An update on tax avoidance principles in South Africa – January 2015
By Ernest MaraisB.Comm LLB (University of Stellenbosch, South Africa/ Maastricht University, Netherlands)Admitted Attorney in the High Court of South Africa and edited by Prof Dr Daniel N.Erasmus BA (Wits) BProc (UNISA) H Dip Tax (Wits) PhD (University KwaZulu-Natal) Admitted Attorney in the High Court of South Africa and US Tax Court Practitioner – Daniel@TaxRiskManagement.com
There has always been a clear distinction between tax avoidance and tax evasion, with the latter referring to an illegal activity undertaken by the taxpayer to free himself from his tax burden. Tax avoidance, on the other hand, allows the taxpayer to arrange his affairs in a perfectly legal manner in order to reduce his income tax liability. This principle was clearly established in the old case of Duke of Westminster v IRC[1], wherein Lord Tomlin held that: “Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise should be. If he can succeed in order them so as to secure the result, then, however unappreciative the commissioner of Inland Revenue or his fellow-taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.”
The point of departure being that a Taxpayer may arrange his affairs in a favourable manner if there`s no provision of law designed to prevent that avoidance or reduction of tax.
Section 103(1) contained the general anti-avoidance rules for years; however SARS found that the provision contained some inherent weaknesses and new portions in Part IIA, ss 80A to 80L were introduced into the act to provide greater clarity on this aspect of our law.
As within the South African legal system the common law has always been developed through the stare decis system. The Supreme Court of Appeal judgment in the matter of CSARS V NWK[2] has raised concern amongst taxpayers regarding, what seemed like a change in precedent, the application of the sham doctrine (simulated transactions) and possibly could change the status quo as set out numerous judgments before.
Some academics argued that the NWK-judgment might have nullified the provisions of the Income Tax Act, as SARS would find it easier to apply the Common law as established in the NWK-case than to apply the statutory provisions; however the situation is not as simple.
Herewith an in-depth discussion of the provision of ss80A to 80L, the NWK-case, as well as more recent judgements on the issue and the current status of this aspect of our law.
Statutory Provisions (ss80A-80L)
As mentioned above, the legislature found the predecessor, section 103(1), to be inadequate and subsequently expanded on these requirements. ss80H-80K contains general provisions and certain procedural issues and will subsequently not be discussed as it relevance are limited in light of the NWK-judgement.
There are four requirements which all must be met before the provisions of ss 80A – 80 L can be applied[3].
- There must be an arrangement.
An arrangement is defined as an agreement that results in a tax benefit. The word ‘arrangement’ includes any of the following six items: transactions, operations, schemes, agreements, understandings, any of the foregoing involving the alienation of property[4].
- The arrangement results in a tax benefit and now constitutes an avoidance agreement.
The word ‘tax benefit’ includes any avoidance, postponement or reductions of any liability for tax. The word ‘tax’ includes any tax, levy or duty imposed by the Act or any other law administered by the Commissioner. Examples of taxes imposed by other acts are VAT, Estate Duty, Stamp Duty and Transfer Duty. An avoidance, postponement or reduction in any of these taxes will therefore also be a tax benefit[5].
- The sole or main purpose of the avoidance agreement must be to obtain a tax benefit.
In terms of ss80G(1), an avoidance agreement is presumed to be have entered into for the purposes of obtaining a tax and the onus is on the Taxpayer to prove that reasonably considered in light of the facts and circumstances that the obtainment of a benefit was not the sole or main purpose.
The word solely or mainly has previously been defined in the matter of SIR v Lourens Erasmus (Edms) BPK[6], where the court defined ‘mainly’ in a quantative measure of more than 50{780f53c297e2c008074d23b865a0ce0b35a4f08852d8e1e49466a5a902c4e44e}.
The only other issue here relates to the interpretation of the word ‘purpose’ which are yet to be defined in light of the new statutory provisions; however in previous cases this has been defined as a ‘dominant’ purpose and not necessarily a subsidiary purpose[7]. It`s still unclear as to whether an objective or subjective-test will be applied in determine the ‘purpose’ of the avoidance agreement, although my personal opinion is that a subjective approach should be taken.
