JULY 2011 – ISSUE 143 CONTENTS COMPANIES

OBJECTIONS AND APPEALS

1968. Offshore assignment of intellectual property

1973. Reasons for an assessment

GENERAL

TAX AVOIDANCE

1969. Judgment against taxpayer

1974. Connected persons

INCOME TAX

SARS NEWS

1970. Capital or revenue

1975. Interpretation notes, media releases and other documents

INTERNATIONAL TAX 1971. Controlled foreign company legislation 1972. Transfer pricing and guarantee fees

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COMPANIES

1968. Offshore assignment of intellectual property The Supreme Court of Appeal, in the case of Oilwell (Pty) Ltd v Protec International Ltd & Others Case No. 295/10 (the Oilwell Appeal), has finally ruled on the issue of the assignment of intellectual property from a South African resident/entity to a non-resident/foreign entity and, in particular, whether approval in terms of regulation 10(1)(c) of the Exchange Control Regulations is required for such transactions. Regulation 10(1)(c) deals with restrictions on the export of capital and states that "No person shall, except with permission granted by the Treasury and in accordance with such conditions as the Treasury may impose, …. enter into any transaction whereby capital or any right to capital is directly or indirectly exported from the Republic".

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Since the decision in Couve v Reddot International (Pty) Ltd 2004 (6) SA 425 (W) there have been a number of conflicting decisions on the exchange control requirements for, and implications of, the transfer of intellectual property from a South African resident/entity to a non-resident/foreign entity. Prior to the Oilwell Appeal the prevailing view was that exchange control approval was required for such transactions in terms of regulation 10(1)(c) and that a failure to obtain approval would result in the transaction being null and void, ab initio. Although, on the face of it, the court in the Oilwell Appeal has provided much needed clarity on the exchange control issues surrounding the transfer of the ownership of intellectual property offshore, the situation is not necessarily as clear or simple as it seems. The court, in dismissing the Oilwell Appeal, essentially found that:   

a trade mark does not qualify as "capital" or a “right to capital” and therefore that regulation 10(1)(c) should not be interpreted to include the assignment of a trade mark; a trade mark, like other intellectual property rights, is territorial in nature and can therefore not be „exported‟; and in the event that a trade mark does qualify as "capital" or a "right to capital", a failure to obtain exchange control approval in terms of Regulation 10(1)(c) does not result in the assignment being null and void, ab initio.

It is interesting that the court, having found that the terms "capital" and "right to capital" should not be interpreted to include a trade mark or any other form of intellectual property, and hence that an assignment of a trade mark offshore does not require exchange control approval in terms of Regulation 10(1)(c), went on to consider the effect of an assignment of intellectual property in contravention of Regulation 10(1)(c). Nonetheless, the court considered the question and found that the absence of National Treasury approval does not mean that the transaction is unenforceable, and that it is theoretically possible to obtain the requisite approval ex post facto. Despite this judgement, the payment of royalties from South Africa to a non-resident for the use of intellectual property still requires exchange control approval (in terms of Exchange Control Regulation 3(1)(c)). Therefore, once the intellectual property has been transferred abroad, the user of such intellectual property in South Africa will be required to obtain exchange control approval before any royalties can be paid to the new foreign owner of the intellectual property. For South African owners of intellectual property, the decision in the Oilwell appeal means that it may now be possible to transfer their intellectual property to foreign persons without the need to go through the often complex, lengthy and expensive process of obtaining exchange control approval. In addition, there is no longer a need to justify the purchase price for any intellectual property to the exchange control authorities. The situation is not, however, as simple as it seems on the surface, as there is a variety of potential tax consequences that must be properly considered before assigning any intellectual property offshore. Despite the fact that the court has found that the terms "capital" and "right to capital" should not be interpreted to include a trade mark or any other form of intellectual property, the trade mark or intellectual property, including any right to use such trade mark or intellectual property, is included in the definition of an asset for capital gains tax (CGT) purposes in the Eighth Schedule to the Income Tax Act No. 58 of 1962 (the Act). Therefore, an assignment of a trade mark offshore by a company will be a disposal of an asset for CGT purposes and the gain or loss realised by the South African owner of the intellectual property will be determined in terms of the provisions of the Eighth Schedule 2

