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Europe gets serious about combating tax evasion

Synopsis March 2008

Tax today*

*connectedthinking

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In this issue

Europe gets serious aboutcombating tax evasion. . . . . 2

No such thing as a tax-freeholiday . . . . . . . . . . . . . 3

Amounts paid in terms of asettlement agreement: income orcapital? . . . . . . . . . . . . 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

Europe gets serious about combating tax evasionGermany’s call in March 2008 for a clampdown on European taxhavens was supported by a majority of the European Union’s27 member states who have made it known that they aredetermined to clamp down on bank secrecy, which they believe is encouraging tax evasion.

There has been new momentum in this

regard since German tax authorities

paid an informant at Liechtenstein’s

LGT banking group a large sum to hand

over data on secret accounts held in

that country, which revealed that 600

Germans held millions of euros in

anonymous trusts in Liechtenstein.

The German finance minister said that

this was not only a tax scam but a

social and moral issue. He also

criticised Austria, Luxembourg and

Belgium for their secrecy and for

negotiating double tax agreements with

tax havens in the Far East that fell short

of the EU’s code on tax transparency.

The revelation of the Liechtenstein data

has also placed the tax havens of

Andorra and Monaco in the spotlight.

Brussels is looking into ways to combat

tax evasion in non-EU states such as

Hong Kong and Macao.

In Italy, magistrates in Rome have begun

an investigation into some 400 Italians

who are suspected of evading tax by

holding secret bank accounts in

Liechtenstein.

Spain, Australia and Greece began

similar investigations last month.

Liechtenstein, a country of some 35 000

inhabitants, lies between Austria and

Switzerland. Over the years, it has lured

thousands of rich investors across the

world with a promise of confidentiality,

and is on an international blacklist of tax

havens.

A review of anti-evasion legislation has

been brought forward

EU finance ministers have ordered the

European commission to bring forward a

review of legislation to counter tax

evasion. Under the EU’s 2005 tax

directive, states are obliged to supply

fellow members with information on their

nationals’ interest income, but Austria,

Belgium and Luxembourg were

exempted from this obligation.

Liechtenstein has said that it wants to

conclude a comprehensive tax fraud

agreement with the European Union.

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Taxpayer tried to pass off free holidays for its employees as a staff-training exercise

The recent decision of the Cape Tax Court in XYZ (Pty) Ltd v

CSARS (case 12244; judgment delivered on 21 January 2008;

not yet reported) is yet another example of failed tax-planning

stratagems based on the premise that SARS assessors are too

naïve to recognise a tax-dodge when they see it.

In this instance the taxpayer, in a nutshell, tried to dress up free

holidays for its employees as a staff-training exercise, to save

their being taxed on the perk as a fringe benefit.

The taxpayer was in the business of timeshare holiday

exchange. Property developers sold timeshare in their holiday

resorts to purchasers who thereby acquired three-year

membership in the taxpayer’s plan, after which they could

renew their membership for an annual fee.

Timeshare resorts are usually structured as shareblock

companies. The purchasers of timeshare become shareholders

in the shareblock company, which entitles them to occupy a

particular unit in a particular timeshare resort for a particular

week of the year. Members of the taxpayer’s timeshare scheme

were entitled to “space-bank” their occupation rights with the

taxpayer, in return for which they were credited with points.

Having accumulated points, a member had three years within

No such thing as a tax-freeholiday

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which to trade-up for a higher grade resort, or use the points to

take holidays of less than a week.

The taxpayer earned its revenue by charging an exchange fee

for each exchange in which a member utilised his points to

reserve accommodation held in the taxpayer’s stock of

space-banked rights of occupation.

Knowledgeable sales staff were vital to thebusiness

Holiday timeshare exchanges were usually made telephonically

between a member of the timeshare scheme and one of the

taxpayer’s call-centre staff, known as “guides”.

Members were often unable to secure a booking at their first

choice of timeshare resort and the role of the guide was to

“cross-sell” and if necessary “up-sell” alternative

accommodation that matched the member’s needs and

aspirations.

The taxpayer believed that well-educated and experienced

telesales guides were key to the success of its business.

