South Africa: Annuities In Perspective And Nicco’s Case; Testing The ‘Disappearance Of Capital’

This article originally appeared in Without Prejudice", November 2006

The definition of ‘gross income’ includes under paragraph (a) ‘any amount received or accrued by way of annuity’. ‘Annuity’ is not defined in the Act.

An annuity means where an income is purchased with a sum of money and the capital has gone and ceased to exist, the principal having been converted into an annuity.

Thus, an annuity may be perpetual (such as bank annuities) or it may be for a long period of time. The most familiar is that which depends upon the life of an annuitant. And there is an equivalent to an annuity in the tenure of a leasehold interest in land. The essence of each case is that the person who procures the annuity if he procures it for money or money's-worth, purchases it, and for that purpose parts with his capital which ceases to exist. He never sees it again.

In ITC 826 KUPER J describes an annuity as ‘an annual payment in perpetuity for the life of the grantee or for a limited period’.

The learned judge pointed out that an annuity may arise in a number of ways. A person may purchase an annuity, he may receive one under a contract of donation or deed of settlement, he may receive one as a reward for past services, or the annuity may flow from a testamentary disposition.

In ITC 761, Price J said:

After considering various dictionary definitions, PriceE J concludes on the main characteristics of an annuity as follows:

PRICE J pointed out that a donor may divide his income no less than his capital among beneficiaries in such a way as to render payments annuities:

In ITC 713, the taxpayer disposed of a manufacturing business of which he was the owner in consideration of the payment to him of £50 per month for his, the taxpayer's, lifetime. It was held that the amounts so received represented an annuity and not a capital accrual.

The Special Court regarded the position as analogous to that in ITC 70, where it was held that a sum of £50 per month payable to a legatee during her lifetime in terms of a bequest contained in the will of her deceased husband was income chargeable with tax. Had a fixed amount been bequeathed to her, that would not have been taxable; but an annuity which she could buy with that money would be taxable.

ITC 584 is an example of an annuity for a limited period. The appellant's wife received certain sums in terms of a bequest made to her under a will. This provided for the payment of certain "annuities and annual sums" consisting of payments of £500 each per annum to the testator's widow and cousin for their respective lifetimes and £300 per annum to the appellant's wife for a period of 10 years from the date of the testator's death. It was held that the amounts in question, although they did not constitute a life annuity, but were payable in terms of the will for a fixed period, fell within paragraph (a) of the definition and were consequently ‘gross income’.

The distinction must be noted between an annuity and the payment of a debt by instalments.

Where a debt existed independently of the contract which gave rise to the annual payment, and the annuity or annual payment was of such a nature that it was not a contract for the purchase of an annuity, but one under which the independent debt was made payable by instalments, the provisions paragraph (a) do not apply to the whole sum payable by such instalments. The Act would be applicable and tax payable in respect of so much of the annual payment as was not a repayment of an instalment of the antecedent debt. Furthermore, tax would be payable upon so much of this annual sum, the annual instalment of purchase money, as consists of interest.

There is no invariable principle that, because a payment is consideration for the transfer of property, it must be looked upon as the price – in the nature of a capital payment. It is necessary to look at each case and determine the nature of the sum.

In Perrin v. Dickson, LAWRENCE LJ emphasised that ‘the Court can look at the transaction, and, if necessary, dissect an annuity, so as to prevent the taxation of that percentage which represented capital.’

A man who sells his property for what looks like an annuity but which on a close examination of the transaction is not really a transmutation of a principal sum into an annuity, but is actually a principal sum the payment of which is spread over a period of time and is paid with interest – calculated in a way familiar to accountants and actuaries, although taking the form of an annuity.

In this type of case it is necessary to break up the sum and decide what it really is, and in doing this the main characteristics of an annuity as set out in ITC 761, must be borne in mind.

It is clear that the description of recurring sums as annuities in any agreement is no guide as to their liability to income tax. The nature of each transaction must be scrutinized. If there is merely a measure of what is ultimately due in respect of a transaction of a capital nature there is no tax liability; but if the payments are in the nature of rent or are essentially income then there is liability; if the amounts received are capable of actuarial calculation then only so much as represents interest is liable to tax.

