The problem of paying with shares resurfaces

February 1st, 2012
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By Barry Ger

Long-standing readers of this column will remember a number of articles previously published that dealt with the tax problem that arises when companies issue shares in themselves in exchange for assets or services (2004 (Sept) DR 61, 2005 (May) DR 55 and 2006 (March) DR 51). These articles criticised the view of the South African Revenue Service (SARS) that the issue of such shares would not qualify as an expense actually incurred for income tax or capital gains tax purposes (subject to certain statutory exceptions). It was pointed out that this could have disastrous tax consequences for the company concerned and that this was in any event wrong in law. It was hoped that these views were vindicated after the Income Tax Special Court in Pretoria roundly rejected SARS’ view in a case in which this issue arose, namely ITC 1801 (2006) (68) SATC 57. A later rejection of SARS’ appeal in this case by the full court of the North Gauteng High Court seemed to settle the matter once and for all (CSARS v Labat Africa Ltd (2010) 72 SATC 75). Unfortunately that was not to be. A recent successful appeal by SARS to the Supreme Court of Appeal (SCA) in the case of CSARS v Labat (SCA) (unreported case no 669/10, 28-9-2011) (Harms AP) has put everything back to where it started and the problem that companies had in paying for assets and services with their own shares has resurfaced.

This column examines this recent case and explores the implications that it may have for taxpayers.

A brief recap

Before discussing the latest judgment, it would be useful to briefly recap the history of share-based payments in South African tax law.

Traditionally, SARS allowed companies a deduction equal to the nominal value of the shares issued to pay for assets or services. In recent years, however, SARS began to deny such claims on the basis that the issue of such shares did not constitute ‘expenditure actually incurred’ for income tax purposes.

When a claim for a capital allowance was denied partly on such a basis, taxpayers took SARS on and the matter ended in the courts, culminating in ITC 1783 (2004) 66 SATC 373. In this decision, delivered on 20 November 2003, the court in obiter agreed with SARS’ view in this regard: A share-based payment would not qualify as an expense actually incurred for income tax purposes. In 2004 SARS issued a draft interpretation note to taxpayers indicating that it would apply this treatment to share-based payments in the future.

SARS’ stance was met by disapproval from taxpayers and commentators. Bowing to the pressure, SARS partially shifted its position and introduced a new s 24B into the Income Tax Act 58 of 1962 via the Revenue Laws Amendment Act 32 of 2004.

In terms of s 24B, a company that issues shares in exchange for an asset would be deemed to have actually incurred expenditure (subject to certain exclusions) to acquire the asset equal to the market value of the asset at the time of acquisition.

But s 24B has many shortcomings, not the least of which is that it does not deal with incidences where services are procured in exchange for the issue of shares or where such share issues discharge an existing liability or where shares are issued in return for shares. Its relief is restricted to circumstances where assets are traded for an issue of shares.

The facts of the case

It was in this milieu that the current case arose.

The facts were much the same as those in ITC 1783. The taxpayer, a company, acquired rights to intellectual property (in this case a trade mark as opposed to a licence agreement as in ITC 1783) as part of its purchase of a business as a going concern. In exchange for these rights, the taxpayer issued shares in itself to the seller.

Prior to 29 October 1999 (ie, the period during which the acquisition occurred) it was possible for taxpayers to claim, as a deduction from their taxable income, a capital allowance for expenditure incurred in acquiring a trade mark (s 11(gA) of the Income Tax Act as it then read). The taxpayer duly claimed this allowance only to have it refused by SARS. (As with ITC 1783, the case arose prior to the introduction of s 24B, which would have deemed expenditure to have been incurred.)

SARS’ argument

SARS argued that in order to succeed in such a claim, actual expenditure had to be incurred in acquiring the trade mark.

While SARS did not deny that the taxpayer had incurred an unconditional obligation to give consideration for the trade mark, it maintained that if the taxpayer only issued shares to pay for the trade mark, it did not, in SARS’ view, expend any money or assets, as no expenditure had actually been incurred. As such, the taxpayer was not entitled to the allowance. As authority for this, SARS proffered ITC 1783.

The taxpayer appealed SARS’ assessment and, against all expectations, won in the special court and in the High Court when SARS took the matter on appeal. As mentioned above, these gains were reversed when the matter went to the SCA.

