1

The letter of the law not followed to the letter!But SARS's erroneousreference does notinvalidate its action

Synopsis January 2008

Tax today*

*connectedthinking

2

But an erroneous reference tothe empowering statute doesnot invalidate action by SARSTo practise as a tax consultant, it is essential to be a pedant.

Momentous consequences can turn on a particular word or

phrase in tax legislation.

It is not surprising, therefore, that the taxpayer’s advisers in

Shaikh v Standard Bank [2007] SCA 178 (RSA) seized on an

apparent error in a formal notice given by SARS to Standard

Bank, and argued that the notice was invalid.

The close corporation of a certain Shaikh had under-declared

the value of goods that it had imported, with the result that

VAT and customs duty had been underpaid.

SARS sought to recover the shortfall. When neither the close

corporation nor Shaikh came up with the money, SARS gave a

formal notice to Standard Bank requiring it to pay over money

held in Shaikh’s account. In terms of section 103 of the

Customs and Excise Act, Shaikh was personally liable for the

customs duty and VAT owed by his cc.

The notice by SARS to Standard Bank professed to be given in

terms of section 114A of the Customs and Excise Act.

In compliance with this notice, Standard Bank paid SARS the

sum of R699 920, being the only funds then in Shaikh’s

account, and later paid over a further sum of R539 993 from

the account.

SARS had invoked the wrong statutoryprovision to appoint Standard Bank as its agent

It transpired that the notice from SARS to Standard Bank

should have stated that it was given, not in terms of section

114A of the Customs and Excise Act, but in terms of section

47 of the VAT Act.

The sole issue for determination by the Supreme Court of

Appeal was whether the notice given to Standard Bank was

consequently invalid, in which event Shaikh would have been

entitled to be repaid.

Unfortunately for the taxpayer, this precise point of law had,

just a short time before, been the subject of a Supreme Court

of Appeal decision in Howick District Landowners Assoc v

The letter of the law not followed tothe letter!

3

Umngeni Municipality 2007 (1) SA 206 (SCA) in which it was

held that –

“Where an empowering statute does not require that the provision in

terms of which a power is exercised be expressly specified, the

decision-maker need not mention it. Provided moreover that the enabling

statute grants the power sought to be exercised, the fact that the

decision-maker mentions the wrong provision does not invalidate the

legislative or administrative act.”

In terms of this dictum, the question was simply whether SARS

had the power to appoint Standard Bank as its agent to recover

the VAT; if the answer were affirmative, then the notice to

Standard Bank was valid and it was irrelevant which statutory

provision SARS professed to rely on.

The court held that the principle laid down in Howick District

Landowners Assoc applied in the present case, and the notice

from SARS to Standard Bank was thus valid.

This principle does not legitimise unauthorisedadministrative acts

It is important to note that – as the Supreme Court of Appeal

pointed out – the principle in question is not a license for

unauthorised administrative acts; the principle legitimises acts

where authority for the act does exist, but the source of that

authority is incorrectly given.

In this issue

Erroneous reference to empowering statute does notinvalidate action by SARS . . . 2

SARS in relentless pursuit - Dave King saga continues . . 4

Liability for STC in respect ofloans to a discretionary trust . 7

Deductibility of interest on a loanincurred to acquire shares . . 8

Editor: Ian Wilson

Written by R C (Bob) Williams

Sub-editor and lay out: Carol Penny

Tax Services Johannesburg

Dis tri bu tion: Elizabeth Ndlangamandla

Tel (011) 797-5835

Fax (011) 209-5835

www.pwc.com/za

4

The on-going tax litigationbetween SARS on the one hand and King on the other isthrowing valuable light on theseldom-explored outer limits ofSARS’s powers to access orfreeze a taxpayer’s assets(including those situatedabroad) that can be realised tosecure payment of a tax debt.

Dave King saga continues

The well-known entrepreneur, David

King, was arrested in 2002 and is now

reported to be facing 322 charges,

including fraud, money laundering,

racketeering and the breach of exchange

control regulations.

