undertaking never again to import goods that infringed Crocs’s

copyright. In response, Moresport’s attorneys wrote to Crocs Inc, denying that they had infringed


the latter’s copyright, and averring that, on the facts of the matter, a statutory exemption from

copyright infringement was applicable in terms of section 15(3A) of the Copyright Act No. 98 of

1978.

This section permits reproductions to be made available to the public where those reproductions

have a primarily utilitarian purpose and were made by an industrial process. In the alternative,

Moresport averred that it had not engaged in “counterfeiting” as defined in the Counterfeit Goods

Act, and that, at the time of importation, it was not aware that Crocs Inc was the owner of any

applicable copyright.

Moresport called on Crocs Inc to instruct SARS to release the detained goods. Subsequent to that

exchange of correspondence, Crocs Inc applied to a magistrate ex parte in chambers at the Cape

Town Magistrates’ Court for a search and seizure warrant in respect of the consignment of shoes in

question, as the statutory sequel to their initial detention on suspicion of being counterfeit goods.

The application was supported by affidavits lodged on behalf of Crocs Inc and, on the basis of

those affidavits, the magistrate granted the search and seizure order. The affidavit filed by Crocs

Inc did not disclose the prior exchange of correspondence in which Moresport had set out its

defence to the claim of copyright infringement and dealing in counterfeit goods. Since this was an

ex parte application, the court granted the order without the magistrate’s hearing Moresport’s

version of events or submissions on the law, and the goods were duly “seized”.

Moresport then applied to the Gauteng High Court for an order setting aside the search and seizure

warrant that had been issued in chambers by the magistrate in Cape Town.

Counsel for Moresport argued that SARS and Crocs Inc had failed to disclose to the magistrate the

correspondence between the two contesting parties in which Moresport had set out in detail the

basis of its defence to the claim of breach of copyright and dealing in counterfeit goods.

Crocs Inc argued that this non-disclosure was not material.

In its decision, the High Court quoted the judgment of the Supreme Court of Appeal in National

Director of Public Prosecutions v Basson 2002 (1) SA 419 where the court held that –

“Where an order is sought ex parte it is well established that the utmost good faith must be

observed. All material facts must be disclosed which might influence a court in coming to its

decision and the withholding or suppression of material facts, by itself, entitled a court to set aside

an order, even if the non-disclosure or suppression was not wilful or mala fide.”

The court in the present matter held that the defence raised by Moresport in its correspondence with

Crocs Inc was relevant and material and ought to have been disclosed to the magistrate, that there

was no justifiable reason why it had not been disclosed. The court set aside the warrant, and

ordered SARS to pay Moresport’s legal costs.

It is noteworthy that, in this appeal, Moresport did not have to prove that the magistrate would not

have granted the warrant of search and seizure if Moresport’s letter to Crocs Inc, setting out the

former’s defence, had been disclosed in the papers laid before court.

The mere fact of non-disclosure to the magistrate was sufficient grounds for the High Court to set

aside the search and seizure warrant issued by the magistrate.


Lessons for importers

A particular difficulty facing importers is that they have no first-hand knowledge as to whether or

not a breach of copyright has occurred in the manufacture of the imported products. It is therefore

difficult – indeed impossible – for them to lay evidence before the court to controvert the prima

facie evidence of copyright infringement adduced by the owner of copyright.

In the wake of these decisions, it seems that importers of goods which might come under suspicion

of being counterfeit would be well advised to require the overseas manufacturers to provide

documentary evidence that there had been no breach of copyright or trademark in the

manufacturing process.

Further, where infringement is alleged it is vitally important that the importer engage with the

authorities in writing, setting out their case. This places the authorities under the obligation to

disclose the importer’s defence at the time of applying for a search and seizure warrant, and these

submissions must be taken into consideration in determining whether a warrant should be issued. A

difficulty facing importers is that they have no first-hand knowledge as to whether or not a breach

of copyright has occurred in the manufacture of imported products.

Approach of the Supreme Court of Appeal

SARS took the Moresport matter on appeal to the Supreme Court of Appeal, which held that the

sole issue was the reasonableness of the suspicion on the part of the SARS officer that the goods

were imported goods and that further investigation would establish that they were subject to

forfeiture under the Customs and Excise Act. The court pointed out that SARS’s hand in this regard

is strengthened by the provisions of sections 101 and 102(1) of the Customs and Excise Act, which

require that any person carrying on business in the Republic must keep books, accounts and

documents relating to his transactions, and produce them on demand.

The court said that the High Court had overlooked an important factor, namely that the taxpayer

had not at any stage contended that the goods had not been imported. It followed that the High

Court had erred in concluding that the SARS officer should have investigated whether the goods

were imported goods.

The Supreme Court of Appeal went on to say that, when considering whether the SARS officer had

reasonable grounds for seizing the goods, there were a number of material facts.

First, the goods were marked as being made in China and bore Chinese inscriptions and the

taxpayer had not contended that the goods were made locally.

Second, the inability of the taxpayer to produce any books or documents recording where and from

whom the goods had been purchased.

Third, the suspicious conduct when the manager had said, in Mr Chen’s presence, that he did not

know where the owner was and then, on a subsequent occasion, introduced Chen to SARS as the

owner.

Fourth, that Chen had produced false VAT and income tax numbers.

Fifth, that despite telling the SARS officer that he had bought the goods in Chinatown, Chen had

been unable to produce documents in the form of invoices or duplicate receipts from the suppliers.


