Section 103(2) of the Income Tax Act, 58 of 1962 empowers the Commissioner (the “Commissioner”) for the South African Revenue Service (“SARS”) to disallow the setting off of an assessed loss or balance of an assessed loss against the company’s income if the relevant requirements are met. A recent Western Cape Tax Court decision, case no IT 13164, has again focused taxpayers’ attention on the requirements to be met in order for section 103(2) to apply. In this case, SARS relied on section 103(2) to disallow the set off of ABC (Pty) Ltd’s (“ABC’s”) assessed loss against income derived by ABC in respect of its 2005 to 2008 years of assessment.
Section 103(2) provides that whenever the Commissioner is satisfied that, inter alia:
- any agreement affecting any company or any change in the shareholding in any company;
- has been entered into or effected by any person solely or mainly for the purpose of utilising any assessed loss, any balance of assessed loss, any capital loss or any assessed capital loss, as the case may be, incurred by the company, in order to avoid liability on the part of that company or any other person for the payment of any tax, duty or levy on income, or to reduce the amount thereof;
- as a direct or indirect result of which income has been received by or has accrued to that company during any year of assessment; and
- the set-off of any such assessed loss or balance of assessed loss against any such income shall be disallowed.
Briefly, the facts in IT 13164 were as follows. ABC was incorporated during 2000 and its shareholder was DX Ltd, an Australian company. Prior to 2002, ABC had established a 120 seat call centre in Cape Town and used this to provide services to telecommunications companies. With effect from 2001, ABC terminated its cellular service provider contracts and disposed of its cellular phone subscriber base to telecommunications companies. This resulted in disputes between ABC and the telecommunications companies in respect of amounts ABC alleged were due to it. ABC still owned the call centre and was bound to the lease in respect of the call centre property.
DX Ltd (“DX”), wanted to sell the shares in ABC and on 1 March 2002, concluded an agreement with JK (Pty) Ltd (“JK”). The agreement was for the sale of the call centre but excluded the shares in ABC. In terms of an option granted to JK, once the disputes with the telecommunications companies had been resolved, JK concluded a sale of (ABC) shares agreement with DX on 5 March 2003. Prior to this, JK had already been searching for a buyer for ABC; it wanted to sell the call centre and lease 30 seats according to its needs.
The shareholder (“A”) of the H group of companies (“H”), had, since the late 1990s, envisaged establishing an enterprise providing business processing outsourcing services. H already had a fitment call centre in Johannesburg (“MNO branch”). A had various ideas for expanding the business process outsourcing model to other call centre areas. Among others, H envisaged providing processing services to its main competitor, VD and while the parties signed a memorandum of understanding in respect of a joint call centre, this did not materialise and H merely performed work for VD. For various commercial reasons, A was considering acquiring a separate call centre and expressed an interest in acquiring ABC’s Cape Town call centre.
During November 2003, H (through MM Investments (Pty) Ltd), acquired the shares in ABC, subject to a lease between JK and ABC in respect of 30 seats. H consolidated the MNO branch into ABC and used the Cape Town call centre for the processing of other claims.
Testimony on behalf of H was that the offer to purchase the ABC shares was based on sound commercial grounds, ie to acquire an established call centre which could give effect to A’s plan to expand the business process outsourcing model to other areas of call centre business, the lease agreement in respect of the Cape Town call centre premises, rental income from the 30 seats leased to JK and the assessed loss. While it was initially envisaged that H could use the Cape Town call centre for a joint venture with VD, as noted, this didn’t materialise.
When questioned about the motive for acquiring the ABC shares, it was agreed on behalf of JK that the primary financial gain for JK at that stage was the assessed loss and easy access to an established call centre. In terms of an earlier court order, the first change in shareholding (ie from DX Ltd to JK) is the relevant change in shareholding for purposes of the case before the Tax Court. The rationale for this order is not evident from IT 13164.
