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Substance Over Form Nothing New

06 May 2011   (0 Comments)
Posted by: Author: Nazrien Kader
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Substance Over Form Nothing New
While the NWK judgement shook up the tax fraternity when the Supreme Court of Appeal of South Africa came down in favour of SARS late last year,history shows that this should not have come as such a surprise to those interested in the case – either from a corporate or a professional services viewpoint.

As long ago as March 1996, the first landmark ruling in favour of SARS with regard to substance over form was seen in the 1996 case of Erf 3183/1 Ladysmith. This case saw the Appellate Division of the Supreme Court finding that a tax exempt entity was used to absorb the deemed taxable income arising out of a lessees’ obligation to improve the property concerned. At that time,the Court drew a distinction between:

•Transactions in which the substance and form coincide – that is, the intended effects of the transaction are wholly in line with, and fully laid out in, the documentation; and
•Transactions which are never intended to have the effect that their documentation purports,or whose intended effect is different in some material way than their form would suggest. These are generally known as sham transactions.

A second ruling that was based on the principle of substance over form, was a 1997 case of the Supreme Court of Appeal in favour of SARS against a company called Brummeria Renaissance. Prior to this ruling, taxpayers were not concerned that SARS would impute income on interest-free loans made available by one person to another. However, the court decided that the right to use an interest-free loan constituted gross income which accrued to Brummeria.

In essence, interest-free loans were made available by different persons to Brummeria in return for so~called life rights which gave the person the right of life-long occupation of a residential unit owned by Brummeria.SARS argued that the right to retain and use the interest-free loan capital had an ascertainable money value which accrued to the companies and that constituted gross income in their hands.

The NWK case in 2010 case saw the Supreme Court of Appeal expand the accepted interpretation of substance over form,after NWK entered into a series of commercial transactions which SARS argued did not reflect the true substance of the transaction. "For taxpayers, the ruling sends a clear message that tax risks should be re-examined and positions analysed to give effect to the terms of an agreement, which must have a real commercial purpose. While the NWK judgement is just one in a series that SARS has won, SARS is using the basis of the judgment to broaden the scope of its audits on structured finance transactions. On 15 February this year,SARS made an announcement to this effect.
"SARS has encouraged voluntary disclosure by taxpayers of transactions of this nature (in terms of the recently effective Voluntary Disclosure Programme) to regularise their affairs, following which SARS is targeting specific transactions for audit. How widespread this will be remains to be seen, however, as organisations will attempt to differentiate themselves from the facts in the NWK case while choosing the most tax-effective method of financing as possible,” explained Nazrien Kader, taxation service line leader at Deloitte.Billy Joubert, director in charge of transfer pricing at Deloitte, points out that the principle of substance over form is important in understanding the significance of certain changes to the transfer pricing rules, which take effect from 1 October this year. Transfer pricing rules apply between group companies which transact cross-border.They are aimed at preventing groups from shifting profits to low tax jurisdictions by transacting at artificial prices which favour the entities in the low tax country.

The legislation has always focused on whether the pricing of such transactions is arm’s length. More specifically,SARS would want to know that by virtue of the transaction, the SA company has neither overpaid, nor undercharged, its foreign group company.The new legislation focuses not so much on the pricing of the relationship but looks more widely at the entire nature of the relationship between the parties. It therefore anticipates that profits may be shifted artificially not only by means of non-arm’s length pricing, but in more complex ways. Therefore taxpayers will be required to show that they have transacted with foreign-related parties as if they were "independent persons dealing at arm’s length”.

At first glance,it seems that compliance with this requirement may,in certain cases,be almost impossible. This is because there are arrangements within multinational groups that simply do not occur between unrelated parties – for example, limited risk arrangements such as limited risk, or stripped, distributors.

SARS has yet to provide us with guidance on the significance of this change. However,it seems unlikely that SARS will stop recognising such structures altogether – particularly since they occur widely in practice within multinationals.Indeed,as the OECD has pointed out,multinationals exist partly because they can achieve efficiencies and synergies which are not available to independent enterprises.
In the absence (at this stage) of guidance from SARS, by reference to OECD principles it seems that the significance of the change is that SARS will apply more of a substance over form approach in evaluating transfer pricing practices.For example,with limited risk arrangements,taxpayers will be required to show not only that the relevant risks are limited contractually. It will be necessary,in addition,to show that the actual management of those risks is done by the party which 
purports to carry them.
In a transfer pricing context, a written policy can be regarded as the form of an intra-group arrangement whereas the actual implementation of that policy is the substance.In view of the new legislation,it seems that implementation is going to become increasingly important.
Source: By Nazrien Kader (TaxTALK)


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