The recent decision of the Johannesburg Tax Court in A (Pty) Ltd v Commissioner for the South African Revenue Service (SARS) addresses for the first time by a South African court hitherto unexplored aspects of key concepts in the capital gains tax regime laid down in the Eighth Schedule to the Income Tax Act 1962, in particular, the fundamental nature of a disposal and the essential nature of a redemption of redeemable shares.
In this case, SARS had disallowed a capital loss claimed by the taxpayer company which had been incurred as a result of the redemption of redeemable preference shares held by it in a second company in the same group on the basis that the loss was a "clogged loss", as envisaged in paragraph 39(1) of the Eighth Schedule to the Income Tax Act.
The first issue was the proper interpretation of paragraph 39(1) and, in particular, whether that provision applied to the redemption of redeemable preference shares, thereby rendering the taxpayer's capital loss a "clogged loss" because of the connection between the taxpayer and the company which had issued those shares, for it was common cause that they were part of the same group of companies and were under common control.
A clogged loss is a loss which, in terms of the Eighth Schedule, must be disregarded in the determination of the disposer's aggregate capital gain or aggregate capital loss; such a loss is ring-fenced and is deductible only from a capital gain arising from the disposal of assets to that same "connected person".
The second issue before the court related to the quantum of the appellant's capital loss.
This turned on the meaning of the word recovery in paragraph 20(3) of the Eighth Schedule; the pivotal question was whether the taxpayer had recovered part of the expenditure incurred in purchasing the preference shares when those shares were redeemed by the issuing company.
If paragraph 39(1) of the Eighth Schedule were applicable, it was clear that the taxpayer's capital loss would be a clogged loss since it was common cause that the taxpayer and the issuing company were "connected persons".
The question was whether this paragraph was indeed applicable. In this regard, the language in which this provision of the Eighth Schedule is expressed was of critical importance.
The spotlight fell on that part of the paragraph which states that a person must disregard any capital loss in respect of the disposal of an asset to any person:
- (a) who was a connected person in relation to that person immediately before that disposal; or
- (b) which is immediately after the disposal a member of the same group of companies as that person.
The term disposal is defined in paragraph 11(1) of the Eighth Schedule, and expressly includes a redemption.
SARS argued that paragraph 39(1) of the Eighth Schedule was applicable and that the redemption of the preference shares constituted a disposal to the company.
The taxpayer company was of the view that the kinds of disposal envisaged in paragraph 39(1) are those in which an asset, or rights in an asset, are transferred from the disposing party to another person; furthermore, that even though paragraph 11(1) explicitly defines disposal as including redemption, the language of this provision - and in particular the word "to" in the phrase "disposal of an asset to any person" - had the effect of confining the application of paragraph 39(1) to those akin to the ones mentioned in paragraph 11(a), such as sales, where there was a transfer of the asset itself, or of rights in the asset, to another person.
The taxpayer company's contention was that where shares are redeemed, there is no transfer of the shares themselves, or of any of the rights represented by the shares, from the shareholder to the redeeming company, and that the shares or the rights are simply extinguished, and cease to exist.
SARS's counter-argument was that the redemption of shares is a kind of "buy-back" of the shares and consequently constitutes a disposal to the redeeming company.
Faced with these arguments and counter arguments as to the proper interpretation of the word disposal in the context of paragraph 39(1), read with paragraph 11(1), the court looked to the legal principles regarding the interpretation of fiscal legislation.
The court said that the wording of paragraph 39(1) clearly covers transactions such as sales or the transfer of assets (including shares) from the disposer to a connected person or company. The difficulty, said the court, arises where there is no transfer of the asset or rights in the asset from the disposer to the connected person.
The court consequently held that paragraph 39(1) of the Eighth Schedule did not apply to the redemption of shares in the present case and that the loss incurred by the taxpayer was therefore not a clogged loss as envisaged in that paragraph.
In the present case the cardinal dispute between the taxpayer company and SARS was whether, in determining the base cost of the shares, the original purchase price of the shares in question fell to be reduced by the aggregate preferential dividend and the redemption premium that was payable in terms of the articles of association of the company which had issued and was now redeeming the shares.
SARS argued that the dividend and the redemption premium constituted a recovery as envisaged in paragraph 20(3) of the Eighth Schedule.
It is noteworthy that this argument is in direct contradiction to the guidance given by SARS in its Comprehensive Guide to Capital Gains Tax (Issue 4) at 8.18, which states that a post-acquisition dividend is not a recovery in the context of paragraph 20(3).
It is surprising that SARS should contradict itself in contesting an appeal and begs the question whether it considers itself bound by its published guidance.
The taxpayer company argued that to treat a dividend or redemption premium as a recovery of the purchase price of the shares would lead to an absurd result and would be tantamount to treating rental received by a property owner as a recovery of the purchase price of the property.
The taxpayer company argued that it had never got back any of the purchase price which it had paid to the bank from which it had purchased the shares.
The redemption premium was received on account of the redemption of the shares and was not a repayment of part of the purchase price.
The court held that, when calculating the taxpayer company's capital loss, SARS had erred in treating the dividend portion and the redemption premium portion of the redemption payments as recoveries of the cost of acquiring the preference shares.
Paragraph 39(1) of the Eighth Schedule, said the court, did not apply to the redemption of the preference shares and the taxpayer company's loss was not a clogged loss that could be deducted only in the manner envisaged in that paragraph.
As to the quantum of the capital loss, the dividends and redemption premium paid to the taxpayer company was not to be treated as a recovery envisaged in paragraph 20(3).Source: Business Day