The Supreme Court of Appeal said that it took issue with the High Court where the latter held that

the SARS officer had to do more by way of investigation than wait for the requisite documentary

proof from the taxpayer. The taxpayer was under a statutory duty to maintain books of account and

documents to reflect from whom the goods had been purchased.

The Supreme Court of Appeal concluded that the taxpayer’s inability to produce such documents,

together with the other suspicious conduct, were sufficient grounds for the SARS officer to

conclude that the goods were liable to forfeiture and that SARS was therefore entitled to seize

them.

The Supreme Court of Appeal upheld SARS’s appeal against the High Court judgment, and set

aside the order made by the latter.

PricewaterhouseCooopers

Customs and Excise Act No. 91 of 1964: s 3(4), s 4(1), s 101, s 102(1), s113A(1)

Counterfeit Goods Act No. 37 of 1997: s 6(1), s15

Copyright Act No. 98 of 1978: s15(3A)


VALUE-ADDED TAX

1696. Deregistration pitfalls

The compulsory VAT registration threshold is set to increase from R300 000 to R1 million in

March 2009 and many business owners are looking forward to the day that they no longer need to

submit VAT returns. However, businesses wishing to deregister should give careful consideration

to the VAT implications of deregistering as it presents a potential minefield for the unaware.

The increase in the compulsory VAT registration threshold is an important step by Government

towards its objective of simplifying tax compliance for small enterprises.

In essence, taxpayers with turnover levels below the new registration threshold have been given

two options:

• retain their status quo, i.e. do nothing; or

• deregister as VAT vendors.

As far as deregistration is concerned, taxpayers have been given two further options:

• register as a micro business and in future be taxed in terms of a new presumptive tax regime

(which will automatically include deregistration as a VAT vendor); or

• deregister as a VAT vendor on the basis of their turnover being below the new registration

threshold.

Whichever option is exercised, cognisance should be taken of the consequences of deregistration to

ensure that informed decisions are taken.

Deemed disposal

When a business deregisters for VAT, it is deemed to dispose of all assets held and certain rights

attaching to the business immediately before deregistration. VAT is payable to SARS on the

consideration for the deemed supply which is the lower of the cost or the open market value of such

assets and rights. This results in VAT being payable to SARS without any commercial sale having

been concluded.

VAT also has to be accounted for on the amount of any outstanding trade creditors on the date of

deregistration (to the extent that input tax deductions have been claimed on the supplies made by

the creditor to the vendor).

In practice, if a person deregisters on 1 March 2009 and settles an existing creditor after that date,

the cash cost of the expense is increased by the input tax deduction previously claimed.

In a worst case scenario, a business that has acquired capital assets shortly before deregistering for

VAT, and who has not settled the supplying creditor before the date of deregistration, would have

to account for VAT on both the value of the asset held as well as the outstanding creditor.

In this case the business would have been entitled to an input tax deduction of R14 but would be

required to account for output tax of R28. It is therefore clear that careful planning is necessary

before a business proceeds with the deregistration process.


Concessions

The legislator has provided some relief for businesses who deregister due to the increased

registration threshold. Essentially businesses will be entitled to settle any VAT liability resulting

from deregistration (excluding any liability resulting from unsettled creditors at the date of

deregistration) over a period of 6 months. The Commissioner for SARS has been given a discretion

to extend the period beyond six months should the situation warrant it. No interest will be payable

on the outstanding amount during this period. For businesses not registering in terms of the small

business tax regime, this relief is only available if they deregister on or before 30 June 2009.

For businesses that opt to be taxed in terms of the small business tax regime in the future, further

relief has been provided. Such business will be entitled to reduce the amount on which VAT must

be paid on deregistration (excluding VAT on outstanding creditors) by R100 000. Essentially this

results in a VAT saving of R12, 280 for the business.

Conclusion

Careful and diligent planning needs to be done before a vendor decides to deregister for VAT

purposes. Critical from a VAT planning perspective is that the vendor settles all creditors in respect

of which the vendor has claimed input tax deductions on the supplies made to the vendor by the

creditor before the date of deregistration. The vendor should also quantify any liability for VAT

that will arise as a result of deregistering and the cash flow implications for the business.

Grant Thornton

Value-Added Tax Act, 1991 (Act 89 of 1991): s8(2), s23, s24

1697. Purpose - the golden rule

The concept of intention is central to the interpretation of income tax law. In fact, intention has

been hailed as the golden rule when dealing with capital versus revenue issues. In value added tax,

the concept of purpose is equally central to the interpretation of VAT legislation but has not been

given the same prominence, notwithstanding the fact that virtually all VAT decisions are based on

the premise of purpose.

Intention versus purpose The central enquiry is into the intention with which a taxpayer acquires, holds and disposes of an

asset. The enquiry is primarily based on a taxpayer’s ipse dixit (the taxpayer’s stated intention). The

taxpayer’s ipse dixit is tested against the surrounding objective evidence which either supports or

contradicts it. The tax courts must decide on a balance of probabilities whether the taxpayer’s ipse

dixit should be accepted, moderated or rejected.

The central test applied in VAT legislation is the purpose test. This test determines the quantum of

VAT incurred by a vendor qualifying as input tax. This stems from the requirement in the

definition of input tax that VAT incurred only qualifies as input tax to the extent that it is incurred

for the purpose of consumption, use or supply in the course of making taxable supplies.