King has reportedly been assessed to

tax in excess of R900 million and one of

his companies, Ben Nevis Holdings Ltd,

has been assessed to tax in excess of

R1 400 million.

The Director of Public Prosecutions,

SARS and the South African Reserve

Bank have been successful in obtaining

court orders, in South Africa and

overseas, to freeze all of King’s funds,

including the assets in several trusts and

business entities. The purpose of these

orders was to preserve assets, which

can later be realised and the proceeds

used to pay SARS the outstanding tax.

The on-going tax litigation between

SARS on the one hand and King and his

associated companies on the other is

throwing valuable light on the

seldom-explored outer limits of SARS’s

powers to access or freeze a taxpayer’s

assets (including those situated abroad),

which can be realised to secure payment

of a tax debt.

Preservation and anti-dissipation order in respect ofan aircraft in France

On 3 September 2002 the South African

High Court issued a preservation and

anti-dissipation order in respect of a

South African-registered Falcon

executive jet (originally valued at R200

SARS in relentless pursuit

5

million), which had been languishing and

deteriorating at an airport in France since

April 2003.

The aircraft was owned by a partnership

between Hawker Air Services (Pty) Ltd,

Hawker Management (Pty) Ltd and Rand

Merchant Bank, the last-mentioned

being an undisclosed partner with a

99.8% interest in the aircraft. SARS had

a VAT-related claim against the

partnership of some R73 million.

The preservation and anti-dissipation

order had the effect of interdicting any

disposal of the aircraft, but (see the

judgement at [3]) did not create a

preferential claim over the aircraft in

favour of SARS.

In spite of that order, Carmel (claiming

that it was not a party to the litigation

and therefore was not bound by the

order) purported to take over the interest

of Rand Merchant Bank and Hawker

Management (Pty) Ltd vis-à-vis the

aircraft. The High Court however, held

that this was a contrived transaction, in

fraudem legis, intended to bypass the

preservation order, and that Carmel was

a tool of King and under his control.

A subsequent extension of that order

required Carmel Trading Co Ltd to return

the aircraft to South Africa; see Metlika

Trading Co Ltd v CSARS 2005 (3) SA 1

(SCA).

The stalemate

Thereafter, a stalemate ensued. The

aircraft remained in France. Carmel,

despite professing a willingness to

procure the aircraft’s return to South

Africa, refused to make funds available

to do so and refused to consent to the

aircraft’s being returned to South Africa

by the sheriff. (See the judgement at [7].)

Meanwhile, the aircraft was not being

kept in a hangar, was fast deteriorating,

and would soon become worthless.

Hangarage would slow the rate of

deterioration but would cost R150 000

per month. Consequently, the earlier

preservation order granted by the court

would soon be nugatory unless it could

be amplified to enable the aircraft to be

sold and the proceeds kept in trust

pending a final resolution of the litigation.

SARS was of the view that King was

determined to thwart the sale of the

aircraft, and (as the judgement records

at [10]) was “patently prepared to see the

value of the Falcon lost rather than being

used to pay SARS”.

The present appeal wasagainst the order that theaircraft be sold

The High Court issued a variation order

to the effect that the aircraft should be

sold by the sheriff and the proceeds kept

in trust pending finalisation of the

litigation.

It was this order that was the subject of

the present appeal. Carmel was

opposing not just the terms of that

particular order, but any sale of the

aircraft.

In his affidavit the Commissioner

contended (see [10]) that –

“the behaviour of the new partnership to leave

the Falcon stranded and neglected in a foreign

country is an obvious and desperate attempt to

prevent our courts from eventually making an

effective order in respect of this valuable asset

[and King] is patently prepared to see the value

of the Falcon lost rather than being utilized to

pay [SARS].”

The court described Carmel’s opposition

to the sale of the aircraft as

schadenfreude (which a dictionary

defines as “malicious or smug pleasure

in somebody else’s misfortune”) and

said (at [13]) that Carmel’s objection to

the sale “lacks reality”.

