In Capstone 556 (Pty) Ltd v CSARS [2014] 77 SATC 1 WC the Western Cape High Court heard an appeal from the decision of the tax court. In issue were: the nature of the proceeds of a disposal of shares; the deductibility of a so-called “equity kicker” by the taxpayer; and how to treat an indemnity payment made by the taxpayer. The tax court found that the proceeds were revenue in nature, the equity kicker was deductible, and the indemnity payment was revenue in nature and deductible. As explained below, the High Court reversed the decisions of the tax court as to the nature of the share sale proceeds and the deductibility of the indemnity payment, and allowed one third of the equity kicker to be added to the base cost of the shares.
The following facts, published in the tax court judgment as ITC 1867 [2013] 75 SATC 273, were not set out in the High Court judgment but are necessary to an understanding of the matter.
Profurn was a listed company which by 2001 faced imminent liquidation. R600 million of its debt was converted into equity, after which the bank held about 78% of the shares in Profurn. Daun, a German businessman, was introduced in or about June 2002 as a person with the ability to turn the fortunes of Profurn around. He insisted on doing this through the JD Group (JDG), which agreed to take Profurn over in exchange for issuing JDG shares to the bank. The bank received the JDG shares in April 2003, and then sold nearly all of them in equal parts to the taxpayer, which was a special purpose vehicle whose sole function was to hold the shares, and one of Daun’s German companies.
The taxpayer acquired its JDG shares on 5 December 2003, and funded the acquisition of the JDG shares through the issue of preference shares to the bank and by borrowings from shareholders.
By April 2004, five months after the taxpayer had acquired the JDG shares, it sold them to a purchaser.
In the 2005 year of assessment SARS assessed the taxpayer to tax on about R201 million arising from the disposal of shares in JDG Ltd. In addition, SARS disallowed as deductions an amount of about R45 million in respect of an “equity kicker” and R55 million in respect of an indemnity obligation. Finally, SARS imposed interest of over R50 million for underpayment of provisional tax [Para 1]. The tax court had found against the taxpayer on the R201 million but in its favour on the other two issues and directed SARS to remit the interest. Both parties appealed to the extent that they had been unsuccessful.
SARS contended that the taxpayer had not intended to hold the shares in question (shares in JDG) as capital assets and/or for purposes of earning dividends, but rather to dispose of them in the short term in pursuance of a scheme of profit-making. In support, SARS pointed out that the taxpayer had held the shares for less than five months; that the taxpayer had financed the purchase from external sources; and that the taxpayer could not benefit from the dividends from JDG, as these had been earmarked for other purposes. While these are generally among the conditions often invoked to support of profit-making inference, it was open to a taxpayer to rebut this inference in the light of all the circumstances. The court then discussed the circumstances.
The likely liquidation of Profurn threatened to destabilise the whole furniture industry in South Africa. It would also have harmed Steinhoff, a major creditor of Profurn and member of the furniture industry. Profurn’s banker approached Daun to mount a rescue operation. Crucially, as it transpired, in his affidavit to the Competition Commission, which was dated nine days before the taxpayer acquired the shares in JDG, Daun stated that the whole purpose of the scheme was a rescue operation, not a profit-making scheme. This contention was not challenged in cross-examination and was supported by the surrounding facts, these being the parlous state of the retail furniture industry and Daun’s readiness to commit his money and efforts to restoring stability to the industry. Daun insisted on doing so through JDG because it was in his opinion the only competent professional manager in the industry.
It was anticipated that the rescue operation would take three to five years to achieve; there was no short-term intention on the part of anyone involved. A R125 million five-year indemnity was concluded, of which the taxpayer bore R62,5 million; and attempts to raise finance for the transaction were based on a three to five year period. The court saw these factors as indicating a large-scale rescue operation anticipated to require both capital and management expertise, and to take three to five years to complete. Thus the court found, in summary, that the taxpayer’s intention when it acquired the JDG shares was to make a strategic investment in a leading company and to hold them for however long it took to bring Profurn back to health, which was anticipated to take three to five years.
The High Court noted that the arrangement had in fact been implemented in June 2002, even though the taxpayer had acquired its shares in JDG only in December 2003, so the period of the arrangement had commenced on the earlier date. However, in about 2003/2004 the world economy “miraculously” turned around. This fact, together with the takeover by JDG and the “unique turnaround strategy” which was an unqualified success, meant that Profurn recovered far earlier than had been expected. At the same time, however, the Rand lost value at an alarming rate and Daun decided to reduce his investments in South Arica. Fortuitously, at this time an opportunity arose to dispose of the JDG shares and they were duly sold. The taxpayer, as a junior partner in the arrangement, had no say in this decision.
In respect of the taxpayer’s 2005 year of assessment, the taxpayer accounted for the proceeds on the disposal of the JDG shares as being of a capital nature.
The High Court took the approach that, despite the objective facts pointing to the taxpayer having sold the JDG shares shortly after acquiring them, and by making use of short-term finance, “[T]he taxpayer’s explanation of the events, including his or her intention in respect of the transaction in question, is therefore relevant and must be tested in the light of all the other circumstances”. “[I]t would be an over-simplification to focus too closely on the bare facts…in drawing an inference as to the intention of the taxpayer”.
The court noted further objective factors that pointed in the direction of the taxpayer having acquired and held the shares as capital assets:
- as a special purpose vehicle, the taxpayer was contractually precluded from doing anything other than acquiring and holding the shares;
- in its financial statements the taxpayer reflected the shares as non-current assets; and
- the taxpayer conducted no trade and did not even hold board meetings.
The taxpayer’s appeal, on this point, was accordingly upheld.
The taxpayer’s liability for the “equity kicker” arose from an agreement between the taxpayer’s holding company and Gensec, which had provided the funding for the arrangement. Gensec was entitled, in addition to interest on the loan, to a share of any profit yielded by the investment. SARS opposed the deduction of this expense by the taxpayer on the grounds that it was the holding company’s obligation, not that of the taxpayer. The High Court rejected this submission and concurred with the tax court’s finding that it was actually the taxpayer that had incurred the obligation. Based on its finding that the shares had been capital assets in the hands of the taxpayer, the High Court then categorised the expense as a “borrowing cost”. Because JDG was a listed company, the court applied the provisions of paragraph 20(2) of the Eighth Schedule to the Act and concluded that one third of the expense should be added to the base cost of the shares.
The court then turned to the indemnity payment. The taxpayer had in July 2004 assumed an unconditional liability to one of Daun’s companies in an amount of R55 million. This was recorded in the taxpayer’s books as a loan. The question to be answered was whether this obligation could be seen as part of the cost of acquiring the JDG shares. The High Court agreed with the tax court’s conclusion that this was a different matter unrelated to the acquisition of the shares. The expense was therefore disallowed.
