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Capital v revenue – the debate is not closed

08 April 2016   (0 Comments)
Posted by: Author: PwC South Africa
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Author: PwC South Africa

Before the introduction of capital gains tax, taxpayers and SARS would frequently engage in an all-or-nothing contest where a taxpayer disposed of an asset. The earlier case reports are littered with cases relating to the capital-revenue debate. With the introduction of a tax on capital gains, there have been few reported decisions in this connection, principally because the fiscus recovers tax on the disposal in any event. SARS has, however, been engaged in a hard-fought dispute relating to a sale of shares which ended up in the Supreme Court of Appeal, on which judgment was delivered on 9 February 2016.


The appeal in the matter of C:SARS v Capstone 556 (Pty) Ltd [2016] ZASCA 2 dealt with a complex corporate rescue operation in the furniture industry, dating back to 2002. At that time, Profurn (a company listed on the JSE) was in severe financial difficulty and its major creditor, FirstRand Bank Ltd ("FirstRand”), sought a means whereby the company might be returned to profitability.

The chief executive of Profurn ("Jooste”) referred FirstRand to a German businessman ("Daun”) who indirectly held a 13% stake in Profurn. Daun consented to participate in a recapitalisation of Profurn, but insisted that a capital injection would be insufficient to effect a turnaround. The company required sound management, and Daun’s participation was subject to one Sussman (who Daun considered was best qualified to turn the business around) being placed in control of the company. Sussman consented to taking over the management, on condition that Daun remained as a shareholder for as long as it took to effect a turnaround.

The parties mutually agreed on a strategy to effect a turnaround, which they anticipated would take in the region of three to five years to achieve.

Under the plan, FirstRand would underwrite a R600 million rights issue and would capitalise a portion of its debt for shares in Profurn. Thereafter Profurn would be merged with the JD Group ("JDG”) and the Profurn shares exchanged for JDG shares. FirstRand would then dispose of the JDG shares to Capstone 556 (Pty) Ltd ("Capstone”) for R600 million.Capstone would finance the purchase consideration out of an investment of R300 million by a German company controlled by Daun, the issue to FirstRand of R200 million’s worth of redeemable preference shares and a new loan from FirstRand of R100 million.

The agreement was substantially reflected in a memorandum of understanding signed by Daun in Germany on 26 June 2002, in which it was expressly stated that risk and reward would pass on that date, notwithstanding that it was subject to the requisite regulatory approval.

The rights issue raised less than R1 million from shareholders and FirstRand subscribed for the remaining Profurn shares, which, following the merger, resulted in FirstRand holding 42 million shares in JDG.

Capstone was incorporated on 2 April 2003. As a result of amendments to the MOU and subsequent agreements, Jooste was invited by Daun to participate in the transactions and Capstone was designated as the investment vehicle for Jooste. FirstRand ultimately disposed of approximately 35 million of the JDG shares, of which one-half were transferred to Capstone and one half to Daun’s German investment holding company. Daun’s company duly effected payment for the shares so transferred, and Jooste made the necessary arrangements for the financing of the acquisition by Capstone. FirstRand required the purchasers of the shares each to issue a R62.5 million indemnity relating to potential tax exposures in Profurn, which had been identified in a due diligence investigation.

The arrangements made by Jooste involved the raising of a loan from Genbel Securities Ltd ("Gensec”) and the issue of redeemable preference shares to FirstRand. Gensec stipulated that, in addition to interest, it be entitled to a portion of any gain on the disposal of the JDG shares in the future ("equity kicker”). The funds advanced to Capstone by Jooste’s interests reflected the same conditions agreed between Jooste and Gensec.

The JDG shares were eventually transferred to Capstone and Daun’s company on 5 December 2003. In the interim, the turnaround strategies had been implemented by Sussman and the affairs of the merged businesses had prospered under his management.

"Book-building” is an exercise of sourcing institutional investors who might be prepared to acquire an interest in a listed company in a transaction which is concluded off the stock exchange.

Jooste’s participation was subject to a stipulation by Daun that Daun should be placed in control of the entire parcel of 35 million shares. In November 2003, Jooste had become aware, in a brief discussion in San Francisco with a bank official ("Pagden”), that the latter was engaged in a "book-building” exercise for another South African company. This is an exercise of sourcing institutional investors who might be prepared to acquire an interest in a listed company in a transaction which is concluded off the stock exchange. Jooste inquired whether such an exercise might be possible for JDG shares.