Carmel argued that selling theaircraft would flout the Bill ofRights

Carmel objected to the sale on the basis

that section 25(1) of our Bill of Rights

provides that no law can permit the

arbitrary deprivation of property, and

argued that an order to sell the aircraft

and keep the proceeds in trust pending

the finalisation of the main litigation

amounted to “an arbitrary deprivation of

Carmel’s property”.

The court held that this argument broke

down on many levels. Firstly, the aircraft

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was not Carmel’s property, although it may

have had a proprietary interest in it as a

partner in the partnership that was a

beneficial owner of the aircraft. However, a

court had already found that Carmel’s

purported taking over of a partnership

interest was fraudulent, and the court now

held (at [15]) that Carmel could not rely on

a simulated or fraudulent agreement.

Moreover, said the court, the partnership

had been dissolved by the liquidation of

one of the partners, and as a former

partner, Carmel had no proprietary claim in

respect of the partnership’s property, but

at best a claim for a proportionate share of

the proceeds.

The court ruled further (at [16]) the sale

would not amount to a “deprivation” of

property. In effect, it would merely

substitute a fund of money for a

deteriorating asset and Carmel’s position

would not, after the sale, be any different

from what it was now. The value of the

asset was being retained for the owner and

creditors.

Moreover, said the court (at [17]) the sale

was not “arbitrary” because there was

sufficient reason for the deprivation and it

was procedurally fair. SARS would not get

control of the proceeds of the sale, which

would be kept in trust on behalf of the

owner of the aircraft.

Overview

Where SARS relentlessly pursues a

taxpayer, seeking out assets that can

be realised to pay off a tax debt, or to

freeze assets pending finalization of a

tax claim, the taxpayer may be

tempted to think that his off-shore

assets are safe from SARS’s clutches.

After all, it is trite that (unless there are

specific co-operation agreements),

one state does not enforce another’s

tax laws.

Whether SARS can enforce a tax debt

due to the government of the Republic

in a foreign country depends on the

terms of the applicable double tax

treaty, and in the absence thereof, on

the law of the country in question. It is

unlikely that a tax debt would be

actionable in the foreign country.

In State of Colorado v Harbeck (1921)

232 NY 71), decided in the state of

New York, it was held that one state is

not a collector of taxes for another.

Similarly, the courts of the United

Kingdom do not entertain a suit by a

foreign country to recover tax due to it.

(See Government of India v Taylor

(1955) 1 All ER 292 (HL); Peter

Buchanan Ltd and Machurg v McVey

(1955) AC 516; Rossano v

Manufacturers Insurance Co [1962]

2 All ER 214.)

However, as the decision of the

Supreme Court of Appeal in the case

under discussion makes clear, where a

taxpayer is subject to the jurisdiction

of the South African courts, our courts

can make a preservation or

anti-dissipation order in respect of his

assets even if they are located in a

foreign jurisdiction. (Breach of such an

order could ground contempt of court

proceedings against the taxpayer in

the South African courts.) Moreover,

our courts can order that an asset

(even if located overseas) in respect of

which a preservation order has been

granted, be sold, and the proceeds

held in trust pending the finalisation of

the litigation.

Whether SARS can enforce a tax debt due to the government of the Republic in a foreign countrydepends on the terms of the applicable double tax treaty, and in the absence thereof, on the law ofthe country in question.

7

The crisp issue in this case was whether

a discretionary trust was a “recipient” as

contemplated in section 64C(1) of the

Act in its pre-amendment form. If the

answer was in the negative, then this

lacuna was capable of being exploited to

avoid or at least defer liability for STC.

In terms of section 64C(1) a “recipient”

vis-à-vis any company was (prior to the

amendment) defined as a shareholder of

the company, or any relative of such

shareholder, or –

“any trust of which such shareholder or relative

is a beneficiary”.

The question was whether these words

included all trusts, or only those in which

the beneficiary in question had a vested

right, thereby excluding from the ambit

of a “recipient” those discretionary trusts

where no vesting had yet taken place.

In 2000 the Act was amended to define a

“recipient”, vis-à-vis a company, as –

(a) any shareholder of such company;

(b) any connected person [as defined] in

relation to such shareholder.

