Commissioner for SARS v Coronation Investment Management SA (Pty) Ltd (1269/2021) [2023] ZASCA 10 (07 February 2023)
The issue before the Supreme Court of Appeal (SCA) in this matter was whether a controlled foreign company (CFC) constituted a foreign business establishment (FBE) as contemplated in the Income Tax Act, No. 58 of 1962 (the ITA).
Bronwin Human
Tax Attorney
Micaela Paschini
Tax Attorney
Coronation Investment Management (Pty) Ltd (the taxpayer) was the sole owner of Coronation Fund Management (CFM), a subsidiary of the taxpayer situated on the Isle of Man. CFM, in turn, was the sole owner of Coronation Global Fund Managers Limited (CGFM), being registered and operating in Ireland.
CGFM had outsourced its investment management functions to Coronation Asset Management (Pty) Ltd (CAM) registered in South Africa, as well as Coronation International Limited (CIL) registered in the United Kingdom.
During the 2011, 2012 and 2013 years of assessment, the taxpayer filed its income tax returns and excluded the net income of CGFM from its taxable income. Subsequently, in April 2015, the South African Revenue Service (SARS) conducted an audit in respect of these years and issued an additional assessment for the 2012 tax year, which included the net income of CGFM and an understatement penalty thereon.
The taxpayer submitted an objection and subsequently appealed the additional assessment, following which SARS issued a reduced assessment. However, a significant portion of the tax debt still remained.
The taxpayer appealed to the Tax Court and argued that CGFM was a foreign business establishment (FBE) in terms of section 9D of the Act. The Tax Court ruled in favour of the taxpayer and set aside SARS’ additional assessments. Accordingly, SARS appealed to the Supreme Court of Appeal (the SCA).
The taxpayer’s case centred around the licence granted to CGFM by the Central Bank of Ireland to operate as a ‘management company’ in terms of the European Communities Regulations under Investment Services Directive 93/22/EEC 2125. The taxpayer contended that CGFM’s business plan, which had been attached to its licence application, presented an outsource business model where CGFM would concentrate on being a product provider and that the eventual licence granted by the CBI did not approve investment management functions.
In addition, the taxpayer asserted that since the actual performance of investment trading functions were not envisaged in CGFM’s business plan, the performance of such functions could not constitute a part of CGFM’s primary functions.
The taxpayer disputed the imposition of the understatement penalty on the basis that it had relied on a tax opinion procured from a leading tax expert. However, the taxpayer did not disclose the contents of the tax opinion.
SARS argued that CGFM’s primary functions comprised investment management and since these functions were outsourced to CAM in South Africa and CIL in the United Kingdom, CGFM lacked economic substance and was not considered to be an FBE in terms of section 9D of the Act.
While it is permissible for a CFC to outsource locational permanence and economic substance, it must comply with the proviso in subsections (aa) to (cc) of the definition of FBE in section 9D(1) of the ITA, which CGFM did not do. Furthermore, SARS imposed the understatement penalty on the imputed net income of the taxpayer’s 2012 year of assessment, on the basis that there had been “a substantial understatement resulting in a penalty of 10% of the tax that would otherwise have been paid”. Whereas the taxpayer had obtained a tax opinion on the matter, it did
not disclose the contents hereof. SARS drew a negative inference from this non-disclosure and thus argued that it was entitled to impose the understatement penalty.
The SCA found in favour of SARS and the appeal was upheld with costs against the taxpayer, including the costs of two counsels. The understatement penalty imposed by SARS was, however, set aside.
The Court considered section 9D of the Act which provides the requirements for an FBE exemption.
To be considered an FBE, the CFC must have a fixed place of business in the foreign country, used for the carrying on of business for a period of not less than one year. In addition, the business must be conducted through one or more office or other structures, which are suitably staffed and have on-site managerial and operational employees who conduct the primary operations. In addition, the premises must be suitably equipped, with suitable facilities for its
primary operations and the reasons for its location being outside South Africa must not be to facilitate a postponement or reduction of tax in South Africa.
An FBE may utilise the structures, employees, equipment and facilities of another company, albeit provided that the other company is subject to tax in the same jurisdiction, as well as a
part of the same group of companies, and is situated in the same country as the FBE.