The court summarised the requirements to be met in order for section 103(2)(b) to apply, ie the Commissioner must be satisfied that:
- any agreement affecting a company (ABC) or any change in shareholding in a company (ABC) has been entered into. This requirement was met and the case was limited to the change in ABC’s shareholding from DX to JK
- the agreement or change in shareholding directly or indirectly resulted in income being received by such company, ie ABC (the “result requirement”)
- the agreement or change in shareholding was entered into solely or mainly for the purpose of utilising any assessed loss, any capital loss or any assessed capital loss (the “purpose requirement”)
“as a direct or indirect result”
In IT 13164, the court held that the result requirement is an objective requirement and that the unbroken chain and tainted income must be identified. Since the case is limited to JK’s acquisition of the ABC shares, the causal link between JK’s motivation for the acquisition and the income had to be established for purposes of section 103(2).
According to the court, “direct and indirect” must not be applied in isolation. The income which is derived by the taxpayer must result from the change in shareholding. It was stated that: “If the legislature intended it to be any remote cause, the section would have been expressed in manner [sic] which reflects that the income could derive from any cause whatsoever.”
Reference was made to ITC 1123 (31 SATC 48). In this case, a new shareholder acquired the shares in a company which was previously involved in the manufacturing industry. The manufacturing business was not revived but income from, inter alia, commission and interest was received. It was held that it is a question of fact whether a company has derived income “directly or indirectly” as a result of the change of shareholding. The company was an empty shell when the new shareholder acquired the shares. The shareholder then arranged financing and introduced a new and separate business. It was held that the income was derived as a direct or indirect result of the change in shareholding.
The court, in IT 13164, held that where the chain of causation is broken between the change in shareholding and the income being derived by the company, the income would not be as a result of the change in shareholding. In this regard, Allie J referred to the “novus actus interveniens” principle, ie, where a new intervening event interrupted the chain of causation.
It was held that in the case of ABC, the income was derived from a later, intervening event and that the income was not contemplated when JK acquired the shares. Allie J held that even if JK had acquired the shares with the intention of selling them to a new shareholder who could utilise the assessed loss, it could not be said that JK, when it acquired the shares, contemplated that the new shareholder would in fact have sufficient income to utilise the assessed loss.
“sole or main purpose”
In this regard, the court held that:
“Although the section refers to ‘any’ change in shareholding; ‘any’ proceeds, ‘any’ time, ‘any’ person, ‘any’ assessed loss ‘any’ such income, the section contemplates a causal link between the change in shareholding, the motivation for the acquisition of the shares by the person who seeks to utilise the assessed loss and the means by which that income came to be owned and declared by the taxpayer.
The more contentious aspect of the formulation is the motivation for the change in shareholding. Those taxpayer companies that can show a sound commercial purpose for the acquisition of the shares will have less difficulty in establishing that they don’t fall foul of the section.”
It was stated that had income been received or accrued to ABC when JK acquired the shares, JK would probably have fallen foul of section 103(2). However, since the income was derived from the efforts of H and after it had acquired the shares, it is the motivation of H in acquiring the shares that should be relevant in determining whether the anti-avoidance provision can be applied. The court referred to various facts and held that those facts supported the conclusion that the specific transaction had strong commercial substance as opposed to being an attempt to purely utilise the assessed loss of ABC.
In terms of section 103(4), the taxpayer bears the onus of proving or showing that the relevant agreement or change in shareholding was not entered into with the sole or main purpose of utilising an assessed loss to reduce, postpone or avoid tax.
In this case, the court was satisfied that ABC had discharged the onus of showing that the sole or main purpose of the change in shareholding to H was not to acquire ABC to utilise its assessed loss and held as follows:
“When the facts are considered in totality, then the H group’s vision and projected business plan dovetailed with the existing call centre business that the taxpayer company had been engaged in, prior to the acquisition of the shares in the taxpayer company”.
The case serves as a reminder that it remains a question of fact whether the requirements of section 103(2) will be met.