Read with the definition of “connected

person”, this amendment made clear

that where a shareholder was a

beneficiary of any trust, whether vesting

or discretionary, the trust would be a

“recipient”.

The minority judgment (per Combrinck

JA, Farlam JA concurring) held that the

Tax Court had correctly found that, in

relation to a trust, the term “beneficiary”

in section 64C(1) prior to its amendment

in 2000 was restricted to a vested

beneficiary, and did not include a person

who, at the relevant time, was a potential

beneficiary. The majority judgment (per

Hurt AJA; Howie P and Lewis JA

concurring) held that the meaning of the

term “beneficiary” in this context was

not restricted to beneficiaries with

vested rights.

The decision of the Supreme Court of Appeal in CSARS v Airworld CC[2007] SCA 147 (RSA) concerns adisputed point of interpretation ofthe Income Tax Act, which hassince been resolved through anamendment to section 64C(1),which became effective as from22 December 2003.

The point at issue in the case istherefore now academic, save inrespect of taxpayers whoseassessment for STC for periodsprior to that amendment is still inthe pipeline.

Liability for STC in respect of loans to adiscretionary trust

Being a decision of the Supreme Court of Appeal, the majority judgment on the interpretation of section 64C(1), prior tothe 2000 amendment, is absolutely binding on all lower courts, and SARS will therefore be obliged to apply the ruling inrelation to all disputed or unprocessed assessments involving company distributions prior to 22 December 2003.

8

The acquisition of shares is aneveryday commercialtransaction. Frequently, thepurchase is financed wholly orpartly by a loan. The tax-deductibility or otherwise of theinterest on that loan is oftenvital to the financialattractiveness of the deal.

It is surprising how oftenpurchasers go into suchtransactions, often involvingvery large sums of money, onthe blithe assumption that theinterest will be deductible,without giving any thought towhether advance tax planning is required to ensure, or at leastmaximise, the chances of suchdeductibility.

A recent example of suchnaiveté is the case of SalliesLimited v CSARS(Johannesburg High Court, case A3034/07; judgment deliveredon 30 November 2007; not yetreported).

Deductibility of interest on a loanincurred to acquire shares

In this case, Sallies Ltd (a listed but

dormant public company) entered into

an agreement with a company

incorporated in the USA to acquire the

entire share capital of Phelps Dodge

Mining (Pty) Ltd for some R74 million,

financed inter alia by a loan of US$6.5

million.

Phelps Dodge Mining (Pty) Ltd changed

its name to Witkop Fluorspar Mine (Pty)

Ltd (“Witkop”) and became the

wholly-owned subsidiary of Sallies Ltd.

Witkop’s main asset was the Witkop

Fluorspar Mine in Zeerust.

On 17 June 1999, Sallies Ltd issued a

circular to its shareholders, motivating

for the latters’ approval and ratification

of the acquisition of Witkop, and such

approval and ratification was duly

secured.

On 23 September 1999, Sallies Ltd and

Witkop entered into a marketing

agreement whereby Sallies was

appointed the sole marketing agent of

Witkop in respect of the latter’s

production of fluorspar, a non-precious

mineral. Witkop was to pay Sallies an

“intent fee” of R3 million and a monthly

fee of R200 000. The agreement was for

a period of five years, after which it

would continue indefinitely until

terminated by either party.

As at 30 June 2000, Sallies had earned

R5 million in respect of such marketing

fees.

Sallies’ claim to deduct theinterest on the loan wasdisallowed by SARS

For income tax purposes, Sallies

claimed a deduction in respect of

interest on the loan, which it sought to

deduct from the marketing fees paid to

it by Witkop.

SARS refused to allow the interest as a

deduction, and issued an assessment

accordingly. Sallies objected to the

assessment, and asserted its claim to a

deduction. When the matter came

before the Tax Court, the court ruled in

favour of SARS.