According to the Court, the core functions of CGFM were indeed investment management, as stated in its Memorandum of Incorporation and as echoed by certain witnesses, i.e., the managing director of CGFM, one of the founders of Coronation Group.
Furthermore, the Court held that “these functions had to fall within the ambit of its business in order to be outsourced. An agent cannot perform a function which does not form part of the business of the principal. In other words, CGFM could not outsource a function it did not
possess in the first place.”
The Court concluded that the primary business operations of CGFM were those of fund management, including investment management. Since these functions were not conducted in Ireland and were, in fact, outsourced to CAM in South Africa and CIL in the United Kingdom, the requirements for FBE status exemption were not met, with respect to the proviso contained in section 9D(1)(aa) to (cc).
With regards to SARS’ claim for understatement penalties, the Court found that SARS was unable to prove that the exclusion of CGFM’s profits from CIMSA’s taxable income was not due to a bona fide error, and accordingly did not discharge its onus in this regard. As such, the understatement penalties were set aside.
TAKEAWAY
South African resident companies must consider the law carefully when incorporating subsidiaries in foreign jurisdictions. Section 9D of the Act is clear on the requirements for an FBE. Critically, taxpayers must be able to evidence that the primary operations of the controlled foreign company are carried out in accordance with the requirements of the FBE exemption in section 9D. In the event of the FBE being non-compliant with the relevant requirements in any way, the total profits of the CFC will be included in the taxpayer’s taxable income, which will result in a significant tax liability
Commissioner, South African Revenue Service v The Thistle Trust (Case no 516/2021) [2022] ZASCA 153 (7 November 2022)
The issue before the Supreme Court of Appeal (SCA) whether the Tax Court was correct to uphold an appeal against the additional assessments raised by SARS against the Thistle Trust (the taxpayer). The additional assessments related to the interpretation of section 25B of the Income Tax Act, No. 58 of 1962 (“the ITA”) and paragraph 80(2) of the Eighth Schedule thereto, in relation to the distribution of capital gains to beneficiaries of trusts.
The taxpayer was a beneficiary of multiple trusts, referred to as ‘Tier 1 Trusts’, within the Zenprop Group. During the 2014–2016 years of assessment, the Tier 1 Trusts disposed of specific capital assets and realised gains thereon. The capital gains were distributed, inter alia, to the taxpayer during the same years of assessment. In turn, the taxpayer distributed these amounts to its beneficiaries in the same years. The proceeds received were treated as taxable in the hands of the taxpayer’s beneficiaries. SARS raised additional assessments for the 2014–2016 years of assessment, in terms of which the capital gains distributed to the taxpayer by the Tier 1 Trusts were treated as taxable in the taxpayer’s hands. SARS further imposed an understatement
penalty, with interest.
The taxpayer lodged an objection, which SARS disallowed. The taxpayer lodged an appeal in the Tax Court, which court found that the Tier 1 Trusts had disposed of capital assets and the gains distributed to the taxpayer (and thereafter its beneficiaries), were amounts as contemplated in sections 25B(1), 25B(2), and paragraph 90(2) of the Eighth Schedule.
As such, per the court, the distribution to the taxpayer’s beneficiaries was a distribution of capital gains taxable in the beneficiaries’ hands.
The Tax Court accordingly set aside the additional assessments and SARS, with leave of the Tax Court, lodged a further appeal to the SCA.
The taxpayer was a beneficiary of multiple trusts, referred to as ‘Tier 1 Trusts’, within the Zenprop Group. During the 2014–2016 years of assessment, the Tier 1 Trusts disposed of specific capital assets and realised gains thereon. The capital gains were distributed, inter alia, to the taxpayer during the same years of assessment. In turn, the taxpayer distributed these amounts to its beneficiaries in the same years. The proceeds received were treated as taxable in the hands of the taxpayer’s beneficiaries. SARS raised additional assessments for the 2014–2016 years of assessment, in terms of which the capital gains distributed to the taxpayer by the Tier 1 Trusts were treated as taxable in the taxpayer’s hands. SARS further imposed an understatement
penalty, with interest.
