In September 2014 in Kluh Investments (Pty) Ltd v CSARS [2015] 77 SATC 23 WC the Western Cape High Court delivered a judgment that stands as a model of the interpretation of legislation. The core issue was the meaning of “farmer” for purposes of the First Schedule to the Income Tax Act. In most cases taxpayers argue that they are genuine farmers and thus have access to the favourable provisions of the First Schedule. In this case the taxpayer was intent on and succeeded in showing that it was not conducting farming operations.
The taxpayer, Kluh Investments, was a special purpose subsidiary of a Swiss company. By agreement with its holding company and Steinhoff Southern Cape (Pty) Ltd it was used as a vehicle to hold land in South Africa with a timber plantation on it. The reason for the transaction was that Steinhoff wanted access to the plantation but did not want to hold land in South Africa. Two years later, Steinhoff changed its mind and the taxpayer disposed of the land and plantation to Steinhoff.
In 2001 Steinhoff purchased the machinery and equipment (including a sawmill) and the taxpayer acquired the land, the timber plantation and certain other assets. Both transactions were treated as going concern acquisitions, thus qualifying for zero rating in terms of section 11(1)(e) of the Value-Added Tax Act, 1991.
Steinhoff and the taxpayer had an oral agreement, based on trust, that Steinhoff would be entitled to conduct the plantation business on the taxpayer’s land for Steinhoff’s benefit. The term of the agreement was indefinite. Steinhoff had access to the land and was entitled to harvest the timber for its own account. Steinhoff used its own equipment, employed employees to work on the plantation and contracted with service providers for the plantation operations. Steinhoff incurred all the operational expenditure and received all the income, and these were reflected in its financial statements. It was not answerable to the taxpayer for its operations. The parties agreed that on termination of the agreement Steinhoff would ensure that the volume and quality of the plantation would be as it had been at inception of the agreement.
The taxpayer had no equipment, employees or expertise in plantation operations. It was common cause that the taxpayer considered the acquisition of the land and plantation as a strategically advantageous long-term investment.
Two years later, increasing timber prices and a scarcity of timber led Steinhoff to change its policy and become amenable to owning immovable property in South Africa.
An independent valuer determined the purchase price and the parties agreed that the taxpayer would sell what they referred to as “the plantation business” to Steinhoff for R144,7 million as a going concern and thus zero-rated for VAT purposes. This description was later amended to refer to the sale of immovable property, standing timber, the plantation sale assets, machinery and equipment and plantation contracts. In addition, the parties agreed that VAT at the standard rate might be payable on the transaction, in which case the taxpayer would issue invoices to Steinhoff. Finally it was agreed that the taxpayer would pay Steinhoff a R12 million “bonus management fee” for the exemplary manner in which it had looked after the taxpayer’s investment.
In its 2004 tax return the taxpayer reflected the disposal proceeds as capital in nature and declared a capital gain of R45,6 million, being the difference between the disposal proceeds of R144,7 million and the valuation of the plantation of R99,1 million of the plantation at 1 October 2001, the date on which CGT came into operation, and claimed the R12 million “bonus management fee” as a deduction.
SARS rejected the treatment of the plantation disposal proceeds as capital in nature, contending that section 26(1) read with paragraph 14 of the First Schedule deemed the proceeds to be part of the appellant’s gross income.
Section 26 provides that the taxable income of any person carrying on farming operations must be determined in accordance with the Act but subject to the provisions of the First Schedule. Because paragraph 14 of the First Schedule applies to the proceeds of plantation disposals, it followed, according to SARS, that a person who receives such proceeds is farming and that the proceeds are gross income and taxable as provided for in the First Schedule.
In the alternative, SARS argued that even though Steinhoff had conducted the plantation operations independently of the taxpayer, it had done so on the taxpayer’s land, the appellant retained a direct interest in the operations and Steinhoff was obliged on termination of the oral agreement to return the plantation in the same condition as it had been at commencement. It followed, according to SARS, that there was a sufficiently close connection between the disposal proceeds and the plantation operations during the subsistence of the oral arrangement to render section 26(1) and paragraph 14 of the First Schedule applicable to the taxpayer.
The High Court found that the alternative basis conflated two distinct issues:
“Section 26(1) does not apply merely because there has accrued to the taxpayer income which has ‘derived from’ farming operations; the section applies to a person carrying on farming operations to the extent that his income is derived from such operations. Two questions must therefore be answered: (i) Was the person whom SARS wishes to tax a person carrying on farming operations during the year of assessment in question? (ii) If so, did the particular item of income in dispute derive from those farming operations?”
The court reviewed the relevant case law and concluded that a number of tax court decisions have, like the tax court in the present matter, similarly conflated the two questions. In rejecting SARS’ first argument the court found that “the purpose of para 14 is not to define what constitutes the carrying on of farming operations, but to characterise a particular type of accrual as gross income rather than capital.”
“[T]here must be conduct by the taxpayer apart from disposing of a plantation previously acquired by the taxpayer in order to constitute the carrying on by him of farming operations”. Put differently, section 26 is the entry point; firstly, the taxpayer must be shown to be carrying on farming operations. Only then would the proceeds from disposal of a plantation, in terms of paragraph 14, be gross income.
On the facts, the taxpayer was not conducting farming operations and section 26(1) did not apply. Therefore the nature of the plantation disposal proceeds fell to be determined in accordance with the normal provisions of the Act, namely that they were capital in nature.
