By Rehnu Vallabh, Tax Consultant at BDO South Africa
The infamous Al Capone once remarked: ‘They can’t collect legal taxes from illegal money’. Capone, the most publicised racketeer of the 1920s, was prosecuted, convicted and sentenced to 11 years imprisonment for federal income tax evasion. Most were probably satisfied with the termination of Capone’s career in this manner, even if tax evasion seemed to be a minor offence when compared with the other crimes attributed to him. The United States Supreme Court in later years revisited the prosecution of Capone in examining the question of whether the fruits of unlawful activity constitute income subject to tax. In Commissioner v Wilcox (1946), the courts held that embezzled funds are not taxable:
Taxable income does not accrue from the mere receipt of property or money which one is obliged to return or repay to the rightful owner, as in the case of a loan or credit… Moral turpitude is not a touchstone of taxability. The question rather is whether the taxpayer in fact received a statutory gain, profit or benefit. That the taxpayer’s motive may have been reprehensible or the mode of receipt has no bearing on the application of the taxing statute.
Less than ten years later, in James v United States, a case involving a union official who had embezzled more than USD700,000 from his union and a related insurance company, the court held that income from illegal activity is taxable despite the recipient’s legal obligation to make restitution.
The taxation of income derived from illegal receipts has also been the subject of examination by South African courts over the years. In South Africa, the Income Tax Act (the ITA) does not specifically provide for the taxation of proceeds derived from illegal receipts and/or activities. Our courts therefore had to question whether such proceeds are included in ‘gross income’ for tax purposes.
In ITC 1789, Judge Olivier remarked that in terms of the Geldenhuys v CIR, an amount forms part of gross income if the taxpayer received it on his own behalf and for his own benefit.
Income derived illegally often escapes the tax net not because it is not taxable but because the revenue authorities are not aware of its existence.
In Cot v G, a 1981 Zimbabwe High Court decision, the court had to decide whether a government agent, who had misappropriated funds meant for secret operations, ‘received’ those funds, for purposes of income tax. The court held that the term ‘received’ should be given its ordinary meaning and that no logical reading would take it to mean a unilateral taking such as theft.
The court cited Geldenhuys v CIR and concluded that it was not only the taxpayer's intention that was important but also the intention of the giver. It was clear that the government had never intended for the thief to keep the funds in question and to do with them as he liked, so the thief could not be said to have received the funds at all.
On 14 October 2010, in the Pretoria High Court, one of the largest fraud cases in South African history approached its finalisation, following an eight-year legal process. Mrs Marietjie Prinsloo of Vanderbijlpark and six members of her extended family were convicted and sentenced to jail terms. They faced 218,683 charges, including fraud, theft, racketeering and money laundering. Prinsloo received a 25-year jail sentence, while her family members received sentences ranging from five to fifteen years. After the collapse of Prinsloo’s scheme in 2002 and her arrest in the same year, the criminal case against her had garnered national media coverage. It became the subject of intense speculation. The legal ramifications of Prinsloo’s fraudulent scheme went beyond the criminal case heard in Pretoria. Three years before the High Court reached its decision, judgment in a separate and related case was handed down in Bloemfontein. This case was less publicised but dealt with taxation - specifically the taxation of Prinsloo’s criminal enterprises. The case heard in Bloemfontein was, in its own way, highly significant and is a landmark in South African tax case law. For the first time in this country’s legal history, a case involving the taxation of illegal income had been heard by the Supreme Court of Appeal.
In this case the fact that MP Finance Group CC had generated its income illegally was not a matter of dispute. What was disputed was whether that fraudulently derived income could be subject to taxation. When the case went to court, both the plaintiff and the appellant had to rely on a precise interpretation of the wording of the ITA and the precedent offered by the very sparse case law on the issue.
The core definition of what constitutes ‘gross income’ has remained unchanged since the introduction of the principal Income Tax Act (ITA) in South Africa in 1914. The definition reads as follows: ‘… the total amount, in cash or otherwise, received by or accrued to or in favour of such resident; during such year or period of assessment, excluding receipts or accruals of a capital nature…’. Legal arguments in the context of illegal income largely revolve around the gross income definition’s ‘received by’.
The taxpayer contended that as the scheme was legally required to immediately refund the tax deposits, there was no basis on which it could be said that deposits were ‘received’ within the meaning of the ITA and they were consequently not subject to tax. The court drew a distinction between the relationship between that of an investor and the scheme operator on the one hand, and that between the scheme operator and the fiscus on the other. It was held that an illegal contract is not without all legal consequences and that it can have fiscal consequences. The enquiry, as between the scheme operator and the fiscus, was whether the amounts paid to the scheme operator in the years of assessment in issue came within the literal meaning of The Act. The amounts paid to the scheme operators were accepted with the intention of retaining them for their own use and benefit and, notwithstanding that in law they were immediately payable, they constituted receipts within the meaning of the ITA and were duly taxable.
MP Finance Group CC (In Liquidation) v C finally decided that the proceeds of unlawful activities and/or receipts are taxable, provided that the taxpayer had an intention to appropriate the proceeds for his own use and benefit.