The Constitutional Court’s decision in the legal skirmish between Absa and the South African Revenue Service is set to increase legal and commercial uncertainty for investors, taxpayers, and financial institutions.
The effect is that any party to a transaction that falls under the general anti-avoidance rules (GAAR) spotlight can now be dragged into potentially long and expensive disputes with SARS.
The dispute arose from a complex, multi-entity funding structure involving the Macquarie Group. Between 2011 and 2015, Absa and its wholly owned subsidiary, United Towers, invested about R1.9 billion in preference shares issued by PSIC Finance 3 (RF) (Pty) Ltd. The returns were treated as tax-exempt dividends, but SARS later concluded that the structure, in substance, converted taxable interest income into exempt income through a series of downstream transactions that were not known to Absa.
Following an audit, SARS invoked GAAR in sections 80A to 80L of the Income Tax Act, issued notices under section 80J, recharacterized the dividends as taxable interest, and raised additional assessments for the 2014 to 2018 tax years. Absa challenged those assessments, arguing it was not a “party” to the avoidance arrangement and had not obtained a “tax benefit” as contemplated in the Act.
The case therefore asked the Constitutional Court to decide not only whether the structure amounted to impermissible tax avoidance, but also how far SARS’s remedial powers extend under GAAR.
Last week, the majority judgment held that Absa had participated in the arrangement and had obtained a tax benefit, while the dissent said SARS had overreached by targeting a party that was unaware of the critical downstream steps.
Julia Choate, tax partner at law firm Bowmans, says the judgment has significantly boosted SARS’s remedial powers under GAAR.
The majority adopted a broad, purposive interpretation of the word “party”, concluding that a taxpayer does not have to have knowledge of all the steps in an avoidance arrangement to be a “party” thereto.
“The rationale for this approach is that limiting the definition to only those parties with full knowledge frustrates the purpose of the GAAR.”
Emilé Cronje, tax executive at ENS, says this broad interpretation removes the risk that will allow “wilful blindness” if the institutional actors, who benefit from a specific arrangement, disclaim knowledge of it.
“If the risk remained, it would have undermined the purpose of the 2006 amendment to the GAAR. The Court wanted to avoid this dangerous precedent that would allow investors to profit from avoidance by claiming ignorance.”
This has far-reaching consequences, says Albert Marais, director at AJM. Liability in terms of GAAR is not only predicated on intentional tax planning, but also by way of participating in an arrangement that effectively creates tax benefits.
The judgment represents a material shift from the approach that was followed in previous anti-avoidance determinations, where the test centred on the purpose for which the taxpayer entered a transaction, he says.
Wide lens
Bowmans tax partner Phuti Kgomo adds that being a “party” to an impermissible avoidance arrangement does not depend on what you knew; it turns on objective participation.
In private equity, structured finance, and any multi-entity funding model, the analysis can no longer stop at credit risk, security, and return analysis. The lens must now widen.
The question investors must ask is what their capital is ultimately enabling. “In large groups with treasury functions and layered funding structures, that is not always a question with a clear answer,” says Kgomo. However, the judgment provides that lack of visibility does not insulate an investor from GAAR exposure.
Another startling aspect of the majority judgment relates to the meaning of tax benefit. Bowmans’ tax partners explain that if any party to an arrangement obtains a tax benefit, all other parties to the arrangement can have their part in the transaction recharacterized by SARS.
Cronje adds that the majority examined the transaction stripped of its avoidance features rather than comparing it with a situation where there is no transaction.
The Court said Absa held preference shares that did not have genuine equity characteristics. It considered form over substance and found that in form the returns were exempt dividends but in substance they were loan interest that was taxable.
“This will create massive legal and commercial uncertainty for investors and taxpayers in future. Personally, I struggle to understand where the Court gets the authority to change one instrument with another at the tax-benefit point,” says Cronje.
Due diligence
Kgomo adds there will likely be more intrusive due diligence of group structures and the use of funding proceeds, more robust (and heavily negotiated) tax indemnities, and possibly an influence on how funding is priced to take this risk into account.
“For transaction structuring, the judgment requires that GAAR considerations are raised up the pecking order and should not be viewed merely as a back-end tax consideration.”
He says the effect is that borrowers looking to maintain their returns could look to push any increased cost of capital to the end consumer. “Whether the end consumer, already under significant strain in the economic environment, can afford it is another question and a risk which the borrower will need to consider.”
Choate notes that the majority judgment recognises the risk of “overreach” by attaching liability to any participant in a transaction later characterised as impermissible, even where the taxpayer’s involvement was commercially sound.
This will be dealt with on a case-by-case basis, without any real guidance on how a taxpayer can demonstrate on the facts and circumstances of its case that it is not a “party to” an arrangement if somewhere down the chain (as happened with Absa) another party engages in impermissible avoidance. “There is no real limitation, in my view, to who SARS can attack,” says Choate.
Full architecture
Cronje says compliance teams performing due diligence in complex structures such as mergers and acquisitions, investments, or disposals of companies will have to understand the full architecture of the arrangement.
“The risk profile for that kind of restructuring has increased significantly.” The boundaries between permissible planning and impermissible avoidance have shifted and become more opaque, he adds.
Procedural disputes between SARS and taxpayers have been increasing, observes Choate. In many instances, the courts have found in favour of taxpayers because of SARS’s failure to exercise a statutory discretion properly.
“One can only hope that the Absa judgment does not have the unintended effect of encouraging further hasty and poorly substantiated decision-making by SARS officials, or a chilling effect on commercial transactions and much-needed investment into the South African economy.”
Amanda Visser is a freelance journalist who specialises in tax and has written about trade law, competition law, and regulatory issues.
Disclaimer: The views expressed in this article are those of the writer and are not necessarily shared by Moonstone Information Refinery or its sister companies. The information in this article is a general guide and should not be used as a substitute for professional tax advice.
