Tuesday 21 June 2011

National Treasury Suspends Intra-group Relief Contained in Section 45 of the Act

On Thursday, 2 June 2011, National Treasury released the Draft Taxation Laws Amendment Bill, 2011 ("DTLAB"), Explanatory Memorandum on the DTLAB 2011, Draft Taxation Laws Second Amendment Bill, 2011 ("DTLSAB"), as well as a Media Statement on the DTLABs 2011.

The DTLAB comprises 183 pages of significant changes to the fiscal laws of South Africa.
The one change that requires specific comment is Government's proposal to suspend the intra-group relief available in section 45 of the Income Tax Act, Act 58 of 1962, as amended ("the Act"), with effect from 3 June 2011.

Most of the proposals contained in the DTLAB were announced in the 2011 Budget presented to Parliament by the Minister of Finance on 23 February 2011.

From an examination of the 2011 Budget Review, published by National Treasury, it is clear that no mention whatsoever was made of the proposal to suspend section 45 of the Act. It has become customary that most of the changes contained in the Tax Bills are announced in the Budget documentation so that taxpayers know what changes they are likely to face and, more importantly, the likely date on which those changes may take effect.

Section 45 forms part of the so-called "group restructuring rules", which were introduced into law by section 44 of the Second Revenue Laws Amendment Act No. 60 of 2001. This section has undergone significant amendments over the years as the authorities have sought to refine the provisions and curtail the perceived abuse thereof.

The corporate restructuring rules were introduced into the Act with effect from 1 October 2001, that is, the date on which capital gains tax took effect in South Africa, to enable groups of companies to restructure their affairs without adverse tax consequences arising. 

There were similar measures in place since 1988 to allow for companies to restructure their affairs without incurring tax liabilities where a qualifying group of companies restructured its affairs.

The Media Statement issued by National Treasury on 2 June 2011, refers to the fact that the DTLAB contains a number of new anti-avoidance measures and contained a separate annexure dealing with the suspension of intra-group roll-over relief currently contained in section 45 of the Act. The DTLAB specifically provides that section 45 will not apply in respect of any asset disposed of on or after 3 June 2011 and before 1 January 2013. Thus, section 45 has, for all practical purposes, been suspended for a period of 18 months to allow the National Treasury to investigate the perceived abuse of the section.

National Treasury, in its Media Statement, points out that the section 45 intra-group roll-over relief was originally intended to facilitate transfers amongst companies which constituted a group as defined in the Act. Thus, the purpose of section 45 was to ensure that the tax system did not pose a barrier to intra-group transfers, whether the transfer took place by way of an exchange of shares, debt or cash, or as a dividend. National Treasury makes the point that intra-group relief is a common feature of most advanced tax systems around the world.

National Treasury is concerned about the way in which section 45 is being used, as taxpayers have, in its view, sought to use it as a means of acquiring businesses and that the section involves what is referred to as "debt push-down structures". National Treasury contends that section 45 allows for the use of excessive debt schemes and creates the means whereby taxpayers utilise so-called "funnel schemes", whereby debt proceeds are indirectly linked to tax-free preference share dividends.

Left: In light of the suspension of intra-group relief, big corporations are reviewing their corporate structures on an on-going basis. 

National Treasury has indicated that section 45 will be suspended for a period of approximately 18 months, during which period the purpose of the section will be re-evaluated, particularly to deal with the concerns that National Treasury has regarding excessive debt. National Treasury has identified the following issues relating to section 45 as part of a larger set of problems and these include:
  • The free use of excessive debt to eliminate substantial amounts of operating income for an extended duration.
  • The seeming freedom to re-characterise shares as debt (or debt as shares) with little regard for accounting and commercial concepts.
  • Excessive tax losses available in the tax system and the potential to move losses amongst entities if a viable business purpose can be asserted.
  • The need for section 45 within an intra-group context, as well as the need for the movement of losses within a single domestic group.
  • The need to allow for interest deductions stemming from leveraged buy-outs, regardless of the form of that acquisition.
It must be remembered that South Africa does not impose tax on a group basis and, thus, section 45 alleviated the adverse tax consequences that would otherwise arise where business assets are moved from one company in a group to another.

