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Case No 685/91
IN THE SUPREME COURT OF SOUTH AFRICA (APPELLATE DIVISION) In the matter between:
P A BURGESS Appellant
and
THE COMMISSIONER FOR INLAND
REVENUE Respondent
CORAM: CORBETT, CJ, E M GROSSKOPF, VIVIER, KUMLEBEN, NIENABER, JJA
HEARD: 19 May 1993
DELIVERED: 2 Junie 1993
J U D G M E N T
2
E M GROSSKOPF, JA
This is an appeal
from the Transvaal Income Tax Special Court, leave having been granted in terms
of sec 86A(5) of the Income Tax
Act, no 58 of 1962, ("the Act") to appeal to
this Court. The point in issue is whether the Commissioner for Inland Revenue
was correct
in holding that a liability for interest which had accrued was, in
the circumstances of the case, not a permissible deduction in
terms of sec 11(a)
of the Act. The Special Court held in favour of the Commissioner, dismissed the
appellant's appeal and confirmed
the assessment in which the claim for a
deduction was disallowed. The facts are as follows.
The appellant is the
managing director of a company doing structural engineering work. He is also a
director of various property owning
companies, some of which own properties on
which the structural engineering business is conducted, and one which owns other
property
which is let. He
3
derives his income mainly from salaries and director's fees paid by
these companies. The appellant owns some shares which are quoted
on the stock
exchange, and prior to October 1987 he speculated in a small way by buying and
selling shares. He also owns some units
in a unit trust.
During 1987 the
appellant was approached by an insurance broker who told him, in the appellant's
words, "over a year period we could
make you a considerable amount of money" and
that all the appellant had to do was to put up a guarantee of R425 000. The
scheme to
which the broker was referring, was one which had been initiated by a
company called Fenton Investments (Pty) Ltd ("Fenton"). The
nature of the scheme
is set out and explained in a number of documents which were before the Special
Court. In addition evidence
was given by Mr M J Gray, a director of Fenton, and
the appellant himself. The Special Court did not criticize the evidence of these
witnesses in any way and, save in a few respects with which I shall deal later,
it was not impugned in argument.
4
From these sources, the following
picture emerges.
The essence of the scheme was that money would be borrowed
from a bank and invested for a short period (one or two years) in assets
such as
shares which were expected to appreciate. At the end of the period the assets
would be realised, the bank repaid, and the
balance pocketed. This type of
investment normally carries the risk that the assets might not perform as
expected, leaving the investor
with no profit and an obligation to repay the
loan. In the Fenton scheme, this risk was reduced. The investment would be made,
not
by purchasing the assets themselves, but by entering into a single-premium
pure endowment policy. The insurance company (Lifegro
Insurance Limited
("Lifegro")) would then manage the money contributed by the investors by way of
premiums in the most advantageous
way. Lifegro was considered to be highly
skilled in this field. And the key to the scheme was that Lifegro would issue a
policy with
a surrender value which was guaranteed if the policy was surrendered
after a year or
5
after two years. Thus Lifegro undertook to repay the amount invested (i e, the single premium) after a year with a profit of four per cent. This did not, of course, guarantee that investors would make a profit. The loans which the investors made would be at 12½ percent (in the present case), thus leaving the possibility of a loss of 8½ percent. Nevertheless, the possibility of a greater loss was eliminated provided Lifegro was able to meet its commitments.
To cater for the possibility that Lifegro might default, the scheme had a further refinement. The transactions would be entered into, not by the individual investor, but by a partnership en commandite of which he and Fenton would be the members. The individual investor would be the limited partner, and would not be liable for partnership debts except to the extent of the bank guarantee, to which I refer later. Fenton, the disclosed partner, would be liable for the balance of the debts, but, as a company with limited
6
liability and few assets, would not be able to pay them. Thus the bank
would effectively carry the risk that Lifegro might not be
able to pay.
The
bank, for its part, lent the money to the partnership for a year. The
partnership paid this amount to the insurance company as
a single premium on an
insurance policy, and ceded the policy to the bank. Provided the insurance
company remained sound the bank
would be sure to receive, at the end of the
year, the borrowed amount plus four per cent. Since, as already said, the bank's
rate
of interest was 12½ percent, it required security for the balance.
