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The letter of the law not followed to the letter!But SARS's erroneousreference does notinvalidate its action
Synopsis January 2008
Tax today*
*connectedthinking
2
But an erroneous reference tothe empowering statute doesnot invalidate action by SARSTo practise as a tax consultant, it is essential to be a pedant.
Momentous consequences can turn on a particular word or
phrase in tax legislation.
It is not surprising, therefore, that the taxpayer’s advisers in
Shaikh v Standard Bank [2007] SCA 178 (RSA) seized on an
apparent error in a formal notice given by SARS to Standard
Bank, and argued that the notice was invalid.
The close corporation of a certain Shaikh had under-declared
the value of goods that it had imported, with the result that
VAT and customs duty had been underpaid.
SARS sought to recover the shortfall. When neither the close
corporation nor Shaikh came up with the money, SARS gave a
formal notice to Standard Bank requiring it to pay over money
held in Shaikh’s account. In terms of section 103 of the
Customs and Excise Act, Shaikh was personally liable for the
customs duty and VAT owed by his cc.
The notice by SARS to Standard Bank professed to be given in
terms of section 114A of the Customs and Excise Act.
In compliance with this notice, Standard Bank paid SARS the
sum of R699 920, being the only funds then in Shaikh’s
account, and later paid over a further sum of R539 993 from
the account.
SARS had invoked the wrong statutoryprovision to appoint Standard Bank as its agent
It transpired that the notice from SARS to Standard Bank
should have stated that it was given, not in terms of section
114A of the Customs and Excise Act, but in terms of section
47 of the VAT Act.
The sole issue for determination by the Supreme Court of
Appeal was whether the notice given to Standard Bank was
consequently invalid, in which event Shaikh would have been
entitled to be repaid.
Unfortunately for the taxpayer, this precise point of law had,
just a short time before, been the subject of a Supreme Court
of Appeal decision in Howick District Landowners Assoc v
The letter of the law not followed tothe letter!
3
Umngeni Municipality 2007 (1) SA 206 (SCA) in which it was
held that –
“Where an empowering statute does not require that the provision in
terms of which a power is exercised be expressly specified, the
decision-maker need not mention it. Provided moreover that the enabling
statute grants the power sought to be exercised, the fact that the
decision-maker mentions the wrong provision does not invalidate the
legislative or administrative act.”
In terms of this dictum, the question was simply whether SARS
had the power to appoint Standard Bank as its agent to recover
the VAT; if the answer were affirmative, then the notice to
Standard Bank was valid and it was irrelevant which statutory
provision SARS professed to rely on.
The court held that the principle laid down in Howick District
Landowners Assoc applied in the present case, and the notice
from SARS to Standard Bank was thus valid.
This principle does not legitimise unauthorisedadministrative acts
It is important to note that – as the Supreme Court of Appeal
pointed out – the principle in question is not a license for
unauthorised administrative acts; the principle legitimises acts
where authority for the act does exist, but the source of that
authority is incorrectly given.
In this issue
Erroneous reference to empowering statute does notinvalidate action by SARS . . . 2
SARS in relentless pursuit - Dave King saga continues . . 4
Liability for STC in respect ofloans to a discretionary trust . 7
Deductibility of interest on a loanincurred to acquire shares . . 8
Editor: Ian Wilson
Written by R C (Bob) Williams
Sub-editor and lay out: Carol Penny
Tax Services Johannesburg
Dis tri bu tion: Elizabeth Ndlangamandla
Tel (011) 797-5835
Fax (011) 209-5835
www.pwc.com/za
4
The on-going tax litigationbetween SARS on the one hand and King on the other isthrowing valuable light on theseldom-explored outer limits ofSARS’s powers to access orfreeze a taxpayer’s assets(including those situatedabroad) that can be realised tosecure payment of a tax debt.
Dave King saga continues
The well-known entrepreneur, David
King, was arrested in 2002 and is now
reported to be facing 322 charges,
including fraud, money laundering,
racketeering and the breach of exchange
control regulations.
