Capital and Revenue: premature termination of distribution agreement & VAT: supplies to non-resident
31 October 2012
Posted by: Herman van Dyk
By Jonathan Silke
Executive summary (SAIT Technical)
Jonathan Silke reflects on the SCA's judgment in Stellenbosch Farmers' Winery Limited v C: SARS 74 SATC 235. The court had to consider two matters:
- Whether compensation received for the premature termination of an exclusive distribution agreement for certain whiskies (including Bells) for a period of ten years was of a capital or revenue nature (bearing in mind that receipts of a capital nature are excluded from the definition of gross income in section 1 of the Income Tax Act)
- The court also had to consider whether services supplied to a non-resident recipient on termination of the distribution agreement were zero-rated.
In the recent Supreme Court of Appeal case of the court had to consider whether compensation received by the taxpayer-company for the premature termination of a distribution agreement entitling it to be exclusive distributor for resale in Southern Africa of certain whiskies for a period of ten years was of a revenue or capital nature and subject to income tax.
The court also had to consider whether services supplied to a non-resident recipient on termination of the distribution agreement were zero-rated.
The facts were that the appellant was a wholly owned subsidiary of Stellenbosch Farmers' Winery Holdings Limited and the latter was in turn wholly owned by Stellenbosch Farmers' Winery Group Limited (‘SFW Group').
The appellant, at all material times, had carried on business as a producer and importer of liquor products, and as a wholesaler of a range of spirits, wine and other liquor products to retailers and, in contradistinction, SFW Group was exclusively a holding company and did not conduct other operational business activities.
The appellant had, since the 1970s, inter alia imported and distributed Bells whiskey, together with Dimple and Haig whiskeys (‘Bells') into South Africa.
United Distillers plc (UD), based in the United Kingdom, had concluded a joint venture agreement (the JV agreement) with SFW Group and Distillers Corporation (SA) Ltd (Distillers) which led to the formation of United Distillers Imports (Pty) Limited (UDI).
The JV agreement provided that UD would enter into distribution agreements with the entities in South Africa appointed by UDI as distributors of UD's products which included Bells and it was further recorded, in respect of SFW Group and Distillers, that the intention was that, as far as possible, the only distributors would be the marketing companies/divisions of those two entities.
As foreshadowed in the JV agreement, a further written agreement relating to the distribution of Bells in South Africa (the distribution agreement) was concluded on 12 May 1992 between UD and an entity styled simply ‘Stellenbosch Farmers' Winery' but which the court accepted was the appellant who did acquire the exclusive rights of distribution of Bells in South Africa and surrounding territories as provided for in the distribution agreement.
In terms of the agreement the appellant undertook not to sell competing products in the area in question and the period of the distribution agreement was ten years, with effect from 1 February 1991, whereafter the agreement was terminable on 12 months' notice and, accordingly, it would, depending on when notice of termination was given, terminate on 31 January 2002 or on a date subsequent thereto.
Until it was terminated on 28 August 1998, the distribution venture proved to be extremely profitable for the appellant as over the years it had built up the Bells brand to the position of a pre-eminent asset in South Africa which it did not occupy anywhere else in the world. Bells sales contributed between 18% and 25% of the appellant's profit or ‘bottom line' and this was significant for it as the sale of spirits delivered the real profit margins as opposed to other products.
After the appellant's loss of the distribution rights for Bells, its trading income dropped very significantly, by many millions of rand, during the ensuing two financial years whereafter it was forced to merge with another entity to avoid bankruptcy.
During 1997 certain corporate structural changes in the form of company mergers took place in the United Kingdom and Europe and the changes effected the union of the spirit and wine businesses of, inter alia, UD and UDI, and the distribution network of another distributor in South Africa, Gilbeys. The aforesaid changes entailed consequences for the liquor market in South Africa and UD accordingly sought to extract itself prematurely from the distribution agreement and negotiations towards that end were set in train.
As a result, a written agreement (the termination agreement) was concluded and the effective date of the agreement was 28 August 1998, ie some three years and five months before the earliest date on which the distribution agreement could have been terminated by UD giving notice as envisaged therein.
The termination agreement provided inter alia that in consideration of payment of the sum of R67 million to the appellant, the latter and UD agreed that certain agreements would terminate and these included the JV agreement and what was referred to as the distribution agreement.
The amount of R67 million was in due course paid to the appellant and its receipt was reflected in its financial statements for the 1999 tax year and it was this receipt that was the subject of the issue in the main appeal in case no 511/2011.
In terms of s 82 of the Income Tax Act 58 of 1962 the onus was on the appellant to establish that the receipt of the R67 million was of a capital nature and that it should not have been assessed to tax as part of its gross income, as had been directed by the Commissioner for SARS.