Purpose is defined in the Oxford Concise English Dictionary as, inter alia, “an object to be

attained, a thing intended and the intention to act”. Intent is defined in the Oxford Concise English

Dictionary as, inter alia, “a thing intended, an aim or purpose and the act of intending”. It would

appear from a scrutiny of the two terms that they share the same basic properties and that the tests

applicable to intention can also be applied to the concept of purpose.


Purpose and application

The intention test requires that the stated intention of a taxpayer (the taxpayer’s ipse dixit) must be

collaborated by the surrounding objective factors. A similar process needs to be followed in

applying the purpose test in value added tax.

For value-added tax, the purpose test is generally less cumbersome to apply at the time of acquiring

goods or services as the actual application to which the goods or service are put at that point in time

is generally conclusive to infer a purpose. It is the subsequent application of such goods or services

for purposes other than use, consumption or supply in the course of making taxable supplies that

creates interpretational difficulties. The VAT administrator needs to decide, based on the specific

facts and circumstances of the case, whether the vendor has changed the purpose with which the

goods or services have been acquired, or whether the subsequent application of the goods or service

was merely a different application of the goods or services in the course of making taxable

supplies.

There are therefore two separate and distinct tests that need to be applied in identifying VAT

qualifying as input tax, i.e. the purpose test and the in the course of making taxable supplies test.

While these two tests at first glance appear to be complementary and interdependent, they are in

fact two distinct separate tests with distinct tax consequences depending on the outcome of each.

The difficulties with the interpretation of the above principles are vividly illustrated in the

residential property development industry where properties developed for resale (taxable supplies)

are often rented out (exempt supplies) in anticipation of the final sale thereof. The remainder of this

article will deal with the principles established in this industry.

A legal view on the issue

The South African tax courts have never been called upon to rule on the issue. The South African

Revenue Service’s (“SARS”) official view on the treatment of fixed property rented out in

anticipation of future supply thereof in terms of a sale is published in VAT News Number 14 of

March 2000.

The New Zealand tax legislator has dealt with this issue in some detail. The following guidance can

be obtained from the New Zealand experience. In Thornton Estate Ltd v CIR (1998) NZTC 13, 577

(SA), it was held that the term use has a wide meaning, including to employ or make use of for a

particular aim or purpose and to use up or consume. The court held that used means “employed for

a particular purpose”. It further held that regard should be had to how the property (in the specific

case) was used during the period of five years up to the date of sale, rather than whether the

property has been used at a particular point in time.

In Sloss v Sloss (1989) 3 NZLR 31, 36 Richardson J held that “The physical occupation of property

is clearly a use of that property. In its ordinary meaning, “use” is not, however, confined in that

way. In its natural meaning it is a word of wide import. The Shorter Oxford English Dictionary

gives as the first meaning, [the] act of using or fact of being used”, and amongst the more detailed

definitions is, “utilisation or employment for or with aim or purpose”. The owner of land may be

said to use the land when, without doing anything on that land, he obtains advantages from the land

(Newcastle CC Royal Hospital (1959) AC 249), and in R v Heyworth (1866) 14 LT 600, 601, Lush

J observed that: “The owner “uses” the place (a slaughter house) by letting it out”. Even the giving

away of property may be a “use” of the property (R v Wampole (Henry K) & Co [1931] 3 DLR

754).”


It was further held in Sloss v Sloss that ‘Use’ can attract many shades of meaning in the various

contexts in which it appears, but one of its primary definitions in the Shorter Oxford English

Dictionary relevant to the present inquiry is “employment for or with same aim or purpose”. The

degree of involvement by the user must vary according to the nature of the particular object. In an

ordinary domestic situation, the ability of both spouses to exercise direct physical advantages or

control will usually establish whether it is for their common use and benefit, - e.g. a holiday cottage

or a family car. But other assets may not be capable of such a physical relationship, and this is the

case with the commercial property here. Its functions were to generate income and serve

(hopefully) as an appreciating asset … Those functions make up its “use” to its owners. (p44)”

In CIR v Lundy (2005) 22 NZTC 19, 637 (CA), the principle has been established that although a

property is being rented and is therefore clearly used for that purpose, the property could at the

same time be used for the purpose of property development (in the same sense that an advantage is

obtained for the purpose of the property development activity by having the property available for

sale as part of the property development activity at that time or in the future). In this regard the

court held:

“Periodic adjustments, on the other hand, may be suitable where the use for non-taxable purposes

is variable or where it is temporary and coincides with continued use in a taxable activity. In the

latter case, one-off adjustments may be difficult to calculate and unfairly large where assets are of

any size. In this case the taxpayer’s principal purpose of the sale of the properties in the course of

their taxable activities subsisted. The properties were therefore at all times being used for those

taxable purposes. They were part of the taxpayer’s trading stock and, indeed remained on the

market at all times. At the same time, they were let for residential purposes, but on a temporary

basis.”

The court further held that:

“There still needs to be an apportionment between taxable and non-taxable uses in the particular

period. This creates conceptual difficulties because it is not possible to separate out the use of the

properties on any time or space basis. In terms of both time and space the properties in this case

are 100% dedicated to use for both purposes.”

Summary of relevant principles

The following general principles can be formulated based on an analysis of the above court cases.

• The purpose with which goods or services are acquired must be determined at the time they are

acquired.

• Unless there is a conscious decision to change the purpose with which the goods or services

have been acquired (and the change in purpose is supported by the vendor’s actual actions), the

original intention will remain undisturbed notwithstanding the actual use to which the relevant

goods or services are put while the vendor holds it (even if the goods are used wholly in an

exempt activity).

