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Capstone 556 (Pty) Ltd v CSARS [2014] JOL 32201 (WCC)

15 September 2014   (0 Comments)
Posted by: Author: Pieter Faber
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Author: Pieter Faber (SAIT Technical Executive: Tax Law & Policy)

Introduction

This is an appeal by the taxpayer to a full bench of the Western Cape High Court against the judgement of the Western Cape Tax Court (ITC 13003 13 Jun 2013) that an amount received by the taxpayer for the sale of shares constitutes a revenue amount to be included in gross income. SARS is also cross appealing against the same courts finding that the amounts paid for the ‘equity kicker’ and ‘indemnity’ in respect of the share transaction constituted amounts deductible from the taxpayer’s gross income. 

Facts

The taxpayer is a special purpose vehicle company and 50 per cent member of a consortium which purchased shares in Profurn Ltd as part of a ‘business rescue operation’ initiated by FirstRand Ltd as the main creditor. The restructure was subject to the condition that JD Group Ltd would be taking over management control of Profurn Ltd, subject to approval of that arrangement by the Competition Commissioner. The rescue plan by the FirstRand Ltd entailed converting R600 million of the R900 million debt owed to the FirstRand Ltd by Profurn Ltd into equity, whereupon the equity in Profurn Ltd was exchanged for shares in JD Group Ltd. Thereupon, 5/6 of such equity interest was sold to the consortium as a strategic investment by them in the furniture industry for R500m. The consortium was however required to retain the shares for a minimum time period.

The taxpayer partly funded its share of the acquisition price through loan finance of R150m obtained from its 100 per cent holding company BVI who in turn obtained the finance from a German company, Gensec. The loan was subject to interest but also contained an ‘equity kicker’ provision whereby Gensec would be entitled, in addition to interest, to a portion of any profits yielded by the share investment. The taxpayer was liable to BVI for this amount in consequence of BVI’s liability to Gensec. The remaining portion was financed by FirstRand Ltd through the issue of preference shares by the taxpayer to the FirstRand Ltd for R100m.

To address concerns by JD Group Ltd on certain identified tax risks identified in Profurn Ltd by the auditors during the due diligence, FirstRand Ltd provided a tax warranty as part of the conditions of the share subscription and exchange. FirstRand Ltd in turn required the consortium to take up a 5/6 obligation to it in respect of the tax warranty provided by FirstRand Ltd in respect of the shares sold to them. 

Profurn Ltd recovered substantially faster than anticipated under the new management and after holding the shares for only five months the consortium partner was ‘fortuitously’ advised by Citibank how to dispose of the shares to institutional investors. After getting approval for the premature disposal of the shares, the shares were to be disposed of to Citibank. The taxpayer was compelled to sell the shares in terms of the consortium agreement which provided for such sale if the other consortium partner elected to sell its shares. However, FirstRand Ltd intended retaining some of the proceeds after the sale to provide cover for the tax warranty. To address this, the consortium parties agreed amongst themselves that the appellant would assign its obligations under the tax warranty to the other consortium partner for an amount of R55 million for full indemnity of its warranty obligation to the FirstRand Ltd irrespective of the amount of the actual warranty claim. The consortium partner then after the sale renegotiated the original indemnity to apply only to it and not the taxpayer. The amount payable by the taxpayer to the consortium partner was done on loan account with set-off in future against any other claims between the parties.

The taxpayer disclosed the amount in its 2005 return as a capital amount but SARS re-assessed the amount as being revenue in nature and issued an additional assessment for R200 million. 

SARS contended that the amount from the sale of shares was revenue and not capital in nature. This conclusion was based on the fact that the taxpayer had at the time of acquisition of the shares not intended to hold them as capital assets or for earning dividends, but rather to dispose of them for short term profit in a scheme of profit making. SARS based their conclusion on the fact that the shares were only held for five months, the shares were financed from external sources and that the dividends that were payable on the shares were earmarked to repay the short term shareholder loan. SARS furthermore disallowed the expenses for the ‘equity kicker’ and ‘indemnity’ payment.

Judgement

Capital v revenue of proceeds from sale of shares

The court approached this question by first concluding in overview that though the onus of establishing the facts is on the taxpayer, in the current matter the majority of facts were common cause and merely the inferences from such facts were in dispute. The court stated that SARS have in their approach over simplified the transaction by focusing too closely on the bare facts and that to evaluate the question properly the bare facts must be evaluated in the broader context of the evidence as a whole.

