Capital gains tax consequences of redemption of redeemable shares
26 March 2012
Posted by: SAIT Technical
Capital gains tax consequences of redemption ofredeemable shares
PWC Tax Synopsis - RC Williams
The decision of the Johannesburg Tax Court in A (Pty) Ltd v Commissioner for the SouthAfrican Revenue Service, handed down on 13 February 2012 (Case No. 12644; not yetreported), addresses for the first time by a South African court hitherto unexplored aspects ofkey concepts in the capital gains tax regime laid down in the Eighth Schedule to the Income Tax Act 58 of 1962, in particular, the fundamental nature of a disposal and the essential nature of a redemption of redeemable shares. Was the capital loss in question a clogged loss?
In this case, SARS had disallowed a capital loss claimed by the taxpayer company which had been incurred as a result of the redemption of redeemable preference shares held by it in a second company in the same group on the basis that the loss was a "clogged loss”, as envisaged in para 39(1) of the Eighth Schedule to the Income Tax Act 58 of 1962. The first issue was the proper interpretation of para 39(1) and, in particular, whether that provision applied to the redemption of redeemable preference shares, thereby rendering the taxpayer’s capital loss a "clogged loss” because of the connection between the taxpayer and the company which had issued those shares, for it was common cause that they were part of the same group of companies and were under common control. A clogged loss is a loss which, in terms of the Eighth Schedule, must be disregarded in the determination of the disposer’s aggregate capital gain or aggregate capital loss; such a loss is ring-fenced and is deductible only from a capital gain arising from the disposal of assets to that same "connected person”.
Does the redemption of redeemable shares give rise to a recovery of their acquisition cost?
The second issue before the court related to the quantum of the appellant’s capital loss. This turned on the meaning of the word recovery in para 20(3) of the Eighth Schedule; the pivotal question was whether the taxpayer had recovered part of the expenditure incurred in purchasing the preference shares when those shares were redeemed by the issuing company.
Was the redemption of the shares a "disposal to any person”?
If para 39(1) of the Eighth Schedule were applicable, it was clear that the taxpayer’s capital loss would be a clogged loss, since it was common cause that the taxpayer and the issuing company were "connectedpersons”. The question was whether this paragraph was indeed applicable. In this regard, the language in which this provision of the Eighth Schedule is expressed was of critical importance. The spotlight fell on that part of the paragraph which states that a person must disregard -any capital loss ... in respect of the disposal of an asset to any person
(a) who was a connected person in relation to that person immediately before that disposal; or
(b) which is immediately after the disposal
(i) a member of the same group of companies as that person .. (Emphasis added.)
The term disposal is defined in para 11(1) of the Eighth Schedule, and expressly includes a redemption. SARS argued that para 39(1) of the Eighth Schedule was applicable and that the redemption of the preference shares constituted a disposal to the company. The taxpayer company argued that this paragraph was not applicable because the redemption was not a disposal "to” any other person.
The nature of a disposal to another person as distinct from a mere extinction of rights
The taxpayer company argued that the kinds of disposal envisaged in para 39(1) are those in which an asset, or rights in an asset, are transferred from the disposing party to another person; furthermore, that even though para 11(1) explicitly defines disposal as including redemption, the language of this provision - and in particular the word "to” in the phrase "disposal of an asset to any person”- had the effect of confining the application of para 39(1) to those akin to the ones mentioned in para 11(a), such as sales, where there was a transfer of the asset itself, or of rights in the asset, to another person. The taxpayer company argued that where shares are redeemed, there is no transfer of the shares themselves, or of any of the rights represented by the shares, from the shareholder to the redeeming company, and that the shares or the rights are simply extinguished, and cease to exist. SARS’s counter-argument was that the redemption of shares is, in essence, a kind of "buy-back” of the shares and consequently constitutes a disposal to the redeeming company.
The court applied the principles of statutory interpretation
Faced with these arguments and counter arguments as to the proper interpretation of the word disposal in the context of para 39(1), read with para 11(1), the court looked to the legal principles regarding the interpretation of fiscal legislation - with the spotlight falling on the significance of the word "to” in the phrase "the disposal of an asset to any person” and the question whether that word could simply be ignored. In this regard the court (at para ) cited the decision in Commissioner for Taxes v Ferreira 1976 (2) SA 653 (RAD), 38 SATC 66 for the proposition that - in interpreting anti-avoidance provisions, such as para 39(1), a wider interpretation is required so as to suppress the mischief at which the provision is aimed and to advance the remedy.