and any gains realised will be subject to CGT at an effective rate of 14%. If the intellectual property is assigned to a connected party offshore, the disposal will be deemed to have taken place at market value for CGT purposes. The assignment may therefore still require the determination of the market value of the intellectual property so assigned. The assignment of intellectual property may also result in the recoupment of certain capital allowances claimed by the South African company for tax purposes, and these recoupments will be subject to income tax at the rate of 28%. Where the intellectual property is assigned for nominal value, such an assignment may also be seen as a deemed donation, and donations tax at 20% may be payable on such a disposal where the nominal value is not considered to be adequate consideration for the intellectual property assigned. In addition, where intellectual property is assigned to a connected party offshore, the South African transfer pricing rules will apply to any royalties charged to a South African group company subsequently using the intellectual property. On the positive side, the ability of South African residents now to assign intellectual property to related parties offshore without exchange control approval certainly opens up international tax planning opportunities for South African groups, which were previously closed, because the exchange control authorities were loathe to approve the transfer of intellectual property to related parties offshore. So, despite the euphoria of no longer requiring exchange control approval for the assignment of intellectual property offshore, the tax consequences of such an assignment need to be carefully considered to ensure that all South African tax liabilities are correctly accounted for, and that any planning opportunities are explored. Edward Nathan Sonnenbergs IT Act: s 8(4)(a), s 31, s 23I, s 56, Eighth Schedule para 1 Exchange Control Regulations: Regulations 10(1)(c), 3(1)(c)

GENERAL

1969. Judgment against taxpayer Taxpayers are no doubt familiar with the “pay now, argue later” rule that was held to be constitutionally valid in the case of Metcash Trading Limited v Commissioner for South African Revenue Service and Another [2000] (62 SATC 84). That case decided that the Commissioner‟s powers to insist on the payment of tax, even though an objection had been lodged against assessments issued, was valid and that it is necessary for the taxpayer first to pay the tax in dispute and then to pursue the objection or appeal. The Constitutional Court did make the point, though, that the Commissioner is empowered to agree to the postponement of tax pending the finalisation of an appeal and that such a decision must be made in compliance with the rules of administrative justice flowing from the Constitution and the provisions contained in the Promotion of Administrative Justice Act No. 3 of 2000. 3

Section 91 of the Income Tax Act No. 58 of 1962 (the Act) gives the Commissioner the power to obtain judgment against a taxpayer by filing a written statement with the registrar without issuing a summons to the taxpayer and without prior notice being issued to the taxpayer. Sometimes the first time the taxpayer becomes aware of a judgment against him or her is when they apply for a loan from a bank or a new credit card, or are informed that their credit rating is poor because a judgment has been taken against them by SARS. The provisions of section 91(1)(b) of the Act were considered by Judge Spilg in the case of MA Sepataka v Commissioner for the South African Revenue Service (Case No: 05/20445) (Sepataka) (not yet reported) in the South Gauteng High Court, Johannesburg, in August 2010. It was indicated in the judgment that on 17 March 2010 the Commissioner filed a notice in terms of section 91(1)(b) of the Act with the Registrar of the South Gauteng High Court, which was approved by a SARS official on 16 March 2010. In terms of the notice, the Commissioner withdrew the statement filed under section 91(1)(b) of the Act whereby judgment had previously been granted against Sepataka on 1 December 2005 Sepataka applied for the rescission of the judgment granted to SARS on the grounds that he had not previously been made aware of the judgment. He only became aware of the judgment after he applied for a mortgage bond and a credit check disclosed the outstanding monetary judgment against him. When a taxpayer fails to submit a return or does not complete a proper tax return the Commissioner may estimate the taxpayer‟s income under section 78 of the Act. The Commissioner was of the opinion that Sepataka had not disclosed all income derived by him as required under the Act and, as a result, on 22 April 2004 raised an additional assessment of R702 215 for the 2001 year of assessment and R597 175 for the 2002 year of assessment. SARS often identifies unexplained income by calculating unexplained increases in a taxpayer‟s net assets from one year to the next. Typically, SARS will begin the capital reconciliation exercise by determining the taxpayer‟s assets at the beginning of the tax year and deducting that total from the taxpayer‟s net assets at the end of that year. When the increase in assets is disproportionate in relation to the taxpayer‟s income and living expenses, SARS will treat the shortfall as unexplained income and seek to tax that amount as taxable income. The Act gives the Commissioner the power to estimate assessments and to obtain judgments against taxpayers based on an estimated assessment. These powers are aimed at ensuring that taxpayers‟ properly disclose the income derived by them for tax purposes. Judge Spilg however, made the following point: “The provision however is draconian and should therefore be exercised with care by properly experienced and suitably qualified personnel, since it may otherwise be reduced to an arbitrary guesstimate with grave consequences to the taxpayer. This is so because the Commissioner is entitled, even if there is an objection or an appeal, to seize and realise assets, including money standing to the

