Court sends a warning to taxpayers in South Africa

A recent Tax Court ruling has warned South African taxpayers that SARS and the courts will look beyond the legal form of transactions to their commercial substance when challenging aggressive tax planning.

This emerged in a recent Tax Court judgment involving seven interconnected corporate taxpayers, where the court sided with the South African Revenue Service (SARS).

SARS argued that a carefully structured corporate acquisition amounted to a so-called “impermissible avoidance arrangement” under the Income Tax Act’s General Anti-Avoidance Rules (GAAR).

The result was that SARS successfully re-characterised what had been presented as tax-exempt dividends into proceeds from the disposal of shares, triggering substantial capital gains tax liabilities for the taxpayers.

Tax Consulting South Africa’s Team Lead of Tax Controversy & International Tax, Richan Schwellnus, said this is another significant victory in SARS’ ongoing campaign against aggressive tax planning.

This dispute centred on the sale of a successful self-storage business. The shareholders had agreed to dispose of their entire shareholding to a specific purchaser.

However, rather than implementing a conventional share sale, the transaction was structured through a series of complex interdependent steps.

First, a target company declared a substantial dividend to its existing shareholders. Next, the buyer simultaneously subscribed for new shares in this company, with the subscription proceeds funding the dividend payment.

Only after these steps had been completed did the shareholders dispose of their now mostly “empty” shares to the purchaser for a reduced nominal amount.

The practical effect was that the shareholders received almost the entire economic value of their investment through dividends that qualified for exemption from normal tax.

At the same time, the subsequent disposal of the shares generated virtually no taxable capital gain.

SARS regarded the dividend and subscription steps as nothing more than a dividend-stripping mechanism disguised as a straightforward sale of shares.

The taxpayers’ defence

The taxpayers in this case argued that the disputed transaction was driven by genuine commercial considerations rather than a transaction disguised to conceal pure tax avoidance, Schwellnus explained.

It was submitted that an earlier restructuring project was already underway before the purchaser expressed interest in acquiring the target business.

The revised structure, they argued, simply represented a commercially efficient method of achieving the sale, while avoiding an unnecessary second layer of taxation.

The taxpayers further contended that there was no tax benefit when the transaction was viewed against the appropriate commercial alternative.

Had the acquisition not proceeded as implemented, they argued, a different form of restructuring would have been undertaken instead.

The taxpayers also relied heavily on professional tax advice obtained before implementation and maintained that the structure complied with the literal wording of the Income Tax Act.

SARS adopted a very different approach. Rather than concentrating on the individual legal steps, the taxman argued that the entire transaction should be viewed objectively and holistically as a single composite arrangement.

According to SARS, the dividend and share subscription aspects of the transaction served no genuine commercial function, beyond converting what would have been taxable sale proceeds into tax-exempt dividend income.

The purchaser ultimately funded the amount received by the shareholders. Control of the business changed completely, and, economically, nothing distinguished the arrangement from a conventional sale of shares.

SARS therefore invoked the GAAR to disregard the alleged artificial steps of the disputed transaction and therefore assessed the shareholders on the capital gains that would ordinarily have arisen.

The court sides with SARS

Ultimately, the Tax Court agreed with SARS’ arguments, confirming that the GAAR enquiry is an objective one, Schwellnus said.

The question is not simply what the taxpayers say they intended, but rather what the arrangement objectively achieved, when viewed in its commercial context.

Applying this approach, the Tax Court found that the dividend and subscription steps had no meaningful commercial effect beyond changing the transaction’s tax consequences.

The purchaser acquired precisely the same business, the shareholders received precisely the same economic value, and ownership passed in exactly the same manner as it would have under a conventional sale.

The only meaningful difference was the tax outcome. “That is misuse or abuse in the sense the GAAR contemplates,” the court said.

“It is not the mere exploitation of a gap or an ambiguity, and not the lawful selection of a less-taxed route among genuine alternatives, but the deployment of a relieving provision in a manner that defeats the object for which Parliament conferred it.”

The court concluded that the arrangement did in fact produce a tax benefit, that its main purpose was to obtain that benefit, and that it displayed several of the “tainted elements” required by the GAAR.

This includes abnormality, lack of commercial substance, the creation of non-arm’s-length rights and obligations, and misuse or abuse of the dividend exemption.

However, while SARS succeeded on the substantive tax issues, Schwellnus said the taxpayers nonetheless achieved an important procedural victory.

During litigation, SARS attempted to rely on an alternative GAAR arrangement that differed from the arrangement identified in its original assessments.

The Tax Court rejected this approach, holding that SARS was bound by the arrangement identified when the assessments were issued and could not fundamentally reformulate its GAAR case during the appeal process.

This aspect of the judgment reinforces that, while SARS enjoys extensive powers under the GAAR, those powers must still be exercised within the procedural framework prescribed by the Tax Administration Act.

A taxpayer win on penalties, but not a complete escape

Another encouraging aspect of this judgment for taxpayers concerns the treatment of penalties, Schwellnus explained.

The court drew an important distinction between the objective application of the GAAR and the taxpayer’s conduct in implementing the transaction.

It found that the taxpayers had obtained comprehensive professional tax advice before implementing the transaction.

They had also fully disclosed the arrangement to SARS as a reportable arrangement, and genuinely believed that the structure complied with the legislation.

In these circumstances, the court held that the 75% understatement penalties imposed by SARS could not stand and remitted those penalties.

It also set aside the provisional tax underestimation penalties and referred the matter back to SARS for reconsideration in light of the principles set out in the judgment.

However, the interest imposed by the revenue service under section 89 of the Income Tax Act remained payable.

“The judgment therefore serves as an important reminder that, even where SARS ultimately succeeds on a complex technical dispute, penalties are not inevitable,” Schwellnus said.

Taxpayers who implement aggressive tax structures without proper consideration are in a worse position to resist punitive action.

However, those who obtain appropriate specialist tax advice, maintain comprehensive supporting documentation, make full disclosure to SARS, and act transparently will usually have better success.

“This judgment provides another clear indication that South African courts are increasingly willing to examine the commercial substance of sophisticated tax structures rather than merely their legal form,” he said.

According to Schwellnus, taxpayers can expect SARS to continue scrutinising arrangements that introduce artificial steps with little or no commercial purpose beyond achieving a more favourable tax outcome.

However, the judgment also demonstrates that an important distinction remains between unsuccessful tax planning and culpable taxpayer conduct.