To summarily to suspend section 45 of the Act, without prior notice in the Budget documentation, by way of a Media Statement, is extremely draconian.

It is questionable also whether this proposal be enacted is valid under the Constitution of the Republic of South Africa, Act 108 of 1996, as amended. Numerous companies have prepared agreements to transfer businesses in terms of section 45 of the Act and the costs they incurred would now appear to have been wasted as a result of this immediate suspension of section 45. It is unfair that businesses should be expected to carry these costs in light of the manner in which section 45 has been suspended. The proposal undermines the rule of law insofar as the tax system is concerned, and cannot be supported.

In addition, corporates are reviewing their corporate structures on an on-going basis and, no doubt, many companies in South Africa were in the process of evaluating the most appropriate manner to rationalise their businesses in South Africa. 

The manner in which section 45 has been suspended in the proposals relating thereto create great uncertainty for taxpayers in South Africa and does not bode well for foreign investors who own groups of companies in South Africa, who are currently in the process of reviewing the manner in which those operations are structured. Investors in a country require certainty as to the legal framework within which they are required to operate. 

The manner in which section 45 has been amended, effectively by way of a press release, seriously undermines the certainty to which both domestic and foreign investors have come to expect in South Africa. This cannot bode well for future economic growth and development and job creation in South Africa.

It is hoped that Parliament will recommend that the proposals contained in the DTLAB, insofar as section 45 are concerned, should be removed from the DTLAB and that the matter should be investigated further before the section is summarily suspended. 

If National Treasury and the South African Revenue Service ("SARS") have concerns about the manner in which section 45 is being utilised by taxpayers, the authorities should rely on the General Anti-Avoidance Rule ("GAAR") contained in sections 80A – 80L, which was introduced in November 2006, and not merely suspend the section whilst the matter is investigated further. The GAAR was introduced after much discussion and debate to replace the anti-avoidance rule contained in section 103(1) of the Act. 

However, it would appear that the Commissioner: SARS is reluctant to rely on the GAAR to attack a perceived abuse of the tax system by taxpayers. This also raises the question of whether the GAAR serves any purpose in the Act, with no cases yet having been reported dealing with the application of the GAAR.

This article first appeared in taxENSight, June 2011 edition. Free Image from ClipArt.

Tuesday 14 June 2011

SARS argues company crossed the tax Rubicon

THE Supreme Court of Appeal delivered judgment last month in the case of Founders Hill (Pty) Ltd v the Commissioner for the South African Revenue Service which dealt with the capital versus revenue nature of proceeds received by a realisation company that acquires land in order to dispose of it.

The leading commentators on tax in SA have expressed the opinion previously that when a company acquires an asset with the purpose of reselling it the proceeds so realised constitutes income liable to tax, with the only exception relating to socalled realisation companies, which are not created in order to dispose of assets as part and parcel of a scheme of profit-making.

In Founders Hill, the company was created for the purpose of realising land formerly owned as a capital asset by its holding company, namely AECI Limited. When a company is referred to as a realisation company it means an entity that has been created to facilitate the disposal of property, and the company does no more than to realise the asset owned by it.

Left: SARS argues company crossed the tax Rubicon: capital vs revenue nature of the proceeds of company's land that was sold for a profit was at issue and the Tax Court...held that...the surpluses realised on the disposal of land was capital in nature.

In the Founders Hill case, SARS contended that the company had crossed the Rubicon when it sold the land on which it realised surpluses. The company on the other hand argued that it had merely realised a capital asset to its best advantage and that the proceeds constituted a receipt of a capital nature and that no tax was payable on the basis that the proceeds were realised prior to the introduction of capital gains tax.

The court took the view that Founders Hill had acquired the property from AECI for the purpose of developing the land and reselling it. Originally, the Commissioner did not assess Founders Hill to tax on the profits made on the land disposed of. However, it subsequently issued revised assessments subjecting those profits to tax.

