By Barry Ger
Readers may recall an article in 2011 (Apr) DR 43 that considered the contentious Supreme Court of Appeal (SCA) case Commissioner for the South African Revenue Service v NWK Ltd 2011 (2) SA 67 (SCA), which appeared to upend South African law regarding so-called ‘simulated transactions’. The judgment handed down by Lewis JA in this case may be interpreted to broaden the circumstances under which courts could treat agreements between parties as simulated and, in so doing, disregard their legal consequences.
The decision had potential implications far beyond the narrow confines of tax planning and it inspired much debate. This has now culminated in two judges of the Western Cape High Court challenging the reasoning of the SCA in the NWK case. In two separate judgments in the full Bench decision of Bosch and Another v Commissioner for the South African Revenue Service (WCC) (unreported case no A94/2012, 20-11-2012) (Davis J) Davis and Waglay JJ criticised aspects of the NWK case and possibly preferred the pre-existing interpretation of the law concerning simulated transactions.
To explore this new development and its implications, it is necessary to set out some of the background related to the law concerning simulated transactions or, as it is often called, the ‘substance over form’ doctrine.
Background to the doctrine
The South African common law principle encapsulated in the maxim plus valet quod agitur quam quod simulate concipitur means ‘what is actually done is more important than that which seems to have been done’. This has been understood to allow courts to champion the legal substance of a transaction over the form in which it is presented if the nature of such a transaction is in dispute.
In the context of tax planning, parties to a transaction may, for example, simulate a transaction to resemble, in form, a lease, when the transaction actually achieves a sale. The tax consequences of sales and leases differ and if such a transaction is brought before a court, application of the principle will ensure that parties are taxed according to the legal consequences of the sale the transaction effects in substance, instead of the lease consequences that the transaction purports to have in its form.
But how do the courts determine the legal substance of a transaction? For over a hundred years prior to the NWK case, the courts used the parties’ intentions as the touchstone. Often a transaction can be disguised in that an agreement that does not express what the parties truly intend. Sometimes dishonesty is not involved and the parties genuinely think they are entering into a particular type of agreement when in fact they are entering into another type of agreement. In both instances the courts will consider if the parties truly intended to give effect to the agreement in accordance with its terms. If they did, then substance follows the form and the agreement will stand. If they did not, then substance contradicts form and the agreement will be disregarded.
In the NWK case, this longstanding test appeared to be abandoned by the SCA. Instead, Lewis JA suggested that an examination of the ‘commercial sense’ or purpose of the transaction was required. At para 55 the court held: ‘In my view the test to determine simulation cannot simply be whether there is an intention to give effect to a contract in accordance with its terms. Invariably where parties structure a transaction to achieve an objective other than the one ostensibly achieved they will intend to give effect to the transaction on the terms agreed. The test should thus go further, and require an examination of the commercial sense of the transaction: Of its real substance and purpose. If the purpose of the transaction is only to achieve an object that allows the evasion of tax, or of a peremptory law, then it will be regarded as simulated. And the mere fact that parties do perform in terms of the contract does not show that it is not simulated: [T]he charade of performance is generally meant to give credence to their simulation.’ According to the judge, if the commercial purpose of the transaction was to achieve ‘an object that allows for evasion of tax or of a peremptory law’, then the transaction would be regarded as simulated.
The NWK case involved a ‘structured finance’ transaction in which a subsidiary of a bank purportedly lent the taxpayer almost R 100 million to buy a quantity of maize but only a net amount of R 50 million in cash was effectively made available. The SCA found that the transaction was arranged in this form to enable the taxpayer to claim interest deductions on the larger amount. Consequently, tax avoidance was the goal and the transaction was simulated.
Effectively the NWK case conflated the ‘substance over form’ doctrine with the general anti-avoidance rules set out in the Income Tax Act 58 of 1962, which allow courts to disregard transactions where the sole or main purpose is tax avoidance. Following this, it seemed that any transaction that achieved tax avoidance could be ‘looked through’. This created a minefield for tax planners who had previously understood the law to be very different.
