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The Cape High Court sets aside a judgment of the Tax Court in relation to plantation farming

10 October 2014   (0 Comments)
Posted by: Author: PwC South Africa
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Author:  PwC South Africa

The decision of the Full Court of the Western Cape High Court in Kluh Investments (Pty) Ltd v CSARS [2014] ZAWCHC 141, where judgment was handed down on 9 September 2014, involved an appeal against the Tax Court decision of Davis J in ITC 1860 (2013) 75 SATC 329.

The High Court judgment of Rogers J (Treverso DJP and Allie J concurring) goes further than merely reaching a different conclusion on the facts, for it clarifies the inter-relationship between section 26(1) of the Income Tax Act 58 of 1962 and para 14 of the First Schedule – key provisions in the taxation of the proceeds of the disposal of a plantation.

The disputed assessment

The disputed assessment had included in gross income the amount derived by the appellant, Kluh Investments (Pty) Ltd (‘Kluh’), from the disposal of a plantation, on the basis that this amount, though inherently of a capital nature, was deemed to be income in terms of para 14 of the First Schedule to the Income Tax Act 58 of 1962. 

The central issue in the appeal was whether para 14 of the First Schedule was applicable to the proceeds of the disposal in the particular circumstances of this case. If it was not applicable, the proceeds in question would retain their character as capital.

The relevant statutory provisions

Section 26(1) of the Income Tax Act provides that –

The taxable income of any person carrying on pastoral, agricultural or other farming operations shall, insofar as it is derived from such operations, be determined in accordance with the provisions of this Act but subject to the provisions of the First Schedule.

Para 14(1) of the Frist Schedule provides that -

Any amount received by or accrued to a farmer in respect of the disposal of any plantation shall, whether such plantation is disposed of separately or with the land on which it is growing, be deemed not to be a receipt or accrual of a capital nature and shall form part of such farmer’s gross income.

In this regard, para 16 of the First Schedule defines a plantation as –

any artificially established tree as ordinarily understood (not being a tree of the nature described in paragraph 12(1)(g)) or any forest of such trees and includes any natural extension of such trees.

The factual background

Companies in the Thesen group (for brevity, ‘Thesen’) had previously owned property in Knysna on which they conducted forestry, timber-growing and plywood manufacturing businesses. The plantation in issue had once been owned by Thesen.

In May 2001, Steinhoff Southern Cape (Pty) Ltd (‘Steinhoff’) purchased Thesen’s Knysna assets as a going concern for R45 million, but the transaction in this form was vetoed by Steinhoff’s board of directors because they did not want their company to own fixed property in South Africa. Steinhoff therefore looked for a third party to acquire the fixed property to enable the transaction to go ahead.

In the event, Kluh was that third party, and it bought the land and the plantation on it.

Within two years, in the light of escalating timber prices and the scarcity of plantation resources, Steinhoff changed its policy and decided that it wanted to acquire ownership of the plantation and the land after all, which it duly bought back from Kluh.

The subject of the sale was described as ‘the plantation business’, defined in the agreement as the machinery, equipment, plantation contracts and immovable property as a going concern. The purchase price of the plantation (defined in the agreement as the standing timber on the land, including the plantation business) was R144 million.

In the additional assessment issued by SARS, the R144 million was treated as part of Kluh’s gross income in terms of para 14 of the First Schedule. In other words, SARS did not regard the proceeds of the disposal of the plantation as a capital transaction, contending instead that section 26(1), read with para 14 of the First Schedule, deemed the proceeds of the disposal of the plantation to be gross income when it accrued to Kluh.

In its grounds of appeal (see the judgment at para [41]), Kluh alleged that its intention had been to acquire and hold the land and the plantation as a long-term investment; that, by agreement, Steinhoff was entitled to conduct the plantation operations for its own benefit; and consequently, that the proceeds of the disposal of the plantation by Kluh were capital and not subject to tax (since the capital gains tax regime had not yet come into force) and that these proceeds did not fall within the scope of para 14 of the First Schedule.

The arguments and counter- arguments in the Tax Court and the High Court

SARS‘s first line of argument (see the judgment at para [43]) was that the mere disposal of an operating plantation by Kluh was sufficient to trigger the provisions of para 14 of the First Schedule, and that it was not necessary for the requirements of section 26(1) to be fulfilled before para 14 could apply.

In the alternative, SARS argued (see para [44]) that, although Steinhoff may have functioned as an independent contractor and not as Kluh’s agent in performing plantation operations, those activities were not only being conducted on land owned by Kluh, but that Kluh retained a direct interest in the operations, inter alia because Steinhoff was required to comply with agreed standards and to restore the plantation to Kluh on termination of the arrangement with the same volume of timber. SARS argued that there was therefore –

‘a sufficiently close connection’ between the proceeds of the disposal of the plantation and the conducting of the plantation operations over the intervening two year period to trigger the operation of section 26(1) and para 14 of the First Schedule.

The onus of proof

The onus was on Kluh to prove on a balance of probability that the proceeds from the disposal of the plantation in 2004 were not subject to tax. The onus of proof in this regard was laid down in section 82 of the Income Tax Act, subsequently substituted by section 102 of the Tax Administration Act 28 of 2011.

As was noted above, SARS had put forward two alternative bases on which s 26(1), read with para 14 of the First Schedule, would apply to the proceeds.

The judgment of the Tax Court

The High Court judgment (see para [46]) records that the Tax Court found in favour of SARS on the alternative basis put forward by SARS (namely that Kluh had retained a direct interest in the plantation operations and that this was sufficient to trigger the application of section 26(1) and para 14 of the First Schedule) and that the High Court therefore did not need to consider the first basis for the assessment, namely that the mere disposal of an operating plantation was in itself sufficient to trigger those statutory provisions.

