14 October 2011

NWK case casting its shadows

The SCA decision in CSARS v NWK Ltd [2011] 2 All SA 347 (SCA); 73 SATC 55 (the NWK case) almost a year ago put the (judicial) cat amongst the (tax) pigeons.

The NWK decision related to a structured finance transaction. What really caught the eye, however, was the SCA's introduction of a so-called "commerciality" requirement. The SCA held that in determining the existence of a simulation, one should go further than merely asking whether the parties intended to give effect to a contract in accordance with its tenor. The SCA pointed out that where parties devise a structure to achieve an objective other than the one ostensibly achieved, they usually do intend giving effect to the transaction on the terms agreed. Hence it was held [at 55]: "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."

Although the SCA acknowledged that a taxpayer could take advantage of a "tax-effective structure", it warned that "... there must be some substance - commercial reason - in the arrangement, not just an intention to achieve a tax benefit or to avoid the application of a law. A court should not look only to the outward trappings of a contract; it must consider, when simulation is in issue, what the parties really sought to achieve." [at 80]

The Tax Court (Western Cape) took up the SCA's invitation when it recently decided a series of tax appeals involving employee share incentive schemes (Cases No 12760, 12828 and 12756 decided by Allie J on 14 September 2011).

In brief, Judge Allie had to consider the tax consequences of so-called deferred delivery share incentive schemes. In such schemes the employee would almost immediately after the grant of an option to take up shares, exercise the option, thereby eliminating any "gain" in the value of the shares for purposes of section 8A of the Income Tax Act, No 58 of 1962. The assumption was that the tax event giving rise to the tax liability took place on the exercise of the option (or the conclusion of the agreement for the purchase of the shares), and not on the subsequent actual delivery of the shares to the employee. Hence the notion of "deferred delivery".

In deciding whether the employee had unconditionally purchased the shares at the time when the option was exercised, the judge turned to the NWK case "...in which guidelines are set out to establish the true substance of a transaction". Having considered various passages from the NWK case dealing with simulation, the judge held that there was still some "conditionality" when the employee exercised the option and, therefore, there was no "complete sale" at the time of exercising the option. Accordingly it was held: "Section 8A is triggered when a gain is made. In the case of deferred delivery schemes, the gain can only be quantified once delivery occurs as that is when acquisition of the shares is complete." And further: "It is clear from the scheme and the way appellants understood its purpose, that it is the right to take delivery against payment at a later date at a price less than the market value of the shares at that later date that created the substantial financial gain which serves as an incentive to employees."

Judge Allie's reference to simulation and the NWK case indicates that he viewed the terms of the deferred delivery share incentive scheme in question as not reflecting the true substance of the agreement. The true substance of the agreement was that the exercise by the employee of the share option amounted to a "conditional" purchase of the shares - thus there was no "complete sale" as yet. The Judge consequently regarded delivery to indicate that "...acquisition of the shares is complete" ie when section 8A is triggered.

As is evident, the NWK shadow looms large.

The NWK case makes it clear that there must be some substance, ie a "commercial reason", for a transaction and not just an intention to achieve a tax benefit or to avoid the application of a law.

The SCA's NWK approach in relation to simulation and its requirement of "commercial reason" shows remarkable overlap with the "business purpose" test found in the USA.

Gregory v Helvering (1934) 69F 2d 809; affd (1935) 293 U.S. 465 US SC essentially held that the taxpayer's corporate "reorganisation" completely lacked any business purpose. The tax relief in respect of same was bluntly denied. In CIR v Transport Trading & Terminal Corp. 176 F2nd 570 (2nd Cir. 1949) Judge Hand described the "business purpose" requirement as follows: "The doctrine of Gregory v Helvering ...has a much wider scope: it means that in constructing words of a tax statute which describe commercial or industrial transactions we are to understand them to refer to transactions entered upon for commercial or industrial purposes and not to include transactions entered upon for no other motive but to escape taxation."

Interestingly, the US Gregory v Helvering and the UK IRC v Duke of Westminster [1936] AC 1, [1935] All ER Rep 259, HL, cases were decided almost simultaneously on different sides of the Atlantic.

Lord Tomlin's statement from Duke of Westminster is oft-quoted: "Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be."

Whereas almost 80 years ago Gregory v Helvering dashed taxpayer hopes in the USA, the Duke of Westminster in the UK (and locally) became the cornerstone for many tax planning strategies.

The NWK case and the apparent enthusiasm with which it is being applied locally could be indicative that the newly introduced "commercial reason" requirement might be taking SA towards some convergence with the "business purpose" test as applied in the USA.

To be on the safe side requires that there should always be a demonstrable non-fiscal financial, business or economic driver for any transaction.

Johan van der Walt

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