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credit of the taxpayer’s bank account, notwithstanding that these actions may jeopardise the taxpayer’s cash flow and business.” Sepataka was dissatisfied with the estimated assessments issued by SARS and formally objected to those assessments on 27 June 2005. Although the taxpayer had objected to the assessments, the Commissioner relied on the powers contained in section 91 of the Act to apply, without notice, for judgment by filing a notice on 7 November 2005 with the Registrar of the South Gauteng High Court, and judgment was granted against the taxpayer on 1 December 2005. It is stated in the judgment that on 29 August 2007 SARS allowed the taxpayer‟s objection in respect of both years of assessment. Judge Spilg points out the estimate made by SARS was incorrect. The judge was satisfied in Sepataka‟s case that the documents submitted by the taxpayer‟s chartered accountant disclosed a bona fide defence to the notice relied upon by the Commissioner to obtain judgment under section 91(1)(b) of the Act, and that it was incompetent for SARS to apply for judgment on the basis that the assessments were under objection. It is interesting to note that Judge Spilg pointed out that the issue of collecting interest and penalties pending an objection or appeal, may be on a different footing to the principal amount of tax due by a taxpayer. Judge Spilg decided that it is incompetent, when regard is had to the rights of objection and appeal, for SARS to obtain judgment against a taxpayer prior to the finalisation of the objection. Judge Spilg reached the conclusion that the judgment against Sepataka could not lawfully be obtained by virtue of the objection being lodged against the assessment and was therefore a nullity, and for this reason the judgment was set aside. The court held that the current statement filed by the Commissioner for judgment under section 91(1)(b) of the Act fell short of providing adequate safeguards against errors occurring in the future. This view of the court must be supported, as concerns arise when, for example, a taxpayer submits an income tax return reflecting a loss derived from trading for the year, whereas SARS treats that loss as income and levies income tax thereon, and subsequently seeks to recover that incorrectly assessed amount of tax and proceeds to file a statement at the court and secure a judgment against the taxpayer. It is important, therefore, that safeguards are in place to ensure that the assessments issued by SARS are correct and, furthermore, that no objection or appeal is pending against the assessments issued by SARS before judgment is taken against a taxpayer. As a result, Judge Spilg granted an order against SARS setting aside the judgment granted against Sepataka on 7 November 2005. It is hoped that SARS will take heed of the comments made by Judge Spilg, and introduce the safeguards in the statements filed in courts in future when seeking judgment under section 91(1)(b) of the Act. Edward Nathan Sonnenbergs IT Act: s 91(1)(b), s 78 Promotion of Administrative Justice Act No. 3 of 2000 5

Previously published in Business Day, Business Law & Tax Review.

INCOME TAX

1970. Capital or revenue There has long been debate over whether shares acquired by executives in terms of executive share incentive schemes are capital assets or trading stock. Typically, when markets are buoyant and the shares appreciate, capital asset stances are commonplace. Whereas, when markets decline, assertions that the shares are trading stock are more likely to emerge. Occasionally, disputes on this issue come before the courts, as was the case in Case Number 12886 (not yet reported), which was heard in the Tax Court in Pretoria (judgment was delivered on 21 October 2010). Briefly, Mr S was granted options to acquire shares in 2003 and again in 2004. In May 2007 he exercised some of the options, acquiring 115 000 shares, and in June 2007 he acquired a further 15 000 shares. It appears that the cost of these shares (including the cost of the options) was R2.67 per share for the first 100 000 shares and R4.36 per share for the remaining shares. At the time of acquisition of the shares by Mr S, the market values were R14.68 and R15.58 per share. It was the evidence of Mr S that he had determined to exercise the options because commentary on the shares‟ performance in the financial press indicated “that a further growth in price of up to 30% was expected”. In support of this, a newspaper article published in 2007 was presented in evidence. It indicated that a price of R18 per share might be expected to be reached over a 12 month period. He had exercised his rights in order to speculate and “make a quick buck” from the expected escalation in market price. As it transpired, the market turned down late in 2007 and the market price of the shares as at 28 February 2008 stood at R9.57 per share. Mr. S, having sold no shares, valued the shares as closing stock for tax purposes at R9.57 per share. He claimed that the cost of the shares for tax purposes was equivalent to the market value at the date upon which he exercised his rights to acquire the shares. By deducting this cost, and including the market value of the shares at year end as closing stock, he contended that he was entitled to claim a net deduction equal to the decline in the value of the shares. Not a share dealer The South African Revenue Service (SARS) countered that he was not entitled to any relief owing to the reduction in the value of the shares. SARS‟ argument was simply that the shares were not trading stock as Mr S was not a share dealer. He had acquired the shares as a perquisite of his salaried employment. He apparently had no history of having dealt in shares and he had not sold any of the shares that he had acquired in May and June 2007 during the relevant year of assessment. In short, he was not a dealer in shares. In any event, it was urged, he had paid R2.67 and R4.36 per share, and this was the cost that he was permitted to deduct. Thus, the amount to be included in trading stock was equal to the cost actually incurred, being lower than the market value. Therefore no net deduction arose. The court would have had to deal with a number of issues if it were to determine the matter fully. In the event, it considered only one issue, and referred the matter back to the Commissioner “to make a revised assessment in light of this judgment”.

