In a unanimous judgment of the Cape Town Tax Court, delivered on 9 May 2018, it was held that a contribution of some R48 million by the taxpayer to a trust, used to facilitate a share incentive scheme for the taxpayer’s managerial staff, was deductible by the taxpayer. The pivotal issue in dispute was whether or not the contribution was in fact made in the production of income of the taxpayer, a requirement of the general deduction formula.
The facts of the matter were as follows. The taxpayer is one of a group of companies, a subsidiary of the group’s holding company which is listed on the JSE. In late 2004 the holding company established a discretionary trust which then acquired a shelf company, NewCo. The employees were offered, and took up, ordinary shares in NewCo at their par value. The employees could not dispose of their shares in NewCo for at least seven years otherwise the shares would be forfeited. The trust and the taxpayer then entered into a contribution agreement in terms of which the taxpayer contributed R48 million to the trust and the trust subscribed for preference shares in NewCo for the same amount. NewCo used this money to acquire shares in the holding company. The preference shares were redeemable after 5 years and had a coupon rate attached to them. After 5 years had lapsed the value of the shares in the holding company had increased to such an extent that their value far exceeded that of the preference share liability. In 2009 the preference shares were redeemed for R48 million and dividends accruing on the preference shares, some R22 million, were declared to the trust. A dividend of R28 million was, at the same time, declared by NewCo. The redemption and payment for the preference share dividends was realised by NewCo by transferring shares in the holding company of equivalent value to the trust. Thereafter the employees were the only shareholders in NewCo and in December of 2009 NewCo disposed of the remaining shares for R16 million. The dividend of R28 million was then paid to the employees by NewCo. The preference share dividend of R22 million vested in the holding company, as sole beneficiary of the trust, but was never paid to the holding company and a loan of the same amount was recorded in the financials as being payable to the holding company. After termination of the scheme NewCo was deregistered in 2012. It was undisputed that the taxpayer was never repaid the contribution of R48 million.
The taxpayer claimed the contribution of R48 million as a deduction against taxable income, spread over the period of the anticipated benefit (i.e. 2005 to 2012). Initially SARS allowed the deductions but then raised additional assessments in 2014 and 2015.
SARS disallowed the deductions on the basis that ‘…the expenditure was not incurred in the production of [the taxpayer’s] income in that there is no direct, causal link between the contribution and the production of income.’ The premise of their argument being that the taxpayer made the contribution to the trust of which the holding company was the sole beneficiary at the time and consequently was the only party to have benefited directly from the contribution made by the taxpayer. The employees were not, in the view of SARS, the beneficiaries of the contribution. However, during the proceedings SARS accepted that a direct or causal link between the contribution and the production of income is not the test; rather it is that there must be a sufficiently close connection between the expense and the income. It is the purpose of the expenditure, from the perspective of the taxpayer, that must be considered, together with what that expenditure actually effects.
Based on previous case law the Tax Court found that it is not necessary for the taxpayer to show that the particular item of expenditure produced any part of the income for the given year of assessment. As long as the taxpayer can show that the purpose of the expense was to produce income, any accompanying benefit to a third party or the realisation of other possibilities does not serve to preclude the legitimate deduction of the expense.
Both of the taxpayer’s witnesses, a tax partner at KPMG and the chief financial officer of the taxpayer, accepted that the employees did not benefit directly from the R48 million paid to the Trust, but emphasised that this had never been the purpose of the scheme. The contribution was a funding mechanism only. In paying the contribution it was the taxpayer’s purpose, as chief operating arm of the group, to incentivise its key management personnel by enabling them to participate indirectly in the growth of the holding company’s shares. It was the contribution that enabled the taxpayer to retain dedicated employees, with an incentive to maintain their allegiance to their employer, and from which they ultimately benefited from the dividends paid to them from the share scheme mechanism.
The fact that the taxpayer anticipated that the holding company would potentially also benefit from the redemption of the preference shares could not, according to the Tax Court, negate the taxpayer’s purpose and intention, which was actually effected by the scheme insofar as the value of the NewCo shares increased significantly, and this benefit, together with the dividends declared by NewCo on the remaining holding company shares following the preference share redemption, actually accrued to the scheme participants. The increase in the value of the holding company shares was directly attributable to the increase in the turnover and profits of the taxpayer.
The fact that 26 key staff were participants in the scheme and only 3 left the taxpayer’s employ during the period of the scheme left the Tax Court to infer that the employees were indeed incentivised by the scheme. Even though the contribution remained under the control of another entity in the group this did not detract from the purpose for which that expenditure was incurred by the taxpayer, namely the production of income.
On the evidence presented, the Tax Court found that the taxpayer’s dominant purpose in setting up and implementing the scheme was to protect and enhance its business and its income. The taxpayer had shown the existence of a sufficiently close causal link between its expenditure and its income producing operation and the additional assessments were set aside.
SARS has in the past issued binding private rulings to the effect that that an employer’s contributions to share incentive trusts would be allowed as a deduction. SARS seemed happy to accept that the purpose of the payments in those instances (made at inception) was to enable the trusts to offer shares designed to give employees an incentive to remain in the company’s employ.
What can be taken away from decision is that a taxpayer bears the onus of being able to demonstrate that the purpose behind any payment made to enable a share incentive scheme must be connected closely enough to its business operations in order to claim a deduction. The taxpayer in this instance was able to do just that despite the fact that the employees did not benefit directly from the initial contribution and the holding company itself would potentially also benefit from the redemption of the preference shares. Each matter will be determined on its own facts. In deciding on a costs order to be made in the matter the Tax Court did not find SARS position to be unreasonable, recognising that each matter is very fact specific and the facts of this matter did not lend itself to an easy answer.