Over the past few years the Courts have become increasingly intolerant of arrangements that are designed to look like legitimate commercial transactions but which are in fact complicated ruses by which the parties collude to secure a tax advantage. The Supreme Court of Appeal recently took this intolerance a notch higher by holding not only that the transactions in question were fake, but by imposing a penalty equivalent to 100% of the tax that was avoided.
The case, Commissioner for the South African Revenue Service v NWK Limited (NWK), involved an arrangement that had been entered into between NWK and First National Bank (FNB). The arrangement was complicated, involving a series of transactions, including a "loan" by FNB of some R97 million, repayment by NWK in the form of a delivery of maize, the issue of promissory notes that were later discounted and forward sales of the right to take delivery of the maize.
As it turned out, the loan, ostensibly for R97 million, was in reality for R50m, and the effect of the forward sales and other transactions were designed to conceal this fact. The parties had never intended to trade in maize. Having regard to the substance of the transaction, it was a loan of R50 million, on which FNB and a subsidiary received 15.27% interest while NKW claimed interest deductions as if it had borrowed R97 million.
The Court said that while there is nothing wrong with arrangements that are tax effective, there is something wrong with dressing up or disguising a transaction to make it appear to be something that it is not.
At the same time, however, it is important to appreciate that a transaction is not necessarily a simulated one because it is devised for the purpose of avoiding liability for tax. After all, it is a well established principle that taxpayers are at liberty to organise their affairs in such a way as to pay the least tax permissible. It follows that transactions designed to reduce a person's tax liability are fine, as long as the parties really intend to give effect to those transactions. NWK argued that it had acted in terms of the agreements, which showed it really intended to give effect to the terms of the relevant contracts.
The Court was not convinced, however, holding that the mere fact that parties perform in terms of a contract does not show that it is not simulated: "the charade of performance is generally meant to give credence to their simulation". The Court said that the appropriate question to be asked, in order to determine whether the loan and other transactions were simulated, is whether the was a real and sensible commercial purpose in the transaction other than the opportunity to claim deductions from income tax on a capital amount greater than R50 million. No such sensible purpose was found to exist and the transactions were found to be simulated.
The amount claimed from NWK by the Commissioner was R47 million, being the tax that should have been paid on the disallowed deductions, plus a penalty of 200% of the unpaid tax plus interest. NWK contended that there were extenuating circumstances in that NWK had not solicited the finance from FNB and played no role in crafting the terms of the various agreements. The Court was of the view that these factors did mitigate against the imposition of the highest penalty and reduced it from 200% to 100% of the additional tax for which NWK was liable.
The Court held that the test to determine simulation cannot simply be whether there is an intention to give effect to a contract in accordance with its terms. Invariably, where parties structure a transaction to achieve an objective other than the one ostensibly achieved they will intend to give effect to the transaction on the terms agreed. The test should thus go further, and require an examination of the commercial sense of the transaction: a test of its real substance and purpose. If the purpose of the transaction is only to achieve an object that allows the evasion of tax, or of a peremptory law, then it will be regarded as simulated. And the mere fact that parties do perform in terms of the contract does not show that it is not simulated: the charade of performance is generally meant to give credence to their simulation.
Similar transactions were very popular some years ago, when the legislative climate was more forgiving, so that many complex non-standard lending arrangements will have been sold by banks to South African companies wishing to secure finance in a tax efficient manner. Many of these structures will still be in place and vulnerable to attack by SARS.
Taxpayers should therefore be careful when entering into complicated financial transactions as the onus of proof will be upon the taxpayer to prove that a transaction is not simulated.
SARS has welcomed the Supreme Court of Appeal's decision as simulated transactions involve an element of misrepresentation and non-disclosure.
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