In the recent case of Commissioner for the South African Revenue Service v Digicall Solutions (Pty) Ltd,(1) the Supreme Court of Appeal (SCA) was requested to consider whether the commissioner for the South African Revenue Service was correct in disallowing the use by Digicall Solutions (Pty) Ltd (the taxpayer) of certain assessed losses under Section 103(2) of the Income Tax Act (58/1962).
To determine a taxpayer's income from its trade, Section 20(1) of the act provides that the taxpayer may offset:
- a balance of the assessed loss brought forward from the previous assessment year; and
- any assessed loss incurred in the current year in carrying on any other trade.
The following requirements must be met for a taxpayer to offset an assessed loss against taxable income:
- the taxpayer must be carrying on a trade;
- the assessed loss may be offset only against income derived from its trading activities; and
- the taxpayer can carry forward only its assessed loss from the immediately preceding assessment year if it carried on a trade during the current assessment year.
Section 103(2) of the act is an anti-avoidance provision which essentially allows the commissioner to disallow the offsetting of an assessed loss or balance of an assessed loss against a taxpayer's income where certain requirements are met. More specifically, Section 103 deals with transactions, operations or schemes which have been entered into to avoid or postpone liability for or reduce amounts of taxes on income and provides that the commissioner must disallow any assessed loss if they are satisfied that:
- any agreement has been concluded affecting any company or that a change in the shareholding of a company has taken place;
- as a direct or indirect result of the above, income has been received by or accrued to that company during the assessment year; and
- the agreement was concluded or the change in the shareholding effected solely or mainly for the purpose of using any assessed loss incurred by the company to avoid or reduce any tax liability.
The tax avoidance as opposed to taxation nature of Section 103 of the act was explained in Glen Anil Development Corporation Ltd v Secretary for Inland Revenue,(2) in which the court held that:
Section 103 of the Act is clearly directed at defeating tax avoidance schemes. It does not impose a tax, nor does it relate to the tax imposed by the Act or to the liability therefor or to the incidence thereof, but rather to schemes designed for the avoidance of liability therefor. It should, in my view, therefore, not be construed as a taxing measure but rather in such a way that it will advance the remedy provided by the section and suppress the mischief against which the section is directed… The discretionary powers conferred upon the Secretary should, therefore, not be restricted unnecessarily by interpretation.
Section 103(4) of the act, which imposes the onus of proof on taxpayers, provides that when it is proved that an agreement or change in shareholding has resulted in the avoidance or postponement of liability for payment of any tax or in the reduction of the amount thereof, it will be presumed that the agreement or change in shareholding was entered into or effected solely or mainly for the purpose of using any assessed loss to avoid or reduce any tax liability. It follows therefore that taxpayers bear the onus of rebutting the above-mentioned presumption by proving that an agreement or change in shareholding was entered into or effected for a commercial objective and not solely or mainly to avoid or reduce any tax liability.
The taxpayer, a South African-resident company and wholly owned subsidiary of an Australian company, established a call centre facility in Cape Town, which sold cellular network service provider contracts for two cellular network providers to customers. In December 2001 the taxpayer, which had an assessed loss of approximately R48 million, terminated its service provider contracts and disposed of its subscriber bases (which were its main source of business) to the two cellular network providers.
To create an exit event for the Australian shareholder that wished to disinvest from South Africa, it was proposed that investment company Global Capital would acquire the shares in the taxpayer and provide services to a rival cellular network provider. During the financial and legal due diligence commissioned by Global Capital in relation to the taxpayer, it was revealed that one of the cellular network providers had instituted proceedings against the taxpayer. As a result, Global Capital could not take over from the taxpayer. As Global Capital had always intended to buy the shares in the taxpayer directly, it was decided that Global Capital would set up a new company for this purpose.
Global Capital acquired a shelf company, Selldirect Marketing Pty Ltd (SDM). The plan was for SDM to acquire the taxpayer's assets and employees and take over the lease in respect of the call centre. In addition, SDM would be granted the option to acquire all of the shares in the taxpayer, to be exercised once the litigation had been resolved. The option would endure for 18 months from the date of the sale agreement, the purchase price being the par value of the shares. Based on the evidence presented to the SCA, SDM was aware of:
- the taxpayer's assessed loss in respect of the tax year ending 30 June 2001, which had not yet been assessed; and
- the fact that under Section 20 of the act, any assessed loss could be carried forward only to a future assessment year, in which the company in question (ie, taxpayer) traded. Accordingly, to use the assessed loss, the taxpayer would "have to be brought back from the grave and start trading again".
