Terry McCarthy, a tax specialist at PricewaterhouseCoopers, says that the decision of the Johannesburg Tax Court in case 11345 handed down on 4 July 2008, is a major blow to SARS, who will probably view the decision as proof positive of the inadequacy of the common law and the Income Tax Act to deal with sophisticated tax avoidance schemes involving the financial structuring of large business deals.
The case involved a loan structured in such a way that, taken together with ancillary agreements, the taxpayer was able to deduct the full cash outflows that it incurred in respect of interest on the loan.
The impetus to arrange the loan in this way came, not from the taxpayer (a public company that was previously an agricultural co-op), but from its bank.
On the face of the loan agreement, the taxpayer borrowed R96 million from a subsidiary of the bank in 1998, repayable in 2003. The loan was to be repaid, not in money, but by delivering to that subsidiary 109 000 tonnes of white maize. The taxpayer procured a hedge of its obligation, with a division of the bank, at a cost of R46 million.
The taxpayer was to pay interest at a fixed rate on the R96 million loan at six monthly intervals by way of promissory notes whose face value totalled R74 million, and this was the amount which it claimed as a deduction under the general deduction formula of the Income Tax Act, and which SARS allowed it to deduct between 1999 and 2003.
In 2003, SARS then realised that (in its view), when account was taken of the complex web of hedging transactions and cessions in securitatem debiti entered into as adjuncts to the loan, the true amount of the loan was not R96 million, but only R50 million. SARS thereupon issued additional assessments, disallowing the interest on a R96 million loan that had previously been allowed as a deduction, and imposing 200% additional tax plus interest.
The taxpayer objected to the additional assessments and the matter came before the Johannesburg Tax Court, where it was heard by a judge and two assessors.
SARS argued that the taxpayer should only be allowed a deduction of interest on R50 million, which it contended was the true amount of the loan. The ostensible loan of R96 million, SARS contended, involved "deliberate simulation and intentional tax evasion".
The appeal of the judgment, which went in favour of the taxpayer and set aside the additional assessments for 1999 – 2003, lies in the way in which the court came to the conclusion that the loan transaction had not been deliberately disguised to conceal an underlying "tacit understanding or unexpressed agreement" on the part of the taxpayer.
The court said that the central issue was the taxpayer's "true intention". Did the taxpayer intend to contract with the bank on the terms reflected in its agreement with the bank, or had it engaged in deliberate deception?
The court answered this question in favour of the taxpayer, despite strong argument by SARS that the many apparent anomalies in the agreement for the delivery of the maize pointed toward a disguised and deliberately deceptive arrangement.
Crucial to the conclusion reached by the tax court was that the taxpayer had trusted the expertise of the bank in the structuring of financial transactions, and had acted in good faith. The bank may well have had a different state of mind, but this could not be attributed to the taxpayer.
This decision starkly exposed the difference between commercial substance (which is a cornerstone of financial reporting), on which SARS placed reliance, and legal substance (the cornerstone of the reality of the transaction). The former examines the financial effect of net cash flows in the transactions, whereas the latter examines whether the parties truly intended to enter into the transactions.
It must also be stressed that the transactions arose when the old general anti-avoidance rules ("GAAR") of the Income Tax Act were applicable, and the Court ruled that the anti-avoidance provisions could not be applied in the alternative. The new GAAR provisions specifically entitle the application of GAAR as an alternative. It is therefore possible that a challenge to a similar transaction under the new GAAR could have resulted in a different outcome.
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