Tax accounting impact of enacted income tax measures
South Africa’s Supreme Court of Appeal (SCA) issued a decision ruling against the taxpayer on 15 October 2021 in the case, The Commissioner for The South African Revenue Service v Spur Group (Pty) Ltd., concluding that there was not a sufficiently close connection between the taxpayer’s contribution to a trust relating to the implementation of an employee share incentive scheme and its income-producing operations to qualify for a deduction under section 11(a) of South Africa’s Income Tax Act (ITA). The court also ruled that the South African Revenue Service (SARS) was not precluded from raising additional assessments in respect of the taxpayer’s 2005-2009 years of assessment by operation of the three-year statute of limitations (known as the “prescription” period in South Africa). The SCA overturned the previous decision of the Western Cape High Court, which ruled for the taxpayer.
Facts of the case
Spur Group (Pty) Ltd (Spur), the main operating entity in the Spur Group of companies, is a wholly owned subsidiary of Spur Corporation Limited (Spur Holdco). In 2004, the companies resolved to implement a new share incentive scheme to benefit Spur’s eligible employees (participants) and to promote Spur’s continued growth and profitability. Spur Holdco established the Spur Management Share Trust, a discretionary trust of which—significantly, as the SCA was to find in its decision—Spur Holdco was the sole capital and income beneficiary. The trust then established a newly incorporated company (Newco), and the participants were offered the opportunity to acquire ordinary shares in Newco at par value in proportions determined by Spur Holdco. The participants were not entitled to deal freely with the Newco shares for at least seven years. In December 2004, Spur concluded a contribution agreement with the trust, under which Spur contributed approximately ZAR 48 million to the trust. The trust used those funds to subscribe for preference shares in Newco. The dividend rate of the Newco preference shares was set at 75% per annum of the prime interest rate, which was a market-related preference dividend rate. The redemption date for the Newco preference shares was set at five years following their issue. Newco applied the ZAR 48 million to purchase approximately 8.3 million shares in Spur Holdco.
The rationale for structuring the scheme in this manner was that the participants would derive value from their ordinary shares only if and to the extent an increase in the market price of the Spur Holdco shares were to exceed the cumulative yield on the preference shares; in other words, 75% of the prime interest rate. The 75% rate, therefore, effectively operated as a benchmark against which the performance of the Spur Holdco shares would be measured for purposes of the scheme. It is not clear whether the SCA considered this rationale in reaching its decision.
During the operation of the share incentive scheme, Newco received dividends relating to its holding of the Spur Holdco shares and it retained the dividends to meet its cumulative preference share obligations towards the trust. In 2009, five years after their issue, the preference shares were redeemed for the ZAR 48 million subscription price, plus accumulated dividends. The redemption amount was settled by Newco’s distribution to the trust of approximately 6.7 million shares in Spur Holdco, shares that had a market value equal to the outstanding redemption amount. This left a “free” balance of about 1.6 million Spur Holdco shares (the 8.3 million shares originally acquired by Newco less the 6.7 million distributed), which Newco disposed of at market price. Using the proceeds, Newco declared dividends to its ordinary shareholders, the participants in the scheme. The share incentive scheme has since been terminated and Newco was deregistered in 2012, although the trust remains in existence and continues to hold the Spur Holdco shares that were distributed to it by Newco.
Spur claimed a deduction of the ZAR 48 million contribution based on ITA section 11(a), spread in terms of section 23H over the period of the anticipated benefit to be derived from the payment, for its 2005 to 2012 years of assessment. The Commissioner originally issued assessments allowing the deduction, but following an audit, additional assessments disallowing the deductions were issued in 2015.
Spur made various misrepresentations and nondisclosures in its income tax returns. For example, in its 2005 income tax return, it answered ‘no’ to questions relating to whether any deductions had been limited under section 23H, whether contributions had been made to a trust and whether the company had been party to the formation of a trust. In its 2006 income tax return, Spur answered ‘no’ to the question whether any deduction had been limited under section 23H. In each of the returns for 2005 to 2008, the deductions claimed in respect of the contribution which were limited by section 23H, were disclosed by Spur under the category “other deductible items” and not under the line item “prepaid expenditure (as limited by s23H).”
