Determining the CGT base cost of shares in a private company at market value
02 November 2015
Posted by: Author: PwC South Africa
Author: PwC South Africa
Determining the CGT base cost of shares in a private company at market value – the Stepney Investments judgment
In CSARS v Stepney Investments (Pty) Ltd  ZASCA 138, where judgment was given by the Supreme Court of Appeal on 30 September 2015, the central issue (see para  of the judgment) was whether the taxpayer, Stepney Investments, had discharged the onus of proving the base cost of certain shares held by it (namely, the 4.37% shareholding in Emanzini Leisure Resorts (Pty) Ltd) which it had disposed of during the 2002 and 2003 tax years.
In other words, Stepney Investments bore the onus of proving the value of those shares on 1 October 2001 when capital gains tax came into force so as to establish the taxable gain (if any) made on their disposal some two years later.
Determining the market value of shares in a private company
Stepney had elected, in terms of para 26(1) of the Eighth Schedule to the Income Tax Act, to use market value as the method of valuing the shares as at 1 October 2001. In terms of para 31(1)(g), ‘market value’ in this context means –
‘the price which could have been obtained upon a sale of the asset between a willing buyer and a willing seller dealing at arm’s length in an open market’.
The interest of the judgment is the guidance that the Supreme Court of Appeal gives (or fails to give) in relation to the broad question of the appropriate method for determining the market value of shares in private companies.
Establishing the market value of shares (or any other property) at a given point in time is, inherently, a hypothetical and somewhat speculative inquiry into what a notional purchaser would have paid in an open market on a particular date.
Shares have aptly been described as a ‘bundle of rights’, which is to say, they are a conglomeration of personal rights (rights in personam) that the taxpayer has vis-à-vis the company, and they are not rights vis-à-vis the company’s property.
It is thus fundamental that a shareholder has no real right (right in rem) in assets owned by the company (Macaura v Northern Assurance Co Ltd  AC 619(H)).
Nonetheless, the value of property owned by a company impacts on what a notional purchaser would be prepared to pay for its shares. Thus, an obvious yardstick for valuing shares is the net asset value (NAV) method. This method has regard to the value of the company’s assets less the value of its liabilities at the relevant time. The net asset value so derived can then be divided by the number of the company’s shares to arrive at the value per share.
This method of valuation is clearly appropriate where the value of the company, as a going concern, is largely determined by the assets that it owns, such as where the company is a property-holding enterprise, or if the company is in liquidation.
The limitation of the net asset method of valuation is that it yields a mere static snapshot at a given moment in time.
A second method of valuation is the income approach, which seeks to estimate the flow of revenue that the company will generate in the future.
Thus, if the company is in a line of business in which consumer demand is on the increase, this will impact on the valuation of its shares beyond their static net asset value at a moment in time. A variant of the income approach is the discounted cash-flow(‘DCF’) method, which entails valuing the business in question on the basis of its forecast future cash flow, discounted back to present-day values through the application of a discount factor.
At issue was the base cost for CGT purposes of the ELR shares
In the Stepney Investments case it was necessary to arrive at the market value, as at 1 October 2001, of particular shares that the company had disposed of during the 2002 and 2003 tax years, namely a 4.37% shareholding in Emanzini Leisure Resorts (Pty) Ltd (ELR).
That company, which at the time was engaged in developing, owning and operating casinos, hotels and related leisure activities, held a 15-year casino licence for the Richards Bay area, granted by the KwaZulu-Natal Gambling Board, and it intended to establish a casino, but litigation by a religious group opposed to the casino had resulted in a delay.
Bridge Capital Services Ltd (‘the Bridge valuation’) utilised the discounted cash-flow method to conduct the valuation commissioned by Stepney Investments and determined the market value of the ELR shares as at 1 October 2001, that is to say, their base cost for capital gains tax purposes.
By contrast, SARS (see para  of the judgment) utilised the net asset method of valuation in ‘adjusting’ down to nil (in terms of paragraph 29(7)(b) of the Eighth Schedule) the Bridge valuation, and this adjusted valuation was the basis of the additional, disputed assessments.
This ‘adjustment’ (as appears from the unreported judgment of the Tax Court) was based on a view taken by an in-house ‘chartered accountant and principal auditor’ at SARS which was so lightweight that SARS’s legal team in the Tax Court did not even try to argue that it was credible.
As the Supreme Court of Appeal noted (at para ) –
No separate independent valuation was done by [anyone] on behalf of the Commissioner [and] ultimately the Tax Court had before it only the Bridge valuation . . . ’
The Supreme Court of Appeal judgment notes (at para ) that SARS –
‘implicitly conceded in the court below that [the net asset valuation method] was inappropriate and that the DCF method should have been used. This concession was properly made.’
The judgment is silent as to why the NAV method was not appropriate
It is regrettable that the Supreme Court of Appeal did not provide guidance for the future by expanding on why the net asset method of valuation was ‘inappropriate’ and why the DCF method was the most suitable method in relation to this particular taxpayer.
It may be inferred, however, that the court accepted that ELR’s line of business was dynamic and changeable, and that the value of the business was dependent on such factors as fluctuations in the disposable income of its client base as the national and regional economy waxed and waned, and the vagaries of public opinion in regard to the attractiveness of casino-based gambling as a leisure activity, as well as the possibility of future legislation that might impact on organised gambling.
