The Kluh-ed up taxpayer wins – a decision on section 26 of the Income Tax Act

In this case, the SCA had to decide whether SARS’s application of s26(1) of the Income Tax Act, No 58 of 1962 (Act) and paragraph 14(1) of the First Schedule to the Act was correct and whether income received within the context of these provisions was capital or revenue in nature. The decision was heard on appeal from the Western Cape High Court in Kluh Investments (Pty) Ltd v Commissioner, South African Revenue Service 2015 (1) SA 60 (WCC), which we reported on in our Tax Alert of 12 September 2014 (Keeping the lid on Pandora’s box). The taxpayer appealed the Tax Court’s decision, which found in favour of SARS. The High Court overturned the Tax Court’s decision, prompting SARS to appeal to the SCA.

Section 26(1) of the Act states that if a person carries on “pastoral, agricultural or other farming operations” the taxable income of that person shall be determined in accordance with the provisions of the Act, but subject to the provisions of the First Schedule. Paragraph 14(1) of the First Schedule states that “any amount received by or accrued to a farmer in respect of the disposal of any plantation shall, whether such plantation is disposed of separately or with the land on which it is growing, be deemed not to be a receipt or accrual of a capital nature and shall form part of such farmer’s gross income”.

Facts

During May 2001, Steinhoff agreed to purchase the forestry, timber-growing and plywood manufacturing business of Thesen as a going concern, including the land and plantation. However, Steinhoff’s ultimate holding company blocked the acquisition of the land and plantation as it was, at the time, not their policy to acquire fixed property in South Africa. Steinhoff then agreed to purchase only Thesen’s machinery and equipment including the sawmill, and the taxpayer - a special purpose vehicle of a Swiss company - agreed to acquire the remaining assets, which included the land and plantation, and took possession thereof. However, Steinhoff then changed its mind and in 2004 purchased the taxpayer’s plantation business. Approximately 90% of the purchase price was in respect of the plantation and the seller realised a significant capital gain of about R45 million. SARS treated this amount as gross income, in terms of s26(1) of the Act, read with paragraph 14(1) of the First Schedule.

Judgment

As there is no definition of ‘farming operations’ in the Act, determining whether a person’s economic activity constitutes farming operations is essentially a question of fact. The SCA found that the approach adopted by the High Court in this regard was confusing, in that the facts should be taken as they stand and should be applied to the provisions of the statute. The relevant facts in this regard are as follows:

• Steinhoff owned the equipment necessary for conducting the farming operations and employed the employees who worked on the plantation, whereas the taxpayer owned no equipment and had no employees and therefore did not receive any operational income between the acquisition and disposal of the plantation.

• In terms of the oral agreement concluded between Steinhoff and the taxpayer in 2001, Steinhoff had to conduct the plantation operations so that it could restore the plantation to its June 2001 state, if the arrangement between it and the taxpayer came to an end. In light of this obligation, it obtained insurance for the plantation against fire.

• From the very beginning, the taxpayer did not want anything to do with any farming operations and the whole “raison d’etre” of the taxpayer’s involvement was to acquire bare ownership of the land and plantation, which Steinhoff was prevented from doing.

The SCA then considered the arguments raised by SARS. Firstly, SARS argued that the purpose of paragraph 14(1) of the First Schedule is to extend tax liability by treating the proceeds of the disposal of a plantation as gross income. The SCA stated that the word ‘farmer’ in paragraph 14(1) “is clearly a short-hand for a person carrying on farming operations as contemplated in s26(1)”. This means that the carrying on of farming operations in terms of s26(1) is necessary for the First Schedule and the deeming provision in paragraph 14(1) to apply. The word ‘farmer’ in paragraph 14(1), a deeming provision, could not be used, as suggested by SARS, to determine whether the taxpayer was a ‘farmer’ or conducting farming operations in terms of s26(1). Therefore, the SCA rejected SARS’s argument.    

Secondly, SARS argued that the mere disposal of the plantation by the taxpayer, as owner of the land, constituted the conduct of operations in terms of s26(1), despite it not being involved in the operations on the land. The SCA found that this argument could be misleading and that paragraph 14(1) recognises that the disposal of a plantation is not a per se farming operation. This is evident from paragraph 14(1), which contemplates that the proceeds of the disposal of a plantation are ordinarily capital in nature even where the taxpayer is a farmer and for this reason then deems it to form part of gross income. SARS conceded that its argument would only hold water if the word ‘farmer’ were substituted with the word ‘taxpayer’ in paragraph 14(1), which the court could not do. This argument was thus also rejected.

Finally, SARS argued that the farming operations were conducted by Steinhoff on behalf of the taxpayer. The SCA held that even if Steinhoff in some sense acted on behalf of the taxpayer, the taxpayer did not have the right to the yield of the plantation, and the use of the land and the plantation, nor did it derive any income from the land and the plantation. These rights were granted to Steinhoff, which it exercised and which received income from it. Only Steinhoff could thus be regarded as a ‘farmer’ in relation to the taxpayer’s plantation. The only risk that the taxpayer faced was that the value of its investment in the land might suffer, similar to the risks faced by a landlord or bare dominium owner if the tenant or usufructuary breached its obligations. The SCA thus also rejected SARS’s argument on this point.

Conclusion and comment

The SCA rejected SARS’s appeal and dismissed it with costs, including the costs of two counsel. The decision highlights the fact that in interpreting and applying tax legislation, the courts will look at all the facts before it and will not be misled by SARS’s arguments, especially when they are aimed at unjustifiably increasing the revenue collected by SARS. In the past week, SARS announced that for the first time in its history, it had collected in excess of R1 trillion in tax revenue for a fiscal year, being the 2015/2016 fiscal year. If SARS thus wishes to increase the tax net and its tax revenue, it needs to amend the existing legislation, at the risk of increasing taxpayers’ already heavy tax burden.