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Capital v Revenue – the SCA sets the record straight

28 June 2012   (0 Comments)
Posted by: SAIT Technical
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By RC Williams (PWC Tax Synopsis June 2012)

In the April 2011 edition of Synopsis we reported on a decision of the Tax Court in the Western Cape, concerning the receipt of compensation for the premature termination of a lucrative distribution agreement. The Tax Court had, surprisingly, in our view, found that the compensation was an amount of a revenue nature and taxable. An appeal against that decision was duly noted by the taxpayer and the Supreme Court of Appeal (SCA) delivered judgment in May 2012.

The facts were uncomplicated. In1992 SFW had obtained the exclusiveright to market whiskies distributedby a United Kingdom company,United Distillers (UD), which included the Bell's brand, an iconic brand in the South African market. In1998, when the distribution agreement still had a period of 41 months to run, UD sought early termination of the agreement. After negotiation, a price of R67 million was agreed and paid to SFW. SARS assessed SFW to income tax on the amount of R67 million, against which assessment SFW had appealed to the Tax Court.

The Tax Court had recognised that the distribution rights were a capital asset, but had nevertheless come to the conclusion that the compensation was a receipt or accrual of a revenue nature and was taxable. SFW had therefore taken the matter on appeal to the SCA.

In the matter of Stellenbosch FarmersWinery Limited v C:SARS [2012] ZASCA 72, the SCA reversed the decision of the Tax Court. In the course of its judgment, the SCA reaffirmed the principles that should generally be applied in relation to thedisposal of an asset in order todetermine whether the proceeds are of a capital or a revenue nature.

Commercially sensible

Kroon AJA, who delivered the judgment of the SCA, in which the remaining Justices of Appeal concurred, emphasised that the adoption of the principles most appropriate to the situation must be commercially sensible. He cited with approval, the dictum of Smalberger JA in CIR v Pick ‘n Pay Employee Share Purchase Trust1992 (4) SA 39 (A) at56 G-I:

"There are a variety of tests fordetermining whether or not a particular receipt is one of a revenue or capital nature. They are laid down as guidelines only – there being no single infallible test of invariable application. In this regard I agreed with the following remarks of Friedman J in ITC 1450 (at 76):

‘But when all is said and done, whatever guideline one chooses to follow, one should not be led to a result in one's classification of a receipt as income or capital which is, as I have had occasion previously to remark, contrary to sound commercial and good sense'.

The SCA found, as an initial point of departure, that the Tax Court had correctly identified that the distribution rights were a capital asset. However, despite finding that the taxpayer had lost an asset, the Tax Court had not found the proceeds on realisation to be of a capital nature.The approach suggested by the Tax Court also was not criticised in that it was necessary to determine whethert he payment was compensation for al oss of the income-earning structure,or compensation for the loss of profits through termination of the agreement. However, the findings of the Tax Court based on the evidence were criticised. Essentially, the SCA found, the Tax Court had sought to interpret the evidence as indicating that what was negotiated was compensation for loss of profit. To do so it had laid emphasis on calculations prepared internally by SFW to determine the compensation that it should claim.

Misinterpretation

These had been based on forecast profits for the remaining period of the distribution rights, and the Tax Court had found that there was a substantial correlation between the calculations and the amount of the compensation finally agreed. However, the findings of the TaxCourt were held by the SCA to be a misinterpretation of the evidence,which showed that the calculations made by SFW had not been divulged to UD. The original settlement amount proposed by SFW was substantially higher than the amount calculated and agreement was reached based on the counter-offer made by UD, which was adjusted to provide against a contingency that the compensation should be found to be taxable.

The Tax Court's approach to the matter by reference to the manner in which SFW accounted for the proceeds also received criticism.Considerable emphasis had been placed on the accountingdisclosure (where the amount had been disclosed as a "cash flow from operating activities”) as well as the fact that the dividend for the year inquestion had substantially been financed by the amount received.

These issues were dealt with byKroon AJA (at [35] and [36]):

"[35] In my judgment, counsel for the taxpayer validly argued that the nature o fa receipt (ie whether it is capital or revenue) for income tax purposes, is not determined by how it is subsequently treated for accounting purposes. Reference (by analogy) was made to the decision in Secretary for Inland Revenue v Eaton Hall(Pty) Ltd [1975 (4) SA 953(A) at 958 B-D] where it was held that accounting practice cannot over ride the correct interpretation of the provisions of the Act and their applicationto the facts of the matter. As appears from the present judgment the facts favour a finding of a capital nature. Second, not only did the financial statement reflect that the receipt of the R67 million was an‘exceptional item', but note 4 to thes tatement specifically recorded that the receipt was ‘compensation for the cancellation of the exclusive distribution rights', which points rather to a receipt of a capital nature.

[36] The second item in the financial statements referred to by the Tax Court was an entry reflecting that a dividend of some R88 million was declared, notwithstanding that, although the taxpayer had the reserves to declare the dividend it did not have the cash on hand to meet the dividend. The point (which had not featured in the Commissioner's pleadings) was however adequately met by counsel's submission that the manner in which a taxpayer deals with a receipt, after it has received it, cannot determine the nature of the receipt, eg the capital nature of the receipt of the proceeds of the sale of a building is not affected by the utilisation of the proceeds to pay a dividend.”

The SCA disagreed with the approach of the Tax Court, which had found that the business of SFW had not been materially affected by the cancellation of the distribution rights because few employees had been discharged as a result. It found (at [42]):

Counsel therefore correctly submitted that the court a quo's reasoning reflected that it erroneously focussed on only physical assets, instead of the much morevaluable incorporeal assets constituted bythe exclusive distribution rights (the loss of which, consequent upon the termination of the distribution agreement, brought in its train the disastrous consequences referred to earlier in this judgment). The compensation for the impairment of the taxpayer's business constituted by that loss is properly to be viewed as a receipt of a capital nature.”

The final determinant identified bythe SCA was the fact that the termination agreement expresslyreferred to payment of full compensation for the closure ofSFW's business relating to the exercise of the distribution rights.The Court found (at [45]):

"There was no reference in the termination agreement to a payment for loss of profits. There is no suggestion that the termination agreement did not reflect the intention of the parties or that it was in any way simulated. It need hardly be added that any suggestion that the taxpayer, faced with the option of concluding a capital transaction with no tax implications or an income transaction with such implications, would chose the latter, is, to say the least, an unconvincing one.”

It was therefore held that SFW had discharged the burden of proof that the termination payment was a receipt or accrual of a capital nature.


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