• Supreme Court of Appeal Rules on Indemnity Payment in Capstone

Supreme Court of Appeal Rules on Indemnity Payment in Capstone

17 March 2016

By Esther van Schalkwyk, Senior Tax Consultant at BDO

In February 2016, the Supreme Court of Appeal (SCA) passed down judgement in Capstone 556 (Pty) Ltd v CSARS. The SCA ruled in favour of the taxpayer that the proceeds received from the sale of shares to be capital in nature, despite the relatively short period for which those shares were held. In an interesting turn of events, the SCA also held that the indemnity payment by the taxpayer indeed formed part of the base cost of the shares, notwithstanding that it was converted from a contingent liability to an unconditional liability by the taxpayer after the date of disposal.

The facts are complex. The matter arose in 2011 when Profurn Ltd, a JSE listed company in the retail furniture industry, encountered serious financial difficulties. As a result, a number of role players in the industry devised a plan to rescue Profurn and stabilise the retail furniture industry.

A Memorandum of Understanding (MOU) was entered on 26 June 2002, reflecting the agreed-upon solution to achieve a capital injection of R600 million in Profurn. The MOU gave rise to a binding commitment that the taxpayer, a special purpose vehicle, would be incorporated to purchase shares in JD Group Ltd (JDG) from FirstRand Bank Ltd, following a merger between JDG and Profurn. The parties agreed that the risks and rewards in respect of the JDG shares would pass to the taxpayer on the effective date of the MOU, being 26 June 2002. The purchase price of the shares was fixed as at 26 June 2002 and interest accrued on the purchase price from that date until payment. Due to delays in obtaining merger approval from the Competition Tribunal, the JDG shares were only transferred to and paid for by the taxpayer on 5 December 2003.

Apart from the capital injection, the rescue plan also largely depended on the managerial skills of one Sussman, the executive chairman of JDG, who would take over the management of Profurn and try to integrate it profitably with JDG.

Two additional liabilities were attached to the acquisition of the JDG shares by the taxpayer.

Firstly, a so-called ‘equity kicker’ would become payable by the taxpayer in terms of the loan advanced specifically for the acquisition of the shares. This was determined as a portion of the gain in the market value of the JDG shares on repayment of the loan in terms of an agreed formula. In the SCA, the parties rightly agreed with the finding of the High Court that the equity kicker constituted ‘borrowing costs’ and, accordingly, that only one third thereof could be included in the base cost of the shares as representing the cost of financing the acquisition of listed shares.

Secondly, a contingent liability was acquired by the taxpayer to the amount of R62,5 million, effective for a period of five years, commencing in early 2003. This represented the taxpayer’s portion of a contingent liability which arose when FirstRand indemnified JDG in respect of contingent tax liabilities of Profurn amounting to R150 million. The taxpayer, together with its co-purchaser of JDG shares, Daun et Cie, therefore each acquired a contingent liability towards FirstRand to the amount of R62,5 million on acquisition of the JDG shares.

Due to an unsolicited and fortuitous book building offer, the taxpayer disposed of its JDG shares in April 2004, only a few months after it had acquired those shares in 5 December 2003. It made a profit of nearly R400 million. The principal question in the appeal was whether the proceeds from the disposal were of a revenue or capital nature. The Tax Court, per Judge Davis , held the proceeds to be revenue in nature. The finding was overturned by a full bench of the High Court in favour of the taxpayer.

The SCA agreed with the Tax Court that one must look at the effective date of the MOU, being 26 June 2002, as the date of acquisition despite the date on which the shares were legally transferred to the taxpayer. The Court confirmed that receipts and accruals arising from a detailed transaction should be considered in its entirety from a commercial perspective and not be subjected to narrow legalistic scrutiny. The purpose of the transaction was accordingly determined as at 26 June 2002.

The taxpayer ultimately succeeded in the SCA that the proceeds should be regarded as capital in nature as it was able to show that its first and primary purpose in acquiring the shares was to rescue a major business in the furniture retail industry by way of a long-term investment of capital. Acquiring the shares therefore did not form part of the operation of a business in a scheme of profit making. It transpired that the taxpayer succeeded in its purpose sooner than had been initially expected due to skilled management and favourable economic conditions. The taxpayer’s intention at acquisition was decisive as the Commissioner did not argue a change of intention by the taxpayer.

In July 2004, after the disposal of the JDG shares, the taxpayer incurred an unconditional liability to the amount of R55 million towards its co-shareholder, Daun et Cie, in substitution for the contingent liability of R62,5 million which it had towards FirstRand. The High Court had held that as the indemnity payment was converted from a contingent liability to an unconditional liability subsequent to the disposal of the shares by the taxpayer, it could not form part of the base cost of the shares because it did not constitute expenditure actually incurred in respect of the costs of acquisition in accordance with paragraph 20(1)(a) of the Eighth Schedule. The SCA disagreed. It held that the contingent liability taken up by the taxpayer in favour of FirstRand undoubtedly formed part of the purchase consideration for the JDG shares. Whether the conversion of the contingent liability to an unconditional liability was financially wise, was immaterial, as was the fact that the conversion occurred after the disposal of the shares by the taxpayer. The words ‘in respect of’ connote a causal relationship. The SCA found that the causal link of the expenditure with the acquisition of the shares was never broken and that the acquisition of the shares remained the causa causans of the indemnity payment despite that it was converted from a contingent liability to an unconditional liability by the taxpayer after the date of disposal. Therefore, the indemnity payment formed part of the base cost of the shares.