Capital gains tax deferred
21 April 2015
Posted by: Author: Ben Strauss
Author: Ben Strauss (DLA Cliffe Dekker Hofmeyr)
Put simply, capital gains tax (CGT) is levied on the capital gain arising on the disposal of an asset, that is, on the difference between the base cost of the asset and the proceeds accruing on disposal.
In terms of paragraph 35(4) of the Eighth Schedule to the Income Tax Act, No 58 of 1962 (Act) when a person disposes of an asset during a current tax year and that person becomes entitled to any amount which is payable in future tax years, that amount is deemed to have accrued to that person during the current tax year. So, if the price of an asset is paid, say, in three equal instalments over three tax years, the person disposing of the asset must account for CGT on full price in the first tax year, that is, the year of the disposal.
That provision is perhaps inequitable as the cash flow does not follow the incidence of tax. Fortunately, there are some principles that mitigate the harsh effects of the rule.
First, it is trite that the rule will only apply to the extent that the person becomes unconditionally entitled to some or all of the proceeds; to the extent that the entitlement to future proceeds is conditional upon the happening of an event, the taxpayer would only need to account for CGT on the future proceeds if and when the event occurs.
Second, in terms of s24M(1) of the Act, to the extent that the proceeds on disposal of an asset will only be quantifiable at a future date, the taxpayer need only account for CGT when the amount becomes quantifiable. For example, if a person sells shares in a company on the basis that a part of the price will be determined with reference to the net profits of the company in a future tax year, then the person would only need to account for CGT in the future tax year when the amount becomes quantifiable.
Third, s24N of the Act provides that, if a person disposes of equity shares in a company for a quantified or quantifiable amount that only becomes due and payable in a future tax year, then the person need only account for CGT in a future year as and when it becomes due and payable, provided certain requirements are met. Notably, the provision only applies if the amount payable is determined with reference to the future profits of the company.
In the case of Gani v Hassim; In re: East Coast Access (Pty) Limited v Gani JOL 32843 (KZD), Mr Gani sold his shares in a company to Mr Hassim. The price of the shares was R5 million in aggregate. The evidence indicated that the parties agreed that Mr Hassim would not pay the price in a lump sum in year one, but in equal monthly instalments over three years with a 'bullet payment' of R2 million at the end of year three.
However, Mr Gani's accountant referred him to the provisions of paragraph 35(4) of the Eighth Schedule to the Act. The accountant advised Mr Gani that he would have to pay CGT in year one, despite the fact that he would only receive the price over a period of three years. The accountant, however, also informed Mr Gani that the principle would not apply if the receipt of the price was made subject to a condition, in which event he would only have to pay the CGT when the condition was fulfilled. For that reason the parties inserted a condition into the agreement between them to the effect that the price would only be paid if the company generated certain levels of profit.
A subsequent dispute arose between the parties. Mr Hassim alleged that, because the agreed profit levels were not attained, he was not obliged to pay Mr Gani the 'bullet payment' of R2 million.
The court found that "[t]he evidence and the probabilities…indicate overwhelmingly that the purpose of the condition regarding the profit target was to delay the payment by Mr Gani of capital gains tax. This was the evidence of Mr Gani and [the accountant], and also Mr Hassim. I do not accept the contention that the purpose of the condition was to ensure that Mr Hassim would be able to pay the entire purchase price out of the profit of the company. Its only purpose was to delay the payment of capital gains tax by bringing the agreement within the ambit of paragraph 13 of Schedule 8 [which relates to the timing of a disposal] or s24N of the Act."
The South African Revenue Service (SARS) may be interested in the finding of the court for the reasons that follow.
First, it is trite that if parties come to an agreement and do not really intend the agreement to have, as between them, the legal effect which its terms convey to the outside world, then the agreement is simulated, and a court will not give effect to the agreement (Commissioner of Customs and Excise v Randles, Brothers & Hudson Ltd 1941 AD 369). As Lewis JA said in the case ofCommissioner for the South African Revenue Service v NWK Limited 2011 (2) SA 67 (SCA),
"[i]f the purpose of the transaction is only to achieve an object that allows the evasion of tax…then it will be regarded as simulated".
In the Gani case the court found on the evidence that the sole purpose of the provision in the agreement was to make the payment of the 'bullet payment' contingent on the company achieving the relevant profit levels.
If that provision was not meant to be binding between the parties (an issue which neither the parties nor the court canvassed) then the provision was simulated and should be disregarded for the purpose of determining the incidence of tax. If it is disregarded, then Mr Gani should have paid CGT on the full price at the time of the sale.
Second, in terms of s80B(1) of the Act, in the case where a taxpayer has entered into an impermissible avoidance arrangement, SARS has the power, among other things, to determine the tax consequences by disregarding any steps in, or parts of the arrangement. In terms of s80A of the Act, an arrangement that results in a tax benefit is an impermissible avoidance arrangement if the sole or main purpose of the arrangement was to obtain a tax benefit and, among other things, it lacks 'commercial substance'. Section 80C(1) of the Act states that an avoidance arrangement lacks commercial substance if, among other things, it results in a tax benefit for a party but does not have a significant effect on either the business risks or net cash flows of the party.
In terms of the definition of tax benefit in s1, the postponement of any liability for tax is a tax benefit.
If the finding of the judge in the Gani case as to the evidence is correct then, arguably, the condition in the agreement, pertaining to the profit levels, having been inserted (according to the judge) only for the purpose of postponing the liability for CGT (a tax benefit), may be seen to be an impermissible avoidance arrangement because it had no effect on the net cash flows of Mr Gani.
In the Gani case the court held that the profit levels had been attained and that Mr Gani was, accordingly, entitled to the R2 million 'bullet payment'.
What the case illustrates is that parties to agreements that have the effect of deferring CGT should exercise great caution.
This article first appeared on cliffedekkerhofmeyr.com.