The Supreme Court of Appeal (SCA) recently handed down its decision in the case The Commissioner for The South African Revenue Service v Spur Group (Pty) Ltd (Case no 320/20)  ZASCA 145. This was an appeal by the Commissioner for the South African Revenue Service (CSARS) against the judgment of the Western Cape High Court, which had, in a split decision, decided the matter in favour of Spur.
The main issue in dispute was the deductibility under section 11(a) of the Income Tax Act of a contribution of R48 million by Spur to a share incentive trust. Specifically, the question was whether the contribution was in the production of Spur’s income as required by that section. If the Court were to find that the contribution was not deductible, then a second issue, of the prescription of the assessments raised by the Commissioner, had to be decided.
Spur Group (Pty) Ltd (‘Spur’), the respondent in the case, is the main operating entity in the Spur Group of companies. It is a wholly owned subsidiary of Spur Corporation Limited (‘Spur Holdco’). In 2004 the companies resolved to implement a new share incentive scheme to benefit eligible employees of Spur (‘the participants’). The purpose of the scheme was to promote the continued growth and profitability of Spur. Spur Holdco established the Spur Management Share Trust (‘the trust’) which was a discretionary trust of which, significantly as the Court was to find in its judgment, Spur Holdco was the sole capital and income beneficiary. The trust then established a newly incorporated company (Newco). The participants were offered the opportunity to acquire ordinary shares in Newco at par value in proportions determined by Spur Holdco. The participants were not entitled to deal freely with the Newco shares for at least seven years. In December 2004, Spur concluded a contribution agreement with the trust, in terms of which approximately R48 million was contributed by Spur to the trust. The trust used the R48 million to subscribe for preference shares in Newco. The dividend rate of the Newco preference shares was set at 75 per cent per annum of the prime interest rate, which was a market-related preference dividend rate. The redemption date for the Newco preference shares was set at five years following their issue. Newco applied the R48 million to purchase approximately 8.3 million shares in Spur Holdco.
The rationale for structuring the scheme in this manner was that the participants would only derive value from their ordinary shares if and to the extent that an increase in the market price of the Spur Holdco shares were to exceed the cumulative yield on the preference shares, in other words, 75 per cent of the prime interest rate. The latter rate therefore effectively operated as a benchmark against which the performance of the Spur Holdco shares would be measured for purposes of the scheme. It is not clear whether the Court considered this rationale in reaching its decision.
During the operation of the scheme, Newco received dividends due to its holding of the Spur Holdco shares and it retained the dividends in order to meet its cumulative preference share obligations towards the trust. In 2009, five years after their issue, the preference shares were redeemed for the R48 million subscription price plus accumulated dividends. The redemption amount was settled by a distribution by Newco to the trust of approximately 6.7 million shares in Spur Holdco, which shares had a market value equal to the outstanding redemption amount. This therefore left a ‘free’ balance of approximately 1.6 million Spur Holdco shares (the 8.3 million shares originally acquired by Newco less the 6.7 million distributed), which Newco disposed of at market price. Using the proceeds, Newco declared dividends to its ordinary shareholders, the participants in the scheme. The share incentive scheme has since been terminated and Newco was deregistered in 2012, although the trust remains in existence and continues to hold the Spur Holdco shares that were distributed to it by Newco.
Spur claimed the deduction of the R48 million contribution in terms of section 11(a), spread in terms of section 23H over the period of the anticipated benefit to be derived from the payment, for its 2005 to 2012 years of assessment. The Commissioner originally issued assessments allowing the deduction. However, following an audit, additional assessments disallowing the deductions were issued in 2015.
In the submission of its income tax returns, Spur made various misrepresentations and non-disclosures. In its 2005 income tax return, it answered ‘no’ to questions dealing with whether any deductions had been limited in terms of section 23H, whether contributions had been made to a trust and whether the company had been party to the formation of a trust. In its 2006 income tax return, Spur answered ‘no’ to the question dealing with whether any deduction had been limited in terms of section 23H. In each of the 2005 to 2008 returns, the deductions claimed in respect of the contribution which were limited by section 23H, were disclosed by Spur under the category ‘other deductible items’ and not under the line item ‘prepaid expenditure (as limited by s23H)’.