Whether Spur’s contribution was incurred in the production of its income
The basis for SARS’ disallowance of the deduction was that Spur’s contribution was not incurred in the production of its income in that “there is no direct, causal link between the contribution and the production of income.” The Commissioner’s reasoning was that Spur had made the contribution to the trust of which Spur Holdco was the sole beneficiary. Spur Holdco was the only party to have benefitted directly from the contribution to the trust in that it would receive the investment in the Newco preference shares. The trust also distributed the preference share capital and the preference shares dividends to its beneficiary, Spur Holdco. The participants were not the beneficiaries of the contribution. Therefore, according to the Commissioner, the relevant causal link was lacking.
The Commissioner did not allege that the contribution was disallowed on the grounds of it being capital in nature or that it was not laid out for purposes of Spur’s trade. The only question on the merits was whether the expenditure qualified for deduction on the basis that it had been incurred in the production of Spur’s income.
It is well-established that to determine whether expenditure was incurred in the production of a taxpayer’s income, the court has to examine the closeness of the connection between the expenditure and the taxpayer’s income-earning operations, having regard to both the purpose of the expenditure and what it actually affects. Hence, both the taxpayer’s purpose in incurring the expenditure (a subjective enquiry into the taxpayer’s aim or object in incurring the expenditure) and the actual effect or result of incurring the expenditure (an objective enquiry) must be considered in light of the taxpayer’s facts and circumstances.
The case went to the Tax Court, where the taxpayer prevailed, and then to the Western Cape High Court, which also ruled in the taxpayer’s favour. The majority in the High Court aligned themselves with the Tax Court findings that the purpose of the expenditure was to incentivise the taxpayer’s key staff through a scheme that facilitated the acquisition of an indirect investment in HoldCo’s shares for scheme participants and that the connection between the contribution and Spur’s income-earning operations was sufficiently close for the expenditure to be deductible. The majority also noted that it had not been suggested that the Spur Group, by making the ZAR 48 million contribution, was entering into a transaction that was disguised to make it appear something that it was not, in particular, with the purpose of evading tax or avoiding a peremptory rule of law. In other words, SARS had not argued that the substance-over-form doctrine should apply.
The SCA overturned the High Court decision on the grounds that the ZAR 48 million contribution did not itself serve to incentivise the participants since it was an amount that would never accrue to the participants. Instead, the contribution ultimately became available for the benefit of HoldCo as the capital beneficiary of the trust. The SCA found that the purpose of the expenditure was not to produce income but
“to provide funding for the scheme, for the ultimate benefit of Spur HoldCo. There was only an indirect and insufficient link between the expenditure and any benefit arising from the incentivisation of the participants. The contribution was therefore not sufficiently closely connected to the business operations of Spur such that it would be proper, natural and reasonable to regard the expense as part of Spur’s costs in performing such operations.”
Although the share incentive scheme was somewhat unusual in that Spur Holdco and not the participants was the income and capital beneficiary of the trust at the time the contribution was made, the SCA’s analysis is open to criticism. The fact that the ZAR 48 million would never accrue to the participants does not mean that the contribution did not benefit them. Without the contribution, there would have been no share incentive scheme and hence, no benefit to the participants. The contribution was thus necessary to bring about the share incentive scheme, the purpose of which was clearly to incentivise Spur’s management and hence, to benefit Spur. On this basis, it is submitted that the link between the contribution and the business operations of Spur was sufficiently close for the contribution to be in the production of Spur’s income and the SCA should have concurred with the High Court’s decision.
An interesting aspect to the SCA decision is that the court did not deal with the contradiction between its finding that the taxpayer’s purpose in making the contribution was to provide an ultimate benefit to Holdco and the stated purpose in the contribution agreement, which was to incentivise the participants. This is puzzling, given that the Commissioner had not alleged that the contribution agreement was a sham or designed to avoid/evade tax, and that the enquiry into the taxpayer’s purpose for incurring expenditure within the scope of the “in the production of income” test is a subjective enquiry into the mind of the taxpayer.
Statute of limitations issue
Since the SCA found that the contribution was not deductible based on section 11(a), the statute of limitations issue had to be decided.
Spur contended that the Commissioner was precluded from issuing the additional assessments by virtue of section 99(1) of the Tax Administration Act because those assessments were issued more than three years from the date of the original assessments. Section 99(1) states that the Commissioner may not make an assessment three years after the date of an original assessment by SARS, unless the fact that the full amount of tax chargeable was not assessed was due to fraud, misrepresentation or nondisclosure of material facts.