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The judgment of the court was based on the issue whether the expenditure incurred by Mr S in acquiring the shares was of a capital or revenue nature. If the expenditure was of a revenue nature, the shares were trading stock. In this regard it relied on the dictum from BP Southern Africa v C:SARS [2007] (69 SATC 79) from paragraph 7 of the judgment: “The purpose of the expenditure is important and often decisive in assessing whether it is of a capital or revenue nature.” It was common cause between the parties that a single venture could constitute a trade, and that shares could qualify as stock in trade. It therefore fell to the court to determine whether there was a trade having regard to the evidence and the inferences to be drawn from the circumstances. The evidence showing that Mr. S had acquired the shares with speculative intention had not been contradicted. He had not invested in shares as capital assets to any relevant measure. An extremely short period of time had passed between the acquisition of the shares and the end of the year of assessment, and no adverse inference arose from his failure to have made a sale within that period. The court concluded: “Thus, in view of the Appellant’s uncontested evidence, together with the common cause facts, and the fact that a “trade” can consist of a single “venture”, it is the finding of this Court that the Appellant’s appeal must be allowed and it is found that the acquisition of the shares became stock in trade.” The Court sidestepped the issue whether a loss was allowable and referred the matter back to SARS to make an assessment. Was there a loss? The critical (and still undecided) issue is the determination of the cost of the shares when Mr S acquired them. SARS argued that he had paid R2.67 and R4.36 per share in order to acquire the shares, and that these were the amounts to be taken into account as representing the cost of trading stock held and not disposed of at the end of the year of assessment. Thus the amounts of the deduction and the inclusion in income as closing stock were the same, and no net loss resulted. It is apparent (although not explicitly so stated in the judgment) that Mr S argued that the cost price of the shares should be deemed to be the market value on the date of acquisition. In terms of section 8A of the Income Tax Act No. 58 of 1962 (the Act), he would have been taxed on an amount equivalent to the difference between the market value and the amount paid for the shares. In effect, the award of the shares at a bargain price was economically the same as if he had been paid an amount in cash and used that amount to acquire the shares. If Mr S was correct, then he would claim a deduction for the cost of the shares in an amount equal to the market value on the date that he acquired the shares. He then would have been entitled in that year of assessment (in terms of the law as it then stood) to account for the trading stock at year end at the lower of cost or market value. The net effect would be a deduction, equivalent to the decline in market value, to which he contended he was entitled. There is no clarity on this issue, and one commentator cautiously inclines to the view that SARS would probably include the amount that has been included in the taxpayer‟s income in terms of section 8A of the Act, as part of the cost of the shares for purposes of determining the value of stock in trade. 7

The following possibilities are intriguing: 

If Mr S had sold the shares on the date on which he acquired them at the same market value, he would have made a handsome accounting gain. For tax purposes he would have been entitled to claim that the gain was not taxable because the difference between the acquisition price paid by him and the market value had been taxed as remuneration and he could not be taxed twice on the same amount. He could, on the other hand, have argued that the shares were acquired for a cost equal to the market value and sold for the same value and therefore there was no profit.

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If Mr S had sold the shares on the final day of the year of assessment for proceeds that would have been less than the market value when he acquired the shares, he still would have recorded an accounting profit. The question then arises whether the correct tax treatment should be to disregard the profit on the basis that it formed part of an amount that had been included in his income at the time the shares were acquired, or to allow him to claim a loss equivalent to the decline in the value of the shares?

Although, economically, these alternative treatments give the same result, they rely on different principles. If the result of the second example is that there would not be a deductible loss, this would result in an intriguing disparity between the determination of the base cost of incentive shares acquired as capital assets and the cost of the same shares acquired as trading stock. The Eighth Schedule to the Act, paragraph 20(1)(h)(i), specifically states that the market value of the security shall be the base cost of incentive shares where market value has been taken into account to determine an amount that has been included in income in terms of section 8A of the Act. However, the position taken by SARS in the case of Mr. S apparently rejects the proposition that the market value of the security at date of acquisition should be taken as the cost of the shares. It appears that SARS is arguing that different methods should be applied in determining the cost of incentive shares acquired by an employee, depending on the employee‟s intention at the date of acquisition of the shares. Lack of consistency The root cause of the problem is the lack of consistency in the legislation, which has apparently been seized upon by SARS as a justification for its position. It is submitted that the Act should be amended to harmonise the trading stock rules with the capital asset rules in this regard, so that the cost incurred or deemed to be incurred in acquiring trading stock are identical to the costs incurred or deemed to be incurred in acquiring capital assets. It is unfortunate that the court, having clearly set out the opposing positions, did not seek to resolve this apparent contradiction, but passed the ball back to SARS. In light of the opposing positions taken by the litigants as to the determination of the cost of the shares and the lack of consistency in the law, the courts may not have seen the last of this dispute. On the question of whether the taxpayer may value shares at the lower of cost or net realisable value, the door has now been shut by the enactment of amendments to section 22 of the Act in the Taxation Laws Amendment Act No. 7 of 2010, which takes effect from the commencement of years of assessment commencing on or after 1 January 2011. However, the inconsistency between determining the cost of trading stock and capital assets remains to be resolved.

