The Supreme Court of Appeal (SCA) has ruled that the South African Revenue Service cannot fundamentally change the factual basis or remedy of a tax avoidance assessment after issuing it.
In a judgment handed down on 5 March, the SCA said the changes SARS attempted to introduce in litigation went to the heart of the assessment and effectively amounted to exercising its statutory powers again without following the required legal process.
In practical terms, the judgment means SARS cannot issue a tax assessment based on one explanation of how a transaction produced a tax benefit and later defend the assessment in court using a materially different explanation.
The ruling came in a dispute between SARS and Pepkor chief executive Pieter Erasmus concerning a dividends tax assessment issued under the general anti-avoidance rule (GAAR) provisions of the Income Tax Act (ITA).
Background to the dispute
The case centred on dividends totalling more than R1.2 billion that were paid to Erasmus by Treemo (Pty) Ltd on 27 March 2015. Erasmus declared the dividends in his 2016 year of assessment but maintained that no dividends tax was payable because Treemo held a substantial balance of secondary tax on companies (STC) credits, which could be used to offset the tax.
STC credits were part of the tax system that applied before South Africa replaced STC with the dividends tax regime. At the time, dividends paid by a company holding sufficient STC credits could effectively be paid without triggering dividends tax for the recipient.
SARS took a different view of the transactions that preceded the dividend payments. After auditing Erasmus’s tax affairs, it concluded that a series of transactions involving several entities constituted an impermissible avoidance arrangement under the GAAR provisions of the ITA.
SARS therefore issued a GAAR assessment for R183.5 million in dividends tax, together with penalties and interest.
The GAAR process
Under the GAAR framework, SARS must follow a structured process before imposing a tax liability on the basis that a transaction constitutes an impermissible avoidance arrangement.
It must first issue a notice informing the taxpayer that the GAAR provisions may apply and setting out the reasons for that view. The taxpayer is then entitled to respond before SARS makes a final determination of the tax consequences.
In July 2020, SARS issued such a notice to Erasmus. The notice described what SARS believed to be the relevant avoidance arrangement and the steps that produced the alleged tax benefit.
According to the notice, the arrangement involved a sequence of transactions beginning in 2014. These included the acquisition by Treemo of shares in several entities that held STC credits, the transfer of those credits to Treemo, and the sale by Erasmus of Pepkor shares and shares in another company, Newshelf 1093 (Pty) Ltd, to Treemo in exchange for shares in Treemo.
A later step involved Newshelf repurchasing shares previously transferred to Treemo. The proceeds of that repurchase were recorded in Treemo’s financial statements as approximately R1.6bn. Shortly afterwards, Treemo declared cash distributions totalling about R1.2bn to Erasmus and smaller distributions to a family trust.
SARS believed these transactions had been structured so that the proceeds of the Newshelf repurchase would ultimately be distributed to Erasmus and the trust as dividends while the STC credits held by Treemo would be used to offset the resulting tax liability.
SARS’s proposed remedy
SARS’s proposed remedy under the GAAR provisions was to disregard all transactions and entities except the Newshelf repurchase and the flow of the repurchase dividend to Erasmus and the trust. On that basis, SARS concluded that the dividend distributions should be subject to dividends tax at the applicable rate.
Erasmus disputed this analysis in his response to the GAAR notice. Among other things, he argued that the dividends were not funded by the proceeds of the Newshelf share repurchase. Instead, he said the distributions were funded by proceeds from a separate transaction involving a share subscription by a family trust in Treemo.
Despite this explanation, SARS proceeded to issue the GAAR assessment, reiterating the analysis contained in the notice and maintaining that the Newshelf repurchase funded the dividend payments.
The dispute moves to the Tax Court
After his objection to the assessment was disallowed, Erasmus appealed to the Tax Court.
In tax litigation, SARS must file a statement setting out the grounds on which it opposes the taxpayer’s appeal. This is known as a Rule 31 statement, referring to the rules governing Tax Court proceedings issued under the Tax Administration Act.
When SARS filed its Rule 31 statement in this case, it changed its explanation of the avoidance arrangement.