The court said (at para ) that - The mischief at which paragraph 39(1 is aimed is clearly to prevent the taxpayer from avoiding or reducing its tax liability by creating a capital loss through the disposal of an asset to a person (including a company) that it is connected to. To allow such losses ... would provide fertile ground for the creation of fictitious losses. Tax liability would be reduced while the asset, or the benefit thereof, would still be retained by the disposer, albeit through the connected person. The court said (at para ) that the wording of para 39(1) clearly covers transactions such as sales or the transfer of assets (including shares) from the disposer to a connected person or company. The difficulty, said the court, arises where there is no transfer of the asset or rights in the asset from the disposer to the connected person. The court said that, according to established canons of construction, the preposition to in the phrase the disposal of an asset to any person could not be ignored unless its inclusion would result in an absurdity so glaring that it could never have been contemplated by the legislature. The inclusion of this preposition, said the court - implies a disposal of a kind in which the asset (or the rights represented therein, in the case of shares) must be transferred to the connected person. As to the nature of the redemption of shares, the court held (at para ) that - The redemption of shares results in the extinction and not in a transfer of the rights embodied in the shares to the company redeeming them, or to any other person.
The court consequently held that para 39(1) of the Eighth Schedule did not apply to the redemption of shares in the present case and that the loss incurred by the taxpayer was therefore not a clogged loss as envisaged in that paragraph.
The quantum of the taxpayer’s loss
The court began its analysis of the quantum of the taxpayer’s loss on the redemption of the shares in question with the fundamental proposition that a capital gain is the excess of the proceeds of an asset on its disposal (or, in the case of a deemed disposal, its market value) over its base cost. In the present case, the cardinal dispute between the taxpayer company and SARS was whether, in determining the base cost of the shares, the original purchase price of the shares in question fell to be reduced by the aggregate preferential dividend and the redemption premium that was payable in terms of the articles of association of the company which had issued and was now redeeming the shares. SARS argued (see para  of the judgment) that the dividend and the redemption premium constituted a recovery as envisaged in para 20(3) of the Eighth Schedule. It is noteworthy that this argument is in direct contradiction to the guidance given by SARS in its Comprehensive Guide to Capital Gains Tax (Issue 4) at 8.18, which states that a post-acquisition dividend is not a recovery in the context of para 20(3).
It is indeed surprising that SARS should contradict itself in contesting an appeal and begs the question whether it considers itself bound by its published guidance. It is submitted that SARS should adopt a more principled approach in these situations and concede its publicly disseminated interpretations where taxpayers fall within the scope of such guidance. The taxpayer company (see para ) argued the contrary, namely that, in the context of the present case, a recovery as envisaged in para 20, would occur only where it had - got back into its possession the expenditure (or part of the expenditure) incurred in respect of the acquisition of the preference shares. The taxpayer company argued that to treat a dividend or redemption premium as a recovery of the purchase price of the shares would lead to an absurd result and would be tantamount to treating rental received by a property owner as a recovery of the purchase price of the property.
The company argued further that it had never got back any of the purchase price which it had paid to the bank from which it had purchased the shares. The redemption premium was received on account of the redemption of the shares and was not a repayment of part of the purchase price. It was further argued that para 20(3) referred to an amount that had been recovered and not to the wider concept of any benefit linked to the acquisition of the asset.
The court held (at para ) that - There is merit in the contention that the fruit derived from an asset will, generally, not constitute a recovery envisaged in paragraph 20(3). On a proper construction of that paragraph, in order for the amount to be a recovery, the taxpayer must have got back the cost (or part) expended in acquiring the asset. The fruits of the asset, such as rent, in the case of the assets being a rental property, or dividends earned in respect of the shares, are, generally, not amounts that have been recovered as contemplated in paragraph 20, but constitute income earned from the particular asset.
The court held (at para ) that, when calculating the taxpayer company’s capital loss, SARS had erred in treating the dividend portion and the redemption premium portion of the redemption payments as recoveries of the cost of acquiring the preference shares.
Par 39(1) of the Eighth Schedule, said the court, did not apply to the redemption of the preference shares and the taxpayer company’s loss was not a clogged loss that could be deducted only in the manner as envisaged in that paragraph. As to the quantum of the capital loss, the dividends and redemption premium paid to the taxpayer company, was not to be treated as a recovery envisaged in par 20(3).