Companies in business rescue often have built-up assessed losses for tax purposes. Competitors wishing to take over the business of the company in business rescue would often view such assessed loss as a valuable asset, in addition to other valuable assets that the distressed company may have.
However, an assessed loss cannot be sold and purchased like other assets, for example, property, plant and equipment. The reason being that the assessed loss by its very nature attaches to the taxpayer (the company) that has incurred/suffered such assessed loss. While the assessed loss cannot be bought and sold as a free-standing asset, ownership of the company itself may well change hands. It is in this context that section 103(2) of the Income Tax Act 58 of 1962 (the ITA) could play a significant role.
In the case of Conshu (Pty) Ltd v Commissioner for Inland Revenue 1975(4) SA 715 (A), the court quoted from DM Stewart The Prohibition of Tax Avoidance: An Evaluation of Section 103 of the South African Income Tax Act 58 of 1962 (1970) 3 CILSA 168 at 189:
"where … taxpayers are individuals, the Revenue has nothing to fear, for assessed loss is not itself transferrable, but where the taxpayer is a company, whose shares can readily change hands, new proprietors will attach themselves to the company and inject new income into it in order to exploit the assessed loss. It is this 'trafficking' and the shares of companies with assessed losses which gave rise to the enactment of s103(2)."
Section 103(2) of the ITA essentially provides that if the accrual or receipt of income in the relevant taxpayer company was a direct or indirect result of an agreement affecting that company or a change in shareholding, which change was "… effected by any person solely or mainly for the purpose of utilising any assessed loss, any balance of assessed loss …" then the set-off of that assessed loss against such income shall be disallowed.
Several earlier cases dealt with the interpretation of section 103 of the ITA and stated inter alia that section 103(2) should be construed in such a way that it will advance the remedy provided by the section and supress the mischief against which the section is directed. The courts have held that the section and the discretionary powers conferred upon the South African Revenue Service (SARS) should not be restricted unnecessarily by interpretation and that the legislature clearly intended to discourage the wilful acquisition of juristic entities for the sole purpose of setting off previously assessed tax losses against profits.
Section 103(2) requirements
In the judgment handed down in case number IT 13164, which was heard in the Western Cape Division of the Tax Court during 2016, the court stated the following at paragraph 64:
"For SARS to rely on s103(2) to disallow the set-off of the assessed loss or the balance of the assessed loss in this matter, SARS must be satisfied that the following three requirements of s103(2) have been met:
64.1 There must have been an agreement affecting the Appellant [the taxpayer in that matter] or a change in shareholding in the Appellant …
64.2 The circumstances in respect of the first requirement must have resulted directly or indirectly in income or any capital gain accruing to the Appellant, and
64.3 The agreement or change in shareholding must have been entered into solely or mainly for the purpose of utilising any assessed loss, any capital loss or any assessed capital loss."
The court in IT13164 stated that the "direct/indirect result" requirement is an objective requirement. The court held that where the chain of causation is broken between the change in shareholding and the income being derived by the taxpayer company in question, the income would not accrue or be received as a result of that change in shareholding and section 103(2) could therefore not be applied. The court referred to the "novus actus interveniens" principle (where a chain of causation is interrupted by a new intervening event).
In the case of New Urban Property Properties Ltd v SIR 1966 (1) SA 215 (A), it was also held that it will always be a question of fact whether a company has derived income "directly or indirectly" as a result of the change in shareholding.
In contrast, the "sole or main purpose" requirement is a subjective requirement. The court in IT13164 stated that "(t)hose 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 this section".
In that case, the court was satisfied that the relevant taxpayer company discharged the onus of showing that the sole or main purpose in the change in shareholding was not to acquire the company to utilise its assessed loss. The court stated that "(w)hen the facts are considered in totality, then the … group's vision and projected business plan dovetailed with the existing … business that the taxpayer company had been engaged in, prior to the acquisition of the shares in the taxpayer company".
The court was satisfied that the following commercial grounds were part of the reason for the decision to acquire the shares in the company with the assessed loss:
- the existing assets of the relevant company would assist in implementing an existing business expansion plan (held by the purchaser) and would assist the purchaser to expand its business into new markets and industries. The court stated that the purchaser's "projected business plan dovetailed with the existing … business that the taxpayer company had been engaged in";
- it was not guaranteed that the purchaser would be able to utilise the assessed loss, as the utilisation of the assessed loss would depend on the continued generation of income. The purchaser was satisfied that the other assets of the company to be acquired will continue to produce income;
- the company had an existing business and foothold in the market, and it would be expensive for the purchaser to establish or acquire its own new assets, premises and technology; and
- the taxpayer company's staff had the necessary intellectual capital, which was their expertise in operating the technology used by the business.
On the question of the meaning of the words "solely or mainly", our courts have previously held that the word "mainly" establishes a purely quantitative measure of "more than 50%". In the context of tax avoidance, it has further been held that the word "mainly" in the phrase "solely or mainly" conveys an idea of dominance.
Ultimately, the outcome and the application of section 103(2) will to a large extent be a factual question and the parties to the transaction (the acquisition of the shares in the company with the assessed loss or any agreement affecting such company) must be able to prove that the sole or main purpose for entering into the transaction was not to be able to utilise the assessed loss, but rather that there were sound commercial reasons for entering into the transaction in question.
Presumption of purpose and burden of proof It is important to specifically note the provisions of section 103(4) of the ITA, which provide that once it has been proved that the agreement or change in shareholding in question would result in the avoidance or the postponement of liability for payment of any tax, it shall be presumed, until the contrary is proved, that the agreement or change in shareholding was entered into or effected solely or mainly for the purpose of utilising the assessed loss, in order to avoid, postpone or reduce the liability for tax.
This is confirmed by the provisions of section 102 of the Tax Administration Act 28 of 2011, which provides that the taxpayer will bear the burden of proving that an amount (such as an assessed loss) may be set-off.
Whenever the majority shareholding is acquired in a company that has carried forward from a previous tax year an assessed loss of more than ZAR50 million (or which expects to have an assessed loss of more than ZAR50 million in the tax year in which that company's shares change hands), regard must be had to South Africa's "reportable arrangement" rules, which are contained in sections 34 to 39 of the Tax Administration Act.
Such an acquisition of shares is now a specifically identified "reportable arrangement". This essentially means that the South African Revenue Service must be specifically notified of the transaction, and must be provided with, inter alia, a detailed description of the steps and key features of the transaction, a description of the assumed tax benefits for all participants and the details of all participants. It is therefore likely that any such share acquisition will be subjected to close scrutiny. Professional tax advice should be obtained prior to entering into a share acquisition of this nature.