• An apportionment adjustment needs to be made where the actual use or application of the goods

or services in the course of making taxable supplies varies from the basis determined by the

original purpose. This adjustment constitutes a change in extent of taxable use adjustment and

not a change in purpose adjustment.


The above principles reflect the application of VAT principles at the purist level and, if applied

appropriately, also support the principle of consumption that is central to VAT systems. In practice

the application of these principles often present challenges.

Difficulties experienced in practice

The residential property development industry often faces VAT challenges. A property developer

developing residential property with the intention of supplying it in terms of a sale may need to rent

out certain of the properties in anticipation of selling the properties. From a VAT perspective the

supply of residential property in terms of an agreement for lease or hire constitutes an exempt

supply, resulting in VAT incurred on the acquisition of the property not qualifying as input tax. The

challenge is to determine whether the rental of the property while a buyer for the property is

actively sought is indicative of a change in the purpose with which the property was acquired.

Current practice

In practice SARS requires an output tax adjustment computed on the open market value of the

properties in the tax period that it is first rented out. On the ultimate disposal of the properties,

output tax must be accounted for on the proceeds realised. The vendor is then allowed a deduction

equal to the amount of output tax previously accounted for.

Legal basis for this practice

SARS has not indicated in terms of which section/s of the VAT Act it requires the adjustments to

be made. As far as the output tax liability on renting out of the properties is concerned, the only

possible basis is an adjustment in terms of section 18(1) of the VAT Act. This is the only section in

the VAT Act that requires an output tax adjustment on the market value of goods or services in the

tax period that the change in application takes place. This section requires a change in purpose.

The application of section 18(1) has the effect that once it has been applied to goods or services, the

goods or services no longer form part of the vendor’s enterprise. Any subsequent supply thereof

does not constitute a taxable supply, unless something intervenes to bring the goods or services

back into the ambit of the VAT enterprise.

The only mechanism available to bring such goods or services back into the ambit of a vendor’s

enterprise is contained in section 18(4)(b)(iii) of the VAT Act. To compensate a vendor for having

to account for output tax on the supply of such goods or services, the section grants the vendor a

deduction against output tax. This is where the difficulty in SARS’ application of the principles

surfaces most vividly.

The deduction that the above section grants a vendor is computed by applying the tax fraction

(14/114) to the lower of the adjusted cost (the amount on which the vendor has actually incurred

VAT) or the market value of the relevant goods or services. In practice this amount will hardly ever

be equal to the amount of the original amount of output tax accounted for when the properties were

first rented out. This can be explained by the following example. Outcome if SARS practice is applied Situation

One Situation

Two Situation

Three Market value on date of first renting out property 1,140,000 1,140,000 1,140,000 Market value on date of sale of property to third party 1,140,000 2,280,000 570,000 Output tax payable in the tax period that the property is first rented out – (18)(1) adjustment

140,000 140,000 140,000

Input tax adjustment in the tax period that the developer sells the property (18(4)(b)(iii) adjustment)

-140,000 -140,000 -140,000

Output tax on sale of property payable in the tax period that the property is sold.

140,000 280,000 70,000


Net output tax payable on transaction 140,000 280,000 70,000

Computed output tax on final sale 140,000 280,000 70,000 Distortion caused by “change in purpose” adjustment (additional VAT payable)

Rnil

Rnil

Rnil

At first glance it would appear as if the SARS practice gives a fair and equitable outcome and that

no distortion results. On closer scrutiny it becomes apparent that the reason why no distortion

occurs is the pragmatic application of VAT principles by SARS (i.e. assuming that the deduction

computed in terms of section 18(4)(b)(iii) will equal the amount of output tax previously accounted

for – essentially “giving back” output tax previously accounted for). These principles are not

supported by the VAT legislation. If challenged in court, it is unlikely to provide support for the

manner in which SARS administers the VAT Act for this specific category of transaction.

If the above combination of section 18(1) and 18(4) is used to account for properties rented out in

the interim, the following adjustments should be made based on the current wording of the

legislation. Outcome on a strict application of the law Scenario

One Scenario

Two Scenario

Three Market value on date of first renting out property 1,140,000 1,140,000 1,140,000 Market value on date of sale of property to third party 1,140,000 2,280,000 570,000 Adjusted cost of property 825,000 825,000 825,000 Output tax payable in the tax period that the developer first rents out the property - (18)(1) adjustment

140,000 140,000 140,000

Input tax adjustment in the tax period that the developer sells the property (18(4)(b)(iii) adjustment)

-101,315 -101,315 -70,000

Output tax on sale of property – payable in the tax period that the property is disposed off.

140,000 280,000 70,000

Net output tax payable on transaction 178,685 318,685 140,000 Computed output tax on final sale 140,000 280,000 70,000 Distortion caused by “change in purpose” adjustment (additional VAT payable)

R38,685

R38,685

R70,000

The above distortions are caused by the section 18(4)(b)(iii) adjustments being quantified with

reference to the lower of the properties’ adjusted cost or market value (as is required by section

18(4)(b)(ii)). SARS’ approach to use the amount previously accounted for as output tax to quantify

the required adjustment has no support in law and effectively undermines the VAT Act’s normal

checks and balances.

The solution

The above distortions are caused by the fact that the transactions are being treated on the basis that

a change in purpose occurs at the time that the properties are first rented out. On close scrutiny it is

clear that no such change takes place as the purpose with which the properties are acquired remains

unchanged at all times; to ultimately supply the properties in terms of a sale.

