The Supreme Court of Appeal delivered judgment on 10 May 2011 in the case of Founders Hill (Pty) Ltd v the Commissioner for the South African Revenue Service (Case No. 509/10) (as yet unreported) which dealt with the capital versus revenue nature of proceeds received by a realization company that acquires land in order to dispose of it.
The leading commentators on tax in South Africa have previously expressed the opinion that where a company acquires an asset with the purpose of reselling it, the proceeds so realized constitutes income liable to tax with the only exception relating to so-called realization companies, which companies are not created in order to dispose of assets as part and parcel of a scheme of profit making. In Founders Hill, the company was created for the purpose of realizing land formerly owned as a capital asset by its holding company, namely AECI Limited. When a company is referred to as a realization company it generally means a company that has been created to facilitate the disposal of property and the company does no more than to realize the asset owned by it. Generally, the view was taken that surpluses realized from sales of property by a realization company are not taxable on the basis that the proceeds received are capital in nature.
The Commissioner: SARS in the Founders Hill case contended that the company had crossed the Rubicon when it sold the land on which it realized surpluses. The company on the other hand argued that it had merely realized a capital asset to best advantage and that the proceeds constituted a receipt of a capital nature and that no tax was payable on the basis that the proceeds were realized prior to the introduction of capital gains tax.
The Court took the view that Founders Hill had acquired the property from AECI for the purpose of developing the land and reselling it. Originally, the Commissioner: SARS did not assess Founders Hill to tax on the profits made on the land disposed of. However, it subsequently issued revised assessments subjecting those profits to tax. The Commissioner also imposed interest on the under payment of provisional tax in terms of section 89quat of the Income Tax Act No. 58 of 1962 as amended, (“the Act”).
Founders Hill objected to the assessments issued to it on the basis that the proceeds of the sales were capital in nature and proceeded on appeal to the Tax Court once the Commissioner disallowed its objection. The Tax Court upheld the appeal lodged by Founders Hill.
The Tax Court held that Founders Hill had acquired the land as a capital asset and that it did not change its nature by the time that it was sold and thus the capital gain realized was not taxable.
AECI Limited had owned the land in excess of its requirements for some time and in 1989 it was recommended that a strategic plan, which had been developed, be accepted, namely, that AECI makes the decision to sell or develop the land and commence the process to do so.
As a result of this decision Founders Hill (Pty) Ltd was created as a wholly and subsidiary of AECI to acquire the land from AECI and to realize that land to best advantage.
Founders Hill itself had no employees and its sole shareholder was AECI and its directors were those of AECI. The land located at Founders View was subdivided and developed by AECI before being transferred to Founders Hill and the profits accrued to Founders Hill. Founders Hill argued that it always intended to realise the land held by it as a capital asset and submitted that it was entitled to realize an asset to best advantage. The Court was thus required to determine whether Founders Hill realized the land owned by it to best advantage or whether it embarked upon the business of selling land. The Commissioner relied on Natal Estates Ltd v Secretary for Inland Revenue 37 SATC 193 where the Special Income Tax Court found that the company had traded in land and dismissed the appeal against the assessment. In the Supreme Court of Appeal it was decided that the taxpayer had changed its intention and that it had become a dealer in land and was thus taxable on the income that it realized from trading therein.
In Founders Hill the Commissioner argued that the company had crossed the Rubicon and thus any surpluses realized on the disposal of the land owned by it constituted income liable to tax. The Tax Court, however, held that the Rubicon had not been crossed and that the surpluses realized on the disposal of land was capital in nature. Lewis JA pointed out that Founders Hill was created as a “realization company” on legal advice and that by acquiring the land from AECI and realising same to best advantage it should not cross the Rubicon. The Court pointed out that the difficulty that Founders Hill faced was the fact that it acquired the land from AECI with the intention of disposing of that land at a profit. The judgment contains an analysis of the tax treatment of realization entities and particularly the decision of the Court in Berea West Estates (Pty) Ltd v Secretary for Inland Revenue, 38 SATC 43. In that case, the profit realized on the disposal of land by a company formed for the purpose of realising land held by different family members was held to be capital in nature.