Deductibility turned on Sallies’ purpose in borrowing themoney

On further appeal to the High Court, the

matter turned on whether the interest

(incurred by Sallies on the loan which

had been utilised to acquire the shares

in Witkop) satisfied the criteria for

deductibility laid down in the general

deduction provisions of the Income Tax

Act 58 of 1962, namely section 11(a)

read with section 23(f) and section

23(g).

In his judgment, Goldstein J quoted

from CIR v Allied Building Society 1963

(4) SA 1 (A) at 13C – D where Ogilvie-

Thompson JA said that, on the facts of

that case, the ultimate use or

destination of the borrowed money

could not be elevated into a decisive

9

factor in determining its deductibility

under the Income Tax Act. The dominant

question was – what was the true nature

of the transaction, and the most

important factor in that inquiry was the

purpose of the borrowing.

If the purpose of borrowing money was

to apply the funds to earn income of a

kind that is taxable under the Act, then

the interest on the loan is a deductible

expense for income tax purposes.

Dividends, however, are exempt from

tax; hence expenditure incurred for the

purpose of producing dividends is not

deductible.

The purpose of a loan, said Goldstein J

must be determined at the time of the

borrowing of the funds.

Goldstein quoted from CIR v Standard

Bank of SA Ltd 1985 (4) SA 485 (A) at

500H – 501C where Corbett JA said that

a distinction has be drawn between the

case where the taxpayer borrows a

specific sum of money and applies it to

an identifiable purpose, and the situation

where (as in the Allied Building Society

case) the taxpayer borrows money

generally (in other words, not to finance

a specific transaction) and on a large

10

scale, simply to raise floating capital for

use in his business. In the former

situation, the purpose of the loan (in

other words, what kind of income it was

intended to produce) can be established.

In the latter situation, no such specific

purpose can be determined, but the

interest satisfies the tests for

deductibility, and is therefore a

deductible expense.

It is clear that the loan in the present

case fell into the first-mentioned

category, and that the specific purpose

of the borrowing could be ascertained.

What was the purpose of theloan in the present case?

Goldstein J said that, in the present

case, of the three witnesses who

testified in the court a quo, only one of

them could give direct evidence of the

taxpayer company’s intention at the time

of the borrowing. However, as Miller J

said in ITC 1185 35 SATC 122 at 123,

the ipse dixit of a taxpayer (in other

words, what he states his intention to

have been) is not decisive on this issue

and a court has to draw its own

inferences as to the operative intention

against the background of the general

human and business probabilities.

In the present case, said Goldstein J, the

witness had testified that Sallies’

purpose, in acquiring the shares in

Witkop, was to generate income in

Sallies by charging Witkop fees for

services provided by Sallies, including

technical, management, and marketing

services. However, said this witness,

dividends were “not on the radar for

many years”.

Goldstein J proceeded to put this

argument under a strong lens.

In the normal course, said Goldstein J (at

[9]) –

“a shareholder is rewarded for his investment

by the receipt of dividends. This fundamental

factor had to be provided not to operate in the

present case”.

The witness, said Goldstein J, had

suggested that Sallies was to be

remunerated in fees. It was implicit that

such fees would have to be

market-related, and any excess would

have to be channelled to Sallies either as

a dividend or as a loan – but neither

would constitute “income”, as defined in

section 1 and the interest would

therefore not be a deductible expense.

Goldstein J found a further flaw in

Sallies’ argument for deductibility in the

fact that the company’s circular to its

shareholders stated that the projected

profits of Sallies and Witkop for the tax

year was R17.85 million. Since Sallies

had no significant source of independent

income, the projected profit must have

been substantially derived from Witkop.

The fees payable by Witkop to Sallies

could not absorb more than a fraction of

this, so it must have been intended that

the balance of the projected profit would

be paid to Sallies by way of a dividend.

Moreover, paragraph 7.11 of the circular

said explicitly that Sallies intended to

pay its shareholders dividends. Such

dividends could only come from the

dividend income it received from Witkop.

All of these factors were nails in the

coffin of the argument that the purpose

of the borrowing was to produce fee

income for Sallies, and not dividends.