The Tax Court (see para [47]) had been unpersuaded by oral testimony that Kluh was not conducting a plantation business and had set great store by the references in contractual documentation and directors’ resolutions recording the appointment of Steinhoff to manage the plantation for Kluh and that what had been sold to Steinhoff in 2003 was a plantation business as a going concern.

The approach of the Full High Court on appeal

On appeal, the Western Cape High Court regarded the critical question (see para [49] of the judgment) as being essentially a legal one that arose from the undisputed facts, namely the import of the oral arrangement by which Steinhoff was permitted to conduct the plantation operations and the further undisputed fact that Kluh retained the ownership of the land and had a commercial interest in the plantation’s being restored to it in due course in good condition and with the same volume of growing timber.

Kluh, for its part, could not dispute that it had retained ownership of the land on which the plantation stood (that is to say, the bare dominium) and that it had a commercial interest in the restoration of the plantation to it in due course in good condition.

Rogers J held that two distinct issues had been conflated

Giving the unanimous judgment of the High Court, Rogers J said (at para [53]) that SARS’s argument, which was based on the closeness of the connection between the proceeds of the disposal and the conducting of farming operations, erroneously conflated two separate issues – as  did the judgment of the Tax Court.

Rogers J said that section 26(1) does not apply merely by virtue of the fact that there has accrued to the taxpayer income that has been ‘derived from’ farming operations; the section applies to a person carrying on farming operations to the extent that his income is derived from such operations.

Rogers J said that two questions must therefore be answered: (i) Was the person whom SARS wished to tax a person who was carrying on farming operations during the year of assessment in question? (ii) If so, did the particular item of income in dispute derive from those farming operations?

Rogers J said (at para [55]) that where the first of these two questions was placed in issue, it was not permissible to proceed directly to the second question as though it would provide an answer to the first. Thus, he said –

The question is not whether the accrual to the taxpayer of a particular item of income is directly connected to the farming operations of any person but whether it is directly connected to (i.e. derived from) the farming operations of the taxpayer himself.

Rogers J said (at para [56]) that some Tax Court decisions, such as ITC 166 (1930) 5 SATC 85 and ITC 1630 (1996) 60 SATC 59, had erred in conflating these two questions. He said that the anterior question is whether the taxpayer to whom income has accrued is a person who was carrying on farming operations.

The interpretation of section 26(1) in the High Court judgment 

The analysis of Rogers J of the language of section 26(1) throws into doubt the long-established and widely held view that income derived by the owner of a farm who leases it in terms of a partiarian lease (that is to say, a lease in which the rent is expressed as being a stipulated proportion of the produce of the land, or a proportion of the proceeds derived from a disposal of the produce) invariably constitutes, in the hands of the land-owner, ‘income derived from farming operations’ for the purposes of the Income Tax Act.

Rogers J took the view that this conclusion overlooks the fact that, for income to be farming income in the hands of the land-owner as envisaged in section 26(1), the land-owner must be the person carrying on farming operations. This, said Rogers J (at para [59]), would indeed be the case if a partiarian lease constituted a partnership, but would not be so if such an arrangement was no more than a lease.

In the view of Rogers J, there can thus be no fixed rule that the consideration accruing to a land-owner in the form of a share of crops or a share of their proceeds is always income from farming operations and not simply rent.

It followed, said Rogers J, that the real issue in the present case was not the secondary one (whether there was a sufficiently close connection between the income and the farming operations) but the threshold enquiry, namely whether Kluh had been carrying on farming operations at all.

From this it followed that SARS could succeed in its argument that the proceeds of the disposal were deemed to be gross income in terms of para 14 of the First Schedule if, and only if, Kluh had been carrying on farming operations. Rogers J said (at para [62]) that –

I thus consider that there must be conduct by the taxpayer apart from disposing of a plantation previously acquired by the taxpayer in order to constitute the carrying on by him of farming operations. (Emphasis added).

As to the alternative basis of the assessment issued by SARS in respect of the farming operations on Kluh’s land carried on by Steinhoff, Rogers J said (at para [70]) that it was clear that Steinhoff was not engaged in these activities as an agent for Kluh, but was doing so for its own account. 

The mere fact, said Rogers J, that Steinhoff was obliged to maintain the plantation and return it at the end of the arrangement with the same volume of timber, did not suffice for Steinhoff’s farming operations to be attributed to Kluh. Nor (see para [74]) was the oral arrangement between Kluh and Steinhoff a lease, because no rental was payable. Moreover, there was no question of Kluh’s having any share of the profits from the farming operations conducted by Steinhoff.

Indeed, Rogers J held (at para [83]), Kluh had not even begun conducting plantation operations and had, from the outset, made the plantation available to Steinhoff so that the latter could conduct plantation operations for its own profit and loss.

The conclusion of the High Court

Rogers J concluded (at para [83]) that section 26(1) was not applicable in the present case. It followed that the Tax Court had erred in applying this provision together with para 14 of the First Schedule, and the appeal against the assessment should have been decided in favour of Kluh.

In short, the finding of the High Court was that Kluh had not been carrying on farming operations, and that the threshold requirement anterior to the application of para 14 of the First Schedule had not been satisfied.

From this it followed that the proceeds of the disposal of the plantation that accrued to Kluh were capital in its hands, and were not an accrual of deemed income in terms of para 14 of the First Schedule.

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