This would be provided by the individual investor in the
form of a bank
guarantee. The cost of providing the bank guarantee would be the only outlay on
the part of the individual investor,
and, as stated above, the amount of the
guarantee was the most he could lose on the transaction in terms of the
partnership deed.
In return he would obtain 90% of the profits made by the
partnership. Fenton would get the
7
rest.
It was clear that the policy
taken out would be a non-standard policy in terms of the Sixth Schedule to the
Act, and that the proceeds
would fall within the investor's gross income in
terms of para (eA) of the definition thereof in sec 1 of the Act. A gain would
accordingly
be taxable. However, the scheme also provided, so its proposers
thought, certain tax advantages. The interest paid to the bank, so
they
considered, would be tax deductible. Since liability for interest would already
accrue during the first year (although interest
would only be payable annually
in arrear), and no income would be payable before the end of the first year, the
liability to pay
interest would accrue before the accrual of income from the
scheme. This would lead to a tax deferment.
This then was the scheme. One feature which seems unusual was the establishment of a limited partnership. One would not have thought that the parties would have found it necessary to guard against a default on the part of a
8
prominent insurance company. Nevertheless, according to Mr Gray's
evidence this was indeed the purpose in interposing the limited
partnership
between the investor and the financial institutions (i e, the bank and the
insurance company). No other plausible reason
has been suggested. The existence
of the partnership certainly made no difference to the payment of tax. There is
accordingly no
reason not to accept Mr Gray's evidence on this point.
When
the appellant was introduced to this scheme it sounded promising to him. The
stock market was booming and there was speculation
that he could obtain an 18 or
20 per cent return on a borrowed amount of R5 million. He discussed the project
with the insurance
broker who had introduced him to it. He also consulted his
bank manager. The bank manager "in turn contacted Syfrets and the likes"
and
came back with a very favourable report on the whole concept. The appellant
decided to enter into the scheme. He obtained a bank
guarantee for an amount of
R425 000 in favour of U A L
9
Merchant Bank ("UAL"). This cost him "something like" R6000. On 27 May
1987 he entered into a partnership with Fenton under the name
of Fenton Limited
Partnership No. 13. On the same day the rest of the transaction was completed:
an amount of R5 million was borrowed
from UAL (for a year at a rate of 12½)
and paid to Lifegro as a single premium on a policy; the policy was issued and
it was
ceded to UAL. The commencement date of the policy was 27 May 1987.
Lifegro guaranteed that on the first anniversary of the policy
its surrender
value would be at least R5 200 000. The interest payable to the bank for that
year was R625 000. This was secured by
Lifegro's guarantee of R200 000 profit on
the policy combined with the appellant's bank guarantee for R425 000.
In
October 1987 there was a crash on the Johannesburg stock exchange. The value of
the fund which Lifegro had created from the money
invested by the various Fenton
partnerships plummeted. It became clear that Lifegro would not, on the first
anniversary of the policy,
pay more
10
than the minimum amount guaranteed by it. There were two
options open to the appellant. He could either get out at the end of the
first
year and bear the loss of the amount guaranteed by him, or he could extend the
investment for another year. If he took the
latter course, he would have had to
renegotiate the loan with UAL. A higher rate of interest would have been
charged. The total amount
of interest would, accordingly, have been higher but
Lifegro's guarantee was also somewhat more generous at the end of the second
year. Nevertheless, unless the investment performed much better in the second
year than it had in the first, the appellant would
benefit by cutting his losses
and getting out. This was the course he adopted and subsequent events proved him
right. The accounts
of the partnership for the period ended 29 February 1988
showed a loss of R477 740 in respect of interest payable to UAL. The interest
had accrued up to 29 February 1988. This loss was allocated to the
appellant.(The appellant's counsel conceded that this was a mistake.
In
11
terms of the partnership deed the appellant's liability for
partnership debts was limited to R425 000, and if the appeal succeeds
the
figures will have to be corrected.) In his Income Tax return for the year ended
29 February 1988 the appellant claimed the amount
of R477 740 as a deduction.