King has reportedly been assessed to
tax in excess of R900 million and one of
his companies, Ben Nevis Holdings Ltd,
has been assessed to tax in excess of
R1 400 million.
The Director of Public Prosecutions,
SARS and the South African Reserve
Bank have been successful in obtaining
court orders, in South Africa and
overseas, to freeze all of King’s funds,
including the assets in several trusts and
business entities. The purpose of these
orders was to preserve assets, which
can later be realised and the proceeds
used to pay SARS the outstanding tax.
The on-going tax litigation between
SARS on the one hand and King and his
associated companies on the other is
throwing valuable light on the
seldom-explored outer limits of SARS’s
powers to access or freeze a taxpayer’s
assets (including those situated abroad),
which can be realised to secure payment
of a tax debt.
Preservation and anti-dissipation order in respect ofan aircraft in France
On 3 September 2002 the South African
High Court issued a preservation and
anti-dissipation order in respect of a
South African-registered Falcon
executive jet (originally valued at R200
SARS in relentless pursuit
5
million), which had been languishing and
deteriorating at an airport in France since
April 2003.
The aircraft was owned by a partnership
between Hawker Air Services (Pty) Ltd,
Hawker Management (Pty) Ltd and Rand
Merchant Bank, the last-mentioned
being an undisclosed partner with a
99.8% interest in the aircraft. SARS had
a VAT-related claim against the
partnership of some R73 million.
The preservation and anti-dissipation
order had the effect of interdicting any
disposal of the aircraft, but (see the
judgement at [3]) did not create a
preferential claim over the aircraft in
favour of SARS.
In spite of that order, Carmel (claiming
that it was not a party to the litigation
and therefore was not bound by the
order) purported to take over the interest
of Rand Merchant Bank and Hawker
Management (Pty) Ltd vis-à-vis the
aircraft. The High Court however, held
that this was a contrived transaction, in
fraudem legis, intended to bypass the
preservation order, and that Carmel was
a tool of King and under his control.
A subsequent extension of that order
required Carmel Trading Co Ltd to return
the aircraft to South Africa; see Metlika
Trading Co Ltd v CSARS 2005 (3) SA 1
(SCA).
The stalemate
Thereafter, a stalemate ensued. The
aircraft remained in France. Carmel,
despite professing a willingness to
procure the aircraft’s return to South
Africa, refused to make funds available
to do so and refused to consent to the
aircraft’s being returned to South Africa
by the sheriff. (See the judgement at [7].)
Meanwhile, the aircraft was not being
kept in a hangar, was fast deteriorating,
and would soon become worthless.
Hangarage would slow the rate of
deterioration but would cost R150 000
per month. Consequently, the earlier
preservation order granted by the court
would soon be nugatory unless it could
be amplified to enable the aircraft to be
sold and the proceeds kept in trust
pending a final resolution of the litigation.
SARS was of the view that King was
determined to thwart the sale of the
aircraft, and (as the judgement records
at [10]) was “patently prepared to see the
value of the Falcon lost rather than being
used to pay SARS”.
The present appeal wasagainst the order that theaircraft be sold
The High Court issued a variation order
to the effect that the aircraft should be
sold by the sheriff and the proceeds kept
in trust pending finalisation of the
litigation.
It was this order that was the subject of
the present appeal. Carmel was
opposing not just the terms of that
particular order, but any sale of the
aircraft.
In his affidavit the Commissioner
contended (see [10]) that –
“the behaviour of the new partnership to leave
the Falcon stranded and neglected in a foreign
country is an obvious and desperate attempt to
prevent our courts from eventually making an
effective order in respect of this valuable asset
[and King] is patently prepared to see the value
of the Falcon lost rather than being utilized to
pay [SARS].”
The court described Carmel’s opposition
to the sale of the aircraft as
schadenfreude (which a dictionary
defines as “malicious or smug pleasure
in somebody else’s misfortune”) and
said (at [13]) that Carmel’s objection to
the sale “lacks reality”.