Whether the contribution by Spur was incurred in the production of its income
The basis for the disallowance by SARS was that the contribution was not incurred in the production of Spur’s income in that ‘there is no direct, causal link between the contribution and the production of income’. The Commissioner’s reasoning was that Spur had made the contribution to the trust of which Spur Holdco was the only beneficiary. Spur Holdco was the only party to have benefitted directly from the contribution to the trust in that it would receive the investment in the Newco preference shares. The trust also distributed the preference share capital and the preference shares dividends to its beneficiary, Spur Holdco. The participants were thus not the beneficiaries of the contribution. Therefore, so the Commissioner argued, the causal link referred to above was lacking.
The Commissioner did not allege that the contribution was disallowed on the basis of it being capital in nature, or that it was not laid out for purposes of Spur’s trade. The only question on the merits was therefore whether the expenditure qualified for deduction on the basis that it had been incurred in the production of Spur’s income.
It is well-established that in order to decide whether expenditure was incurred in the production of a taxpayer’s income, the court has to assess the closeness of the connection between the expenditure and the income earning operations of the taxpayer, having regard to both the purpose of the expenditure and to what it actually affects. Hence, in applying the above test, both the purpose of the taxpayer in incurring the expenditure (a subjective enquiry into the aim or object the taxpayer had in mind in incurring the expenditure) and the actual effect or result of the incurral of the expenditure (an objective enquiry) must be considered in light of the particular facts and circumstances of the taxpayer.
The matter proceeded to the Tax Court, in which the taxpayer was victorious, and then to the Western Cape High Court, which again, with a 2/1 margin, ruled in the taxpayer’s favour.
The High Court judgment records the following extract from the contribution agreement that was concluded between Spur and the trust:
4.1 The Trustees shall be obliged to apply the initial Contribution, as well as any income or
property derived therefrom, to incentivise the Eligible Participants (being the [taxpayer’s]
employees) in accordance with the import and intent of the NewCo Scheme as more fully
appears in the circular to ... Shareholders dated 30 November 2004 and the Rules and any
subsequent schemes adopted by the [taxpayer] and the Trust from time to time.
4.2 In furtherance of the aforesaid objective, the parties agree that the Trustees shall be
obliged to apply the entire Initial Contribution in subscribing for preference shares in Maxshell 72
Investments (Proprietary) Limited (“NewCo”) as contemplated in the Rules.”
The majority in the High Court aligned themselves with the findings of the Tax Court, that the purpose of the expenditure was to incentivise the taxpayer’s key staff through a scheme which facilitated the acquisition of an indirect investment in the shares of HoldCo for scheme participants and that the connection between the contribution and Spur’s income earning operations was sufficiently close for the expenditure to be deductible in terms of section 11(a). The majority also noted that it had not been suggested that the Spur Group, by making the R48 million contribution, was entering into a transaction that was dressed up or disguised to make it appear something that it was not, especially with the purpose of evading tax or avoiding a peremptory rule of law. In other words, SARS had not argued that the so-called ‘substance over form’ doctrine should apply.
The Supreme Court of Appeal, on the other hand, overturned the judgment of the High Court in a unanimous decision. The basis for the decision was that the R48 million contribution did not itself serve to incentivise the participants since it was an amount that would never accrue to the participants. Instead, it ultimately became available for the benefit of HoldCo as the capital beneficiary of the trust. As a result, the Court found that the purpose of the expenditure was not to produce income but “to provide funding for the scheme, for the ultimate benefit of Spur HoldCo. There was only an indirect and insufficient link between the expenditure and any benefit arising from the incentivisation of the participants. The contribution was therefore not sufficiently closely connected to the business operations of Spur such that it would be proper, natural and reasonable to regard the expense as part of Spur’s costs in performing such operations.”