This resulted in a net loss for that year. The Commissioner in his determination
of the appellant's taxable
income disallowed the deduction in its entirety and
issued a second revised assessment accordingly. As I have already stated, the
appellant objected to the disallowance and appealed to the Special Court without
success. Hence this appeal.
Although the loss in question was suffered by the
partnership, it was common cause that in principle the appellant was entitled to
deduct his share of the loss from his personal income. See Sacks v
Commissioner for Inland Revenue 1946 AD 31. Section 24H of the Act was not
yet in force in the relevant tax year and need not be considered. The only
question in
issue in this appeal is whether the
12
deduction of interest
claimed by the appellant is permissible
in terms of the general deduction formula laid down in sec
11(a) of the Act. This provision reads as follows:
"For the purpose of determining the taxable income derived by any person from carrying on any trade within the Republic, there shall be allowed as deductions from the income of such person so derived - (a) expenditure and losses actually incurred in the Republic in the production of the income, provided such expenditure and losses are not of a capital nature;"
The Special Court held that the deduction for
interest had rightly been disallowed because the
appellant
had not shown that the expenditure had been incurred in
the
production of income derived by him "from carrying on any
trade". The
first main issue on appeal was whether the
Special Court was correct in this view.
In terms of sec 1 of the Act " 'trade' includes
every profession, trade, business, employment, calling,
occupation or venture, including the letting of any property
and the use of or the grant of permission to use any patent
... or any design ... or any trade mark ... or any copyright
13
... or any property which is of a similar nature."
Mr Levin, who appeared
for the Commissioner in this appeal, argued that there were two reasons why the
appellant's activities could
not be regarded as the carrying on of a trade. The
first was that the appellant's actual purpose in making the investment was to
reap the reward flowing from the fiscal advantages. The possibility of the
scheme generating a commercial return, he contended, was
contemplated, but was
merely incidental. In short, he contended that, on the facts properly construed,
the appellant did not engage
in a trade, the scheme being nothing more than a
tax engineering device. The fiscal advantage to which he referred was the tax
deferment,
which I mentioned earlier, arising from the difference in time
between the accrual of the liability to pay interest to UAL and the
accrual of
the benefits under the policy.
At the outset it should be emphasized that we are not here dealing with an attack by the Commissioner on an
14
alleged tax avoidance scheme in terms of sec 103 of the Act.
The sole question before us is whether the appellant was carrying on
a trade
within the meaning of sec 11(a). And despite the existence of the partnership
with Fenton as the managing partner, the parties
approached this appeal by
concentrating on the appellant's position, and, in so far as it may be relevant,
the appellant's state
of mind. In my view this was correct. On a proper analysis
of the facts the partnership existed only as a part of the structure through
which the appellant participated in the scheme. It is the legal effect of his
participation that has to be determined.
In support of this part of his
argument Mr Levin relied mainly on English decisions. Essentially, he said, the
enquiry is whether
the transaction "... ought ... when viewed fairly and
rationally, to be classed as a trading transaction ..." (see FA & AB Ltd
v Lupton (Inspector of Taxes) [1972] AC 634 at 644E]. With this proposition
I agree. For the rest the English cases on tax avoidance are not really in point
for
15
present purposes, although some of their reasoning may
be
relevant. In the recent case of Ensign Tankers (Leasing)
Ltd
v Stokes (Inspector of Taxes) [1992] 2 All ER 275 the
House
of Lords gave an exposition of the law relating to tax
avoidance
schemes after a thorough discussion of earlier
cases. As stated by Lord Goff
in the latter case at p 295 d-
e:
"Unacceptable tax avoidance typically involves the creation of complex artificial structures by which, as though by the wave of a magic wand, the taxpayer conjures out of the air a loss, or a gain, or expenditure, or whatever it may be, which otherwise would never have existed. These structures are designed to achieve an adventitious tax benefit for the taxpayer, and in truth are no more than raids on the public funds at the expense of the general body of taxpayers, and as such are unacceptable".
The present case is clearly not of the same type as
those considered in the above mentioned English authorities.