The taxpayer lodged an objection, which SARS disallowed. The taxpayer lodged an appeal in the Tax Court, which court found that the Tier 1 Trusts had disposed of capital assets and the gains distributed to the taxpayer (and thereafter its beneficiaries), were amounts as contemplated in sections 25B(1), 25B(2), and paragraph 90(2) of the Eighth Schedule.
As such, per the court, the distribution to the taxpayer’s beneficiaries was a distribution of capital gains taxable in the beneficiaries’ hands.
The Tax Court accordingly set aside the additional assessments and SARS, with leave of the Tax Court, lodged a further appeal to the SCA.
SARS argued that paragraph 80(2) of the Eighth Schedule applied and section 25B of the ITA did not.
Specifically, the proceeds received on disposal of the assets by the Tier 1 Trusts constituted capital gains in their own hands, following which the gains were then distributed to the taxpayer. As such, paragraph 80(2) of the Eighth Schedule was solely applicable.
The taxpayer had acquired a vested right to the capital gains distributed to it but not to the capital assets themselves. The taxpayer then distributed this amount to its beneficiaries and, in doing so, it did not realise a capital gain in respect of the disposal of a capital asset as contemplated in paragraph 80(2) of the Eighth Schedule. As such, the capital gains accrued pursuant to the disposal of the capital assets by the Tier 1 Trusts were taxable in the hands of the taxpayer.
SARS further argued that this section concerns the taxation of income accruing to trusts and their beneficiaries, whereas the amounts herein were of a capital nature. As such, section 25B did not apply.
The SCA found in favour of SARS and the appeal was partially upheld with no order made as to costs.
The SCA held that, in determining what ‘any amount’ constituted for purposes of sections 25B(1) and 25B(2) of the ITA, the sections were to be read as a whole. Whereas section 25B(2) of the ITA concerns ‘any amount’ when considering the provisions of section 25B as a whole, it is clearly concerned with amounts of an income nature and not of a capital nature. As such, capital gains are excluded from the meaning of ‘any amount’ for purposes of section 25B.
The SCA concluded that section 25B applies to the taxation of the income of a trust or its beneficiaries and that the Eighth Schedule deals with capital gains in the hands of trusts or their beneficiaries. Thus, it concluded that the Tax Court had erred in finding that section 25B of the ITA was applicable in this instance. Furthermore, the Court held that the ‘conduit-pipe principle’ did not find application herein.
In determining whether SARS correctly imposed the understatement penalty, the SCA held that SARS was entitled to levy a penalty where a taxpayer submitted a return understating its taxable income or deemed taxable income. In this instance, however, SARS imposed an understatement penalty of 50%, which relates to circumstances where a taxpayer has no reasonable grounds for the tax position taken. The taxpayer had, however, obtained a legal opinion to support its position. It was accepted that the understatement by the taxpayer was a bona fide and inadvertent error, as it believed that section 25B was applicable. The penalties were thus set aside.
In addition, on the basis that the CGT assessment resulted in a tax liability due to SARS, the taxpayer would be liable for interest in terms of section 89quat(2) of the ITA.
A trust cannot apply the provisions which deal with distributions of income and capital to beneficiaries simultaneously. Distributions are either classified as income or capital and the treatment thereof for tax purposes will depend on such classification. Furthermore, where a taxpayer makes a bona fide and inadvertent error, SARS may not impose an understatement penalty.
Lance Dickson CC V Commissioner for SARS
(A211/2021) [2023] ZAWCHC (31 January 2023)
In this matter, the High Court was seized of the issues whether correct behavior was applied by SARS as a basis for the understatement penalty imposed or if a different penalty should have been imposed. Furthermore, if the penalty imposed by SARS was incorrect, the further issue was whether a different (higher) penalty might have been imposed instead.
Lance Dickson Construction CC (the taxpayer) owned immovable property, and concluded a sale agreement with a related entity (the purchaser), in terms of which the purchaser agreed to purchase the property for R25.2 million. This was calculated on the basis that, once subdivided, the property would comprise 72 individual erven valued at R350 000 each. KMC would pay R350 000 to the taxpayer when each erf was on-sold to a final purchaser. The agreement stated that
the capital gains tax (CGT) on the entire transaction would be paid by the taxpayer on an ad hoc basis as and when each erf was onsold, and the relevant amount had been received by the taxpayer.