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pwc IT Act: s 8A, s 22, Eighth Schedule para 20(1)(h)(i),

INTERNATIONAL TAX

1971. Controlled foreign company legislation As part of the 2011 Budget, SARS conceded that the current South African Controlled Foreign Company (CFC) legislation contained in section 9D of the Income Tax Act No. 58 of 1962 (the Act) is overly complex. According to National Treasury's Tax Proposal Document for Budget 2011, certain provisions can interfere with normal business conduct, whilst others create unintended loopholes. National Treasury has, therefore, proposed that the CFC rules are further refined to focus the legislation without compromising its purpose. It is not the first time that National Treasury has proposed simplifying the CFC legislation. In 2009, the ruling system, contained in the then section 9D(10), was partially replaced with a high-taxed net income „exemption‟. The „exemption' is contained in the proviso to section 9D(2A) of the Act and applies where the income of the CFC is subject to a minimum level of tax. The purpose of the „exemption' is to disregard CFC income if little or no South African tax is at stake once South African foreign tax credits in section 6quat of the Act are taken into account. At first sight the proviso seems simple to apply; if the CFC is subject to a minimum level of tax, there is no CFC income. However, a deeper examination of the proviso reveals that its application is very complex and gives rise to a number of unanswered questions. Generally, in terms of the CFC rules, where a South African or South Africans jointly hold more than 50% of the participation rights in a foreign company, the company is a CFC. Unless an exemption or exclusion applies, an amount equal to the net income of a CFC is included in each South African resident's income in the proportion of the participation rights of the South African resident in the CFC to the total participation rights in the CFC. Section 9D of the Act contains complex rules as to how the net income of the CFC is calculated and the circumstances in which amounts are included or excluded from the net income calculation. The proviso to section 9D(2A) provides that the net income of a CFC will be Rnil if the amount of foreign tax payable by the CFC is equal to or greater than 75% of the South African income tax that would have been payable by the CFC for the foreign tax year of the CFC had the CFC been a South African tax resident. In determining the foreign tax payable by the CFC, tax payable to all spheres of Government, the provisions of any applicable double tax agreement and any credit, rebate or right of recovery of the foreign tax must be taken into account. Any tax losses of the CFC and any tax losses of any other company (if the CFC is in a jurisdiction that applies group tax) must not be taken into account. Therefore, in determining whether the CFC qualifies for the exclusion, taxpayers cannot assume that if the corporate income tax rate of the CFC is at least 21% (75% of 28%) the proviso will apply. Determining whether the proviso applies requires a detailed calculation of the CFC's taxable income as if the CFC was a South African tax resident. This means that the South African resident holding participation rights in the CFC will need detailed financial information for the CFC in order to prepare 9

a South African taxable income calculation for the CFC. If the actual foreign tax payable by the CFC is at least 75% of the South African income tax that would be payable based on the South African taxable income calculation for the CFC, the CFC's net income is deemed to be nil. Some of the difficulties with the South African taxable income calculation that must be performed in order to determine whether the proviso applies are evident from the following examples: 

The proviso was included by the Taxation Laws Amendment Act, No. 17 of 2009, which was promulgated on 30 September 2009 but applies retrospectively to any foreign tax year of a CFC ending during years of assessment ending after 1 January 2008. It is therefore possible that a taxpayer completing his income tax return for the 2008 year of assessment during 2009 could have included in his CFC income for the 2008 year amounts that should have been excluded in terms of the proviso. There appears to be no mechanism in the legislation or income tax returns to correct this.

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Although income tax is an annual event, certain capital allowances such as the section 12C allowances are deductible when plant or equipment is brought into use for the first time by the taxpayer. If a CFC uses plant or equipment that would in principle qualify for the section 12C allowance, it is not clear when applying the proviso whether the provisions of section 12C can be used because the equipment may not have been brought into use for the first time by the CFC in the 2008 year of assessment when the proviso is first applied. If the section 12C allowance cannot be used it is possible that the 75% test would not be met if the CFC is entitled to a similar allowance under the rules of the jurisdiction where it operates.

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An income tax deduction is allowed for bad debts in terms of section 11(i) of the Act but only if, inter alia, the amount was included in the taxpayer's income in the current or a prior year of assessment. On a strict reading of section 11(i) of the Act, amounts that accrued to a CFC before the effective date of the proviso but which became bad after the effective date of the proviso cannot be deducted in determining whether the proviso applies.

There are countless other examples of provisions in the Act that will be difficult to apply in calculating a CFC's taxable income for purposes of determining whether the proviso applies. It is submitted that these and other difficulties in applying the provisions of section 9D should be addressed in a SARS Interpretation Note on the application of section 9D. It is contended further that any additional refinements to the CFC legislation should consider the effort required by taxpayers to comply with the rules in relation to the additional tax that is collected by SARS. Edward Nathan Sonnenbergs IT Act: s 9D, s 9D(2A), s 9D(10), s 11(i), s 12C, s 6quat

1972. Transfer pricing and guarantee fees With effect from 1 October 2011, section 31 of the Income Tax Act No. 58 of 1962 (the Act), governing transfer pricing and thin capitalisation, will be replaced. Essentially, in the case of crossborder transactions between “connected persons” as defined, the new section 31 provides that one will determine whether the taxable income of each person that is party to the transaction can be justified compared to the same transaction entered into between independent persons dealing at arm's-length.