The Commissioner abandoned the earlier contention that the dividend payments had been funded by the Newshelf share repurchase. Instead, the Rule 31 statement accepted Erasmus’s explanation that the funds had come from a share subscription by a family trust in Treemo.
SARS then advanced a different theory of the avoidance arrangement. According to the revised explanation, the arrangement involved a circular flow of funds between Erasmus and the trust.
Under this version of events, the trust subscribed for new shares in Treemo, Treemo paid dividends to Erasmus, and Erasmus used the dividend proceeds to pay a call-option premium to the trust. The trust then used those funds to pay the subscription price for the shares it had acquired in Treemo.
SARS contended that this circular flow of funds, together with earlier transactions involving STC credits, constituted the impermissible avoidance arrangement.
Erasmus applied to the Tax Court to have the Rule 31 statement set aside as an irregular step.
He argued that SARS was not entitled to change both the factual basis of the alleged avoidance arrangement and the remedy applied under the GAAR after the assessment had already been issued.
The Tax Court agreed and set aside the Rule 31 statement. SARS then appealed to the SCA.
The key question before the SCA
The central issue before the Court was whether the Commissioner for SARS had the legal authority to change the factual grounds of the GAAR assessment and the proposed remedy in the Rule 31 statement opposing the taxpayer’s appeal.
The Commissioner argued that two provisions authorised the changes.
First, he relied on section 80J(4) of the ITA, which allows the Commissioner to revise or modify his reasons for applying the GAAR if additional information becomes available.
Second, he relied on Rule 31 of the Tax Court rules, which allows SARS to introduce a new ground of assessment in its litigation statement, provided that doing so does not amount to replacing the entire factual or legal basis of the assessment.
The Court’s analysis
The SCA rejected both arguments.
The Court held that section 80J(4) permits the Commissioner to modify his reasons for applying the GAAR only during the stage before a tax assessment is issued.
Once the assessment has been made, the earlier notice process has effectively been completed. As the Court explained, once a GAAR assessment has been raised, the notice “is overtaken and no purpose could be served by giving the Commissioner the power to modify it”.
The Court also rejected the argument that Rule 31 could be used as an independent source of authority to make such changes.
Rule 31, the Court said, is a procedural provision and cannot authorise a fresh exercise of the Commissioner’s statutory powers under the GAAR framework.
Two core components of a GAAR assessment
In explaining its reasoning, the Court emphasised that a GAAR assessment has two essential components.
The first is the description of the avoidance arrangement – the steps or parts of the transaction that SARS says constitute an impermissible tax avoidance arrangement.
The second is the remedy chosen under the GAAR provisions to neutralise the tax benefit, such as disregarding certain steps or re-characterising the transaction.
Both elements form part of the Commissioner’s statutory power to determine the tax consequences of an avoidance arrangement.
Why the changes were unlawful
Because the revised statement replaced the original description of the avoidance arrangement and introduced a different GAAR remedy, the Court found that SARS had effectively sought to make a new GAAR determination, which cannot be done through a Rule 31 statement.
“The modification and amendment affect both components of the Commissioner’s assessment powers under the GAAR. They go to the core of the determination made by the Commissioner under section 80B(1). In effect, they amount to a new exercise of that power without the requisite prior legal steps having been followed. This is not permitted under the GAAR provisions. As I have found, section 80J(4) doesn’t give the Commissioner the power to do so. Nor is it expressly or impliedly authorised under any other GAAR provision,” said Judge Raylene Keightley, writing for the Court.
“The lawful exercise of the GAAR assessment powers is a necessary precondition for the lawful exercise of the Commissioner’s Rule 31(3) power. In the absence of this, Rule 31(3) cannot operate as an independent source of power to permit the modification and amendment effected by the Commissioner in his Rule 31(3) statement,” Judge Keightley said.
Outcome of the appeal
The SCA dismissed SARS’s appeal and upheld the Tax Court’s order setting aside the Rule 31 statement.
SARS was ordered to pay Erasmus’s costs, including the costs of two counsel.
