ARTICLE
14 December 2004

New Cases: Is a Forex Dealer Trading Inside or Outside South Africa?

The mass of recent tax legislation and the increasing complexity of business have meant that not many tax cases reported in the past few years have involved a simple enquiry to be dealt with by means of old established precedent from the courts. The recently reported ITC 1779 66 SATC 353 is, however, such a case.
South Africa Corporate/Commercial Law
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By Prof. Peter Surteees

The mass of recent tax legislation and the increasing complexity of business have meant that not many tax cases reported in the past few years have involved a simple enquiry to be dealt with by means of old established precedent from the courts. The recently reported ITC 1779 66 SATC 353 is, however, such a case.

The taxpayer, who resided in Cape Town, was employed on a full time basis by a firm of registered accountants and auditors. During the 2002 year of assessment, after attending a course in South Africa provided by the local franchise holder of a United States entity called Global Forex Trading ("GFT"), he began to trade after hours as a foreign exchange dealer. GFT was a division of a corporation based in Michigan in the United States of America. The facilities provided by the local franchise holder included appropriate computer software as well as a dedicated line for trading on the internet. The taxpayer also required the use of a suitable computer for his trading purposes as, in order to carry on this trade, he had to keep himself informed of political and economic events that might influence exchange rate movements and to study the trends and other information available to him through the software on his computer. In addition, before trading he acquired the necessary Reserve Bank approval, on the strength of which he had transmitted to GFT an obligatory amount of USD1 000 and an additional voluntary amount of USD2 000. These amounts were intended as security for any losses that he might incur from his dealings.

The manner of his trading was that he effected currency swaps with GFT. He would, for example, one day take a short position in USD by selling USD100 000 for an equivalent amount of pounds sterling ("GBP") at the current exchange rate. The procedure was that GFT would make an offer at a particular exchange rate and the taxpayer could, if he found the rate attractive, accept by conveying his decision electronically. Within two days he would effect a counter swap transaction in terms of which he would dispose of an amount of GBP equal to USD100 000 at the rate of exchange ruling at the time of the second transaction. He would then make a loss or profit on these transactions depending upon the movement of the USD-GBP exchange rate. There were no actual transfers of the currencies involved. Alternatively, the taxpayer could also take a long position by purchasing USD100 000 on day one and then effect a reverse transaction within two days. Any profit that he made was credited to his forex trading account with GFT and any loss was discharged from that account. During the course of the year of assessment he transferred a total of USD10 500 to GFT in order to meet his obligations to it.

In his income tax return for the 2002 year of assessment, the taxpayer set off against his other income a loss of R158 964 which had arisen from his foreign exchange dealings. Because there was no dispute as to the fact that the taxpayer’s foreign exchange dealings constituted a trade as defined in the Act, the only issue was whether this trade was carried on outside South Africa as contemplated in the proviso to section 20(1) of the Income Tax Act.

C:SARS refused to allow the set-off on the grounds that the taxpayer was carrying on the trade outside South Africa, and disallowed the set-off in assessing him. The taxpayer’s objection having been rejected, he appealed to the tax court, contending that his trade had been conducted in the Republic.

The relevant part of section 20 provides that, whereas losses from one trade either incurred during the year or brought forward from a previous year may be set off against the income of the taxpayer, set-off is not permitted where such a loss has been incurred "in carrying on any trade outside the Republic".

Of vital importance to his trading success and to the case was his decision-making as to which transactions to enter into and the timing of those decisions. Equally important to the case was the fact that all his trading took place from his home in Cape Town.