There are various matters relating to the interpretation of the purpose of the taxpayer. In the matter of SIR v Geustyn, Forsyth and Joubert[8] the court held that: “It was found that it was not the sole or main purpose of the conversion from a partnership to a company to avoid tax. It is quite clear that such conversions may take place for reasons other than obtaining a tax benefit (for example to obtain limited liability), which generally renders s 103(1) in-effective. The onus of proof that the sole or main purpose was not tax avoidance, however, rests upon the taxpayer himself. It was held in SIR v Gallagher that the general anti-avoidance rules cannot be applied due to the fact that the taxpayer implemented a scheme with the sole or main purpose to limit estate liability.”[9]
- If the avoidance agreement is in context of business, one of four requirements must be met namely:
4.1 Means or manner not normally employed[10]
This requirement is met if the means or manners it was entered into or carried out would not normally be employed for bona fide business purposes other than obtaining a tax benefit,[11]
4.2 Right or Obligations not normally created[12]
This requirement is met if the rights or obligations created would not normally be created between person`s dealing at arm`s length.[13]
4.3 Lack of commercial substance[14]
Section 80C (1) provides a general rule for determining whether an avoidance agreement lacks commercial substance. The general rule is that an avoidance agreement lacks commercial substance if it results in a significant tax benefit for a party, but the avoidance agreement does not have a significant risk upon either the business risks or the net cash-flow of that party. Section 80C (2) contains a non-exclusive set of characteristics that serves as indicators for a lack of commercial substance, such as round-trip financing, the legal substance or effect of the agreement as a whole differs significantly from legal from its individual steps, accommodating a tax indifferent party, the inclusion of elements that have the effect of cancelling or offsetting each other. [15]
4.4 Misuse or abuse of provisions of the Act[16]
This provisions attempts to ensure that the purpose of the legislation and the intention of the legislature in respect of other provisions of the act as well as the provisions of ss80A-80L are taken into account. This merely confirms the requirements of the rules of interpretation and the Constitution namely that the contextual and purposive approach must be followed in the interpretation of the GAAR. This process it was argued will lead to a finding of ‘abusive tax avoidance’ if:
- A taxpayer relies on specific provision in order to achieve an outcome that those provisions seek to prevent;
- A transaction defeats the underlying rationale of the provisions that are relied upon, or
- An arrangement circumvents the application of certain provisions, such as specific anti-avoidance rules, in a manner that frustrates or defeats the object, spirit or purpose of those provisions.[17]
CSARS V NWK 2011 (2) SA 67 (SCA)
Facts:
The Taxpayer met with representatives of FNB with a view to update its existing banking facilities with the addition of a term finance facility of R50 million. Pursuant to a proposed lending structure conceived of by FNB, the taxpayer then entered into the following series of agreements:
(a) a subsidiary of FNB that dealt in financial instruments, Slab Trading Company (Pty) Ltd, lent an amount of R96 415 776 to NWK, to be repaid after 5 years;
(b) the Capital amount would be repaid by NWK delivering to SLAB, at the end of the 5 year period, in 109 315 tons of maize;
(c) interest would be payable on the capital sum at a fixed rate of 15.41{780f53c297e2c008074d23b865a0ce0b35a4f08852d8e1e49466a5a902c4e44e} per annum payable every 6 months, and to this end NWK issued ten promissory notes for the total of amount of interest, R74 686 861;
(d) to fund the loan, Slab discounted the notes to FNB, and NWK paid FNB as the holder of the notes;
(e) Slab sold it ‘rights to take delivery of the maize at the end of the five year period to First Derivatives, a division of FNB, and this forward-sale, for the sum of R45 815 776, enabled FNB to pay the full amount of the loan to NWK;
(f) NWK purchased from First Derivatives the right to take delivery of the same quantity of maize for the sum of R46 415 776, payable immediately on conclusion of the contract, with delivery to take place five years thence, which contract would neutralise the risks associated with NWK`s own future delivery;
(g) It had been proposed that SLAB would cede its rights to a trust company to relive Slab of the ‘administrative burden’ of the transaction, but the transaction did not eventuate;
In terms of the transaction the amount lent to the taxpayer by Slab was R96 415 776. During the 1999 to 2003 years of assessment, the taxpayer claimed as a deduction from its income interest paid by it to FNB as holder of the notes, the amount claimed being equal to the face value of the promissory notes issued to Slab and sold by Slab to FNB.