SDM conducted the taxpayer's business in Cape Town and took over its lease. Once SDM started conducting the business, it reportedly realised that the facilities in the call centre exceeded what was required by SDM. Consequently, SDM decided that it would need to sell the call centre and lease back only the facilities that it required (ie, 30 out of the 120 seats available in the call centre) from the relevant purchaser. Global Capital initiated the sale process of the taxpayer and the call centre and was in discussions with Glasfit. Glasfit, together with its rival PG Glass, was looking to set up a business process outsourcing venture which would require a call centre. Glasfit made multiple offers to SDM for the acquisition of the taxpayer and the call centre; however, SDM did not accept these on the basis that the offers substantially undervalued the taxpayer.
Having ensured that the taxpayer was trading on 30 June 2002 the assessed loss was carried forward to the 2003 assessment year. SDM then exercised the option to purchase all of the shares in the taxpayer on 19 September 2002 although, at such time, there was nothing left in the taxpayer other than the assessed loss. Notably, although the option was exercised on 19 September 2002 SDM did not purchase the shares by way of a formal agreement until 5 March 2003. A further agreement was concluded on 7 May 2003 between SDM and the Taxpayer, under which the taxpayer reacquired its business from SDM.
SDM and Glasfit resumed negotiations for the sale of the shares in the taxpayer and on 3 October 2003 SDM accepted Glasfit's offer to acquire the shares in the taxpayer. The sale agreement was concluded on 25 November 2003.
Between 2004 and 2008, Glasfit was able to inject income from the venture located in the consolidated call centre into the taxpayer, enabling the taxpayer to use its existing assessed loss.
In November 2010 the commissioner issued additional assessments against the taxpayer, in respect of the 2005 to 2008 income tax periods, disallowing its use of the assessed loss, under Section103(2) of the act. The taxpayer lodged an objection, which was disallowed by the commissioner. The taxpayer appealed to the Tax Court.
The taxpayer contended that the income injected by Glasfit and received after the second change in shareholding (ie, when Glasfit had purchased the shares in the taxpayer from SDM), was beyond the scope of Section 103(2) of the act, as this income had not resulted directly or indirectly from the first change in shareholding (ie, when SDM had acquired the shares from the Australian shareholder). More specifically, the taxpayer provided that the income against which the assessed loss had been offset by the taxpayer in the 2004 to 2008 tax years had resulted directly or indirectly from the second change in shareholding, upon which the commissioner could not rely.
The commissioner was of the view that if the taxpayer's contentions were to be followed, taxpayers could artificially effect more than one change in shareholding to circumvent the provisions of Section 103(2) of the act. It was submitted that to permit such an interpretation "would be contrary to the principle that the subsection should be considered in a manner that advances the remedy and suppresses 'trafficking' in shares of companies, with assessed losses".
The Tax Court found that the first change in shareholding had not directly or indirectly resulted in income being received by or accruing to the taxpayer. The Tax Court submitted that the income had not been derived from the first change in shareholding, but rather from a later intervening event (ie, the second change in shareholding). Further the income had not been contemplated when SDM acquired the shares from the Australian shareholder. The Tax Court, while referencing the breaking of the chain of causation referred to in delictual cases as a nova causa interveniens, reasoned that the income had not been the result of the first change in shareholding.
Accordingly, the Tax Court granted an order setting aside the assessments and referred the matter back to the commissioner for reassessment on the grounds that the taxpayer was entitled to offset the assessed loss against its income during the relevant years. The commissioner appealed against this decision to the full court of the Western Cape Division of the High Court.
Similar to the Tax Court, the High Court found that the first change in shareholding had not directly or indirectly resulted in any income being received by or accruing to the taxpayer. The High Court was even more explicit in its reliance upon the delictual test of causation, concluding that although the first change in shareholding may have been the sine qua non of the taxpayer's receipt of income, it was not the causa causans. The High Court concluded that the second change in shareholding which was the effective cause and dismissed the appeal with costs on the grounds that the requirements of Section 103(2) of the act were not satisfied.
The SCA provided that Section 103(2) states that a change in shareholding must result, directly or indirectly, in income being received by or accruing to the taxpayer during any assessment year. Finding in favour of the commissioner, the SCA held that:
The direct or indirect receipt of income by the taxpayer does not have to occur in the same tax year as the change in shareholding of the taxpayer. It may occur in any year of assessment, provided it results directly or indirectly from the change in shareholding.
The first change in shareholding therefore resulted indirectly in income being received by or accruing to the taxpayer during the 2005 to 2008 years of assessment. The Commissioner was accordingly correct in concluding that the provisions of s103(2) of the Act were satisfied and in disallowing the taxpayer's claim to set-off the assessed loss against such income, during these years of assessment.
It is evident that the determination of whether an assessed loss is used to reduce or avoid tax is an entirely factual enquiry. Accordingly, the necessary evidence (eg, board minutes, correspondence and other documentation) to support the commercial objective must be documented.
For further information on this topic please contact Gigi Nyanin at Cliffe Dekker Hofmeyr by telephone (+27 115 621 000) or email (firstname.lastname@example.org). The Cliffe Dekker Hofmeyr website can be accessed at www.cliffedekkerhofmeyr.com.
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