To this end, the taxpayer gave its staff the opportunity to visit

the various resorts on its books by allocating each employee

17 000 points annually for the purpose of “resort education”, so

that they could visit several of the taxpayer’s resorts each year

and gain first-hand knowledge. This would assist them in

advising clients and implementing successful exchanges.

The taxpayer’s employees were not obliged to use all or any of

the points allotted to them, and they were permitted to use the

points at resorts of their own choosing. But they were not

allowed to cash in any unused points.

The taxpayer’s attitude was that it was in the interests of its

commission-remunerated guides to acquire product knowledge

through personal experience of the resorts in which they were

selling rights of occupation.

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Staff took up resort accommodation that wouldotherwise have been vacant

Because members of the taxpayer’s timeshare scheme were

given precedence, the rights of occupation that were in

practice most often exercised by employees were those that

were about to “burn”, in other words those accommodation

rights that would otherwise not be exercised at all.

In argument to the court, the taxpayer likened an unexercised

right of occupation to an empty seat on an aircraft, and took

the view that it would prefer an employee to exercise a right of

occupation, rather than have it not exercised at all.

This was because low occupancy was bad for the resorts, and

it would cost the taxpayer nothing to allow employees to

exercise rights of occupation that were about to “burn”.

In terms of the taxpayer’s scheme, its employees had to pay for

their own transport to the resorts, and pay for meals and

amenities they used. After their visit to a resort, employees

were required to complete a resort evaluation form. They were

only permitted to book two weeks per annum at a standard

resort, and not more than one unit at a resort with a higher

grading. They could not make bookings during peak times, nor

could they sell or otherwise dispose of their points, or give

them out privately to friends or family.

The taxpayer regarded the allocation of points to its staff as an

integral element in the training of employees and not as a form

of remuneration for services rendered.

The taxpayer’s standard letter of appointment for its employees

obliged the latter to participate in on-going learning, which

could take place outside of normal working hours and over

weekend in the interests of performance improvement.

The taxpayer’s self-assessment to fringebenefits tax and SARS’s response

In terms of para 3(1) of the Seventh Schedule to the Income

Tax Act 58 of 1962 (a statutory code for the taxation of fringe

benefits granted by an employer to an employee) a taxpayer is

required to determine and enter in its tax return “the cash

equivalent of a taxable benefit” given to its employees. Such

cash equivalent is then taxable in the hands of the employee as

part of his or her “gross income”.

Acting in terms of the Seventh Schedule, and in the light of the

way in which it operated its points system, the taxpayer in this

case assessed the cash equivalent of the taxable benefit granted

to its employees by way of exchangeable points to be nil.

SARS became aware of the facts of the matter in the course of

a routine audit, and responded by issuing an assessment for

the PAYE that (according to SARS) the taxpayer should have

deducted and paid over to the fiscus. The assessment was

made in terms of para 2(d), or alternatively para 2(h) of the

Seventh Schedule. These two subsections govern, respectively,

the provision by an employer of residential accommodation free

of charge or for less than the rental value, and amounts owing

by an employee to a third person, which the employer has paid

without requiring reimbursement.

In its computation of tax liability, SARS adopted the current

market value of accommodation at the timeshare resorts in

question and issued the taxpayer with an assessment to some

R11 million in tax for the 2002 – 2006 tax years, plus a

R1 million penalty for failing to deduct and remit PAYE on the

taxable value of the benefits in question. In addition, SARS

levied a charge for interest on the overdue tax of some

R2.8 million.

SARS issued the taxpayer with an assessment to some R11 million in tax for the 2002 – 2006 taxyears, plus a R1 million penalty. In addition, it levied a charge for interest on the overdue tax of some R2.8 million.

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Did the employees receive a taxable benefit?

The taxpayer argued that it had not provided its employees

with “accommodation” as envisaged in the Seventh Schedule,

but had merely provided employees, via its points system, with

a right to exchange those points for rights of occupation at the

resorts in question.

That right, contended the taxpayer, was an asset, that is to say,

a non-monetary item of property.

