Few tax cases in recent years have evoked as much interest as the recent case of CSARS v NWK, in which the Supreme Court of Appeal (SCA) expanded the accepted interpretation to the legal doctrine of substance over form.
In short, the maize trading company NWK entered into this series of complicated, interlinked and in certain respects self-cancelling commercial transactions with FNB. The effect of the structured series of transactions was that the amount of interest deducted economically included the capital amount of the loan actually intended to be advanced by FNB to NWK.
SARS raised additional assessments on the basis that the agreements concluded between NWK, FNB and its subsidiary did not reflect the true substance of the transaction. It was argued that if effect is given to the true intention of the parties, the parties entered into a loan agreement, and that the amount of this loan and resultant interest would be substantially lower than the amounts claimed. SARS also contended that some of the transactions had no commercial reality and that these were only entered into to disguise the true nature and amount of the loan transaction intended by the parties. SARS furthermore contended that the sole purpose of entering into this series of transactions was to obtain a tax benefit by way of increased interest deductions, by disguising the true nature of the transaction. In the alternative SARS contended that the series of transactions constituted a tax avoidance scheme contemplated by section 103(1) of the Income Tax Act.
NWK argued that the contracts concluded between NWA, FNB and its subsidiary were performed in accordance with the terms of the agreements and as such, based on an interpretation of previous case law, the doctrine of substance over form could not be invoked.
The Tax Court found in favour of NWK, after which SARS appealed to the SCA.
The SCA, in considering the matter, confirmed that there was nothing wrong in principle with entering into arrangements that are tax effective, but stated that there is something wrong with dressing up or disguising a transaction to make it appear to be something that it is not, especially if that has the purpose of tax evasion and avoidance of tax.
In assessing whether the transaction in point with simulated the court he held that the test to determine simulation cannot simply be whether there is an intention to give effect to a contract in accordance with its terms. The test should go further and require an examination of the commercial sense of and reason for the transaction, of its real substance and purpose. If the purpose of the transaction is only to achieve an objective that allows the availing of tax benefit it will be regarded as being simulated. The SCA also held that mere fact that parties perform in terms of the contract does not show that it is not simulated as “the charade of performance” was generally meant to give credence to the simulation of transaction.
In this particular case the court agreed with the Commissioner that in order to ascertain the true intention of NWK one had to ignore entirely all the rights and obligations in respect of certain transactions, despite the fact that effect had been given to these transactions.
Based on the previous interpretation of case law, substance over form challenges by SARS were traditionally difficult for SARS to prove in transactions where agreements were implemented in accordance with their form. The NWK judgement has, however, increased SARS’s ability to attack transactions in terms of the substance over form doctrine.
In addition the SCA also addressed the argument by NWK’s counsel that SARS could not use the general anti-avoidance provisions (section 103(1) in this case) in the alternative to a substance over form attack. In terms of this argument it was submitted by NWK that the Commissioner cannot satisfy himself that the transaction has been entered into for the sole or main purpose of avoiding tax, whilst on the other hand it argues that the transactions do not reflect the true substance of the arrangement, as these arguments are inherently conflicting. The SCA held in this regard that the raising of a substance over form argument by SARS does not preclude them from raising the general anti-avoidance provisions in the alternative.
Although most cases dealing with substance over form in the tax context seem to involve financing transactions, the principles enunciated apply to all transactions. The principles of this judgement will also not necessarily be universally applicable and one would need to consider the facts, merits and commercial rationale for each individual transaction. The judgement does, however, increase the risk of a successful attack by SARS in respect of transactions that have similar characteristics to the NWK transaction and we would advise taxpayers to reassess tax risk and the validity of existing defences in respect of transactions in light of this new judgement.