As was noted above (and see the judgment at para ), SARS had not commissioned its own independent valuation of the value of the ELR shares.
Instead, in its revised assessment, SARS (purportedly applying the net asset value method but in reality almost arbitrarily) valued the shares in question at nil. In this regard, the Supreme Court of Appeal observed at para  that –
‘There was clearly considerable value attached to ELR’s sole asset, the casino licence. It was not seriously disputed that a casino licence which grants the holder exclusive rights in respect of the specified area for a period of 15 years has considerable value.’
In essence, SARS confined itself (see para ) to attacking the reliability of the Bridge valuation commissioned by Stepney Investments without putting forward any substantive valuation of its own.
The conduct on the part of SARS in assigning a nil value to the shares in question raises important questions, and it is regrettable that this did not come under closer critical scrutiny by the Supreme Court of Appeal. Since the judgment in SARS v Pretoria East Motors (Pty) Ltd  ZASCA 91 it has been clear that SARS must have a basis for issuing an assessment and cannot issue assessments to tax that are plucked from thin air. In that case, the Supreme Court of Appeal said (at para ) that the approach taken by the SARS auditor in the matter then before the court was –
‘that if she did not understand something she was free to raise an additional assessment and leave it to the taxpayer to prove in due course at the hearing before the Tax Court that she was wrong. Her approach was fallacious. The raising of an additional assessment must be based on proper grounds for believing that, in the case of VAT, there has been an under-declaration of supplies and hence of output tax, or an unjustified deduction of input tax. In the case of income tax it must be based on proper grounds for believing that there is undeclared income or a claim for a deduction or allowance that is unjustified. It is only in this way that SARS can engage the taxpayer in an administratively fair manner, as it is obliged to do. It is also the only basis upon which it can, as it must, provide grounds for raising the assessment to which the taxpayer must then respond by demonstrating that the assessment is wrong.’ (Emphasis added).
A cynical reader might infer that, in the present matter, SARS’s strategy in valuing the shares in question at nil in its additional assessment was to try to engineer a situation where, if Stepney Investments was unable, in the ensuing litigation, to discharge the onus of proving that the Bridge valuation was accurate, the court would have no choice but to disallow the taxpayer’s objection to the assessment, thereby leaving intact the assessment with the nil value.
If such indeed was the stratagem, it did not succeed.
In the event, in the litigation in the Tax Court and the Supreme Court of Appeal, the only valuation of the shares that was on the table (see para ) was the Bridge valuation and no other.
In giving judgment, the Supreme Court of Appeal concluded (at para ) that the Bridge valuation, put forward by Stepney Investments, was ‘fatally flawed’ and that the Tax Court had erred in upholding it.
Such a finding would usually be catastrophic for the taxpayer in that, if he fails to discharge the onus of proving the correctness of his objection in the Tax Court, the assessment will usually then prevail and the taxpayer will be obliged to pay the assessed amount of tax.
In this case, however, SARS had (as was noted above) taken the approach in its revised assessments (see the judgment at para ) of determining the base value of the ELR shares in issue – that is to say, their market value as at 1 October 2001 – as being nil.
Fortunately for the taxpayer, SARS conceded in the Supreme Court of Appeal (though not, apparently, in the Tax Court – see para ) that a nil value was insupportable. As was noted above, in its judgment (at para ), the Supreme Court of Appeal said in this regard that–
‘counsel for the Commissioner very properly conceded that the value of the shares cannot be nil. There was clearly considerable value attached to ELR’s sole asset, the casino licence. It was not seriously disputed that a casino licence which grants the holder exclusive rights in respect of the specified area for a period of 15 years has considerable value.’
The court went on to say that–
‘it is in the interests of justice that a proper valuation be calculated. The Tax Court should have remitted the matter to the Commissioner for further investigation and assessment in terms of s 83(13)(a)(iii) of the Act.’
These two findings by the Supreme Court of Appeal had four important consequences.
First, although the taxpayer had not succeeded in affirmatively proving the market value of the shares in question as at 1 October 2001, it was common cause that the nil valuation accorded to the shares by SARS in the disputed assessments was insupportable.
Second, the disputed additional assessments were set aside by the court.
Third, the taxpayer was awarded its costs in the Tax Court and also in the Supreme Court of Appeal – a not inconsiderable monetary solace for this lengthy saga.
The fourth consequence was that the Supreme Court of Appeal ordered that the matter be remitted, not to the Tax Court, but to the Commissioner ‘for further investigation and assessment’. In the circumstances, it would have been pointless to refer the matter back to the Tax Court, given that the only valuation on the table – the Bridge valuation – had been held to be fatally flawed.
The future of this dispute will be that (unless the parties can negotiate a settlement) the Commissioner, having considered the matter afresh, will issue yet a further additional assessment and the taxpayer will have another bite at the cherry in objecting to the new assessment if its determination of the base cost of the shares is unacceptable. In the meantime, Stepney Investments will presumably revise the Bridge valuation and submit an amended version to SARS.
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This article first appeared on pwc.co.za.