Some months later, Pagden approached Daun with a proposal that his bank carry out a book-building exercise for the shares in JDG. Following Daun’s acceptance of the proposal, offers for 28 million shares were presented at a price almost three times the price at which they were originally acquired. The offer was accepted and Capstone disposed of 14 million shares held by it on 29 April 2004 and shortly thereafter sold the remaining 3.5 million JDG shares that it held to another company at a slightly higher price.

Jooste then negotiated repayment of the Gensec loan, and Capstone paid the equity kicker in addition to any amounts of outstanding capital and interest as agreed.

At the same time, Capstone agreed to pay Daun’s company R55 million under an agreement which provided that Daun’s company would assume full liability for the indemnity to FirstRand relating to the contingent tax liability of Profurn.

Capstone therefore had to deal in its 2005 return of income with the taxation of the proceeds on disposal of the shares and the manner in which the expenditure on the equity kicker and the payment for assumption of the indemnity should be dealt with.

In its return, Capstone declared the gain on disposal of the shares as a taxable capital gain and claimed deduction of the equity kicker and the indemnity payment. SARS taxed the disposal as ordinary income and disallowed the deductions claimed.

In the Tax Court, the taxation of the proceeds as a receipt of revenue was confirmed, and, as a result, the equity kicker and exemption payment were held to be deductible.

Capstone took the Tax Court decision to the High Court on appeal, and the Court held that the proceeds were indeed of a capital nature, that one-third of the equity kicker could be included in the base cost of the shares and that the remainder of the equity kicker and the indemnity payment were not deductible and did not form part of the base cost of the shares.

SARS challenged the High Court’s finding and the matter thus came before the Supreme Court of Appeal.

The decision

Capital v revenue

In a thorough review of the law, Van der Merwe AJA confirmed the principles that have been established over the past century for distinguishing between proceeds of a capital nature and proceeds of a revenue nature.

The general proposition that applies in matters such as these is stated thus at [24]:

Whilst recognising that it is not universally valid, our courts have in circumstances such as the present consistently applied the test that a gain made by an operation of a business in carrying out a scheme of profit-making, is income and vice versa.

Acknowledging that a taxpayer may have had mixed purposes, the only course is to identify the dominant factor operating to induce the taxpayer to effect the purchase of the asset.

As to what constitutes a scheme of profit making, the Court expressed reservations about arriving at simplistic conclusions, at [26]:

Hefer AP, in Samril Investments (Pty) Ltd v Commissioner, South African Revenue Service [2003] ZASCA 118; 2003 (1) SA 658 (SCA) para 2, confirmed that the ‘usual test for determining the true nature of a receipt or accrual for income tax purposes is whether it constituted a gain made by an operation of business in carrying out a scheme for profit-making’. He pointed out that profit-making is also an element of capital accumulation. He said that:

‘Every receipt or accrual arising from the sale of a capital asset and designedly sought for with a view to the making of a profit can therefore not be regarded as revenue. Each case must be decided on its own facts . . .’

Thus the mere intention to profit is not conclusive. There must be ‘an operation of business in carrying out a scheme for profit-making’ for a receipt to be income. That expression refers to the use of the taxpayer’s resources and skills to generate profits, usually, but not always, of an on-going nature.

Turning then to the sale of assets, the Court stated that identifying the intention of the taxpayer is key, and (at [28]):

In determining this intention the court ‘is not concerned with that kind of subjective state of mind required for the purposes of the criminal law, but rather with the purpose for which the transaction was entered into’. (See Secretary for Inland Revenue v Trust Bank of Africa Ltd 1975 (2) SA 652 (A) at 669E-G.) This was formulated as follows in Pick ‘n Pay at 58F-G:

‘Contemplation is not to be confused with intention in the above sense. In a tax case one is not concerned with what possibilities, apart from his actual purpose, the taxpayer foresaw and with which he reconciled himself. One is solely concerned with his object, his aim, his actual purpose.’

Acknowledging that a taxpayer may have had mixed purposes, the only course is to identify the dominant factor operating to induce the taxpayer to effect the purchase of the asset.

Establishing the purpose of the taxpayer is a question of fact, and Van der Merwe AJA was at pains to point out that this must be determined by a conspectus of all of the facts and circumstances.

The first important fact was that the acquisition of the share occurred on 26 June 2002 and not on 5 December 2003 when the certificates were issued. From this, it followed (at [35]):

In substance and in commercial reality the purpose of the acquisition of the shares must in my judgment be determined as at 26 June 2002, in the context of events leading to the MOU.