Moreover, said Goldstein J, Sallies’

income and expenditure statement for

the year in question was destructive of

its argument that it had taken out the

loan for the purpose of earning fees from

Witkop. This statement reflected a profit

of only R31 028, which represented a

return of about 0.43% on the borrowed

money, and the purpose of the loan

could not have been to generate such a

small return.

In the result, the court held that it had

not proved that it had acquired the

shares in Witkop “in the production of

income”; the appeal failed and the

interest was thus not deductible.

What was the purpose of the loan?Goldstein J proceeded to put theirargument under a strong lens.

11

Tax planning lessons from this judgement

This judgment underlines the difficulties that frequently

arise in cases where an acquiring party in relation to

an acquisition may derive income from the acquired

company in the form of fees, or some other trading

transaction. In some cases, taxpayers have been able

to persuade the Courts that their purpose in acquiring

shares was to derive taxable income streams.

However, this appears to have been a remote

possibility in this matter. .

A tax consultant would have said to Sallies – if you

want to be entitled to a deduction in respect of the

interest on the loan to acquire the Witkop shares, you

are going to have to prove that your purpose in

borrowing the funds was not to earn dividends, but

management fees. In terms of the Income Tax Act, the

onus is on you to prove this. How do you intend to

discharge that onus, for it will not be sufficient for a

witness simply to stand up in court and, hand on

heart, swear that this was indeed Sallies’ intention?

In the present case, the language of the circular to

shareholders was seized on by the judge as being

inconsistent with an intention not to earn dividends

from Witkop. In hindsight, that circular ought to have

been vetted by a tax professional, and its adverse

implications identified and considered before it was

issued.

There are limits to what tax-planning can achieve. In

the present case, it is likely that no gloss or

restructuring could have disguised the fact that the

purpose of the loan was primarily to generate dividend

income from Witkop.

An advisor might have suggested that Sallies should

negotiate two entirely separate loans, even if from the

same lender. The first loan could have been for an

amount which Sallies would admit had been taken out

for the purpose of earning dividends, and Sallies

would have to resign itself to the interest on this loan

being non-deductible.

In respect of the second loan, Sallies would argue that

this amount had been borrowed for the purpose of

generating fee income from Witkop, and that the

interest was therefore deductible. For this argument to

be credible, the ratio of the moneys borrowed under

this second loan vis-à-vis the prospective fee income

would have to be attractive on ordinary business

principles. Even this approach would still carry with it

considerable risk of disallowance of all the interest.

Where there is just one loan (as in the present case)

the courts determine the deductibility of interest by

giving effect only to the taxpayer’s dominant purpose

in borrowing the money.

If the dominant purpose was to produce dividend

income, then none of the interest will be deductible,

even if part of the taxpayer’s purpose was to produce

non-dividend income. The attitude of the courts in this

respect – which is pragmatic if illogical – is clear from

the concurring judgment of Schwartzman J in the

present case.

This publication is provided by PricewaterhouseCoopers Inc. for information only, and does not constitute the provision of professional advice of any kind. The information

provided herein should not be used as a substitute for consultation with professional advisers. Before making any decision or taking any action, you should consult a

professional adviser who has been provided with all the pertinent facts relevant to your particular situation. No responsibility for loss occasioned to any person acting or

refraining from action as a result of any material in this publication can be accepted by the author, copyright owner or publisher.

© 2007 PricewaterhouseCoopers Inc. All rights reserved. PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International Limited,

each of which is a separate and independent legal entity. PricewaterhouseCoopers Inc is an authorised financial services provider.

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Given the rapid development incorporate governance standards, theincreased risk inherent in thesepositions and the additional timecommitment required, it is notsurprising that there is a greaterreluctance to take on a Non-Executive Director position.

The Non-Executive Directors BestPractice and Fees Report is a newpublication fromPricewaterhouseCoopers, whichfocuses on companies listed on theJohannesburg Securities Exchange(JSE). It does, however, covercompanies that may have duallistings on other exchanges.

The first part of the Report draws onexamples of global best practice,whether prescribed by Regulation orevidenced in market best practice.

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