SCA rejects valuation methodology of shares

In a judgment delivered on 30 September 2015 the Supreme Court of Appeal rejected the taxpayer’s valuation methodology of its minority holding in Emanzi Leisure Resorts (Pty) Ltd (ELR) in CSARS v Stepney Investments (Pty) Ltd [2015] ZASCA 138 (not yet reported in SA Tax Cases). The court found that assumptions in the taxpayer’s calculation of the base cost of the shares it had sold were defective in several respects.
Background facts
Stepney held 23.73% of the equity of ELR, which was engaged in developing, owning and operating casinos, hotels and related leisure activities. ELR was awarded a casino licence for a period of 15 years in respect of an area in Richards Bay. ELR subsequently became involved in a dispute with a religious group which opposed the development of the casino at the site. This caused a delay in the establishment of the casino. While the dispute was raging, ELR obtained a temporary licence to establish a casino at a site in Empangeni.
Stepney disposed of its shares in ELR during the 2002 and 2003 years of assessment, during the period when ELR possessed a permanent casino licence which it was unable to use and was in the process of acquiring the temporary licence.
The shares Stepney disposed of were a pre-valuation date asset as defined in paragraph 1 of the Eighth Schedule to the Income Tax Act, 1962 (Act), being an asset acquired prior to 1 October 2001 and still on hand at that date. For the purposes of calculating its base cost in determining its capital gain or loss, Stepney decided to use the market value of the shares on the valuation date in accordance with paragraph 26(1)(a) and paragraph 29(1)(c) of the Eighth Schedule . The market value would, in terms of paragraph 31(1)(g), be “the price which could have been obtained upon a sale of the asset between a willing buyer and a willing seller dealing at arm’s length in an open market”.
Stepney relied on a valuation performed by a third party, Bridge Capital Services (Pty) Ltd, on the value of the ELR shares (Bridge valuation). Based on this valuation, Stepney contended that it had sustained a loss on the disposal of the shares because their aggregate base cost had exceeded the proceeds on disposal.
SARS was not satisfied with the Bridge valuation and issued additional assessments adjusting the valuation date value to nil. SARS disallowed Stepney’s objection to these additional assessments. Stepney then appealed to the tax court, which set aside the disallowance, upon which SARS appealed to the SCA.
At the heart of the dispute was the Bridge valuation and whether the value it placed on the ELR shares was reasonable. The onus was on Stepney to show that the Bridge valuation was reasonable, and in the tax court a multitude of evidence was led by the parties, either criticising or defending the valuation.
Criticism of the valuation methodology
One of the first points of contention was the methodology used in valuing the shares. The Bridge valuation was done by using the discounted cash flow (DCF) method. This was contended to be the most appropriate method in respect of the valuation of an asset such as shares. It entails valuing the business of an entity based on its future forecast free cash flows, discounted back to present value through the application of a discount factor. SARS, on the other hand, in adjusting the base cost valuation to nil, used the net asset value (NAV) valuation method. SARS later conceded that the NAV method was inappropriate and that the DCF method should have been used.
Criticism of the valuation
Despite its concession on the methodology, SARS had several other criticisms against the Bridge valuation. Stepney however, contended that SARS had only ever criticised the Bridge valuation on the basis that the incorrect valuation methodology was used and was precluded from raising further criticisms at the tax court stage. It argued that, in doing so, SARS impermissibly sought to change its grounds of assessment. The SCA found that this contention could not be upheld as it was clear from the SARS statement of grounds of assessment that SARS contested the Bridge valuation as a whole on the basis that the market value of the ELR shares had been “overstated/inflated”. SARS had further set out various reasons for its contention, these being:
(1) the DCF calculation in the Bridge valuation relied on forecast amounts calculated in 2001. However, at the time of the valuation other information was available which would have had a material effect on the value. This information included management accounts available in 2004 (when the Bridge valuation was done) containing actual figures and showed that the figures forecast in 2001 were unreasonable. Stepney argued that to take the actual figures into account would amount to applying hindsight. The SCA, however, held that having regard to the actual figures would have been reasonable in the circumstances, and that valuers were duty bound to assess the reasonableness and correctness of figures presented to them. Overlooking such information resulted in a gross overstatement of the projected revenue forecast, which in turn led to a material inflation of value in the Bridge valuation;
(2) incorrect statutory rates were used in the tax calculations, resulting in an understatement of the tax amount. It was uncontroverted that an understatement of the tax amount had led to an overstatement of value in the Bridge valuation;
(3) there were material shortcomings in the reliability of the projected capital expenditure in that it failed to take into account any expenditure for the construction of the temporary casino, and this had a material impact on the valuation;
(4) the Bridge valuation failed to take cognisance of the term of the casino licence (15 years). The terminal value in respect of the future forecast free cash flow was in effect calculated on the basis that there was no risk of the licence not being renewed upon expiry of the 15 year period. The terminal value figure was based on revenue flows into perpetuity. The SCA held that the loss of exclusivity after 15 years should have been taken into account, and the failure to do so would also have an impact on the Bridge valuation;
(5) the fact that the company had a licence which it could not put to economic use as a result of the unresolved litigation was a risk factor that was not taken into account but ought to have been;
(6) the same discount rate was applied to all entities in the group of ELR. The valuation failed to assess the ELR casino separately and with due regard to its own particular risk factors. This had an adverse impact of the discount factor applied. The “one size fits all” approach used was inappropriate in the circumstances.
Conclusion
Accordingly, the SCA found that the Bridge valuation was fatally flawed in the various respects outlined above. A court is entitled to reject a valuation if it is not satisfied with the investigations and assumptions underpinning it. The SCA found that the tax court was wrong in upholding the valuation, and as a consequence Stepney had failed to discharge its onus of proving the market value and thus also the aggregate base cost of the shares. However, SARS also properly conceded that the value of the shares could not be nil, as there was clearly considerable value attached to ELR’s sole asset, the casino licence.
The SCA found that it was in the interests of justice that a proper valuation be calculated, and upheld the appeal with costs. But it allowed Stepney’s appeal in the tax court to the extent that the matter be remitted to SARS for further investigation and assessment. Stepney was awarded costs in the tax court in that SAR’s grounds of assessment in valuing the shares at nil were unreasonable.
With acknowledgments to Nuhaa Amardien, Norton Rose Fulbright.