Section 18(2) of the VAT Act specifically provides for the situation where there is a change in

application/use of goods or services without a change in purpose. It is significant to note that this

test does not require a change in purpose; it merely looks at the actual application or use of goods

or services in the course of making taxable supplies. It therefore recognises that goods can be held

for a dual purpose, i.e. for both taxable and exempt purposes at the same time.

Section 18(2) adjustments are based on the adjusted cost of the relevant goods or services on an

annual basis. This ensures that the integrity of the VAT cost in the system is protected and that no


additional VAT (be it input or output tax) is created by the application of the inappropriate VAT

principles. This can be demonstrated as follows: Outcome on a strict application of the law (based on the SARS practice)

Scenario One

Scenario Two

Scenario Three

Market value on date of first renting out property 1,140,000 1,140,000 1,140,000 Market value on date of sale of property to third party 1,140,000 2,280,000 570,000 Adjusted cost of property (amount on which VAT was paid)

825,000

825,000

825,000 Output tax payable at the end of the financial year in which the developer first rents out the property - (18)(2) adjustment

101,315 101,315 101,315

Input tax adjustment in the tax period that the developer sells the property (16(3)(h) adjustment)

(101,315) (101,315) (70,000)

Output tax on sale of property – payable in the tax period that the property is disposed of.

140,000 280,000 70,000

Net output tax payable on transaction 140,000 280,000 101,315 Computed output tax on final sale 140,000 280,000 70,000 Distortion caused by “change in use” adjustment (additional VAT payable)

Rnil

Rnil

R31,315

At first glance it would appear that a distortion results in cases where there is a reduction in the

market value of the goods or services. This is however not a distortion caused by the incorrect

application of VAT principles.

The net VAT cost (in the above example R31,315) is the level of consumption that has taken place

while the goods or services have been used for purposes other than in the course of making taxable

supplies (in this case exempt supplies being the supply of a dwelling in terms of a rental

agreement). The appropriate application of VAT consumption principles underlying VAT systems

must and should give rise to a “consumption charge” if goods or services are consumed while such

goods or services are used in the course of activities other than taxable activities.

Conclusion

The principles discussed in this article are universal VAT principles and are essential to ensure a

deep understanding of VAT systems, mechanisms, checks and balances. It also ensures that the

integrity of VAT systems is protected and that VAT legislation is equitably applied. It will ensure

that the “Purpose – the golden rule in value added tax” is given its appropriate place in the tax

arena.

Grant Thornton

Value-Added Tax Act No. 89 of 1991: s 18(1), s 18(2), s 18(4)(b) (iii)


INCOME

1698. Recoupment of deductible expenditure

An “extra-statutory arrangement” does not alter the fundamental principles vis-à-vis the

recoupment of deductible expenditure. The decision of a full court of the Cape High Court in

CSARS v Wooltru Property Holdings (Pty) Ltd [2008] (70 SATC 223) (judgment given on 7

August 2008) provides valuable guidance as to which company in a group is saddled with a

recoupment of previously-deducted tax allowances in circumstances where SARS has consented to

the filing of a consolidated income tax return and the group has undergone rationalisation.

An agreement of lease had been concluded between the Municipality of Cape Town and the

Wooltru group of companies on 23 March 1982.

In terms of the lease, one of the subsidiaries in the Wooltru group, namely Wooltru Properties (Pty)

Ltd – which was subsequently renamed Wooltru Property Investments (Pty) Ltd – had acquired

leasehold rights over a certain site known as “Mayor’s Garden” on which the group’s headquarters

in Cape Town were situated.

Wooltru Properties was required to effect certain leasehold improvements to the leased property

after which it claimed deductions totalling some R24 million for this expenditure in terms of

section 11(f) and (g) of the Income Tax Act No. 58 of 1962.

Following a rationalisation by the Wooltru group, there was a transfer of the leasehold rights from

Wooltru Properties to Wooltru House Properties (Pty) Ltd. Thereafter, the latter company, being

now the holder of the leasehold rights, claimed similar allowances totalling some R26 million in

respect of further improvements it effected to the leased property.

Wooltru House Properties went into voluntary liquidation, and the leasehold rights held by it were

transferred to the group holding company, Wooltru Property Holdings (Pty) Ltd, as a liquidation

dividend in specie at a value of some R82 million. This distribution constituted a receipt of a capital

nature in the latter company’s hands, and was thus not liable to income tax.

The latter company in turn disposed of the leasehold rights to a third party for R100 million. The

prior deductions for leasehold improvements had been recouped – but by which company?

SARS treated the last-mentioned disposal as a recoupment in terms of section 8(4)(a) of the Act of

expenditure totalling some R50 million, being the aggregate deductions claimed for leasehold

improvements, namely the aforementioned amounts of R24 million and R26 million.

Section 8(4)(a) provides that – “There shall be included in the taxpayer’s income, all amounts

allowed to be deducted or set off under the provisions of section 11 to 20 inclusive … which have

been recovered or recouped during the current year of assessment.”

The question was – which company in the group had recouped this expenditure? SARS took the

view that it had been recouped by the holding company, Wooltru Property Holdings.

The complicating factor in the application of section 8(4)(a) in this case was that, in the interim,

SARS had approved a so-called “extra-statutory arrangement” with the Wooltru group whereby –


“the income and expenditure of the operating companies comprising the Wooltru property-owning

sub-group within the Wooltru group of companies rendered a consolidated income tax return to

[SARS] in the name of Wooltru Properties”.