Although it must be acknowledged that the scheme implemented by Spur was somewhat unusual in that Spur Holdco and not the participants was the income and capital beneficiary of the trust at the time the contribution was made, the analysis of the Court is, with respect, open to criticism. The fact that the R48 million would never itself accrue to the participants does not mean that the contribution did not benefit them. Without the contribution, there would have been no share incentive scheme and hence, no benefit to the participants. The contribution was thus necessary to bring about the share incentive scheme, the purpose of which was clearly to incentivise Spur’s management and hence, to benefit Spur. On this basis, it is submitted that the link between the contribution and the business operations of Spur was sufficiently close for the contribution to be in the production of Spur’s income and the Court should have concurred with the judgment of the majority in the court a quo.
It is interesting that in support of its conclusion, the Court cited among other cases, the decision in Solaglass Finance Co (Pty) Ltd v Commissioner for Inland Revenue 1991 (2) SA 257 (A). With respect, in that case, the reason the taxpayer lost was that the then Appellate Division found that the loan losses incurred by the taxpayer did not pass the requirement that the losses be wholly and exclusively laid out for purposes of the taxpayer’s trade. In that case the Court found that the losses passed the ‘in the production of income’ test, which was the only issue in dispute in the Spur case; the Commissioner having accepted that the expenditure incurred by Spur had been laid out for purposes of Spur’s trade.
Another interesting aspect to the judgment is that the Court did not deal with the contradiction between its finding that the purpose of the taxpayer in making the contribution was to provide an ultimate benefit to Holdco and the stated purpose in the contribution agreement, being to incentivise the participants. This is puzzling, given that the Commissioner had not alleged that the contribution agreement was a sham or designed to evade tax, and that the enquiry into the purpose of the taxpayer in incurring expenditure for the purposes of the test for ‘in the production of income’ is a subjective enquiry into the mind of the taxpayer.
The prescription issue
Since the Court had found that the contribution was not deductible in terms of section 11(a), the prescription issue had to be decided.
Spur contended that the Commissioner was precluded from issuing the additional assessments by virtue of section 99(1) of the Tax Administration Act, in that the additional assessments were raised more than three years from the date of the original assessments.
The above provision states that the Commissioner may not make an assessment three years after the date of an original assessment by SARS, unless the fact that the full amount of tax chargeable was not assessed was due to fraud, misrepresentation or non-disclosure of material facts.
Although there had clearly been misrepresentations and non-disclosures in the relevant returns submitted by Spur, Spur argued that these statements were negligently and inadvertently made. It also asserted that the Commissioner had failed to establish the required nexus between the incorrect statements in the returns and the failure by the Commissioner to charge the full amount of tax during the three-year period. No SARS official applied his or her mind to the assessments and no audit was performed within that period. Furthermore, it was not the errors in the returns which caused SARS to allow the deductions claimed, but rather the decision by SARS not to consider the tax returns and Spur’s annual financial statements, which were filed together with the returns, which Spur argued should have raised red flags and led to an audit.
The Court was scathing in its criticism of Spur’s assertion that the wrong entries in the tax returns were negligent and inadvertent, which it described as “patently false”.
It found the answer ‘no’ to the question whether contributions had been made to a trust and whether the company had been party to the formation of a trust, to be a misrepresentation and found it striking that these incorrect answers were repeated. It also found that it “simply boggles the mind” that Spur answered ‘no’ to the questions regarding section 23H for each and every year from 2005 to 2009 and that Spur’s inclusion of deductions limited by section 23H in a general line item was a deliberate misrepresentation and a non-disclosure of material facts.
Spur attempted to put the blame for the errors on a new accountant, who had recently taken over the role, on the basis that she was not fully appraised of the details of the scheme. However, the Court found that this attempt could not succeed, firstly because she had never been called to testify on this aspect and secondly, because the public officer of the company had signed off the relevant returns as being correct.