The court a quo (see ITC 1850 (2011) 73 SATC 228) held that the question to be answered was whether the appellant had been compensated for the capital value of the exclusive distribution right, ie whether the compensation of R67 million paid for the early termination of the distribution right was paid as compensation for the loss of the value of the capital asset, the distribution right, and therefore destined to fill a hole in the taxpayer's assets, or whether it was paid as compensation for a loss of profits in the sales of Bells, which would be the result of the early termination of the distribution right.
The second issue before the court related to the appeal in case no 504/2011 (see ITC 1852 (2011)73 SATC 253) where the Commissioner had determined that the receipt of the R67 million by the appellant (a registered vendor for VAT purposes in terms of the Value-Added Tax Act 89 of 1991) was subject to VAT at the rate of 14% in terms of s 7(1) of Act 89 of 1991.
The appellant's appeal to the court a quo against that determination had been successful and the present appeal by the Commissioner was against the substituted order of the court a quo that the receipt of R67 million by the appellant was subject to VAT at the rate of zero per cent in terms of s 11(2)(l) of the Act.
It was common cause between the parties both in the court a quo and in the Supreme Court of Appeal that the matter concerned the issue of the supply of services in the course of an enterprise and not the supply of goods.
The Commissioner, now as the appellant in case no 504/2011, appealed against the order of the court a quo setting aside the assessment by him that the taxpayer's receipt of the sum of R67 million was subject to VAT at the rate of 14% in terms of s 7 of Act 89 of 1991 and the court a quo's declarator that the receipt by the taxpayer of the sum of R67 million was subject to VAT at the rate of zero per cent in terms of s 11(2)(l)(ii) of the Act.
The dispute between the parties centred around the issue whether the receipt of R67 million related to ‘services' as defined in s 1 of the Act, supplied by the taxpayer to a non-resident and not ‘directly in connection with movable property situated inside the Republic of South Africa', as envisaged in s 11(2)(l)(ii) of the Act.
Both matters before the court found their origin in related sets of facts, many of which were common cause or not in dispute.
Kroon AJA, who delivered the unanimous judgment of the court, dealt firstly with the question whether the appellant had acquired distribution rights and stated that it did acquire the exclusive rights of distribution provided for in the distribution agreement and the judgment of the court a quo (ITC 1850 (2011)73 SATC 228) correctly proceeded on the premise that it was the appellant who had surrendered the distribution rights in question and in consideration thereof had received payment of the sum of R67 million.
The evidence also disclosed that the party with which negotiations were held in respect of the termination of the distribution rights was in fact the appellant as substantiated by the evidence of its managing director, the corporate strategy and planning manager and the managing director of UDI and the evidence was not challenged.
The court then went on to consider whether the receipt of R67 million was of a capital or revenue nature and noted that while the Income Tax Act 58 of 1962 contained a definition of ‘gross income', which excluded receipts or accruals of a capital nature (save for certain exceptions which were not relevant for present purposes), there was no definition of ‘receipt or accrual of a capital nature' and there was no single criterion for determining whether a receipt or accrual was to be categorised as capital or income.
The judgment of the court a quo set out a tabulation of a number of the guidelines which had been recorded in previous decisions of the courts but it was not necessary in the present judgment to repeat the tabulation and reference would be made only to those guidelines that appeared to be appropriate for a resolution of the issue on hand.
The court stated that the finding of the court a quo that the exclusive distribution rights held by the appellant in terms of the distribution agreement was a capital asset had been correct and in this court that common approach was persisted in which was clearly correct and it followed that, consequent upon the termination agreement, the appellant had lost an asset.
The court noted further that the ruling of the court a quo against the appellant had implied that the receipt of the R67 million by it was ‘a gain made by an operation of business carrying out a scheme for profit-making' which was a wellb – established guideline test considered by Smalberger JA to be the appropriate one in CIR v Pick ‘n Pay Employee Share Purchase Trust 54 SATC 271 but that would mean that in the present matter the appellant, admittedly in possession of a capital asset and treating it as such, changed its intention in respect thereof and decided to convert its use of the capital asset (part of its income-producing structure) to use thereof as trading stock (part of its income-producing activities) and the court was unable to align itself with that proposition.
The judgment of the court a quo recognised that in the valuation of a capital asset it was not inappropriate to have regard to the profits anticipated from the use of the capital asset and stated that ‘while the method of calculation of the amount of compensation is an important factor, it is not determinative of the nature of the receipt' and stated further that this was so because: ‘It is a normal principle of valuation of a capital asset, whether it be land or the goodwill of a business or otherwise, to use the profits expected to be earned from the utilisation of the asset as a basis or starting point for the relevant calculations' – per McEwan J in ITC 1341 (1980) 43 SATC 215 at 224.