Carmel argued that selling theaircraft would flout the Bill ofRights
Carmel objected to the sale on the basis
that section 25(1) of our Bill of Rights
provides that no law can permit the
arbitrary deprivation of property, and
argued that an order to sell the aircraft
and keep the proceeds in trust pending
the finalisation of the main litigation
amounted to “an arbitrary deprivation of
Carmel’s property”.
The court held that this argument broke
down on many levels. Firstly, the aircraft
6
was not Carmel’s property, although it may
have had a proprietary interest in it as a
partner in the partnership that was a
beneficial owner of the aircraft. However, a
court had already found that Carmel’s
purported taking over of a partnership
interest was fraudulent, and the court now
held (at [15]) that Carmel could not rely on
a simulated or fraudulent agreement.
Moreover, said the court, the partnership
had been dissolved by the liquidation of
one of the partners, and as a former
partner, Carmel had no proprietary claim in
respect of the partnership’s property, but
at best a claim for a proportionate share of
the proceeds.
The court ruled further (at [16]) the sale
would not amount to a “deprivation” of
property. In effect, it would merely
substitute a fund of money for a
deteriorating asset and Carmel’s position
would not, after the sale, be any different
from what it was now. The value of the
asset was being retained for the owner and
creditors.
Moreover, said the court (at [17]) the sale
was not “arbitrary” because there was
sufficient reason for the deprivation and it
was procedurally fair. SARS would not get
control of the proceeds of the sale, which
would be kept in trust on behalf of the
owner of the aircraft.
Overview
Where SARS relentlessly pursues a
taxpayer, seeking out assets that can
be realised to pay off a tax debt, or to
freeze assets pending finalization of a
tax claim, the taxpayer may be
tempted to think that his off-shore
assets are safe from SARS’s clutches.
After all, it is trite that (unless there are
specific co-operation agreements),
one state does not enforce another’s
tax laws.
Whether SARS can enforce a tax debt
due to the government of the Republic
in a foreign country depends on the
terms of the applicable double tax
treaty, and in the absence thereof, on
the law of the country in question. It is
unlikely that a tax debt would be
actionable in the foreign country.
In State of Colorado v Harbeck (1921)
232 NY 71), decided in the state of
New York, it was held that one state is
not a collector of taxes for another.
Similarly, the courts of the United
Kingdom do not entertain a suit by a
foreign country to recover tax due to it.
(See Government of India v Taylor
(1955) 1 All ER 292 (HL); Peter
Buchanan Ltd and Machurg v McVey
(1955) AC 516; Rossano v
Manufacturers Insurance Co [1962]
2 All ER 214.)
However, as the decision of the
Supreme Court of Appeal in the case
under discussion makes clear, where a
taxpayer is subject to the jurisdiction
of the South African courts, our courts
can make a preservation or
anti-dissipation order in respect of his
assets even if they are located in a
foreign jurisdiction. (Breach of such an
order could ground contempt of court
proceedings against the taxpayer in
the South African courts.) Moreover,
our courts can order that an asset
(even if located overseas) in respect of
which a preservation order has been
granted, be sold, and the proceeds
held in trust pending the finalisation of
the litigation.
Whether SARS can enforce a tax debt due to the government of the Republic in a foreign countrydepends on the terms of the applicable double tax treaty, and in the absence thereof, on the law ofthe country in question.
7
The crisp issue in this case was whether
a discretionary trust was a “recipient” as
contemplated in section 64C(1) of the
Act in its pre-amendment form. If the
answer was in the negative, then this
lacuna was capable of being exploited to
avoid or at least defer liability for STC.
In terms of section 64C(1) a “recipient”
vis-à-vis any company was (prior to the
amendment) defined as a shareholder of
the company, or any relative of such
shareholder, or –
“any trust of which such shareholder or relative
is a beneficiary”.