The structures of the Fenton scheme, as I set it out above,
were designed to achieve the commercial results of a short
term gain on the investment of borrowed money with some
limitation on the extent of possible losses. No part of the
16
structures can be described as artificial. Each one was
designed for a commercial purpose. The expenses incurred in the cost of the
bank
guarantee and the interest paid to UAL were actual expenses. The appellant paid
them, and had to sell assets to do so. If the
expected profit had materialised,
the appellant would have had to pay tax on it. Of course, there was also an
expected benefit by
reason of the tax deferment, but this arose from the very
nature of the transaction, viz, that interest became due before any profit
was
realized. It was not something which was contrived in an artificial way.
Mr
Levin's argument on this aspect of the case was based purely on the appellant's
supposed purpose in entering into the transaction,
viz, on the proposition that,
although it was a part of the appellant's purpose to make a profit out of the
transaction, his main
purpose was to secure the fiscal advantage of a tax
deferment. This argument postulates that, but for the appellant's purpose to
secure a tax advantage
17
from the scheme, he would have been carrying on a trade.
I
do not think that this argument is sound in law, even if the facts supported it.
If a taxpayer pursues a course of conduct which,
standing on its own,
constitutes the carrying on of a trade, he would not, in my view, cease to be
carrying on a trade merely because
one of his purposes, or even his main
purpose, in doing what he does is to obtain some tax advantage. If he carries on
a trade, his
motive for doing so is irrelevant. See in this regard,
Lupton's case, supra, at pp 646C to 647G (Lord Morris of
Borth-y-Gest), 655G (Viscount Dilhorne); W T Ramsay Ltd v Inland Revenue
Commissioners and Others [1982] AC 300 (HL) at p 323E and the Ensign
Tankers case, supra, at pp 291h to 292a. Of course the position might
be different if a transaction "is so affected or inspired by fiscal
considerations
that the shape and character of the transaction is no longer that
of a trading transaction" (Lupton's case, supra, at p 647G). That
is clearly not the case here. As I have pointed out, the shape
18
and character of the transaction in the present case were inspired entirely
by commercial considerations.
Moreover and in any event, the facts do not in
my view support Mr Levin's contention. As I have stated above, the Special Court
expressed
no criticism of the two witnesses who testified in the case, namely Mr
Gray and the appellant himself. On the contrary, the Court
said: "I place on
record that no adverse inference as to their credibility could be drawn from the
manner in which the witnesses
gave the evidence".
In evidence in chief the appellant stated
categorically that the tax savings or tax benefits did not
play a
substantial part in his decision to participate in the
scheme. He was extensively cross-examined on this, but did
not waver. When
asked why he entered into the scheme, he
said:
"Well, it looked, as I say, I did react prudently in the sense that I went to the bank manager and tried to get some feedback from that side on a more conservative basis and everything looked very good and obviously the carrot dangled in front of us was
19
the capital gain on it, the growth or the potential growth."
As regards the tax benefit, he said: "It
certainly wasn't sold ... to me as a tax benefit". He conceded that the tax
benefits were
mentioned to him prior to his entering into the scheme, and that
these benefits might be significant, but he maintained that it was
the prospect
of profit which attracted him, not the possibility of a tax deferment.
Mr
Gray was to the same effect, although he obviously could not testify as to the
appellant's state of mind. He emphasized that the
only tangible benefit which
could be derived from the tax deferment was that the investor would, for the
year or two during which
the deferment was effective, be able to invest the
money which he would otherwise have had to pay in tax. In the appellant's case
he would, according to Mr Gray, have been able to gain a maximum of R6000 in
round figures in this way. On the other hand, a
20
profit of 20 per cent on the money invested would have given
him a net R310 000. These estimates were not challenged in cross-examination.
Counsel's only counter was that the tax deferment was certain while the profit
on the investment was uncertain. Mr Gray conceded
this.
In argument before us
Mr Levin advanced two main reasons why the appellant's evidence in this regard
should not be accepted. The first
was the emphasis placed in a promotional
brochure on the tax advantages accruing under the scheme. The appellant's
evidence was that
he saw the brochure prior to entering into the scheme, but
that he was more impressed by the profit forecasts contained in it than
in the
tax benefits. There is in my view no reason to doubt his word on this.