The Taxpayer was at first successful in its claim for the deduction of such interest, but the commissioner, acting in terms of section 79 of the act, subsequently issued additional assessments disallowing in part the deductions previously allowed. The taxpayer appealed successfully to the tax court, judgment recorded as ITC 1833, and on appeal by the commissioner to the SCA:
i) The test to determine simulation cannot simply be whether there is an intention to give effect to a contract in accordance with its terms. Invariably where parties structure a transaction to achieve an objective other than ostensibly achieved they will intend to give effect to the transaction on the terms agreed. The test should thus go further, and require an examination of the commercial sense of the transaction: of its real substance and purpose. If the purpose of the transaction is only to achieve an object that allows the evasion of tax, or of a peremptory law, then it will be regarded as simulated. And the mere fact that parties do perform in terms of the contract does not show that it is not simulated: the charade of performance is generally meant to give credence to their situation:
ii) The purported loan of R96 415 776 was a simulated transaction, providing the taxpayer with the opportunity to claim deductions of interest on a capital amount in excess of R50 million;
iii) The purported loan was a transaction to disguise the real agreement between the parties, which was a loan of R50 million.
iv) The penalty of 200{780f53c297e2c008074d23b865a0ce0b35a4f08852d8e1e49466a5a902c4e44e} imposed by the Commissioner was severe and out of proportion to the wrong committed, and was reduced by 100{780f53c297e2c008074d23b865a0ce0b35a4f08852d8e1e49466a5a902c4e44e} of the additional tax levied;
v) The Commissioner`s appeal was upheld with costs;[18]
Discussion:
The Court affirmed that that a taxpayer is free to arrange his affairs so as to minimise the tax liability and that there is nothing wrong with arrangements that are tax affective, with the qualification:
But there is something wrong with dressing up or disguising a transaction to make it appear to be something that it is not…
Furthermore that, in his view the test to determine simulation cannot simply be whether there is an intention to give effect to a contract in accordance with its terms. Invariably where parties structure a transaction to achieve an objective other than ostensibly achieved they will intend to give effect to the transaction on the terms agreed. The test should thus go further, and require an examination of the commercial sense of the transaction: of its real substance and purpose. If the purpose of the transaction is only to achieve an object that allows the evasion of tax, or of a peremptory law, then it will be regarded as simulated. And the mere fact that parties do perform in terms of the contract does not show that it is not simulated: the charade of performance is generally meant to give credence to their simulation.[19]
After the judgment there seemed to be confusion as to whether this judgment changed the long established principle that parties may arrange their affairs in such a way as to avoid the imposition of a tax or remain outside the scope of a tax provision. The dictum seemed to suggest that, even if a transaction was ‘genuine’ in the sense that parties intended to give effect to it according to its tenor and even if it lacked what Innes CJ in Zanderg v Van Zyl[20] called: “A real intention definitely ascertainable, that differed from the simulated transaction’, the transaction would nonetheless be characterised as simulated if its only purpose was to evade tax”[21]
The difficulty created by the NWK-judgement was that it stood in stark contrast with the established judgement of Watermeyer CJ, in Randles Bros & Hudson Ltd v Commissioner of Customs & Excise[22]: “I wish to draw particular attention to the words a real intention, definitely ascertainable, which differs from a simulated intention’, because they clearly indicate what the learned Judge meant by a ‘disguised’ transaction. A transaction is not necessarily a disguised one because it is devised for the purpose of evading the prohibition in the Act or avoiding liability for the tax imposed by it. A transaction devised for that purpose, if the parties honestly intend it to have effect according to its tenor, is interpreted by the Courts accordingly to its tenor, and then the only question is whether, so interpreted, it falls within or without the prohibition of tax.”[23]
This well-established principle has been entrenched in South African law for ages and has recent been reaffirmed in the matter of Erf 3183/1 Ladysmith & Another v CIR[24]. This created uncertainty as to whether the Court intended to overturn the century-old principle as clearly established, and relied upon, after the Randles Bros-judgement.