The question was whether these words
included all trusts, or only those in which
the beneficiary in question had a vested
right, thereby excluding from the ambit
of a “recipient” those discretionary trusts
where no vesting had yet taken place.
In 2000 the Act was amended to define a
“recipient”, vis-à-vis a company, as –
(a) any shareholder of such company;
(b) any connected person [as defined] in
relation to such shareholder.
Read with the definition of “connected
person”, this amendment made clear
that where a shareholder was a
beneficiary of any trust, whether vesting
or discretionary, the trust would be a
“recipient”.
The minority judgment (per Combrinck
JA, Farlam JA concurring) held that the
Tax Court had correctly found that, in
relation to a trust, the term “beneficiary”
in section 64C(1) prior to its amendment
in 2000 was restricted to a vested
beneficiary, and did not include a person
who, at the relevant time, was a potential
beneficiary. The majority judgment (per
Hurt AJA; Howie P and Lewis JA
concurring) held that the meaning of the
term “beneficiary” in this context was
not restricted to beneficiaries with
vested rights.
The decision of the Supreme Court of Appeal in CSARS v Airworld CC[2007] SCA 147 (RSA) concerns adisputed point of interpretation ofthe Income Tax Act, which hassince been resolved through anamendment to section 64C(1),which became effective as from22 December 2003.
The point at issue in the case istherefore now academic, save inrespect of taxpayers whoseassessment for STC for periodsprior to that amendment is still inthe pipeline.
Liability for STC in respect of loans to adiscretionary trust
Being a decision of the Supreme Court of Appeal, the majority judgment on the interpretation of section 64C(1), prior tothe 2000 amendment, is absolutely binding on all lower courts, and SARS will therefore be obliged to apply the ruling inrelation to all disputed or unprocessed assessments involving company distributions prior to 22 December 2003.
8
The acquisition of shares is aneveryday commercialtransaction. Frequently, thepurchase is financed wholly orpartly by a loan. The tax-deductibility or otherwise of theinterest on that loan is oftenvital to the financialattractiveness of the deal.
It is surprising how oftenpurchasers go into suchtransactions, often involvingvery large sums of money, onthe blithe assumption that theinterest will be deductible,without giving any thought towhether advance tax planning is required to ensure, or at leastmaximise, the chances of suchdeductibility.
A recent example of suchnaiveté is the case of SalliesLimited v CSARS(Johannesburg High Court, case A3034/07; judgment deliveredon 30 November 2007; not yetreported).
Deductibility of interest on a loanincurred to acquire shares
In this case, Sallies Ltd (a listed but
dormant public company) entered into
an agreement with a company
incorporated in the USA to acquire the
entire share capital of Phelps Dodge
Mining (Pty) Ltd for some R74 million,
financed inter alia by a loan of US$6.5
million.
Phelps Dodge Mining (Pty) Ltd changed
its name to Witkop Fluorspar Mine (Pty)
Ltd (“Witkop”) and became the
wholly-owned subsidiary of Sallies Ltd.
Witkop’s main asset was the Witkop
Fluorspar Mine in Zeerust.
On 17 June 1999, Sallies Ltd issued a
circular to its shareholders, motivating
for the latters’ approval and ratification
of the acquisition of Witkop, and such
approval and ratification was duly
secured.
On 23 September 1999, Sallies Ltd and
Witkop entered into a marketing
agreement whereby Sallies was
appointed the sole marketing agent of
Witkop in respect of the latter’s
production of fluorspar, a non-precious
mineral. Witkop was to pay Sallies an
“intent fee” of R3 million and a monthly
fee of R200 000. The agreement was for
a period of five years, after which it
would continue indefinitely until
terminated by either party.
As at 30 June 2000, Sallies had earned
R5 million in respect of such marketing
fees.
Sallies’ claim to deduct theinterest on the loan wasdisallowed by SARS
For income tax purposes, Sallies
claimed a deduction in respect of
interest on the loan, which it sought to
deduct from the marketing fees paid to
it by Witkop.