There seems to have been consensus between counsel and the court that the various income tax cases, all emanating from the Appellate Division and dealing with the concept "from any source within the Republic", contained useful guidelines for considering the matter here in issue. The first and, as appears from the judgment, most useful case considered was Millin v CIR 3 SATC 170. Mrs Millin, a celebrated author, received income in the form of royalties from sales of her books in the United Kingdom. The taxpayer argued that the source of the income was the UK, because that was where the contract with her publishers had been concluded. However, according to the judgment of Solomon CJ,

"If we apply the same test here it would appear that the source of the whole amount received for royalties was in the Union. It is true that in this case no capital in the ordinary sense of that term was employed by Mrs Millin. It was the exercise of her wits and labour that produced the royalties. They were employed in the Union, and it matters not, on the analogy of the Overseas Trust case, that the grant to her publishers of the right to publish her book was contained in a contract made in England. Her faculties were employed in the Union both in writing the book and in dealing with her publishers, and, therefore, on the test applied in the cases cited, the source of the whole of her income would be in the Union."

The next case considered was CIR v Lever Bros and Unilever Ltd 14 SATC 1, where the court was burdened with the task of deciding the source of interest received in terms of a loan. Watermeyer CJ, in one of his many profound dicta in tax matters, found that "the source of receipts, received as income, is not the quarter whence they come, but the originating cause of their being received as income, and that this originating cause is the work which the taxpayer does to earn them, the quid pro quo which he gives in return for which he receives them".

In CIR v Epstein 19 SATC 221 the facts were that the taxpayer, an agent in Johannesburg, had entered into an agreement with a partnership Hendrickse & Co in Argentina, in terms of which he exported asbestos for sale there by the partnership. In effect, Epstein and Hendrickse & Co were in partnership in this enterprise. The taxpayer contended that the source of his profits from the sales was Argentina, where the sales had taken place. However, the court found that, as all the activities of the taxpayer had taken place in South Africa, and as it was as a result of them that he had earned the profits, their source was South Africa.

Also on point was the decision in CIR v Black 21 SATC 226, where a stockbroker was able to show that he was carrying on two separate and distinct businesses, one in Johannesburg and the other in London, as a result of which the profits from his London operations was found not to be from a South African source. Schreiner ACJ said in his judgment: "But the Commissioner would be entitled to succeed in this appeal if he could show that the only true and reasonable conclusion on the facts found was that the dominant, or main or substantial or real and basic cause of the accrual of income was to be found in Johannesburg".

Finally, in Transvaal Associated Hides and Skin Merchants v COT 29 SATC 97 the taxpayer, a South African company, carried on its business in both Botwana and South Africa. Hides were purchased and cured in Botswana, after which they were despatched to purchasers. The Court of Appeal of Botswana found that the processes carried out in Botswana were the dominant factors in the accrual of the income. Maisels JA, drawing from Schreiner ACJ’s judgment in Black’s case, said: "the position is different when the activities of a person are performed in two or more countries. In such cases, it would appear that the locality of the source must be determined by reference to those of the activities which constitute ‘the dominant or main or substantial or real and basic cause’ of the accrual of income".

After considering all these judgments, the court applied the Millin dictum and found that, although certain elements of the taxpayer’s trading activities took place in the USA, the exercise of his wits and labour played the essential role in his trading. There was no doubt that he had exercised these in the Republic when he made the crucial trading decisions. The application of the "dominant" or "main" or "substantial" or "real and basic" cause tests that had emerged from the other cases cited would, in the view of the court, lead to the same result.

It is interesting that, in all the cases cited, the taxpayer had been trying to show that the source had been elsewhere. In the present case, the decisions were successfully used to show the opposite.

Because this case involved the treatment of an assessed loss in the 2002 year of assessment, section 20A, which was introduced into the Act in 2003, was not applicable. This section provides for the ring-fencing of assessed losses from secondary trades, which the trade in this case certainly was. Under section 20A, taxpayers such as the appellant in this case will have to ensure that they do not incur losses in their secondary trades in three out of any five years. If they do, they will not be able to set off their losses against other income, but only against future profits from the secondary trade.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

ARTICLE
14 December 2004

New Cases: Is a Forex Dealer Trading Inside or Outside South Africa?

South Africa Corporate/Commercial Law
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