Spur’s further argument that the Commissioner had all the relevant and correct facts because Spur’s annual financial statements were submitted with the tax returns and that the correct information could be distilled from them, was dismissed by the Court as “unhelpful”. It stated that “the mere fact that an astute auditor or assessor could have been able to ascertain from supporting documentation the fact that the return contains a misrepresentation, cannot mean that there is no misrepresentation in the first place”.
In approaching the question whether SARS had discharged the onus upon it to show that the non-assessment within the three-year period was the result of the misrepresentations and non-disclosures, the Court considered SARS’ relevant internal processes in the years in question in relation to the making of original and additional assessments.
A senior manager in SARS’ Large Business Centre testified that in the first instance, SARS accepts a return at face value and issues an assessment without human intervention. Only the tax return, and not any supporting documents or schedules, is taken into account for purposes of issuing an original assessment. The Court found that the issue of face value assessments was recognised and accepted by the Court in Commissioner for Inland Revenue v Mutual Unit Trust Management Company Ltd 1990 (4) SA 529 (A), albeit in the context of a defence of a practice generally prevailing, in which the Court accepted that the return could thereafter be reconsidered more thoroughly in the three-year period following the original assessment.
The Court found that it was clear that the integrity of the SARS assessment process depends largely on the correctness of the information provided in a return. Since the senior manager testified that typically in a day, over one hundred thousand returns would be received at SARS, it was not possible for the auditors to perform a manual check of every return to ensure that it did not contain any errors. Instead, the tax return contains various specific questions which act as “triggers” which would lead to further steps being taken to either resolve the matter at that stage or proceed to an audit. A ‘yes’ answer to the section 23H question and to the question whether a contribution was made to a trust were, according to the senior manager’s testimony, risk factors which would have triggered a risk alert for SARS.
The Court found that the senior manager’s testimony made perfect sense and that a face value assessment process was “understandably” undertaken by SARS. It added that as a matter of policy, a court would be loath to come to the assistance of a taxpayer that had made improper or untruthful disclosures in a return, which would offend against the statutory imperative of making a full and proper disclosure in a return. Accordingly, the Court found that the misrepresentations and non-disclosures by Spur caused the Commissioner not to assess Spur correctly within the 3-year prescription period.
Although in this case the Court found that Spur had deliberately misrepresented certain facts and had not disclosed others and therefore was always unlikely to find in its favour on the prescription issue, the acceptance by the Court of a face value assessment process in which no supplementary information is considered at the assessment stage may prove problematic for taxpayers in other circumstances. The questions asked of taxpayers in tax returns do not cover every possible circumstance. Also, it is not always clear how to answer certain of the questions in a given situation. Taxpayers in these situations, or those with complex tax issues who make disclosures that are supplemental to the income tax return, may be at risk of a Court finding, based on the approach in this case, that the statutory prescription period did not commence to run upon initial assessment. This is because it may be found that SARS was justified in issuing face value assessments based only on the information and responses to questions provided by the taxpayer in the return itself. If the information and responses do not trigger a risk alert, SARS may be found to be justified in not investigating the taxpayer’s affairs within a 3-year period.
The share incentive scheme implemented by Spur was somewhat unusual as noted above, in that Spur Holdco and not the participants was the income and capital beneficiary of the trust at the time the contribution to the trust was made. Had the scheme been structured such that the participants and not Spur Holdco would share in the amount contributed to the trust, the contribution would likely have been allowed as a deduction. Nevertheless it is, with respect, submitted that the Court should still have found that the contribution was in the production of Spur’s income.
Taxpayers should take note of the importance of providing accurate information and answers to questions posed in tax returns in order for prescription to apply. It is clear that reliance by the taxpayer of disclosures in annual financial statements submitted together with the tax return is insufficient for prescription to apply if the tax return itself is materially incorrect.
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