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The current thin capitalisation rules, which provide a safe harbour debt to equity ratio of 3:1, will be aligned with the transfer pricing rules of whether one is dealing with an arm's length transaction. An interesting area where section 31 of the Act, that is the old and new provisions, may be applicable is in the context of a guarantee between group companies. Often in a group context guarantees are provided by a parent company in respect of the debt of a subsidiary (or vice versa) and subsidiaries guarantee the debt of a sister entity. The question arises whether a fee should be charged by the entity providing the guarantee to a group company in the other jurisdiction. In other words, would independent third parties acting at arm's- length have charged a fee? The Canadian case of General Electric Capital Canada v Her Majesty the Queen [2009] TCC 653 (General Electric) considered this issue. The parent company in the United States charged its subsidiary (the subsidiary) a 1% fee for guaranteeing the subsidiary's debts owing to third party creditors (the fee). The subsidiary sought to deduct the fee, which was disallowed by the Canadian Revenue Authorities (the Revenue Authorities) on the basis that the subsidiary received no economic benefit and the arm's length price would be zero. The Revenue Authorities argued that the fee could not exceed the value of the benefit that is the increased credit rating for the group, resulting from the services (guarantee) provided by the parent company. Extensive submissions were made by both parties as to which methodology should be used to determine whether the guarantee had been provided on an arm's- length basis. A detailed analysis was conducted into the benefit obtained by the subsidiary (and the group) that received an increased credit rating where its debts were guaranteed by its parent company. The court confirmed that, in determining whether one is dealing with an arm's- length transaction, the following approach adopted by the OECD should be followed: "Application of an arm's-length principle is generally based on a comparison of the conditions in a controlled transaction with the conditions in transactions between independent enterprises. In order for such comparisons to be useful, the economically relevant characteristics of the situations being compared must be sufficiently comparable. To be comparable means that none of the differences (if any) between the situations being compared could materially affect the condition being examined in the methodology (e.g., price or margin) or that reasonably accurate adjustment can be made to eliminate the effect of any such differences." The court held that a 1% guarantee fee was equal to or below an arm's-length price in the circumstances, as the subsidiary received a net economic benefit from the transaction (i.e. the economic benefit of 1.83% was calculated under the yield approach, accordingly, a fee of 1% for the economic benefit was regarded as being arm's length). If one has the opportunity to read the General Electric judgment, one will appreciate how technical the analysis may become to determine whether one is dealing with an arm's-length transaction. In the appropriate circumstances, a fee will not have to be charged for a guarantee provided in a group context. However, one must ensure that both parties have given due consideration that is taking into account the benefits and risks to each party, whether or not a fee should be charged for the guarantee. One should also not lose sight of the exchange control implications of cross-border guarantees. Cliffe Dekker Hofmeyr IT Act: s 31 SARS Practice Note 2 11

SARS Practice Note 7

OBJECTIONS AND APPEALS

1973. Reasons for an assessment

Rule 3(1)(a) of the Rules promulgated under section 107A of the Income Tax Act No. 58 of 1962 (the Act), provides that a taxpayer that is aggrieved by any assessment may, by written notice, request the Commissioner for the South African Revenue Service (the Commissioner or SARS) to furnish reasons for the assessment. When are the reasons furnished by the Commissioner adequate? This was one of the issues considered by the Supreme Court of Appeal of South Africa (SCA) in the matter of the Commissioner for the South African Revenue Service v Sprigg Investment 117 CC t/a Global Investment [2010] (73 SATC 126) (Sprigg Investment or the taxpayer). The facts were that after a tax audit conducted by SARS in 2004 into the affairs of Sprigg Investment 117 CC (the taxpayer), SARS issued a letter of audit findings against the taxpayer, in 2006. The letter of audit findings set out SARS' findings, which findings related to employees' tax and Value-Added Tax (VAT), the evidence in support of its findings and legal conclusions. In response to SARS' letter of audit findings, the taxpayer submitted a lengthy and detailed response in which it denied the main conclusions reached by SARS. SARS proceeded to issue a letter of assessment against the taxpayer followed by formal assessments. The taxpayer did not accept the assessment and requested the Commissioner to furnish reasons for the assessment under Rule 3(1)(a) of the Rules prescribing the procedures to be observed in lodging objections and noting appeals, promulgated under section 107A of the Act. The request for reasons was set out in two letters, which contained 97 detailed questions targeting three items of the assessment. SARS did not respond to each and every question but rather gave brief explanations in respect of each tax item assessed and referred the taxpayer to its letter of assessment, which incorporated the reasoning set out in the letter of audit findings. SARS' view was that the request by the taxpayer required a response of such an extraordinary nature that any response would be akin to responding to questions usually asked in a court of law. The taxpayer took issue with the reasons furnished by SARS and approached the Tax Court for that court to compel the Commissioner to furnish adequate reasons. The Tax Court found in favour of the taxpayer and ordered the remittal of the letters of assessment to the Commissioner for reconsideration. It is against the finding of the Tax Court that the Commissioner appealed to the SCA. In adjudicating the question of the adequacy of the Commissioner's reasons, Maya JA, expressed agreement with the standard of what constitutes "adequate reasons" as laid down by the Federal Court of Australia in Ansett Transport Industries (Operations) Pty Ltd and Another v Wraith and Others (1983) 48 ALR 500 at 507: "[T]he decision-maker [must] explain his decision in a way which will enable a person aggrieved to say, in effect: "Even though I may not agree with it, I now understand why the decision went against 12

