Some Observations On The New General Anti-Avoidance Rule (GAAR)
01 February 2006
Posted by: Author: Ernest Mazansky
Some Observations On The New General Anti-Avoidance Rule (GAAR)
At the time of writing this article the revised draft of the GAAR to replace section 103(1) of the Income Tax Act ("the Act") had been published for further comment, and it is expected that there will be some further tweaking of its terms(but definitely no substantive changes).By the time this article is published, the new GAAR will have been enacted by Parliament and will be awaiting the President's signature before it becomes law.
Section 103(1) of the Act essentially incorporated four tests before it could be invoked by SARS, as follows:
·There had to be a transaction, operation or scheme.
·This had to have the effect of avoiding, reducing or postponing any tax under the Act (ie income tax, STC, donations tax, withholding tax).
·The sole or main purpose of the transaction, operation or scheme had to be the avoidance, reduction or postponement of any tax administered by SARS, ie not just income tax but estate duty,stamp duty,VAT, customs duty, etc.
·Finally, there had to be the so-called abnormality requirement, in terms of which the means or manner of undertaking the transaction was not how it would normally be done, or the transaction had created rights or obligations that would not normally be created between persons dealing at arm's length.
The new GAAR, now contained in Part IIA of Chapter III of the Act as new sections 80A to 80L, still incorporate these four basic principles, but now goes a lot further. It is no secret that the old section 103(1) had largely been rendered toothless by the various decisions of the Supreme Court of Appeal (in my personal view because SARS applied the section in the wrong circumstances).The most important finding in the well-known Conhage case, which was the final nail in the coffin, was that as long as the entire series of transactions when seen as a composite whole was undertaken solely or mainly for commercial (ie non-tax) reasons, the scheme could not be attacked,even if certain elements or legs in the scheme were undertaken solely or mainly for tax purposes.
This has now changed, in that one now looks not merely at the transaction, operation or scheme (now known as an "arrangement") as a whole, but one can look at all steps therein or parts thereof. This allows SARS to attack a particular leg of a transaction if that leg was solely or mainly tax-motivated(all the other requirements having been met) even if the scheme as a whole was purely commercially motivated. The changes go much further than that, and I set down hereunder very briefly some of 16 those changes in order to give a flavour of the expanded scope of the GAAR:
·Apart from the abnormality test (which is not always easy for SARS to prove), an avoidance arrangement (as it is now called and which means an arrangement which results in a tax benefit) will be an"impermissible avoidance arrangement" if its sole or main purpose was to obtain a tax benefit and, as an alternative to the abnormality requirements being present,the arrangement lacks "commercial substance" or it would "frustrate" the purpose of any provision in the Act (in essence,it would be an abuse of that provision).
·In determining the tax consequences,once an impermissible avoidance arrangement is being attacked, SARS can disregard or combine or recategorise any steps; or it can disregard certain parties; or it can even deem connected persons to be a single person.
·Another option would be recategorise income or expenditure or to re-allocate income or expenditure among parties.
·In testing whether the avoidance arrangement lacks commercial substance, various things will be looked at. One of trip financing".Another is if there is the use of a so-called "accommodating or tax indifferent party" (generally this will be a party who will not be taxed on a particular amount, eg because it is a non-resident or because it has appropriate expenses or assessed losses to shelter the income) and various other criteria are present; or there are offsetting or self-cancelling elements where there is no substantial change in the economic position of one or more of the parties.An example given by SARS is the following, many holding companies have financed their subsidiaries by way of loans which do or could bear interest.
A bank, instead lends money at interest to the subsidiary (which interest will continue to be tax-deductible) and the subsidiary uses the proceeds to repay the holding company.The holding company then invests in redeemable preference shares issued by the bank.The dividends on the preference shares are only marginally lower than the interest paid by the subsidiary (because the bank is able to shelter the interest received and so pay most of it out as a dividend on the preference shares) and the preference shares would be pledged to the bank to secure the loan.
In this regard SARS would consider that there is round trip financing and that the transactions cancel each other out without any substantial change in the economic position of either the company or the bank (because repayment of the loan is dependant upon redemption of the shares and vice versa, and what is paid out in interest comes back in dividends).What SARS then might do is simply combine for this purpose the holding company and subsidiary.Then SARS would claim that all that has happened is that money has been borrowed from the bank to fund an investment in preference shares, resulting in a disallowance of the interest.
While one can have sympathy for SARS in finding the need to expand the scope of the GAAR, the new provisions are going to create a large measure of uncertainty when undertaking future deals.Part of the reason for this is that some new terms and descriptions have been enacted which are not used anywhere else in the Act (and have not been used in any other legislation) and have not been interpreted by the Courts.
Thus it is difficult to know precisely the reach of these terms.Also, some of the terms are colloquial in nature, making it even more difficult for a court to interpret, remembering that historically legislation is drafted in very precise legal terms. Examples of some of these new terms are as follows:SARS can determine tax consequences by "combining" a party with another.What exactly does this mean?
·An avoidance arrangement will lack commercial substance if it does not have a "substantial effect" (whatever this means) on business or commercial risks or on net cash flows.It is true that we speak colloquially of "cash flow" or "net cash flow", but this is a loose accounting or commercial term how will a court interpret it? And what is the difference between a business risk and a commercial risk?
·What does it mean when there are "elements" that are "canceling" or "offsetting" each other.In the example above, can it really be said that the issue of a preference share of f sets or cancels the loan?
Commercially maybe; legally - definitely not.
·The term "funds" is defined to include not only cash, but also "cash equivalents". It is true that this is a term used in financial statements, but how does a court interpret this? What is equivalent to cash?
·A person will be an accommodating or tax-indifferent party if the participation of that person could result in gross income being "shifted" to another party.Bearing in mind that to be gross income an amount must be received by or accrued to a person.How, having been so received or accrued, can it then possibly be "shifted" to someone else? Maybe what this really means is that there might be a transaction which has a similar result, for example, an expense, such as a management fee, which is charged against the income but is then taxed in someone else's hands.But this is not shifting gross income.
·Another indication would be if the character of an amount is "converted" from revenue to capital.To my way of thinking it is impossible to do this.Certainly one does use that term colloquially to achieve certain objectives.For example, if a foreign company is being wound up and the profits are being returned to the shareholders, what the shareholder receives is a taxable dividend which is revenue.
But if instead, prior to the distribution, the shareholder gets his or her money back by selling the shares to someone else, the receipt will be capital.Colloquially that may be converting revenue to capital, but certainly not legally, and a court's function is to interpret the law.And there are other such difficulties.No doubt in time these issues will be clarified as the court comes to grips with them.The problem is that it is likely to be at least ten years before the first case comes before the Supreme Court of Appeal.
And until then ….
Source: By Ernest Mazansky (TaxTALK)