In addressing the legal question of capital vs revenue the court reaffirms the approach that no single litmus test can make the determination and it usually is a matter of degree depending on the circumstances. The court, in applying the intention of acquisition test confirms that the intention and statement of intention by the taxpayer is not conclusive of the actual intention as the latter must be determined with critical scrutiny and weighing it against the objective facts. In determining the intention the court clarifies that it is not what the taxpayer contemplated to do that is relevant but what was his actual purpose or object was.

In reviewing the facts the court found that the effective date of the transaction preceded the actual acquisition date as used by SARS by nearly 15 months. It furthermore found that that the motivation for the transaction was well documented in the Competition Commission application made prior to the effective date, which evidence was not challenged by SARS indicating that the taxpayer intended to acquire the shares as capital and not in a scheme of profit making. The court concluded that the overwhelming evidence supports this statement of intention on acquisition that the taxpayer intended to make a strategic capital investment which was to last for a period of at least three years. The court disagreed with the finding of the tax court and held that the finding was contrary to the same facts concluded on by that court. The court also held that the tax court had erred in holding that the taxpayer had to prove definitively its intention on acquisition, as the onus threshold was met merely on a balance of probability.  The court also held that the evidence presented did not indicate a mixed intention on acquisition as held by the tax court. The court found that other objective factors such as the disclosure of the asset as a non-current asset in the financial statements and that no trade was conducted, thus eliminating the existence of floating capital supported the finding of the shares being held on capital account.

In determining the intention on sale and whether a change in intention existed, the court held that the tax court did not review the decision to sell by the taxpayer in context and affirmed the legal principle that the sale of an asset for substantial profit shortly after its acquisition is important, but not conclusive, especially if there was an intervening event. The court held that the consortium partner had presented sound evidence as to why it chose to sell the shares, namely on the fortuitous opportunity presented by Citibank on an unrelated transaction. Furthermore the court concluded that the intention on sale by the appellant was irrelevant as in this case it had no choice to sell, it was in fact compelled to do so once the consortium had decided on this course of action. The court concluded that it was satisfied that the taxpayer simply intended to dispose of the asset and did intend converting a capital asset into trading stock.

The taxpayer’s appeal on this ground was accordingly upheld. 

This finding, however, meant that the tax court’s conclusion that the concomitant expenses were also revenue was overturned which meant that the court now had to determine whether the expenses could form part of the base cost of the shares. 

Deductibility of ‘equity kicker’

In respect of the question of the incurral of the expenditure, the court found that SARS’ approach to this question was overly formalistic by failing to have regard to the basic commercial reality of the transaction. In this regard the court upheld the tax court finding that the taxpayer did indeed in substance incur an unconditional legal obligation. 

As to whether the costs incurred could form part of the base cost in terms of paragraph 20 of the Eighth Schedule, it had to be determined whether the costs constituted ‘borrowing costs’ in terms of paragraph 20(2)(a) which would then exclude them from the base cost. The court found that the meaning of ‘borrowing costs’, taken in context, would be the overall costs expended by a taxpayer in acquiring an asset with borrowed money. The court held that the facts presented indicated that the kicker was intended to provide the lender with a higher return, the lender regarded it as a return on the investment and was an obligation arising from the loan. It therefore concluded that the ‘equity kicker’ did constitute borrowing costs, however, it also held that the exception in paragraph 20(1)(g) of the Eighth Schedule applied, which allows a third of the borrowing costs if the finance was used to acquire listed shares as in the current instance and the taxpayer was therefore entitled to such expenditure as part of base cost.

SARS’ cross appeal on this point was therefore partially upheld.

Deductibility of ‘indemnity’ expense

The court accepted the tax courts findings pertaining to the facts of the indemnity payment and also accepted the finding that an unconditional liability was created between the consortium partners in respect of the indemnity expense. The court found that it therefore still needed to address whether the expense constituted a cost of acquisition. The court held that the original tax indemnity to FirstRand Ltd on acquisition of the shares had remained contingent and that the renegotiated indemnity with the consortium partner was an intervening event which causally separates the expense from the acquisition. The court held that the indemnity was more properly a cost of disposal and not of acquisition.

SARS’ cross appeal on this matter was therefore upheld and the expense was excluded from base cost.

Costs

The court only made a provisional cost order to allow the parties to present argument in respect thereof if they so chose and provisionally awarded the taxpayer only 80 per cent of the cost of two counsel.

Please click here to view full judgement.



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