In Berea West, Holmes JA referred to the cases relied on by the editors of Simon’s Taxes in reaching the opinion that where a company is formed for the purpose of facilitating the realization of property and the company does no more than acts as the means whereby the interest of its shareholders may be properly realized in the property, such surpluses are capital in nature and thus not liable to tax. In the Berea West case the Court concluded that the company had not traded in land and was therefore not taxable on the surpluses realized by it on the sales of land over time. In Berea West, the company was created for the purpose of realizing assets for the benefit of various beneficiaries and not for a single shareholder as was the case in Founders Hill.
Lewis JA noted that where an interposed realization company will be treated as holding assets acquired by it as capital assets from the seller in special circumstances as set out in Berea West’s case and not merely where the realization company acquires property for the avowed purpose of disposing of same at a profit.
The Court, in distinguishing the decision of the various cases dealt with by it on realization companies made the point that where a real justification exists for the formation of the realization company or trust, the proceeds received on disposal of the property should be regarded as capital in nature. Where, for example, more than one person transfers assets to the interposed entity, that is the realization vehicle and without the interposition of a company or trust it would have been difficult to realize the assets, the proceeds on sale of such assets should constitute a receipt of a capital nature.
It was pointed out by the Court that the fact that Founders Hill stated that it had acquired the properties from AECI as capital assets did not mean that they were in fact capital assets for tax purposes. Founders Hill was created to develop the land owned by it and to sell it. The Court therefore held that the surpluses realized by Founders Hill on the disposal of the land represented profits made as part of a scheme of profit making and therefore revenue derived from capital productively employed and was therefore liable to tax. Lewis JA held that Founders Hill had acquired the land from AECI as stock in trade and then conducted the business of trading in that property and that the surpluses realized were taxable as income. The Court therefore confirmed the Commissioner’s assessments issued for the years in question.
The Court was also required to consider the imposition of interest on the underpayment of provisional tax in terms of section 89quat of the Act. The Court referred to the fact that Founders Hill had acted on legal advice and in the mistaken belief that it disposed of its property as a capital asset as a realization company should not give rise to the imposition of penalty interest on the underpayment of provisional tax. Thus, the Court directed that the Commissioner must waive the interest levied on the underpayment of provisional tax. Unfortunately, the provisions of section 89quat have been amended such that the Commissioner’s discretion to waive the interest on the underpayment of provisional tax has been significantly narrowed. The section now requires that the Commissioner must have regard to the circumstances of the case and must be satisfied that the interest payable under section 89quat (2) arises as a result of circumstances beyond the control of the taxpayer and not that the taxpayer acted reasonably. It is therefore far more difficult currently for taxpayers to motivate a waiver of interest on the underpayment of provisional tax than what was previously the case.
It was pointed out above that the Founders Hill case dealt with a tax dispute which arose before the introduction of capital gains tax, in South Africa. Prior to the introduction of capital gains tax the proceeds realized on the disposal of an asset would either constitute an amount of a revenue nature liable to tax or capital in nature and therefore not liable to tax. When capital gains tax was introduced during 2001 amendments were introduced to the law to cater for the situation where assets held by a person as a capital asset become trading stock. In effect the value of the asset up to the date on which the item became trading stock would be treated as capital in nature and any excess received thereafter would be taxable as income. Thus, had capital gains tax been in force at the time that AECI Limited proposed to deal in the land owned by it, it may have been possible for AECI Limited to argue that a certain of portion of the value attributable to the fixed property constituted an amount of a capital nature subject to capital gains tax and not income tax by virtue of the provisions contained in paragraph 12 of the Eight Schedule to the Act.
The fact that a taxpayer owning property transfers that property to a realization company will, based on Founders Hill and other cases cited in the judgment, not automatically mean that the proceeds received by the realization company on the sale of that property constitutes a receipt of a capital nature.