The second basis on which Mr Levin tried to cast doubt on the appellant's evidence, was by showing how valuable the tax deferment could have been. In his heads of argument he tried to show that, by investing at 15 persent
21
compound the money he would otherwise have had to pay in tax,
the appellant could make a sum of R65 720. It was not explained how
the
appellant, who was able to borrow money from the bank at 12½ per cent,
could obtain 15 per cent from a safe investment.
To this calculation the
appellant replied, in a set of supplementary heads of argument, with his own
calculation which came to a
net amount of R5 533. In argument Mr Levin stuck to
his figure.
I do not propose analysing the various calculations presented to
us. How much the appellant could gain from the tax deferment depends
on a number
of factors. It would depend firstly on whether he had the money to invest, and
on the rate of interest which he could
obtain. Then the period for which he
could invest the money would depend on how he could juggle his payments of
provisional tax.
In particular it would depend on his getting the Commissioner's
consent in terms of para 19(1)(c) of the Fourth Schedule to the Act
to pay
provisional tax on less than the basic amount. In the
22
absence of such consent his payment of provisional tax would have had
to be based on his most recent assessment. This would reduce
the benefit of the
tax deferment.
None of these matters was canvassed in evidence. There is no
suggestion that the appellant was aware of these rather complicated ways
of
taking maximum advantage of the tax deferment. In fact, what evidence there is,
indicates the contrary. It appears from the appellant's
original tax assessment
for the 1988 tax year that he had paid his provisional tax on his basic amount.
One must therefore assume
that he did not receive the Commissioner's consent to
pay tax on his expected income (which would in effect be consent not to pay
provisional tax in that year at all because he would be incurring a net loss).
This payment of provisional tax would, by itself,
affect the theoretical
calculations put before us, since it was made out of money which, in terms of
the respondent's calculations,
should have been invested at 15 per cent.
Moreover it tends to confirm
23
the appellant's evidence that the tax deferment was not his
main reason for entering into the scheme.
In my view the appellant's evidence
that his main purpose in making the investment was to make a profit from it has
not been impaired
in any way, and must stand.
I turn now to the second ground
advanced by Mr Levin in support of the proposition that the appellant was not
carrying on a trade.
This argument presupposes that the appellant's main purpose
in entering into the scheme was to earn a profit. Nevertheless, it is
contended,
"an 'investment' of the nature in question will not, as a matter of law, and on
the common cause facts amount ... to the
carrying out of a trade" (I quote from
the heads of argument).
It is well-established that the definition of trade, which I have quoted above, should be given a wide interpretation. In I T C 770 (1954), 19 SATC 216 at p. 217, Dowling J said, dealing with the similar definition of
24
"trade" in Act 31 of 1941, that it was "obviously intended to embrace
every profitable activity and ... I think should be given the
widest possible
interpretation."
In the present case the appellant argued that its
participation in the Fenton scheme amounted to a "venture" which is included in
the definition of "trade". In I T C 368, (1939) 9 SATC 211 at p 212, "venture"
is defined as "a transaction in which a person risks
something with the object
of making a profit". This is borne out by dictionary definitions. Thus The
Oxford English Dictionary (2nd
ed) gives as the appropriate definition "an
enterprise of a business nature in which there is considerable risk of loss as
well as
chance of gain; a commercial speculation." Webster's Third New
International Dictionary gives "a business enterprise of speculative
nature."
See also the definitions quoted in I T C 1476 (1990), 52 SATC 141 at p 148. In
the Afrikaans text of the Act sec 11 speaks
of a "bedryf" which is defined to
include, inter alia, "elke
25
professie, handelsaak, besigheid, diens, beroep, vak of onderneming".
The word "onderneming", which corresponds to "venture" in the
English text,
seems in general somewhat wider although it is capable of bearing the same
meaning. Thus it is translated in Bosman,
van der Merwe and Hiemstra, Tweetalige
Woordeboek, as, inter alia, "venture, risky undertaking".