SARS refused to allow the interest as a
deduction, and issued an assessment
accordingly. Sallies objected to the
assessment, and asserted its claim to a
deduction. When the matter came
before the Tax Court, the court ruled in
favour of SARS.
Deductibility turned on Sallies’ purpose in borrowing themoney
On further appeal to the High Court, the
matter turned on whether the interest
(incurred by Sallies on the loan which
had been utilised to acquire the shares
in Witkop) satisfied the criteria for
deductibility laid down in the general
deduction provisions of the Income Tax
Act 58 of 1962, namely section 11(a)
read with section 23(f) and section
23(g).
In his judgment, Goldstein J quoted
from CIR v Allied Building Society 1963
(4) SA 1 (A) at 13C – D where Ogilvie-
Thompson JA said that, on the facts of
that case, the ultimate use or
destination of the borrowed money
could not be elevated into a decisive
9
factor in determining its deductibility
under the Income Tax Act. The dominant
question was – what was the true nature
of the transaction, and the most
important factor in that inquiry was the
purpose of the borrowing.
If the purpose of borrowing money was
to apply the funds to earn income of a
kind that is taxable under the Act, then
the interest on the loan is a deductible
expense for income tax purposes.
Dividends, however, are exempt from
tax; hence expenditure incurred for the
purpose of producing dividends is not
deductible.
The purpose of a loan, said Goldstein J
must be determined at the time of the
borrowing of the funds.
Goldstein quoted from CIR v Standard
Bank of SA Ltd 1985 (4) SA 485 (A) at
500H – 501C where Corbett JA said that
a distinction has be drawn between the
case where the taxpayer borrows a
specific sum of money and applies it to
an identifiable purpose, and the situation
where (as in the Allied Building Society
case) the taxpayer borrows money
generally (in other words, not to finance
a specific transaction) and on a large
10
scale, simply to raise floating capital for
use in his business. In the former
situation, the purpose of the loan (in
other words, what kind of income it was
intended to produce) can be established.
In the latter situation, no such specific
purpose can be determined, but the
interest satisfies the tests for
deductibility, and is therefore a
deductible expense.
It is clear that the loan in the present
case fell into the first-mentioned
category, and that the specific purpose
of the borrowing could be ascertained.
What was the purpose of theloan in the present case?
Goldstein J said that, in the present
case, of the three witnesses who
testified in the court a quo, only one of
them could give direct evidence of the
taxpayer company’s intention at the time
of the borrowing. However, as Miller J
said in ITC 1185 35 SATC 122 at 123,
the ipse dixit of a taxpayer (in other
words, what he states his intention to
have been) is not decisive on this issue
and a court has to draw its own
inferences as to the operative intention
against the background of the general
human and business probabilities.
In the present case, said Goldstein J, the
witness had testified that Sallies’
purpose, in acquiring the shares in
Witkop, was to generate income in
Sallies by charging Witkop fees for
services provided by Sallies, including
technical, management, and marketing
services. However, said this witness,
dividends were “not on the radar for
many years”.
Goldstein J proceeded to put this
argument under a strong lens.
In the normal course, said Goldstein J (at
[9]) –
“a shareholder is rewarded for his investment
by the receipt of dividends. This fundamental
factor had to be provided not to operate in the
present case”.
The witness, said Goldstein J, had
suggested that Sallies was to be
remunerated in fees. It was implicit that
such fees would have to be
market-related, and any excess would
have to be channelled to Sallies either as
a dividend or as a loan – but neither
would constitute “income”, as defined in
section 1 and the interest would
therefore not be a deductible expense.
Goldstein J found a further flaw in
Sallies’ argument for deductibility in the
fact that the company’s circular to its
shareholders stated that the projected
profits of Sallies and Witkop for the tax
year was R17.85 million. Since Sallies
had no significant source of independent
income, the projected profit must have
been substantially derived from Witkop.