Although Spur clearly had made misrepresentations and nondisclosures in the relevant tax returns, Spur argued that these statements were negligently and inadvertently made. It also asserted that the Commissioner had failed to establish the required nexus between the incorrect statements in the returns and the failure by the Commissioner to charge the full amount of tax during the three-year period. No SARS official applied his or her mind to the assessments and no audit was performed within that period. Furthermore, it was not the errors in the returns that caused SARS to allow the deductions claimed, but rather the decision by SARS not to consider the tax returns and Spur’s annual financial statements, which were filed with the returns, which Spur argued should have raised red flags and led to an audit.
The SCA was scathing in its criticism of Spur’s assertion that the wrong entries in the tax returns were negligent and inadvertent, which it described as “patently false.” The court found the answer ‘no’ to the questions whether contributions had been made to a trust and whether the company had been party to the formation of a trust, to be a misrepresentation and found it striking that these incorrect answers were repeated. It also found that it “simply boggles the mind” that Spur answered ‘no’ to the questions regarding section 23H for each from 2005 to 2009 and that Spur’s inclusion of deductions limited by section 23H in a general line item was a deliberate misrepresentation and a nondisclosure of material facts.
The SCA dismissed Spur’s argument that the Commissioner had all the relevant and correct facts because Spur’s annual financial statements were submitted with the tax returns and that the correct information could be distilled from them as “unhelpful.” It stated that “the mere fact that an astute auditor or assessor could have been able to ascertain from supporting documentation the fact that the return contains a misrepresentation, cannot mean that there is no misrepresentation in the first place.”
In approaching the question whether SARS had discharged its burden to show that the nonassessment within the three-year period was the result of the misrepresentations and nondisclosures, the SCA considered SARS’ relevant internal processes in the years in question in relation to the making of original and additional assessments. A senior manager in SARS’ Large Business Centre testified at trial that SARS accepts a tax return at face value and issues an assessment without human intervention. SARS only takes the tax return, and not supporting documents or schedules, into account for purposes of issuing an original assessment. The SCA found that the issue of face value assessments was a recognised and accepted practice.
The SCA concluded that it was clear that the integrity of the SARS assessment process depends largely on the accuracy of the information provided in a return. Since the senior manager testified that typically in a day, over 100,000 returns would be received at SARS, it was not possible for the auditors to perform a manual check of every return to ensure that it did not contain errors. Instead, the tax return contains various specific questions that function as “triggers” that would lead to further steps being taken to either resolve the matter at that stage or proceed to an audit. A ‘yes’ answer to the section 23H question and to the question whether a contribution was made to a trust were, according to the senior manager’s testimony, risk factors that would have triggered a risk alert for SARS.
The SCA found that the senior manager’s testimony made sense and that a face value assessment process was “understandably” undertaken by SARS. It added that as a matter of policy, a court would be loath to come to the assistance of a taxpayer that had made improper or untruthful disclosures in a return, which would offend against the statutory imperative of making a full and proper disclosures. Accordingly, the SCA found that Spurs’ misrepresentations and nondisclosures caused the Commissioner not to assess Spur correctly within the three-year statute of limitations period.
Although in this case the SCA determined that Spur had deliberately misrepresented certain facts and had not disclosed others and, therefore, was unlikely to find in its favour on the statute of limitations issue, the SCA’s acceptance of a face value assessment process in which no supplementary information is considered at the assessment stage may prove problematic for taxpayers in other circumstances. The questions asked of taxpayers in tax returns do not cover every possible circumstance. Also, it is not always clear how to answer certain questions in a given situation. Taxpayers in these situations, or those with complex tax issues that make disclosures that are supplemental to the income tax return, may be at risk of a court finding, based on the approach in this case, that the statute of limitations period did not begin to run at the time of the initial assessment. This is because it may be found that SARS was justified in issuing face value assessments based only on the information and responses to questions provided by the taxpayer in the return itself. If the information and responses do not trigger a risk alert, SARS may be justified in not investigating the taxpayer’s affairs within a three-year period.
The share incentive scheme implemented by Spur was somewhat unusual in that Spur Holdco rather than the participants was the income and capital beneficiary of the trust at the time the contribution was made to the trust. Had the scheme been structured such that the participants and not Spur Holdco would share in the amount contributed to the trust, the contribution would likely have been allowed as a deduction. Nevertheless it is, with respect, submitted that the SCA should still have found that the contribution was in the production of Spur’s income.
Taxpayers should take note of the importance of providing accurate information and answers to questions in tax returns for prescription to apply. It is clear that the taxpayer’s reliance on disclosures in annual financial statements submitted with the tax return is insufficient for prescription to apply if the tax return itself is materially incorrect.