In a recent judgement Roshcon (Pty) Ltd v Anchor Body Builders CC & Others[25], the supreme court of appeal tried to clarify the confusion created by the NWK-judgement. Roshcon was not a tax-case; it concerned the supplier and floor plan agreements relating to the sale of trucks, with a reservation of ownership to a finance house as security until the trucks were fully paid for by the purchaser. On the assumption that the NWK-case had transformed our law that in regard to simulated transactions, counsel contended that the agreements in question were a disguise or simulation, amounting in fact to a pledge of the trucks without delivery of possession as required by the law. In rejecting this argument, the SCA took great care to reaffirm the well-established principles relating to simulations, and to explain it`s comments in the NWK-case.[26]
As previously underlined, the big arouse among tax practitioners regarding judge Lewis`s statement in the NWK-case: “If the purpose of the transaction is only to achieve an object that allows the evasion of tax, or of a peremptory law, then it will be regarded as simulated.”
This suggested that even an honest transaction might be deemed a simulation and in fraudem legis if it lacked a sound commercial purpose. Moreover, it blurred the distinction between motive and intention so carefully drawn by the SCA in the earlier case of Hippo Quarries (Tvl) (Pty) Ltd v Eardley[27] where the genuineness of a cession was in question: “Motive and purpose differ from intention. If the purpose of the parties is unlawful, immoral or against public policy, the transaction will be ineffectual even if the intention to cede is genuine. That is a principle of law. Conversely, if their intention to cede is not genuine because the real purpose of the parties is something other than cession, their ostensible transaction will likewise be ineffectual. That is because the law disregards simulation.”[28]
In the Roshcon-case the SCA has now said that these concerns were unfounded: the underlined sentence in the passage from NWK-case quoted above should be read in context of the passage as a whole, and the passage itself should be read in light of the discussion that preceded that. Read, in that light it was manifestly not the intention of Lewis JA to upset the established principles regarding simulated transactions.[29]
Accordingly, Wallis JA in Roshcon said: “Whether a particular transaction is a simulated transaction is therefore a question of its genuineness. If it is genuine the court will give effect to it, if not, the Court will give effect to its underlying transaction that it conceals. And whether it is genuine will depend on a consideration of all facts and circumstances surrounding the transaction.” Those circumstances include the commercial purpose of the transaction, any unusual features of the transaction, and the manner in which parties intend to implement it. The presence of unusual features which serves no commercial purpose would thus give rise to a suspicion that the transaction was not a genuine one.
In the income tax cases such as NWK, explained Wallis JA, parties may seek to take advantage of Income tax legislation in order to obtain a reduction in their overall liability for income tax. The various mechanisms for doing this involves taking straightforward commercial transactions and adding complex additional elements solely for the purpose of claiming increased or additional deductions from taxable income, or allowances provided for in the legislation. “The feature of those that have been treated as simulated transactions by the courts is that the additional elements add nothing of value to the underlying transaction and are very often self-cancelling.” This was the case in NWK where a range of unrealistic self-featuring had been included solely to disguise the true nature of the loan. The requirement was therefore met in the NWK-case and therefore the simulation principle applied.[30]
The Roshcon-case, as discussed above, provided great clarification on the NWK-judgement; however prior to this case it created an immense amount of confusion especially having regard to the general anti-avoidance provisions, as discussed above.
