It is a general principle of South African income tax that a taxpayer is taxed on the receipt or accrual of an amount. However, it is often necessary and equitable to take into account certain events arising subsequent to the accrual of an amount in pursuance of the disposal of an asset for capital gains tax (CGT) purposes.
One such example is where two parties who enter into a contract for the purchase and sale of a certain asset at a certain price, subsequently amend the terms, resulting in a variation of the proceeds received on the disposal of the subject asset, notwithstanding the fact that such amount has already accrued to the disposing party. Logic dictates that there must be a mechanism in order to cater for such a scenario, so that the taxpayer is not subject to tax on amounts, that are never actually received. Paragraph 35(3)(c) of the Eighth Schedule to the Income Tax Act, No 58 of 1962 (Act) attempts to provide for such a scenario. The tax court recently handed down an interesting judgment on this issue (case no. 13935, 14 December 2016, as yet unreported) (Case).”
Facts, issues and judgment of the tax court
In short, the following facts were before the court:
· on 10 August 2010, the taxpayer disposed of shares it held in D Ltd in the open market in terms of a sale agreement;
· the proceeds derived from the sale were paid in full by the relevant purchasers in the market and received by the taxpayer’s stockbrokers on its behalf;
· on 7 December 2010, the money held on the taxpayer’s behalf was transferred to a certain entity located in the United Arab Emirates (UAE);
· this transfer was undertaken against the taxpayer’s will, in what appeared to be a misappropriation of the funds.
Under the circumstances, the taxpayer argued that paragraph 35(3)(c) of the Eighth Schedule to the Act (Eighth Schedule) should apply, with the result that the proceeds derived from the sale of the shares should be reduced by the amount allegedly embezzled. In short paragraph 35(3)(c) sets out certain circumstances in which proceeds may be reduced. It provides as follows:
The proceeds from the disposal, during a year of assessment, of an asset by a person, as contemplated in subparagraph (1) must be reduced by — (c) any reduction, as the result of the cancellation, termination or variation of an agreement or due to the prescription or waiver of a claim or release from an obligation or any other event during that year, of an accrued amount forming part of the proceeds of that disposal. [Our emphasis]
The main issue before the court, was the meaning and ambit of the words “or any other event” as it was common cause that there was no cancellation, termination or variation of the sale agreement nor was there prescription or the waiver of a claim or a release of an obligation.
The court first referred to a previous case, namely ITC 1880 78 SATC 103 which also dealt with the application of paragraph 35(3)(c) of the Eighth Schedule, in which Wepener J held that a narrow interpretation should be given to the words “or any other event” to denote similar categories as those expressed by the preceding words in the paragraph. In particular, Wepener J relied upon the eiusdem generis rule which is sometimes expressed as the latin maxim noscitur a sociis, which in essence means that the measuring of a word may be ascertained by reference to those associated with it. In other words the all-encompassing general words take their meaning and colour from the other specific words associated or linked to it. On this approach, the court held that while “any” may indicate a broad and unlimited term, in the specific instance it was limited to two broad categories, namely the changing of terms to the sale agreement, or where a person is released from an obligation.
The court in the Case agreed with the narrow interpretation given the words “any other event” in ITC 1880 and accordingly held:
Having regard to the context in which the words are used and their clear purpose, it is sufficient to establish that the words apply to situations where the purchaser of an asset is partially or wholly released from the obligation to pay for the asset disposed of. Ultimately, the words were not intended to apply to an embezzlement of the nature alleged in this case, for the reasons stated herein. The set–off or deduction contemplated is one which flows as a consequence of extinguishing the taxpayer’s right to receive payment and the payee’s obligation to pay. The relevant nexus is to the event that causes such extinguishing not, to a subsequent unrelated event caused by a person who held no obligation to pay for the asset disposed of and who acted outside the agreement to dispose of the asset. The nexus cannot be a broad and vague one between the accrual and the deduction’s event, irrespective of how remotely it is connected to the failure to actually retain/receive the funds. If the legislature intended a deduction to be available for any unrelated reason, that would have the consequence of a reduced payment, it would have expressed itself in words conveying that meaning.
Allie J thereafter expressed that the purpose behind paragraph 35(3)(c) of the Eighth Schedule was to provide relief in the form of a deduction from the proceeds of a disposal of an asset in certain circumscribed instances. The particular instance he had in mind was where proceeds had not been paid but had already accrued to the taxpayer, yet the provision for payment of the funds cancelled. In summation, the facts did not fall within the ambit of paragraph 35(3)(c) of the Eighth Schedule due to the fact that the funds were already received by the taxpayer and furthermore, the alleged embezzlement was committed by a party that was unrelated to the transaction for the disposal of shares.
It is clear that the courts have thus far been loath to extend the meaning of the words “any other event” as an all-encompassing phrase. Importantly, “any other event” not only envisages an event which falls within the two broad categories first introduced in ITC 1880, but there must also be a link or causal nexus between the reduction of the proceeds and the taxpayer’s right to receive payment (or conversely the purchasers obligation to make payment).
What is interesting to note, is that the judgment is silent on whether the taxpayer could claim an ordinary capital loss which would have placed him in a similar tax position, notwithstanding the non-application of paragraph 35(3)(c) of the Eighth Schedule. Perhaps, the hurdle in that regard was that there was in essence a loss of cash which does not fall within the meaning of “asset” in the Eighth Schedule thereby prohibiting the taxpayer from a claiming a capital loss. Having said that, Interpretation Note No. 80 issued by the South African Revenue Services (SARS) in November 2014 states as follows in respect of the potential loss of a capital nature:
In contrast [to cash/currency], a bank account is an asset for CGT purposes, being a debt claim against the bank. It follows that embezzlement, fraud or theft involving a bank account may give rise to a capital loss assuming that it does not represent a loss of floating capital allowable under s11(a). To the extent that the expenditure on the bank account is allowable under s11(a) it will result in the reduction in the base cost of the bank account under paragraph 20(3)(a) of the Eighth Schedule. Similarly, the expenditure on the bank account must be reduced under paragraph 20(3)(b) of the Eighth Schedule by any portion of that expenditure that has been recovered or has become recoverable from any other person (for example, the thief or an insurer).
Ultimately, however, it appears the taxpayer in this Case not only paid tax on the disposal of his shares, but also suffered a loss of his after-tax profit which could not have been compensated for by allowing a reduction of proceeds or the claiming of a capital loss. Nevertheless, issues often arise subsequent to entering into transactions, which require the technical application of certain tax rules. In particular, the cancellation of contracts may result in certain unintended consequences. The Taxation Laws Amendment Act, 2015 (TLAA 2015) introduced several new rules in respect of the cancellation of contracts in an attempt to deal with some of the anomalies arising in practice. In particular, the TLAA 2015 introduced the following:
· A new non-disposal event was introduced in the form of para 11(2)(o) which applies when a sale is cancelled in the same year of assessment.
· Paragraph 20(4) was introduced to reinstate the base cost when the sale is cancelled in a subsequent year of assessment. In addition, to reflect actual economic value/expenses incurred post entering into the contract, the base cost of the asset reacquired will take into account any subsequent expenditure incurred by the new owner as allowed under paragraph 20 of the Eighth Schedule.
· Further additional paragraphs 3(c) and 4(c) were included in the Eighth Schedule to reverse the original capital gain or loss in the year of cancellation.
It is therefore vital to carefully consider the specific facts and circumstances in each case in order to ensure that no unintended consequences arise in the hands of taxpayers while undertaking sale transactions.