Now in the
present case the appellant clearly, in my view, undertook a venture in the above
sense. He laid out the money required
to obtain a bank guarantee, and risked the
amount of the guarantee, in the hope of making a profit. It was a speculative
enterprise
par excellence.
In the judgment of the Special Court and the
argument on behalf of the Commissioner some doubt was cast on whether the
appellant himself
realized the risks inherent in the scheme. In my view this
does not matter. An undertaking does not in my view cease to be a venture
merely
because the person pursuing it is of a sanguine temperament.
26
In conclusion on this point I must make it clear that although an element of risk is included in the concept of a "venture" in its ordinary meaning, I must not be taken to suggest that a scheme like the present would only constitute a "trade" if it is risky. Whether it would or not would depend on its own facts. If there is no risk involved, it might still be covered by giving an extended meaning to "venture" or by applying the rest of the definition, which is in any event not necessarily exhaustive. See Meyerowitz and Spiro on Income Tax, para 610. Thus in argument Mr Levin accepted that a person who borrowed money at a low rate of interest and invested it at a higher rate, would be engaged in a trade even if his investment was a safe one. For present purposes it is not, however, necessary to pursue this matter further.
Finally Mr Levin argued that the expenditure in the present case was of "a capital nature" and therefore fell outside the terms of sec 11(a) of the Act. The argument, as I
27
understood it, was as follows. An insurance policy is a
capital asset and a gain made by investing in one is, in principle, a capital
gain. The legislature has, in para (eA) of the definition of "gross income",
included gains received or accrued from insurance benefits
under non-standard
policies. This does not, however, change the essentially capital nature of the
policy or of such gains. Therefore,
so it is concluded, any expense incurred in
obtaining a policy must also be of a capital nature.
There are, in my view,
two answers to this contention. First, in terms of para (eA) any gain made by
the appellant from the scheme
would be part of his gross income. If one assumes
that the policy which produces that income is a capital asset, the appellant
would
have borrowed money to procure the capital asset which produces the
income. In I T C 1124 (1969), 31 SATC 53 at p 55-56, a case similar
to the
present, Trollip J, as President of the Transvaal Income Tax Special Court,
held:
"In the present case the interest paid was the
28
recurrent or periodical charge or 'rental' payable for the continued use by the appellant company of the money lent to it. Such interest was not intended or calculated to, nor did it in fact, improve, augment or preserve those aforementioned capital assets, or form part of or add to the cost of acquiring them or enhance their value. Consequently, we do not think that in the circumstances of this case the interest was so closely identified or associated with those capital assets that it must itself be regarded as being of a capital nature."
These findings are in my view equally
applicable to the facts of the present case. See also Meyerowitz and Spiro on
Income Tax, para 664, Silke on South African Income Tax, 11th ed,
para 7.36, De Koker and Urquhart, Income Tax in South Africa, para 10.3,
Commissioner for Inland Revenue v Genn & Co (Pty) Ltd 1955 (3) SA 293
(A) at p 300D and Commissioner for Inland Revenue v Drakensburq Garden Hotel
(Pty) Ltd 1960 (2) SA 475 (A) at p 480A.
But, in any event, I cannot
agree that the insurance policy in the present case constituted a capital asset.
The scheme was a short
term speculation with borrowed money. The intention was
to surrender the policy after a year
29
or two so as to realize the appreciation of its underlying
assets. The scheme does not in its nature differ from the speculative purchase
of land or shares with the intention of . re-selling at a profit. An asset so
held is not a capital asset and a profit made on its
realization does not
constitute a capital gain. I do not think authority is needed for this
conclusion. And the mere fact that the
vehicle used for the speculation was an
insurance policy cannot, in my view, make any difference.
For all these
reasons I consider that the appellant's claim for a deduction in respect of his
liability for interest should have been
allowed.
The appeal is allowed with
costs, including the costs of two counsel. The order of the Special Court is set
aside and the second revised
assessment is remitted to the Commissioner for
Inland Revenue for re-assessment on the basis that a deduction of R425 000 be
allowed
for the year ended 29 February 1988.
30
E M GROSSKOPF, JA
CORBETT, CJ, VIVIER, JA KUMLEBEN, JA NIENABER, JA Concur
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