A brief comparison of the GAAR principles with the NWK-case, prior to the Roshcon-judgement:
As discussed above, prior to the Roshcon-case, it seemed as if the Court completely intended to overturn the well-established common law principle relating to simulated transaction. The question here is what the effect of the judgement was on the general anti-avoidance portions as stipulated in ss80A-80L of the Income Tax Act.
As a matter of interest, it seems as if the Court in the NWK-case failed to distinguish between Tax Evasion and Tax Avoidance with the distinction being clearly recorded in the Income Tax Act, the one being a criminal offence with the latter only resulting in the transaction been neutralised and an interest penalty imposed on the taxpayer.
[Quoting from Broomberg]One can understand, of course, that Lewis JA evidently considers it to be unacceptable that members of the public should be permitted to enter into transactions which create binding rights and obligations, for the sole purpose of avoiding tax; and many may agree with that sentiment. That, however, does not justify the Court in overriding the basic common law principle, and in creating a new common law rule to counter such tax-avoidance. One reason is that, quite apart from the fact that it breaches the Rule of Law, there was no need for the judiciary to intervene. The fact is that the Court in NWK has sprung into action some 70 years too late[31].
By 1941 the Legislature had already come to recognise that the basic common law rule, which respects the integrity of all genuinerights and obligations even if created to avoid tax, and only attacks simulated transactions, did not provide adequate protection for the Treasury. In the result, the Legislature introduced a statutory general anti-avoidance provision, in the form of section 90 of the 1941 Income Tax Act, which subsequently appeared as section 103(1) and then section 80A et seq of the 1962 Act.[32]
This legislation were created for the purposes of allowing the commissioner to attack this type of transaction when he`s of the view that the sole or main purpose for entering into the transaction was the avoidance of tax, if all the other requirement of this section were met as set out above.
Broomberg believes that the statutory general anti-avoidance provisions creates an insuperable obstacle in the way of creating a new juristic common law anti-avoidance provision. This becomes obvious when regard is had to the principles which have consistently been reaffirmed by the Appeal Court when dealing with, on the one hand, the common law principles relating to simulated transactions and expressed in the maxim plus valet quod agitur quam quod simulatione concipitur, and on the other hand the general anti-avoidance provisions.[33]
These principles are summarised, by Broomberg, as follows:
- Under the common law a taxpayer is allowed to arrange his affairs in the most tax efficient way. If the same economic result can be achieved in different ways, the taxpayer is allowed to opt for the most tax beneficial manner;
- However, if a transaction is entered into for the purpose of avoiding tax, the general anti-avoidance provisions may allow the commissioner to disregard the rights and obligations created by the parties and impose tax as if other rights and obligations were created;
- The Parliament has laid down precise rules and limits within which the rights and obligations may be disregarded: Principally that the transaction may have one or two tainted elements, as specified in the legislation, e.g. it has given rise to the rights and obligations;
- If a transaction has been entered into, for the purpose of avoiding tax and it falls within the scope of the general anti-avoidance provisions, the commissioner must disregard the actual rights and obligations created by the parties and must impose tax as set out in the GAAR provisions;
- Similarly, if a transaction has been entered into for the purposes of avoiding tax, but does not fall within the scope of GAAR; i.e. there`s no presence of any tainted element, then again the commissioner has no discretion and may not disregard the actual rights and obligations of the parties involved. [34]
Conclusion:
Since the NWK-judgement great uncertainty arose regarding the application of the doctrine relating to simulated transactions and the interpretation of substance-over-form doctrine. The judgement seemed to suggest a shift in the well-established common law position and possibly, contrary to the separation of powers doctrine, a disregard of the statutory provisions (or almost nullifying the existence thereof).