me. I am now in a position to decide whether that decision has involved an unwarranted finding of fact, or an error of law, which is worth challenging."This requires that the decision-maker should set out his understanding of the relevant law, any findings of fact on which his conclusions depend (especially if those facts have been in dispute), and the reasoning processes which led him to those conclusions." This standard was accepted and endorsed by the SCA in Minister of Environmental Affairs & Tourism v Phambili Fisheries (Pty) Ltd [2003] (6) SA 407 (SCA) (Phambili). The taxpayer contended that the Commissioner's reasons did not meet the Phambili test because the Commissioner had failed to disclose the reasoning process that led to his conclusion. The court found that the letter of assessment, which the taxpayer was urged to read in conjunction with the letter of findings, stated in plain terms for which taxes the taxpayer was being assessed , namely employees' tax and VAT. This letter also explained the reasons for the imposition of the taxes, penalties and interest. The evidential basis for SARS' main factual findings, those findings and the legal consequences that flowed from them, were clearly set out in the letter. The court held that there was absolutely no reason why the taxpayer was unable to formulate its objection and upheld SARS' appeal, finding that the Commissioner's reasons were adequate for the purpose for which they were sought. From the comments made by the court, it understood its role as being to consider whether the taxpayer had been adequately furnished with the Commissioner's actual reasons for the assessments to enable it to formulate its objection thereto. The court stated that its role was not to adjudicate on the cogency or rationality of the Commissioner's reasons. One of the noteworthy issues to come from the judgment is the importance the court seems to have attached to the taxpayer's response to the letter of audit findings. In this regard, Maya JA stated the following: “Notably, the respondent did not, at that stage, complain about the quality of SARS' factual findings or that it did not understand why they had been made. What it did instead, as Fyfe properly acknowledged, was reply in fine detail as to why it disagreed with the reasoning and findings and clearly had no difficulty responding to them.” As a result of the taxpayer submitting a detailed response to the letter of audit findings, it seems that the court inferred from this that the taxpayer understood or was aware of the Commissioner's reasons. Besides providing an important indication of how our courts will apply the Phambili test when testing the adequacy of the reasons furnished, this case also serves as a caution to taxpayers to be circumspect in their submissions to SARS, particularly the level of detail contained in those submissions. Edward Nathan Sonnenbergs IT Act: s 107A and related Rule 3(1)(a)

TAX AVOIDANCE

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1974. Connected persons In tax, as in business, it matters a lot whether or not you are connected. In most tax systems across the world, a taxpayer‟s relation to other entities with which it transacts determines whether a range of anti-avoidance legislation will apply or not. Whether the parties are called “related parties”, or “connected persons” as is the case in South Africa, this implies a non-arm‟s-length commercial relationship between transacting entities and forms the cornerstone upon which revenue authorities seek to justify the application of anti-avoidance legislation. In the South African domestic tax law, transfer pricing provisions are applied to adjust prices in respect of transactions between resident and non-resident connected persons. Deemed market value proceeds apply in respect of the disposal of assets between connected persons and a deemed dividend with resultant Secondary Tax on Companies (STC) is triggered if any benefit is granted to a connected person in relation to the shareholder. Connected persons provisions also feature in the context of hybrid equity instruments, hybrid debt instruments and diversionary rules related to the attributable net income of controlled foreign companies. With this substantial volume of anti-avoidance legislation that could be triggered if one enters into dealings with a connected person, it is essential to establish whether the transacting parties are connected persons when entering into transactions. South African taxpayers face a treacherous task of navigating extremely complicated, clumsy and disjointed legislation to determine their tax fate. Internationally, best practice requires legislation, and in particular anti-avoidance legislation, to be clear and understandable. In this, South Africa is unfortunately still lacking. Taking the definition of a connected person as set out in section 1 of the Income Tax Act, Act No. 58 of 1962 (the Act), a company is a connected person in relation to another company that would form part of the same group of companies if the expression “at least 70%” with reference to shareholding in the definition of a “group of companies” was replaced by the expression “more than 50%”. To put this in context, the definition of a “group of companies” also has a different meaning depending with which part of the Act one works. The first step is to determine the appropriate definition of a “group of companies”, and then apply the 50% exception to that definition to determine whether or not one complies with the first test of the “connected person” definition. The second test for a company in relation to another company is that company will be a connected person if at least 20% of the equity shares in the company are held by that other company, and no shareholder holds the majority voting rights in the organisation. This seems straightforward to determine but, again, there are exceptions. For transfer pricing purposes, transactions relating to intellectual property and knowledge, the phrase “and no shareholder holds the majority voting rights in the company”, should be disregarded. This has the effect of lowering the threshold of a connected person for purposes of specified transfer pricing provisions. With effect from 1 October 2011 this lower threshold, and the required disregarding of the phrase, will be applied to all transactions, thus expanding the potential application of transfer pricing provisions. These two tests apply in circumstances where there is a direct shareholding. Where there is no direct shareholding, a company will be a connected person in relation to another entity if such other entity is managed or controlled (more than 50% shareholding) by any person who or which is a connected person in relation to such company. In practice this requires careful analysis. The final twist in this complicated situation is that the connected person test must be applied in converse. Therefore, if company B is a connected person in respect of company A, company A will 14