Moreover, the appellant validly argued that the nature of a receipt (ie whether it is capital or revenue) for income tax purposes, was not determined by how it was subsequently treated for accounting purposes and reference (by analogy) was made to the decision in SIR v Eaton Hall (Pty) Ltd 37 SATC 343 where it was held that accounting practice cannot override the correct interpretation of the provisions of the Income Tax Act and their application to the facts of the matter and, as appeared from the present judgment, the facts favoured a finding of a capital nature; moreover, not only did the financial statement reflect that the receipt of the R67 million was an ‘exceptional item', but note 4 to the statement specifically recorded that the receipt was ‘compensation for the cancellation of the exclusive distribution rights', which points rather to a receipt of a capital nature.
The court noted that the manner in which a taxpayer dealt with a receipt, after it had received it, could not determine the nature of the receipt, eg the capital nature of the receipt of the proceeds of the sale of a building was not affected by the utilisation of the proceeds to pay a dividend.
One of the guideline tests adverted to in the court a quo, borrowed from the decision in ITC 1341 (1980) 43SATC215, was whether a substantial part of the income-producing structure of the taxpayer had been sterilised by the transaction in question and in Silke on South African Income Tax at para 2.233.23 the following appeared: ‘An amount received by way of damages or compensation for the loss, surrender or sterilisation of a fixed capital asset or of a taxpayer's income-producing machine is a receipt of a capital nature'.
The appellant's counsel therefore correctly submitted that the court a quo's reasoning reflected that it had erroneously focussed on only physical assets, instead of the much more valuable incorporeal assets constituted by the exclusive distribution rights (the loss of which, consequent upon the termination of the distribution agreement, brought in its train the disastrous consequences referred to earlier in the judgment) and the compensation for the impairment of the taxpayer's business constituted by that loss was properly to be viewed as a receipt of a capital nature.
Finally, it had to be emphasised that clause 4.5 of the termination agreement referred to payment of full compensation for the closure of the taxpayer's business relating to the exercise of the distribution rights (an asset) and there was no reference in the termination agreement to a payment for loss of profits; moreover, there was no suggestion that the termination agreement did not reflect the intention of the parties or that it was in any way simulated and it need hardly be added that any suggestion that the taxpayer, faced with the option of concluding a capital transaction with no tax implications or an income transaction with such implications, would chose the latter, was, to say the least, an unconvincing one.
Accordingly, the appellant, which did not carry on the business of the purchase and sale of rights to purchase and sell liquor products, did not embark on a scheme of profit-making and it did discharge the onus of establishing that the receipt of R67 million was of a capital nature.
Therefore, the Commissioner had erred in including the receipt in the appellant's gross income and assessing same to tax and the appellant was accordingly entitled in the main appeal to the relevant orders set out in the judgment.
Lastly, the court dealt with the issue whether the receipt of R67 million was subject to VAT at the rate of zero per cent and noted at the outset that it was correctly common cause both in the Tax Court and this court that the matter concerned the issue of the supply of services in the course of an enterprise, and not the supply of goods.
The court a quo had found that, by agreeing to the early termination of the distribution right, the appellant had surrendered the remaining portion of the right, and that such surrender constituted the supply of services in the course of an enterprise by the taxpayer to UD for VAT purposes and there could be no quarrel with the correctness of these findings.
The Commissioner's argument could not be upheld- ie that the services supplied by the taxpayer were constituted by the act of surrender and that the movable property in connection with which those services were directly supplied by the taxpayer was the exclusive distribution right provided for in the distribution agreement, now coming to an end in terms of the termination agreement, which right was situated within the Republic where it was being exercised; moreover, the distinction sought to be drawn by the Commissioner between the act of surrender and the right surrendered was not a valid one.
The finding of the court a quo that the exclusive distribution right, which was incorporeal property, was not situated in the Republic was correct and the situs of an incorporeal right is where the debtor resides – MV Snow Delta: Serva Ship Ltd v Discount Tonnage Ltd 2000 (4) SA 746 (SCA) at paras 9–10.
In this case the place of residence of the debtor, UD, was the United Kingdom, where it was registered and the matter therefore fell squarely within the purview of s11(2)(l)(ii) of Act 89 of 1991.
The taxpayer accordingly had discharged the onus resting on it in terms of s 37 of Act 89 of 1991 to establish that the supply in question was subject to value-added tax at the rate of zero per cent, and that the contrary decision of the Commissioner was wrong.
In the result the main appeal (case no 511/2011) was upheld with costs, including the costs of two counsel and in the second case (case no 504/2011) the appeal was dismissed with costs, including the costs of two counsel.