The decisions of the lower courts

The lower courts came to the conclusion that the taxpayer had incurred expenditure equivalent to the market value of the trade mark received in exchange for the shares and a claim for an allowance based on this amount could not be denied. This was based on two reasons:

  • Firstly, it was considered that the expression ‘expenditure actually incurred’ meant that the taxpayer had to have incurred an unconditional obligation in respect of the amount concerned and, once this obligation was incurred, the expenditure became deductible.
  • Secondly, reference was made to a number of foreign and local decisions that confirmed that the issue of shares constitutes real consideration given by the issuing company.

The findings of the SCA

Harms AP in the SCA rejected both of these reasons.

He dismissed as unhelpful the foreign and local decisions the judges from the lower courts had used to support their rulings. In his analysis, these cases did no more than establish that the issue of shares amounted to consideration given by a company. They did not assist in interpreting the meaning of ‘expenditure’ in the Income Tax Act.

In his view, expenditure, an undefined term in the Income Tax Act, had to be given its ordinary dictionary meaning, which required a ‘diminution’ or at the very least a ‘movement of assets’ of the person who expends the funds. When shares are issued, a company’s assets do not diminish or move and hence the issue of shares could not constitute expenditure.

He agreed that had the taxpayer in the case issued the shares for cash to the seller of the trade mark and then used the cash proceeds to purchase the trade mark, the transaction would have given rise to expenditure in the taxpayer’s hands. However, because the parties skipped this intermediate step and exchanged the issued shares for a trade mark, no expenditure, under his interpretation, had arisen.

Effectively, Harms AP reinstated the reasoning in the original case of ITC 1783 and SARS’ disallowance of the deduction was upheld.

A word of criticism

With all due respect to Harms AP, it must be said that even if this interpretation of expenditure is correct, the application of it in this case can be criticised.

When goods or services are purchased on credit in year one and no payment is received until year two, they also, on Harms AP’s understanding of expenditure, would seem not to give rise to any ‘diminution or movement of assets’ in year one as no cash is passed to the creditor initially. Does this mean that all deductions claimed for non-cash expenditure should be disallowed?

Of course not. When a credit sale occurs, there is indeed a diminution of assets in these circumstances as a liability arises in the purchaser’s hands to pay the creditor. It is this liability that diminishes the purchaser’s assets even though no cash passes between the parties initially. Hence expenditure is incurred and should be successfully claimed as a deduction in year one.

In the same way, the assets of the taxpayer in the case under consideration diminished when it acquired the trade mark. On acquisition of the trade mark, a liability arose in its hands to provide consideration to the seller of the trade mark. That liability, even if it arose for a split second, served to diminish the assets of the taxpayer. There was thus expenditure in its hands even under Harms AP’s understanding of the term.

Harms AP makes a distinction between exchange transactions and sale transactions, but in truth the distinction is artificial. In both exchanges and sales, a liability arises that diminishes the assets of the seller or exchanger. The difference is in the consideration used to settle that liability. Exchanges simply mean that goods or services are consideration for receiving goods and services rather than cash. The fact that different consideration is used does not mean that a liability does not arise and a diminution of assets does not occur.

Implications of the judgment

Irrespective of the flaws in the court’s reasoning, the case is an SCA decision and is law for all intents and purposes.

What does this mean for taxpayers? There is at least succour where assets are exchanged for the issue of shares: Section 24B can be used to deem expenditure to have been incurred in the issuer’s hand equal to the value of the assets received in exchange. This rule will not apply, however, where shares are issued in exchange for services. In these cases, an incongruity will arise in that the recipient of the shares will be taxed on their value, whereas the issuer of the shares will not be permitted a deduction for tax purposes.

To avoid this, taxpayers will need to structure such transactions carefully to make them tax efficient. It would seem that taxpayers who wish to issue shares as consideration for services will first have to issue the shares for cash, which would then be used to pay for the services received. In other words, cash would have to flow between the parties. This would result in taxpayers having to incur unnecessary non-tax charges in the form of banking fees. It would also make transactions more complicated than necessary and more expensive (as financing from banks would be needed).

It is hoped that the legislature can resolve the inequity and inconsistency arising from this unfortunate case and expand s 24B to include services exchanged for share issues.

Barry Ger BBusSc LLB BCom (Hons) (Taxation) (UCT) is a tax consultant in Cape Town.

This article was first published in De Rebus in 2012 (Jan/Feb) DR 48.