In terms of the Seventh Schedule, “assets’ provided by an

employer to an employee as a fringe benefit are taxable in the

latter’s hands at their market value. The taxpayer company

argued that, in all the circumstances, the value of these

“assets” (in other words, the rights of occupation at resorts

which had not been taken up by customers) had a nil market

value because their employees were not permitted to cash in

their right to stay at the resort, and take the money instead.

In arguing that the cash equivalent of the fringe benefit in question

was the amount of money into which the employee could convert

the benefit – in this case nil – the taxpayer invoked the decision of

the High Court in Stander v CIR 1997 (3) SA 617 (C).

In this case, a certain Mr Stander had received, as a prize, an

overseas trip. In terms of the conditions attaching to the prize,

he could not sell or otherwise cash in the prize – he had to take

the free holiday or nothing at all.

The court in Stander’s case held that, for income tax purposes,

the “value” of the prize in Stander’s hands was the amount of

money into which he could convert it. Since the conditions

attaching to the prize were that he could not exchange it for

cash, nor could he transfer it to anyone else, its value in his

hands was nil.

Unfortunately for the taxpayer in the present case, the Supreme

Court of Appeal had just given its judgment in the much-

publicised case of CSARS v Brummeria Renaissance (Pty) Ltd

2007 (6) SA 601 (SCA) which held that Stander’s case had been

wrongly decided, and that the criterion of value for income tax

purposes, was its objective monetary value, and not the

amount of money into which the taxpayer could convert it.

In the current case, the court held that the principle laid down

in Brummeria Renaissance was applicable in the matter at

hand. Hence, said the court –

“The right to accommodation is a benefit for which an employee would

have had to pay if he or she had not been given it for nothing. That right

had a money value and the fact that it cannot be alienated does not

negate the value”.

Was the accommodation a holiday or a trainingexercise?

In the current case, the taxpayer’s second argument was that

the purpose of providing its employees with accommodation at

its timeshare resorts was not to give them a free holiday, but to

equip them to give improved service to clients through their

personal knowledge of the resorts.

Unfortunately for the taxpayer, SARS shot down this argument

by laying before the court a document the taxpayer provided to

its staff, which said –

“You’ve worked hard all year. You’ve been part of an international team

that’s dedicated to arranging great Holiday experiences for [our]

members. Now it’s your turn to enjoy a Resort Educational ...”

The court also pointed out that if the taxpayer had intended to

accommodate its employees at resorts for training purposes,

“one would have expected a structured plan” in this regard,

rather than a points system that allowed the employees a wide

choice. The fact that points were allocated, said the court –

“is indicative of the fact that this privilege ... is not only a management

tool, but also a privilege given to staff in order to retain the services, to

reward them for services rendered and further their morale. The fact that

employees have to report back to the [taxpayer] on conditions at resorts

is clearly but a convenient by-product of what is mostly an enjoyable

experience for most employees”.

Also damaging to the taxpayer’s argument was evidence laid

before the court that its employees would repeatedly visit the

same resort, often within a short period of time.

All in all, the allocation of points to employees, said the court,

was in the nature of a free holiday, given by way of a fringe

benefit as a reward for services rendered or to be rendered by

them.

Also damaging to the taxpayer’s argument was that its employees would repeatedly visit the sameresort, often within a short period of time.

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A good idea, badly executed

The tragedy from the taxpayer’s perspective (apart from its eventual multimillion rand tax bill)

was that the germ of the idea was sound.

The decision of the Supreme Court of Appeal in the

Brummeria Case that Stander’s case was wrongly

decided was clearly an unforeseen factor, given that

the concept of money’s worth had hitherto relied on

the capacity of the recipient to turn the benefit to

money. Notwithstanding this unfortunate turn of legal

precedent, coming as it did just before the decision in

this matter, it might have been possible to have saved

a large tax bill.

After all, many genuine business expenses involve an

element of personal enjoyment for the employees

involved. A business trip, with accommodation at a

classy hotel, is not unrelieved drudgery. A business

lunch with a client at a good restaurant, with fine food

and wine, has an enjoyable dimension, and there is no

principle of tax law that says that only the client’s bill

is tax-deductible.

It is implicit in the Seventh Schedule that a benefit falls

outside of its scope – and is thus not a benefit taxable

in the hands of the employee – if the benefit in

question enures to the advantage of the employer, not

the employee.