This, the judgment tells us (at para [5]) was “resorted to as a practical method of reducing the tax

compliance burden upon the sub-group of property-owning companies”.

The right to claim deductions in respect of leasehold improvements, which was initially held by

Wooltru Properties, passed, as a result of an intra-group rationalisation in terms of section 48 of the

Taxation Laws Amendment Act 87 of 1988, to Wooltru House Properties.

The latter company had duly claimed and was allowed to deduct from its gross income expenditure

totalling some R26 million in respect of further improvements to the leased property.

SARS’s approval of the rationalization was conveyed by way of a letter which stated that – “The

current method of returning the income and expenditure of the subsidiary property-owning

companies …. may continue and all the income and expenditure of the subsidiaries … may be

accounted for in the tax return of Wooltru Property Holdings (Pty) Ltd provided that, for each year

of assessment, a balance sheet is nevertheless submitted for each of the affected subsidiaries.”

SARS took the view (see para [9] of the judgment) that the allowances previously granted to

Wooltru Properties and the further similar allowances granted to Wooltru House Properties were

recouped via the eventual sale of the leasehold rights to a third party and were recouped by the

holding company, Wooltru Property Holdings. The holding company, Wooltru Property Holdings,

contended (see para [9] of the judgment) that no amount had been recouped by it, since it had

neither claimed nor been granted, in its own right, any of the allowances in question since these had

been claimed by and granted to its subsidiaries.

SARS argued (see para [14] of the judgment) that the extra-statutory arrangement, agreed to by

SARS whereby Wooltru Property Holdings was permitted to declare all the income and

expenditure of its subsidiaries by way of a consolidated income tax return had the consequence that

all income and expenditure reflected in the holding company’s returns had accrued to and been

incurred by that company, and that its subsidiaries must be regarded as conducting business as its

nominees or agents.

What was the effect of the consolidation in terms of the extra-statutory arrangement?

The court held (at para [18]) that, properly interpreted, SARS’s letter, quoted above, which allowed

all the income and expenditure of the subsidiary property-owning companies to be accounted for in

the tax return of the holding company, did not have the result that the income or expenditure of any

of the subsidiaries ceased to be their income or expenditure.

Moreover, said the court (at [18]) –

“it was only after such income was received or had accrued and the expenditure had been

incurred, that it was transferred to the holding company to be accounted for in the consolidated tax

return.”

It followed that, even after the extra-statutory arrangement was put into place, the subsidiaries

continued to trade and derive income and become liable to tax (and entitled to deduct expenditure)

in their own right. The court said that there was no merit in the contention that, after SARS

approved a consolidation of the accounts, the subsidiaries conducted business as nominees or


agents for the holding company. Nor had they antecedently divested themselves of any income on

which they would be liable to tax.

A fundamental tax principle resolved the case

In the result, the court cut through the tangle of facts and reached a conclusion by applying one of

the fundamental principles of tax law, as laid down by the Appellate Division in CIR v

Witwatersrand of Racing Clubs (1960) 23 SATC 380, namely, that once income is received by or

accrued to a taxpayer it forms part of his gross income for income tax purposes, and that no

subsequent disposal of that income by the taxpayer can undo that fact. In the current matter, the

effect of the “extra-statutory arrangement” was that income had first accrued to the affected

subsidiaries, thus fixing them with tax liability on that income, and the income was only thereafter

transferred to the holding company.

Similarly, the subsidiary companies had incurred expenditure in their own right in effecting

improvements to the leased property. It followed, said the court (at [31]) that the subsidiary

companies which had been granted the tax allowances for the leasehold improvements remained

the entities in whose hands such allowances were recoupable.

The court accepted (at para [34]) that section 8(4)(a) of the Act does not contemplate a recoupment

of expenditure by a taxpayer where the latter was not the party who had incurred the expenditure.

In the present matter, the holding company had not been granted, in its own right, a deduction for

expenditure on leasehold improvements and having not claimed such a deduction in its own right, it

could not be liable for the subsequent recoupment of that expenditure.

PricewaterhouseCoopers

IT Act: s 11(f), s 11(g) and s 8(4)(a)

Taxation Laws Amendment Act No. 87 of 1988: s 48


ANTI-AVOIDANCE

1699. Setback for SARS

SARS has often complained that the anti-avoidance provisions of our Income Tax Act are

inadequate to cope with sophisticated tax avoidance stratagems, particularly those involving

complex financial arrangements.

The recent decision of the Johannesburg Income Tax Court in ITC 1833 [2008] (70 SATC 238)

(judgment handed down on 4 July 2008) may at first reading seem to corroborate SARS’s view in

this regard.

In this article, we examine whether the outcome of this matter hinged on a strategic error by SARS

in the legal route it took to challenge the arrangement in question.

The judgment identified the issues at stake as follows (emphasis added) –

“[16] The Commissioner’s principal contention is that whilst the loan to the [taxpayer] has

been represented by all the parties to the transactions as a loan of R96 415 776, in substance

and reality it is a loan of R50 million. It argues that in consequence the [taxpayer] should only

be allowed an interest deduction based on interest on a capital amount of R50 million with any

excess disallowed, and that interest and a 200% penalty should be levied on the consequent

underpayment of tax, on the basis that the transaction involved deliberate simulation and

intentional tax evasion. …

[17]…The Commissioner contends that the tax returns rendered by the [taxpayer] contained

incorrect statements … to the effect that the transaction was a genuine commercial transaction

and that portion of the deductions claimed in the [taxpayer’s] tax returns for the years of

assessment ending 1999 to 2003 were represented to be in respect of interest payable in terms

of the promissory note payments, when in reality they were in respect of repayments of capital.