The second issue pertinent to the inquiry was whose intention should be identified. Here the Court was dealing with a company, and it was noted (at [37]) that, generally, the intention of a company is determined by ascertaining what its directors acting as such intended; however, authority was cited that the intention may in certain instances be established by reference to persons other than the board of directors to whom authority may have been delegated. On this basis, Van der Merwe AJA found (at [38]):

Mr Daun was de facto in control of the shares from their effective acquisition to their disposal. Mr Daun therefore determined the purpose of their acquisition. At the time of their disposal, he, aided by Mr Schouten, was in any event the controlling director of Capstone. Whether or not the shares should be sold, was solely the decision of Mr Daun.

The Court then proceeded to examine the evidence given in relation to Daun’s intention. First, the Court summarised the approach to this issue in the Tax Court and the High Court as not being "rounded and complete”.

It was evident that SARS was not going to fare well in the consideration of the evidence when Van der Merwe AJA reflected on the credibility of the evidence at paragraph [42]:

The tax court did not comment on the credibility of the witnesses. No doubt that is because no adverse comment was called for. The evidence reads well. It portrays Mr Daun as a straight-forward, no-nonsense businessman who regarded a handshake agreement as binding and more important than hundreds of pages of legal documents. There can be no criticism of any of the other witnesses. Mr Daun’s evidence was materially corroborated by all the other witnesses. His evidence was not detracted from by objective facts or the probabilities and, importantly, was not contradicted. It follows that there was no reason not to accept the evidence of Mr Daun as to the aim with which the shares were acquired or the circumstances in which they were sold.

The Court found that Daun was unshaken in rigorous cross-examination in which SARS’ counsel sought to coax an admission out of him that he had intended to turn the shares to profitable account by realisation. The Court summarised this evidence as follows at [45]:

Mr Daun obviously made the investment because he was of the opinion that the rescue operation could be successful. And it was naturally anticipated that a turnaround of the business would result in an increased share price. But this is neutral, it says nothing about the aim of the acquisition. Virtually every capital asset is purchased in the hope and anticipation that it will increase in value and in contemplation of the possibility that it may in future be sold at a profit. Mr Daun contemplated a resale of the shares at a profit as one of several possibilities. These possibilities were to be explored at the appropriate time in future.

It was noted that the surrounding circumstances pointed in favour of Daun’s explanation.

SARS’ argument that Jooste was in fact the person who caused the accrual to Capstone, because he had set up the book-building operation, was rejected. It was found that the conversation in San Francisco had been of short duration and inconclusive and that Pagden had unilaterally taken the initiative in subsequently proposing the possibility thereof to Daun. The decision to commission the book-building exercise was taken solely by Daun, after consultation with Sussman, to whom he had made a commitment to remain invested, and with his wife in Germany.

The Court therefore found at [52]:

In my judgment it is clear from the evidence that the first and primary purpose of the acquisition of the shares was to rescue a major business in the retail furniture industry by long-term investment of capital. This involved a commitment of capital for an indeterminate period involving considerable risk and only a very uncertain prospect of a return. Assuming the rescue was successful, it was uncertain what would happen next. In effect all options were open. All of this was consistent with an investment of a capital nature that was realised sooner than initially expected because of skilled management and favourable economic circumstances. It was not a purchase of shares as trading stock for resale at a profit.

The remaining issue related to the treatment of the payment of R55 million for the indemnity.

In the following extracts from paragraph [55] of the judgment, Van der Merwe AJA outlined why the payment should form part of the base cost of the shares.

It is beyond question that the contingent liability of Capstone in terms of the indemnity to FirstRand formed part of the consideration for the acquisition of the shares... The unconditional obligation in terms of the indemnity settlement to pay R55 million … was undertaken in substitution of the contingent obligation to FirstRand... The causal link with acquisition of the shares was not broken. The acquisition of the shares remained the causa causans of the indemnity settlement... It was the mechanism by which the contingent liability incurred as part of the acquisition of the shares was monetised and rendered a quantifiable component of the cost of the shares.

The takeaway

The thorough description of the facts and the careful application of the principles of evidence and of the tax law resulted in a clear judgment which has brought to an end a long-running dispute in the course of which the basis of taxation was contested. The judgment makes it clear that in such disputes the evidence relating to the purpose of the parties and credibility of the witnesses is paramount.

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