The Roshcon-case has now provided clarity on the judgement and confirmed that the simulation principle still requires an element of dishonesty, deception or disguise. In the absence thereof, the principle cannot apply. This is also consistent with the statutory provisions of ss80A-80L, which confirm that all three of the first four elements must be present i.e. (i) There must be an arrangement, (ii) must result in a tax benefit, (iii) for the sole or main purpose of avoiding tax. The tainted element is found in the presence of one of the elements of the fourth requirement being (i) Means and manners not normally employed, (ii) Rights and obligations not normally created, (iii) lack of commercial substance and (iv) Misuse or abuse of the provisions of the act. The element of purpose as set out in the third requirement read with the fourth requirement were found lacking in the NWK-case as it seemed to suggest that any transaction created solely or mainly for the purpose for tax saving reasons and there was no commercial substance, the transaction could be set aside, despite the parties might having the intention the agreement to have effect according to its terms.
The Supreme Court of Appeal fortunately had the opportunity in the Roshcon-case to clarify all uncertainty previously created in the NWK-case, by firstly rejecting the proposition that the NWK-case has taken the law into a new direction and secondly by reaffirming the previous position regarding the essence of an element of disguise or lack of genuineness. The question remains whether a transaction is a simulated transaction is therefore a question of genuineness and, if not, the Court will give effect to the underlying condition concealing it.
There were some passages in the NWK-case that seemed to suggest that the essence of a simulated transaction were whether it lacked commercial purpose, but this was not an accurate position as it was interpreted out of context of the judgement and the facts and circumstances as a whole.
In conclusion, the NWK-case was either incorrect or ambiguously drafted which created immense confusion and uncertainty. Fortunately, the Roshcon-case came along which allowed the SCA to clarify the issues and provide context of the judgment in light of the well-established common law portions and in consistence with the statutory provisions of the Income Tax Act.
_________________________________________________________
[1]Duke of Westminister v IRC (1953)
[2]CSARS v NWK 2011 (2) SA 67 (SCA). Hereinafter referred to as the NWK-case.
[3]Van Schalkwyk L, Silke: South African Income Tax 2014, Lexis Nexis (et 812)
[4]Ss80L
[5]Ss80L
[6]SIR V Lourens Erasmus (Edms) Bpk 1996 (4) SA 434 (A)
[7]CIR V KING 1947(2) SA 196 (A)
[8]SIR V Geustyn, Joubert & Fosyth 1971 (3) SA 467 (A)
[9]Van Schalkwyk L, Silke: South African Income Tax 2014, Lexis Nexis (et 814)
[10]S 80A(a)(i)
[11]Van Schalkwyk L, Silke: South African Income Tax 2014, Lexis Nexis (et 814)
[12]S80A(c) (i)
[13]Van Schalkwyk L, Silke: South African Income Tax 2014, Lexis Nexis (et 814)
[14]S80A(a)(ii)
[15]Van Schalkwyk L, Silke: South African Income Tax 2014, Lexis Nexis (et 814-815)
[16]S80A(c) (ii)
[17]Van Schalkwyk L, Silke: South African Income Tax 2014, Lexis Nexis (et 811)
[18]Emslie & Davies, Income Tax Cases and Materials, 3rd Edition 2011 (et 844)
[19]Van Schalkwyk L, Silke: South African Income Tax 2014, Lexis Nexis (et 823)
[20]Zandberg v Van Zyl 1910
[21]Wilson I, PWC Synopsis Tax Today, April 2014.
[22]Randles Bros & Hudsons v Commissioner of Customs & Excise 1941 AD 369
[23]Wilson I, PWC Synopsis Tax Today, April 2014.
[24]Erf 3183/1 Ladysmith & Another v CIR 1996(3) SA 942 (A)
[25]Roshcon (Pty) Ltd v Anchor Auto Body Builders CC & Others ZASCA 40
[26]ENSafrica Tax Team, “Simulated transactions: welcome clarification from the Supreme Court of Appeal”, 9 April 2014.
[27]Hippo Quarries (Tvl) (Pty) Ltd v Eardley
[28]ENSafrica Tax Team, “Simulated transactions: welcome clarification from the Supreme Court of Appeal”, 9 April 2014.
[29] See footnote 64.
[30]See footnote 64.
[31]Broomberg E, The Taxpayer, Volume 60 (et 199 – 200). Direct Quote from article.
[32]See footnote 67.
[33]See Footnote 67.
[34]See footnore 67.