In the case of the purchase of an annuity, capital is surrendered for what is wholly income and the whole is taxable.

Where an annuity is paid partly out of income and partly out of capital, as in the case of annuitants in a deceased estate, the whole income received is taxable in the hands of the recipient.

It cannot be said that whenever a contract stipulates for annual payments that those payments are necessarily of the nature of annuities. But where the agreement between the parties involves no obligation to pay a definite total sum the annual payments may be so taxable. Under the Act an annuity, payable under a trust will or otherwise, once it is clear that it is an annuity is taxable in the hands of the annuitant or beneficiary.

Higgo was a pensioner, who had been a member of the Reckit & Colman Pension Fund, and then transferred by investing the relevant amount in a retirement income option with Momentum.

Higgo entered into an agreement with Momentum in terms of which he would invest an amount just in excess of R6 million in a ‘life annuity’ with Momentum with effect from 1 September 1998 which would give him an initial guaranteed income of R41 666 per month and this could be revised annually at the taxpayer’s instance within certain limits.

The aforementioned agreement also provided that the taxpayer could instruct Momentum to vary the investments and for which purpose he was to employ a financial adviser for whose decisions he accepted full liability. Higgo was responsible for paying Momentum an ‘upfront’ investment fee, as well as an annual investment fee, and he was not allowed to make any withdrawals from his investment save for certain specified amounts. The monthly income which the taxpayer would receive was persumably taxable and Momentum deduct PAYE there from.

SARS had taxed Higgo on the basis that the periodic amounts paid to him by Momentum in terms of the aforementioned agreement was an annuity and thus gross income in terms of paragraph (a) of the definition of ‘gross income’.

The taxpayer contended that he should not have been taxed in terms of paragraph (a) above, but that he should rather have been taxed on the basis that the income generated on the capital amount invested by him constituted ‘gross income’ under the general portion of the definition of ‘gross income’, i.e. the capital portion of his monthly drawdown was not taxable income.

The crisp issue to be determined by the Tax Court was whether the periodic payments paid to the taxpayer by Momentum in terms of the aforementioned agreement constituted an annuity, in particular, whether the capital ceases to exist and is converted into an annuity.

The taxpayer contended that he had, in effect, made a loan to Momentum and had been receiving repayments on the loan and not an annuity. Consequently the capital amount of approximately R6 million was paid to Momentum by the Reckit & Colman Pension Fund on behalf of and for the benefit of Higgo and in determining the nature of the periodic payments regard must be had only to the terms of the agreement.

Higgo contended further that in terms of the agreement Momentum undertook to act as HIggo’s agent in investing the capital in such units as Higgo chose and Momentum had no proprietary or financial interest in the capital sum, the capital sum and the income earned being held solely for the benefit of Higgo and after his death that of his dependants, until both the income and capital were exhausted.

SARS contended that the funds invested with Momentum did not vest in the taxpayer but vested first in Reckit & Colman Pension Fund and subsequently in Momentum.

SARS contended further that Higgo was not the ‘true owner’ of the investment because he could not draw the money at will.

Judge Traverso held that although the agreement in issue between the Higgo and Momentum bore a likeness to an annuity and it was clear that the taxpayer at all times thought that he was buying an annuity, the real question to decide was therefore whether the terms of the agreement were such that it in fact constituted an annuity. It must be borne in mind that the cases suggest that the main distinguishing feature is that in the case of an annuity the investor forgoes his capital in return for annual payments.

Judge Traverso concluded that it was evident that although the Higgo had agreed to tie up his capital in order to obtain payment from his Pension Fund, in effect, the agreement provided for the return of all his capital plus the income derived there from until the capital was exhausted and accordingly it was not an annuity.

In the High Court of the Cape Provincial Division Judge Foxcroft held that the money which Momentum received on behalf of the Higgo was money which it was obliged to invest for the benefit of Higgo in order to carry out the contractual obligation.

Judge Foxcroft further commented that the ‘disappearance of capital’ test is particularly misleading in a situation such as the present. Throughout his life Higgo will be in control of the investment of the capital. Higgo is entitled to regulate within agreed limits how much of this is to be paid to him annually. In a very real sense, therefore, the capital cannot be said to have ‘disappeared’.

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.