Consequently the additional tax and interest were leviable.

[18] In the alternative, the Commissioner seeks to rely on an application of section 103 of the

[Income Tax] Act. The submission is that the series of transactions constituted a “transaction,

operation or scheme” as contemplated therein which had the effect of avoiding, postponing or

reducing the [taxpayer’s] liability for income tax in the 1999 to 2003 years of assessment, and

should therefore be set aside.

The court concluded that the taxpayer had discharged the onus of proving that its true intention was

to contract with the bank on the terms reflected in the agreements to which it was a party, and that

the taxpayer had intended to give effect to those agreements in accordance with what they said.

The court therefore set aside the additional assessments spanning the five year period of the loan.

SARS’s alternative argument added a second string to its bow in arguing that the taxpayer should

be entitled to deduct only interest on a loan of R50 million, not a loan of R96 million. SARS

contended that section 103 of the Act (the general anti-avoidance provision) gave it the power to

disregard any abnormal transaction that the taxpayer had entered into for the purpose of avoiding

tax.

The court held that it was not open to SARS to argue, firstly, that the loan agreement was a disguise

and, secondly, to argue that it avoided tax.


The court pointed out that these arguments were mutually inconsistent, and that SARS must nail its

colours to the mast one way or the other. Either the loan agreement was genuine or it was a sham.

SARS must make up its mind which of these propositions to argue for.

If the agreement was a sham, then once the court penetrated the sham and gave effect to the true

underlying agreement, no tax was avoided. If the agreement was genuine, then no tax had been

avoided, for the taxpayer was entitled to the tax deductions arising out of the agreement.

In the current case, SARS had chosen to argue that the taxpayer had not succeeded in avoiding tax,

because the loan agreement was a sham, and once the sham was penetrated, it was not entitled to

the deduction it had claimed.

The court said that, having presented its case on the basis that no tax had in fact been avoided,

SARS could not now argue that the taxpayer had indeed avoided tax and was caught by the anti-

avoidance provisions of section 103.

It is indeed likely that this is not the last that will be heard of this dispute, and the matter may well

be expected to come before the Supreme Court of Appeal. However, it is noteworthy that there are

now new general anti-avoidance provisions in the Act, which, had they been in effect at the time of

the transactions under dispute in this matter, possibly would have resulted in a different outcome.

Under the new general anti-avoidance rules, it is now expressly provided that the anti-avoidance

provisions may be invoked by SARS as an alternative for or in addition to any other basis for

assessment. Had this provision been in force at the time, the Court in this matter would have been

compelled to consider the application of anti-avoidance principles.

PricewaterhouseCoopers

IT Act: s103 (now repealed), s 80A-E Editorial Comment: Refer item 1674.


INTERNATIONAL TAX

1700. STC Ruling

Introduction

The High Court was recently required to determine the nature of secondary tax on companies

("STC") in the case of Volkswagen of South Africa (Pty) Ltd v Commissioner: South African

Revenue Service, [2008]

(70 SATC 195). Volkswagen of South Africa (Pty) Ltd ("VW SA") paid and declared dividends to

its holding company, namely, Volkswagen AG in 2004 and 2005 and, initially, paid over the STC

to the Commissioner: SARS ("the Commissioner"). VW SA subsequently instituted the action in

the High Court to seek a refund of STC on the basis that it had paid over too much STC to the

Commissioner on the grounds that the provisions of Article 7 of the double taxation agreement

("DTA") concluded between the Republic of South Africa ("South Africa") and the Federal

Republic of Germany (“Germany”) was applicable and that the tax should be reduced from 12.5%

to a rate of 7.5%.

VW SA applied for a refund from the Commissioner under section 102 of the Income Tax Act, Act

58 of 1962, as amended ("the Act"), and after the Commissioner refused to accede to its request for

a refund, it approached the High Court for relief on the basis that the court declares that VW SA

was entitled to a refund from the Commissioner of some R51.4 million.

VW SA’s argument

VW SA’s company secretary contended that the company was resident for tax purposes in South

Africa and was a wholly-owned subsidiary of Volkswagen AG. VW SA completed and submitted

STC returns to the Commissioner, effecting payment of tax at 12.5% of the net dividends declared

by VW SA in the relevant dividend cycle. At the time that the DTA was concluded between South

Africa and Germany, STC did not exist. VW SA’s company secretary alleged that STC is a tax that

is substantially similar to the tax on dividends that was in existence when the DTA became

effective between South Africa and Germany and, as a result thereof, the DTA applies, as

envisaged in Article 2 of the DTA.

VW SA claimed a refund of the STC that it believed had been overpaid by way of a letter dated 29

November 2006 and the matter was subsequently discussed at a meeting held during December

2006 with the Commissioner. The Commissioner’s representatives contended that the DTA did not

apply to STC on the basis that it did not constitute a tax on dividends but a business tax and, thus,

the provisions of the agreement could not apply. During May 2007, VW SA sent a further letter to

the Commissioner, claiming the payment of refunds of STC overpaid and sought that refund under

section 102 of the Act, and also claimed that the amounts were recoverable under the common law

principles of unjustified enrichment.

