The definition of gross income, as defined in section 1 of the Income Tax Act, 58 of 1962 ("the Act"), specifically excludes an amount, received or accrued to a person, which is capital in nature. The Act is silent on the term 'capital nature', and in cases of uncertainty it is left to the courts to decide whether a receipt is of a capital or revenue nature.
The Supreme Court of Appeal ("SCA") delivered judgment in favour of the South African Revenue Service ("SARS") on 10 May 2011 in the case of CSARS v Founders Hill (509/10) [2011] ZASCA 66, where the court was tasked with deciding whether proceeds from the sale of land sold by a realisation company is taxable as income. In short, Founders Hill was a realisation company formed by AECI Limited ("AECI") specifically to acquire property that had become surplus to the needs of AECI 'for the sole purpose of realising same to the best advantage and within a period of one year of completion of such realisation to be voluntarily wound-up.'
In her judgment, Lewis JA concedes the well established principle, that a taxpayer is entitled to realise a capital asset to its best advantage. However, she stated that calling an entity a realisation company (and limiting its objects and restricting its selling activities in respect of the assets transferred to it), is not in itself a magical act that inevitably makes the profits derived from the sale of the assets of a capital nature.
In the case of Founders Hill supra the court held that there was never a change of intention as Founders Hill's original intention was always to acquire and deal with the land as its trading stock. This statement has a profound impact on the classification of proceeds on capital or revenue account, and is important for taxpayers who own property on capital account and decide to realise it to its best advantage. The question whether a taxpayer is the business of selling cannot only depend on the degree of its activities, and the extent of marketing and construction of houses can now no longer be decisive.
The courts have established special principles over time applicable to the disposal of assets, and in the case of Berea West Estates (Pty) Ltd v SIR [1976] 38 SATC 43, the court decided that disposals by a realisation company and by merely calling an entity a realisation company does not result in the profits derived from the sale of assets constituting an amount of a capital nature. However, in the Founders Hill supra decision, the court held that Founders Hill could never have acquired the property on capital account to the extent that it had the stated intention to realise same, and failed to state that one should consider objectively whether the taxpayer is actually trading or carrying on a business.
Following the decision in Founders Hill supra, taxpayers will now find themselves in a position where they may not dispose of a capital asset, that was acquired as an investment, without incurring income tax on such disposition, if they had an intention to dispose of the asset in the future with the hope of making a profit.
The impact of the judgment will have far-reaching effect that is not limited to realisation companies. It will also affect the tests which have been established over many years by case law, which are applicable in determining the general nature of the proceeds of the sale of assets, and reducing intention and activities of the taxpayer to one of the many factors that will be taken into account in the determination of the nature of the proceeds.
Thus, as a result, if the taxpayer is actually trading or carrying on a business, any disposal of a capital asset shall bear income tax implications when it can be proven by SARS that the taxpayer had an intention to dispose of the asset upon acquisition thereof.
The impact can be illustrated by way of the following example:
If a taxpayer purchases property as an investment, but intends to realise the property (at a later stage) at a profit, such realisation will be considered to be of a revenue nature due to the fact that the taxpayer had acquired the property with the intention to realise it for a profit. Accordingly, such a property will be deemed to be trading stock and, as a result, any profit derived will be included in the taxpayer's taxable income.
From the judgment it is not clear whether it was the court's intention that the tests applied in this case must be applied to all transactions or whether it only applies to realisation companies. However, until this is clarified, taxpayers are bound by the precedent set down in the judgment and need to be mindful of the potential impact thereof when structuring their affairs.
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.