The Bosch case
The law stood like this for almost two years until the Bosch case. The taxpayers in this case were two employees of a large listed company. Both were beneficiaries of the group’s employee share incentive scheme, which was a typical ‘deferred delivery’ arrangement. Such schemes were popular prior to a 2004 change in income tax law. Essentially, they involved employees exercising options to acquire shares in an employer company at just below their current market value, which were delivered and paid for at a much later date. According to an interpretation of the law prevalent at the time, employees who participated in these schemes would avoid being taxed on the gain in share value that arose between the exercise date and the delivery date. Instead they would be taxed on the difference between the value of the shares at the exercise date and the option price.
The South African Revenue Service (SARS) sought to challenge this interpretation of the law and subjected the taxpayers to income tax on the value of the shares on the delivery date less the option price paid.
SARS was successful in the lower tax court but when the taxpayers appealed to the Western Cape High Court, the taxpayers’ interpretation of the pre-2004 law on ‘deferred delivery schemes’ was favoured.
SARS then attempted to argue an alternative point: Those aspects of the ‘scheme’ in question were simulated transactions.
According to SARS, despite the form of the scheme, there was no real unconditional sale at the time of exercise of the option. Instead, the substance of the scheme was that the taxpayers’ rights would only become unconditional at the delivery date. To disguise this, the scheme, SARS alleged, contained uncommercial terms, the only commercial purpose of which was to avoid taxation of an amount calculated using the value of the shares at the time of delivery.
This then made the scheme a simulated transaction in terms of the approach adopted in the NWK case. SARS contended that it was for the court to apply the true substance of the transaction and use the share value on the delivery date in calculating the amount to be taxed in the taxpayers’ hands.
Judgments in the Bosch case
Both judgments in the Bosch case rejected SARS’ argument in this regard albeit for different reasons. The appeals of the taxpayers were thus upheld with costs.
Davis J (with Baartman J concurring) advised that the NWK case should not be interpreted to have changed the law regarding simulated transactions. The judgment of the SCA in the NWK case should be read in a manner coherent with the law prior to the decision, rather than as a decision that ‘ruptures’ over a century of jurisprudence. In this regard, Davis J found that the SCA merely required, as part of the inquiry into whether a simulated transaction is present, examination of the real commercial sense of the transaction.
Whereas the NWK case clearly involved a taxpayer disguising its intentions, on the evidence there was no such subterfuge in the Bosch case. The share incentive scheme was honestly designed and intended to have its specific effect. It could not, therefore, be regarded as a simulated transaction, even if aspects of it were entered into with the intention of avoiding tax.
Waglay J, in a separate judgment, concurred with Davis J’s conclusion, but disagreed with his interpretation of the NWK case. He found that it did depart from existing case law on simulated transactions and laid down the rule that any transaction that has the aim of tax avoidance will be deemed a simulated transaction regardless of whether the transaction is a genuine one (para 4). However, he added: ‘NWK cannot be read to serve as a precedent in this case where evasion is not the issue. In any event, any transaction which has its purpose [as] tax evasion is unlawful as tax evasion constitutes a criminal offence in terms of the Income Tax Act; NWK cannot therefore be authority for setting aside a transaction as simulated by reason of being a vehicle for tax evasion as this is automatic in terms of the law. On the other hand, if the words “evasion of tax” are to be substituted with “avoidance of tax” then the dictum goes against the accepted practice in our income tax law which permits transactions aimed at tax avoidance. Furthermore, the confusion created by the judgment mitigates against it serving as a precedent binding upon the lower courts.’
Stare decisis
Does the Bosch case offend the stare decisis principle, which requires that lower courts are bound by decisions of higher courts? Was the High Court in this case not bound to adhere to the SCA’s ratio decidendi in the NWK case?
The majority decision by Davis J did not, however, breach the precedent established by the NWK case. Davis J applied the NWK case, and merely interpreted it in a manner consistent with pre-existing law. Further, it could be argued that the NWK case itself disregarded the stare decisis principle when it chose to break from years of precedent in assessing simulated transactions without providing adequate reasons for doing so.
Barry Ger BBusSc LLB BCom (Hons) (Taxation) (UCT) is a tax consultant in Cape Town.
This article was first published in De Rebus in 2013 (Jan/Feb) DR 62.