Commissioner’s counter-argument

The Commissioner denied that STC constitutes a tax on dividends as envisaged in Article 7 of the

DTA concluded between South Africa and Germany. The Commissioner denied that VW SA had

paid any amount which exceeds an amount properly chargeable under the provisions of the Act

and, alternatively, alleged that if the court decides that VW SA had overpaid any amount, such

amount was paid in accordance with the practice generally prevailing at the date of the payments

and, therefore, the refund of such amounts is prohibited under section 102(2)(a) of the Act.

Furthermore, the Commissioner contended that VW SA’s sole remedy was to seek a refund under

section 102 and that there was no basis for any claim on the grounds of enrichment. In addition, the


Commissioner pointed out that STC has been applied uniformly on all South African resident

companies and that no DTA has ever been invoked by a South African resident company or the

Commissioner to reduce the rate at which STC is levied, below that specified in section 64B(2) of

the Act. The Commissioner also denied that STC replaced the erstwhile “non-resident

shareholders’ tax” ("NRST"), which continued to apply until 1 October 1995, when it was

abolished with the result that no withholding tax applied to dividends thereafter.

VW SA’s further arguments

VW SA contended that STC does not become payable unless and until a dividend is declared, with

the result that the tax cannot be regarded as a tax on the income of a company declaring dividends.

VW SA persisted in its argument that STC is, essentially, a tax on dividend income distributed by

the company and pointed out that the liability for STC reduces the amount of distributable income

available for payment to shareholders in a manner substantially similar to that which would apply

to withholding tax on dividends, such as NRST.

Article 7 of the DTA

“Article 7 of the DTA concluded between South Africa and Germany provided as follows:

1. Dividends paid by a company which is a resident of a Contracting State, to a resident of the

other Contracting State may be taxed in that other State.

2. However, such dividends may be taxed in the Contracting State of which the company paying

the dividends is a resident, and according to the law of that State, but the tax so charged shall

not exceed:

• 7.5% of the gross amount of the dividends if the recipient is a company (excluding

partnerships) which owns directly at least 25% of the voting shares of the company paying

the dividends;..."

The court proceeded to analyse the provisions contained in sections 64B and 64C of the Act and

reached the conclusion that amounts deemed to be dividends in terms of section 64C(2), do not

comply with the definition of “dividends”, contained in Article 7(4) of the DTA. The court

expressed the view that STC is a sui generis tax, which is payable on those amounts constituting

dividends and deemed to constitute dividends. The court reached the conclusion that STC is a tax

on the company declaring the dividend and is not borne by the recipient of the dividend. It pointed

out that a tax on dividends is customarily payable by the recipient of the dividend. The court

referred to various commentators on STC and concurred with the views expressed by those

commentators that STC is not a tax on dividends, but is a tax imposed on the company declaring

the dividend.

Conclusion

In the result, the court held that Article 7(2) of the DTA refers to a recipient of dividends and not to

a company declaring the dividend. Thus, it was held that the benefits conferred by the article can

only be enjoyed by the recipient of the dividends and not the company declaring the dividends. As

a result, VW SA failed in its attempt to secure a refund of STC, such that the rate of STC was

reduced from 12.5% to 7.5%, under the provisions of the DTA concluded between South Africa

and Germany.

Parliament has now passed Revenue Laws Amendment Bill No. 80 of 2008 ("RLAB"), which

contains the draft provisions introducing the dividends tax which may be introduced during the

course of 2009. That tax will replace STC and will, based on the judgment referred to above, fall

within the relief available under the DTAs concluded between South Africa and Germany, and

other trading partners. STC is a unique tax and did not fit comfortably with the DTAs and this is

one of the reasons that it is being replaced by the dividends tax contained in the RLAB.


Edward Nathan Sonnenbergs.

IT Act: s102, s 64B (2), s 64C

DTA between South Africa and Germany: Article 2 and 7

Editorial comment: It needs to be noted that the Revenue Laws Amendment Bill 2008 has now

become an Act with effect from 8 January 2009.


SARS NEWS

1701. Interpretation notes, media releases and other documents

2 February 2009 - Media Release: Reporting South African Trade Statistics

30 January 2009 - Media Release: South African Trade Statistics for December 2008

29 January 2009 Media Release: Joint Media Statement by the South African Revenue Service and

the Banking Association of South Africa

16 January 2009 Legal & Policy: Date on which section 15(1) Taxation Laws Second Amendment

Act, No 4 of 2008 shall come into operation (Administrative penalty in respect of non-compliance)

(GG 31763 – 31 December 2008)

16 January 2009 Legal & Policy: Regulations issued under section 75B Income Tax Act, 1962,

prescribing administrative penalties in respect of non-compliance (GG 31764 – 31 December

2008)

15 January 2009 Media Release: Seizure of illicit goods

14 January 2009 Media Release: Urgent notice to taxpayers and tax practitioners

Readers are reminded that the latest developments at SARS can be accessed on their website

http://www.sars.gov.za

Editor: Mr M E Hassan

Editorial Panel: Mr KG Karro (Chairman), Dr BJ Croome, Mr MA Khan, Prof KI Mitchell,

Prof L Olivier, Prof JJ Roeleveld, Prof PG Surtees.

The Integritax Newsletter is published as a service to members and associates of the South African

Institute of Chartered Accountants (SAICA) and includes items selected from the newsletters of

firms in public practice and commerce and industry, as well as other contributors. The information

contained herein is for general guidance only and should not be used as a basis for action without

further research or specialist advice. The views of the authors are not necessarily the views of

SAICA.

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