Founders Hill objected to the assessments issued to it on the basis that the proceeds of the sales were capital in nature and proceeded on appeal to the Tax Court once the Commissioner disallowed its objection. The Tax Court upheld the appeal lodged by Founders Hill.

The Tax Court held that Founders Hill had acquired the land as a capital asset and that it did not change its nature by the time that it was sold and therefore the capital gain realised was not taxable.

AECI Limited had owned the land in excess of its requirements for some time and in 1989 it was recommended that a strategic plan, which had been developed, be accepted, namely that AECI makes the decision to sell or develop the land and commences the process to do so. As a result of this decision Founders Hill (Pty) Ltd was created as a subsidiary of AECI to acquire the land from AECI and to realise that land to best advantage.

Founders Hill itself had no employees and its sole shareholder was AECI and its directors were those of AECI. The land located at Founders View was subdivided and developed by AECI before being transferred to Founders Hill and the profits accrued to Founders Hill. Founders Hill argued that it always intended to realise the land held by it as a capital asset and submitted that it was entitled to realise an asset to best advantage. The court was required to determine whether Founders Hill realised the land owned by it to best advantage or whether it embarked upon the business of selling land.

In Founders Hill the Commissioner argued that the company had crossed the Rubicon and therefore any surpluses realised on the disposal of the land owned by it constituted income liable to tax. The Tax Court, however, held that the Rubicon had not been crossed and that the surpluses realised on the disposal of land was capital in nature.

Judge Lewis, in the Supreme Court of Appeal, pointed out that Founders Hill was created as a “realisation company” on legal advice and that by acquiring the land from AECI and realising same to best advantage it should not cross the Rubicon. The judgment contains an analysis of the tax treatment of realisation entities and particularly the decision of the Court in Berea West Estates (Pty) Ltd v Secretary for Inland Revenue. In that case, the profit realised on the disposal of land by a company formed for the purpose of realising land held by different family members was held to be capital in nature. Judge Lewis noted that an interposed realisation company will be treated as holding assets acquired by it as capital assets from the seller in special circumstances as set out in Berea West’s case and not merely where the realisation company acquires property for the avowed purpose of disposing of same at a profit.

It was pointed out by the court that the fact that Founders Hill said that it had acquired the properties from AECI as capital assets did not mean that they were in fact capital assets for tax purposes. Founders Hill was created to develop the land owned by it and to sell it. The court therefore held that the surpluses realised by Founders Hill on the disposal of the land represented profits made as part of a scheme of profit-making and therefore revenue derived from capital productively employed and was therefore liable to tax. Judge Lewis held that Founders Hill had acquired the land from AECI as stock in trade and then conducted the business of trading in that property, and that the surpluses realised were taxable as income. The court confirmed the Commissioner’s assessments issued for the years in question.

The court was also required to consider the imposition of interest on the underpayment of provisional tax in terms of section 89quat of the act. The court referred to the fact that Founders Hill had acted on legal advice and in the mistaken belief that the disposal of its property as a capital asset as a realisation company should not give rise to the imposition of penalty interest on the underpayment of provisional tax. Therefore, the court directed that the Commissioner must waive the interest levied on the underpayment of provisional tax. Unfortunately, the provisions of section 89quat have been amended such that the Commissioner’s discretion to waive the interest on the underpayment of provisional tax has been narrowed significantly.

It was pointed out above that the Founders Hill case dealt with a tax dispute that arose before the introduction of capital gains tax in SA. When capital gains tax was introduced during 2001 amendments were introduced to the law to cater for the situation where assets held by a person as a capital asset become trading stock. Therefore had capital gains tax been in force at the time that AECI Limited proposed to deal in the land owned by it, it may have been possible for AECI Limited to argue that a certain of portion of the value attributable to the fixed property constituted an amount of a capital nature subject to capital gains tax and not income tax by virtue of the provisions contained in paragraph 12 of the Eighth Schedule to the Act.

Dr Beric Croome is a tax executive at ENS. This article first appeared in Business Day "Business Law & Tax Review" June 2011. Free Image from ClipArt.