Thus, in the hypothetical scenarios just outlined, the

business trip and the business lunch, were (in their

purpose and effect) for the benefit of the employer,

and any enjoyment or cost-saving by the employee

was merely incidental and, for tax purposes, irrelevant.

Thus, if the timeshare company in the present matter

had genuinely intended (and if it were able, when push

came to shove, to persuade the tax court that it

genuinely believed) that it would be good for its

business if its consultants had personal knowledge of

the timeshare resorts in question, then a

well-structured system of enabling those consultants

to gain that knowledge at company expense, as one

element in a genuine staff-training programme, would

not (it is submitted) have constituted a taxable fringe

benefit in the employees’ hands.

The flaw in the taxpayer’s case was not in the

underlying idea, but in its ill-considered and flawed

execution, including the damaging policy document

which in effect, admitted that the intention was to

reward employees.

If the employees had received free accommodation at

the timeshare resorts in the course of a genuine and

reasonable staff-training programme in which the

employer decided on the when and where, and

ensured that the employees stayed at a variety of

resorts and did not simply frequent their favourite one,

the outcome of the case may well have been

favourable to the taxpayer.

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Amounts paid in terms of a settlement agreement: incomeor capital?

Caution: be specific or pay the price

Taxpayer could not give aclear and coherent account ofwhat the money was paid for

The judgment of the High Court in WJ Fourie Beleggings CC v CSARS (caseA264/2006; judgment given on 6 August 2007; not yet reported) starts by saying that the issue in the case was – “whether an amount of R1 292 760 which waspaid to the appellant during the year of assessment ending 28 February 2002pursuant to a settlement agreement, was a capital receipt and thereforenon-taxable or a revenue receipt which is taxable”.

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The taxpayer was the lessee of a hotel in Potchefstroom. In

2001, Naschem, a division of Denel (Pty) Ltd, requested the

taxpayer to provide accommodation and meals for a

delegation of thirty-eight students from the United Arab

Emirates who were to be trained by Naschem in South Africa.

The taxpayer agreed to do so for a consideration of just under

R9 million.

The students duly took up accommodation in the taxpayer’s

hotel, but following the attack on the Twin Towers in New York

on 11 September 2001, they abruptly departed without notice,

after wrecking their hotel rooms by burning carpets, making

holes in the mattresses and damaging the furniture.

The taxpayer threatened to sue Naschem and, after some

negotiation, these two parties reached an out-of-court

settlement whereby Naschem would pay the taxpayer

R1 292 760 in full and final settlement.

A sensible settlement, except in relation to tax

It was of course sensible to avoid the expense and

unpredictability of litigation by reaching a settlement.

Less astute was that neither party (nor their professional

advisers) seems to have given a moment’s thought to the tax

consequences of the settlement.

Naschem’s legal adviser later testified that she did not know

how the settlement figure was computed, and that her brief

was simply “to get [the hotel] off their backs and to settle the

matter out of court by keeping the settlement amount as low

as possible”.

Tax law is clear

The tax principle at stake is clear.

Compensation accruing to a taxpayer for damages is of a

revenue nature (and thus subject to income tax) when the hole in

the taxpayer’s pocket that the compensation fills is of a revenue

nature, for example, compensation for the loss of profits.

Compensation is capital (and usually subject to capital gains

tax) when the hole which it fills is of a capital nature, such as

loss of or damage to the taxpayer’s capital assets. (See

Burmah Steam Ship Co Ltd v CIR (1930) 16 TC 67; Bourkes

Estate v CIR 1991 (1) SA 661 (A).)

But since the settlement agreement in question merely

recorded the monetary amount of the settlement and not what

it was for, the question of precisely what the taxpayer was

being compensated for remained mysterious. Indeed, the two

contracting parties may have had different views on what the

compensation was for.

In the result, the lessee of the hotel became embroiled in

litigation after all – but with SARS, rather than with its client,

Naschem. SARS contended that the compensation was of a

revenue nature, and thus subject to income tax, and issued an

assessment accordingly, which the taxpayer contested.