When the taxpayer rendered its 2017 return, however, none of the individual erven had been on-sold. As such, the taxpayer did not disclose the sale in the return. SARS picked up on this when
it reviewed the 2017 tax return in conjunction with earlier tax assessments and was of the view that the taxpayer was liable for the full CGT amount. SARS thus raised additional tax and an understatement penalty of 25% for reasonable care not taken in completing the return, under s223(1) of the Tax Administration Act, No. 28 of 2011.
Pursuant to a dispute lodged by the taxpayer, the matter was appealed in the Tax Court which upheld SARS’ view and the 25% penalty. The taxpayer took the matter on further appeal to the High Court.
The taxpayer conceded that it had made a substantial understatement, following which the issues in dispute narrowed to the understatement penalty imposed.
The taxpayer contended that it had not acted unreasonably in adopting the tax position; nevertheless, the understatement did not arise from its return completion process and, therefore, the basis of the understatement penalty was inappropriate. An understatement in this case would instead have arisen from the tax position taken by the taxpayer.
As any understatement in this case was not causally connected to the process followed by the taxpayer in completing its return, SARS had identified the incorrect behaviour in applying the
understatement penalty. In this case, it was a difference in legal interpretation.
The failure to levy a higher understatement penalty thus confirmed that SARS was satisfied that the underestimation was not deliberate or a result of negligence, otherwise it would have been obliged to levy a higher penalty.
SARS argued that the imposition of the 25% understatement penalty was justified on the basis that the taxpayer had not taken reasonable care in completing its return. Reasonableness would
have required the taxpayer to have known that the sale of the property in September 2016 and subsequent registration on 27 October 2016, was a disposal event that triggered proceeds which
accrued to the taxpayer during the 2017 year of assessment. As the failure to make this declaration fell below the standard of a reasonable person in similar circumstances, the understatement penalty was correct.
However, during cross-examination in the Tax Court, the SARS official (the witness), who was tasked with investigating the taxpayer’s 2017 return, accepted that she had chosen the wrong
behavioural category vis-à-vis the understatement penalty. The witness conceded that SARS had erred in imposing a 25% penalty but went on to suggest that the taxpayer should be happy with the lesser penalty as its conduct had been unreasonable either way.
The Court found in favour of the taxpayer and directed SARS to alter the 2017 additional assessment to exclude the understatement penalty imposed with costs awarded in favour of the taxpayer.
Section 221, read with section 222 of the Tax Administration Act, allows SARS to impose a penalty where the taxpayer has understated its taxable income (where this does not stem from a
bona fide inadvertent error). It was common cause that the taxpayer had understated its CGT liability and that this was not due to a bona fide inadvertent error.
The Court found that the witness for SARS was unable to distinguish between the two understatement categories. SARS’ case for understatement penalties was made on the basis of the taxpayer not having taken reasonable care in completing its tax return (and nothing else).
Despite this, in its own evidence, SARS admitted that the understatement penalty was levied on the basis of the taxpayer having no reasonable grounds for the tax position taken. The Court also found that the Tax Court had incorrectly relied on the case of Purlish Holdings (Pty) Ltd v Commissioner of SARS [2019] ZASCA 04. In that case, the SCA had determined that the Tax Court was unable to unilaterally increase understatement penalties imposed by SARS. It was on this basis that the Tax Court stated that it was not empowered to increase the understatement
penalty imposed on a taxpayer to 50%; it was equally unable to allow the taxpayer to escape liability for 25% of the penalty imposed by SARS.
If SARS elected to impose a 25% understatement penalty, it was required to prove the factual basis therefor when its determination was challenged by the taxpayer. SARS did not do so and there is no basis for it to recover that penalty from the taxpayer. The Tax Court was thus wrong
in confirming the understatement penalty of 25%. As SARS also did not prove any basis for the 50% penalty, this was not contended by the taxpayer and did not apply.
This case serves as a reminder of the limits on SARS’ power. Ironically, through its own lenience in levying a reduced penalty on the taxpayer, SARS undermined its own case with the result that the understatement penalty fell to be remitted. This affirms that SARS is bound by the provisions
of the Tax Administration Act and must prove the facts upon which the understatement penalty is based. This case further clarifies the power of the Tax Court to vary an understatement penalty.
Binding Rulings