The fees payable by Witkop to Sallies
could not absorb more than a fraction of
this, so it must have been intended that
the balance of the projected profit would
be paid to Sallies by way of a dividend.
Moreover, paragraph 7.11 of the circular
said explicitly that Sallies intended to
pay its shareholders dividends. Such
dividends could only come from the
dividend income it received from Witkop.
All of these factors were nails in the
coffin of the argument that the purpose
of the borrowing was to produce fee
income for Sallies, and not dividends.
Moreover, said Goldstein J, Sallies’
income and expenditure statement for
the year in question was destructive of
its argument that it had taken out the
loan for the purpose of earning fees from
Witkop. This statement reflected a profit
of only R31 028, which represented a
return of about 0.43% on the borrowed
money, and the purpose of the loan
could not have been to generate such a
small return.
In the result, the court held that it had
not proved that it had acquired the
shares in Witkop “in the production of
income”; the appeal failed and the
interest was thus not deductible.
What was the purpose of the loan?Goldstein J proceeded to put theirargument under a strong lens.
11
Tax planning lessons from this judgement
This judgment underlines the difficulties that frequently
arise in cases where an acquiring party in relation to
an acquisition may derive income from the acquired
company in the form of fees, or some other trading
transaction. In some cases, taxpayers have been able
to persuade the Courts that their purpose in acquiring
shares was to derive taxable income streams.
However, this appears to have been a remote
possibility in this matter. .
A tax consultant would have said to Sallies – if you
want to be entitled to a deduction in respect of the
interest on the loan to acquire the Witkop shares, you
are going to have to prove that your purpose in
borrowing the funds was not to earn dividends, but
management fees. In terms of the Income Tax Act, the
onus is on you to prove this. How do you intend to
discharge that onus, for it will not be sufficient for a
witness simply to stand up in court and, hand on
heart, swear that this was indeed Sallies’ intention?
In the present case, the language of the circular to
shareholders was seized on by the judge as being
inconsistent with an intention not to earn dividends
from Witkop. In hindsight, that circular ought to have
been vetted by a tax professional, and its adverse
implications identified and considered before it was
issued.
There are limits to what tax-planning can achieve. In
the present case, it is likely that no gloss or
restructuring could have disguised the fact that the
purpose of the loan was primarily to generate dividend
income from Witkop.
An advisor might have suggested that Sallies should
negotiate two entirely separate loans, even if from the
same lender. The first loan could have been for an
amount which Sallies would admit had been taken out
for the purpose of earning dividends, and Sallies
would have to resign itself to the interest on this loan
being non-deductible.
In respect of the second loan, Sallies would argue that
this amount had been borrowed for the purpose of
generating fee income from Witkop, and that the
interest was therefore deductible. For this argument to
be credible, the ratio of the moneys borrowed under
this second loan vis-à-vis the prospective fee income
would have to be attractive on ordinary business
principles. Even this approach would still carry with it
considerable risk of disallowance of all the interest.
Where there is just one loan (as in the present case)
the courts determine the deductibility of interest by
giving effect only to the taxpayer’s dominant purpose
in borrowing the money.
If the dominant purpose was to produce dividend
income, then none of the interest will be deductible,
even if part of the taxpayer’s purpose was to produce
non-dividend income. The attitude of the courts in this
respect – which is pragmatic if illogical – is clear from
the concurring judgment of Schwartzman J in the
present case.
This publication is provided by PricewaterhouseCoopers Inc. for information only, and does not constitute the provision of professional advice of any kind. The information
provided herein should not be used as a substitute for consultation with professional advisers. Before making any decision or taking any action, you should consult a
professional adviser who has been provided with all the pertinent facts relevant to your particular situation. No responsibility for loss occasioned to any person acting or
refraining from action as a result of any material in this publication can be accepted by the author, copyright owner or publisher.
© 2007 PricewaterhouseCoopers Inc. All rights reserved. PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International Limited,
each of which is a separate and independent legal entity. PricewaterhouseCoopers Inc is an authorised financial services provider.
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