In court, the taxpayer (through the sole member of the cc) put

forward several conflicting versions of what the compensation

was for.

He first said that he did not know how the settlement figure

had been computed, then later testified that he now

remembered that it was R1.1 million plus VAT for damages,

and R34 000 for legal fees. Later, he said the settlement figure

included the costs of repairing the students’ vandalisation of

hotel property. Still later he said that the compensation was “to

alleviate his cash flow”. Thereafter, he admitted that he had

used about R1 million of the settlement to repay a loan, and

R500 00 to repay trade debts.

In summary the court said that, in his testimony, Fourie, the

sole member of the close corporation –

“could not give a clear and coherent account of what the money was

paid for. Nor could he give an acceptable explanation as to how the

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money was computed. ... Fourie vacillated to such an extent that

the true purpose and effect of the compensation, on his evidence,

defies delineation”.

SARS argued that the settlement payment was

compensation for loss of the taxpayer’s future profits, and

was therefore of a revenue nature and subject to income

tax.

The onus was on the taxpayer to prove theassessment was wrong

The court pointed out that, in terms of the Income Tax Act,

the taxpayer bore the onus of proving, on a balance of

probabilities, that the assessment was wrong and that the

compensation in question was in fact of a capital nature.

On a conspectus of the evidence placed before it, the

court said that the hotel itself was the taxpayer’s capital

asset – its income-producing structure. That structure had

not been crippled or destroyed by the cancellation of the

Naschem agreement. The hotel had continued as a profit-earning

asset. The contract with Naschem was thus not an essential part of

the taxpayer’s income-earning structure, but was merely a normal

contract incidental to its business. The compensation paid to the

taxpayer was for the loss of profit that it would have made if the

students had not moved out prematurely.

The actual amount of the compensation agreed upon, said the

court, was a “thumb-suck”. Even if it had been paid to enable the

taxpayer to effect repairs, it would still have been of a revenue

nature.

In the result, said the court, the taxpayer had not succeeded in

proving that the compensation was of a capital nature, and its

appeal against the assessment must be dismissed.

The result of the judgment was that the amount of the

compensation would have to be included in the taxpayer’s gross

income in the determination of its taxable income on which income

tax was payable.

The court said that the hotel itself was the taxpayer’s capital asset – its income-producing structure.That structure had not been crippled or destroyed by the cancellation of the agreement. The hotelhad continued as a profit-earning asset.

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A failure of tax planning

In hindsight, it was an elementary failure in tax planning for

the parties not to have ensured that the settlement agreement

specified what the compensation was for.

This was no less important to Naschem as to the taxpayer,

for Naschem’s legal advisers ought to have drafted the

settlement agreement in a manner that made it a tax-

deductible expense.

There was also a logical inconsistency in the taxpayer’s

argument. If – as its sole member, Fourie contended – the

compensation payable by Naschem had been to cover the

cost of repairs for the damage done by the students, then the

taxpayer (the close corporation) ought simply to have

conceded that the compensation was of a revenue nature,

and thus to be included in its gross income, and should have

claimed the cost of repairs as a tax deduction. The

compensation and the cost of repairs would then have

cancelled each other out, with a tax-neutral result.

It was silly for the taxpayer to have used the compensation to

pay off trade debts. This was inconsistent with the taxpayer’s

claim that that the compensation was in respect of the cost

of repairs. The taxpayer should rather have used the

compensation to pay for the repairs, and then borrowed

whatever was necessary to pay its trade debts, for the

interest on this loan would have been tax-deductible.

Tax in Africa SurveyThis is the first “Tax in Africa” survey of

its kind and it originates from a growing

need among foreign investors who are

considering Africa as a viable investment

destination. The survey focuses on key

tax, business and regulatory challenges

faced by companies operating in Africa.

The main findings of the survey confirm

the view that tax systems across the

African continent are extremely divergent

and most require modern tax reforms to

make the region more attractive to doing

business. Other trends emerging, which

are consistent with global trends, are the

focus on managing tax risk and

compliance, the need for tax function

effectiveness within companies and the

growing demand for tax skills.

If you would like to receive an electronic

copy of the survey please email Manusha

Pillay manusha.pillay@za.pwc.com.

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