automatically be a connected person in relation to company B. Sounds simple and logical, but quite different and difficult to test in complicated corporate transactions. Let‟s illustrate the application by a simple example: company A (A) holds 60% of the shares in company B (B) and 40% of the shares in company C (C). The other 60% of the shares in C are held by one shareholder. We need to establish whether C is a connected person in relation to B. For purposes other than transfer pricing, B will be a connected person in relation to A, as A holds more than 50% of the shares in B. C will not be a connected person in relation to A as, despite A holding more than 20% of the shares in C, the other shareholder in C holds the majority. As A does not control C, C is not connected to B, and B is also not connected to C. For transfer pricing purposes, intellectual property and knowledge related transactions, and post 1 October 2011 transactions, the analysis is different. A will be connected to B as it holds more than 50% of the shares in B. A will also be connected to C as it holds more than 20% of the shares in C and the requirement for the lack of majority voting rights must be disregarded. C will not be a connected person in relation to B on account of the joint control provision, as A does not control C. However, this must also be tested conversely. As A is connected to C, and also controls more than 50% of B, B is a connected person in relation to C on account of the joint control provisions. As B is a connected person in relation to C, C will also be a connected person in relation to B. Considering that this complicated test is required for testing a simple example, it is of concern whether taxpayers are always aware that they are at risk of being subjected to anti-avoidance legislation. This is clearly not conducive to establishing tax certainty in South Africa and illustrates the need to overhaul complicated and clumsy tax legislation. Edward Nathan Sonnenbergs IT Act: s 1 definition of “connected person”, s 1 definition of “group of companies”, s 64C

SARS NEWS

1975. Interpretation notes, media releases and other documents Readers are reminded that the latest developments at SARS can be accessed on their website http://www.sars.gov.za     

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Income Tax Act, 1962 Ruling BPR 105 re tax implications for a resident relating to a single premium whole life insurance policy issued by an off-shore insurer Customs and Excise Act, 1964 Rules for section 64E relating to accredited client status – implementation from 1 August 2011 Customs and Excise Act, 1964 Tariff amendments in Schedules Nos. 1 and 3 Income Tax Act, 1962 Notice published by the DTI in terms of section 12I - Tax Allowance Programme High Court Judgment – Section 40 of Value-Added Act, 1991 and section 91 of Income Tax Act, 1962 Appeal of rescission of judgment on outstanding VAT and PAYE arising from submission of VAT 201s and EMP201s without payment High Court Judgments added under 2001 and 2000 Customs and Excise Act, 1964 High Court Judgments for 2008 and 2007 added Customs and Excise Act, 1964 High Court judgments added under 2011, 2009 and 2008 Customs and Excise Act, 1964 15

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Tax Guide for Micro Businesses 2011-12 High Court Judgments – Judgments under 2002 and 2006 added Tax Court Judgment on definition of „gross income‟; application on pre-retirement withdrawal from Municipal Pension Fund Income Tax Act, 1962

Editor: Mr M E Hassan Editorial Panel: Mr KG Karro (Chairman), Dr BJ Croome, Mr MA Khan, Prof KI Mitchell, Prof L Olivier, Prof JJ Roeleveld, Prof PG Surtees. The Integritax Newsletter is published as a service to members and associates of The South African Institute of Chartered Accountants (SAICA) and includes items selected from the newsletters of firms in public practice, and commerce and industry, as well as other contributors. The information contained herein is for general guidance only and should not be used as a basis for action without further research or specialist advice. The views of the authors are not necessarily the views of SAICA. All rights reserved. No part of this Newsletter covered by copyright may be reproduced or copied in any form or by any means (including graphic, electronic or mechanical, photocopying, recording, recorded, taping or retrieval information systems) without written permission of the copyright holders.

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