Capstone (“the Respondent”) acquired shares as a result of restructuring a JSE listed company, namely Profurn Limited (“Profurn”). During 2001, Profurn found itself in serious financial difficulty and so a “rescue plan” was formulated to rescue Profurn. The rescue plan was complicated and involved high risks that required approximately 5 years to implement. At the time, Profurn was indebted, inter alia, to FirstRand Bank Ltd in excess of R900 million. The strategy was that FirstRand would convert R600 million of the debt into equity, thereafter, a merger of Profurn with another, more financially stable company, namely J D Group Limited (“JDG”), in exchange for JDG shares. FirstRand would then sell the JDG shares to the Respondent (a special purpose vehicle) for R600 million. Another private company, Daun et Cie, would also invest R300 million in the Respondent to pay half of the purchase price of the shares. During 2004, the Respondent disposed of approximately 17 million shares in JDG and made a profit of nearly R400 million.
The Respondent paid capital gains tax (“CGT”) on the proceeds of the sale, however, SARS issued an additional assessment in terms of which the proceeds were taxed as revenue. In addition, SARS disallowed certain deductions in respect of an “equity kicker” and a R55 million settlement of indemnity obligation. The Respondent opposed the additional assessment, however the Tax Court found that the proceeds constituted revenue but revised the assessment to allow for the aforesaid deductions. The Respondent appealed to the full court.
The full court upheld the Respondent’s contention that the proceeds were capital in nature as opposed to revenue. However, the full court then had to consider whether the equity kicker and settlement of indemnity obligation had formed part of the base cost of the sale of shares transaction, since the base cost is deducted from the proceeds to determine CGT. The full court found inter alia that in terms of the Income Tax Act 58 of 1962 (“the Act”), the base cost does not include, inter alia, borrowing costs (including interest). In this regard, only one third of the money borrowed to finance the acquisition of listed shares would form part of the base cost and, as such, the full court held that only two thirds of the equity kicker fell to be included in the capital gains. The parties were in agreement with this decision. However, the full court found that the indemnity settlement of R55 million did not form part of the base cost of the purchase of the shares. SARS appealed the decision by the full court and the Respondent accordingly noted a cross appeal.
Appeal before the Supreme Court of Appeal
The SCA had to consider two issues, namely (i) whether the profit from the sale of the shares was of a revenue or capital nature, and(ii) whether a contingent liability incurred as part of a share purchase transaction (later converted into an unconditional liability), in the amount of R55 million, formed part of the base cost of the shares.
The first issue: the appeal
The SCA stated that our courts have steadily applied the test that a gain made by operation of a business in carrying out a scheme of profit making, is income, and that where a profit comes about from a sale of an asset that the intention of the taxpayer in holding or acquiring the asset is decisive. As such, the question is whether the shares were acquired by the Respondent for the purpose of reselling them at a profit.
Apart from the intention of the taxpayer aforesaid, the court must consider other factors, which inter alia include:
• The nature of the taxpayer’s business activities;
• The period that the asset was, or anticipated to be, at the time of acquisition;
• Risks undertaken; and
• In certain circumstances, indeterminacy of a clear intention of the taxpayer.
In applying the above to the facts before it, the SCA was of the view that at the time of the acquisition of the shares in question, a profit was by no means inevitable and that the probability of rescuing Profurn was uncertain. At the time, the main objective of the acquisition of the shares was to rescue Profurn as opposed to make a profit. The SCA held that the above was indicative of an investment of a capital nature that was merely realised sooner than anticipated and that the Respondent sufficiently proved that the proceeds were of a capital nature. Accordingly, SARS’ appeal on this issue was dismissed.
The second issue: the cross appeal
In terms of the Act, base costs include expenditure actually incurred for the acquisition. In this regard, the SCA stated that it is “trite that ‘expenditure actually incurred’ refers to an unconditional legal obligation to pay”. To this end, the SCA was of the view that the Respondent’s contingent liability to FirstRand formed part of the consideration for the acquisition of the shares. The unconditional obligation (the indemnity to pay R55 million to Duan et Cie) was taken in place of the contingent liability to FirstRand, and as such, the acquisition of the shares was the immediate cause for the indemnity settlement.
Accordingly, the SCA held that it was unable to agree with the finding of the full court, and that the liability incurred by the Respondent to pay R55 million to Duan et Cie constituted “expenditure actually incurred” and, as such the cross appeal succeeded.
Where a profit comes about from a sale of an asset, the intention of the taxpayer in holding or acquiring the asset is decisive for the purpose of determining whether the proceeds of a transaction are considered revenue or of a capital nature.