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[2018] ZAWCHC 23
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L Taxpayer v Commissioner for the South African Revenue Service (A124/2017) [2018] ZAWCHC 23; [2018] 2 All SA 478 (WCC); 81 SATC 79 (27 February 2018)
IN
THE HIGH COURT OF SOUTH AFRICA
(WESTERN
CAPE DIVISION, CAPE TOWN)
Case
No: A124/2017
L
TAXPAYER
Appellant
and
THE
COMMISSIONER FOR THE SOUTH AFRICAN
REVENUE
SERVICE
Respondent
Court
:
Justice R Allie, Justice J Cloete
et
Justice L Nuku
Heard
:
31 January 2018
Delivered
:
27 February 2018
JUDGMENT
CLOETE
J:
Introduction
[1]
This is an appeal in terms of
s 133 of the Tax Administration Act
[1]
against the judgment of the Tax Court handed down on 13 December
2016 in which it upheld the disallowance by SARS of interest
deductions claimed by the taxpayer in respect of the 2010 to 2012
years of assessment.
[2]
The central issue is whether,
as the taxpayer contends, there is a sufficiently close connection
between the interest expense incurred
by him on a loan facility with
Investec Bank (“the Investec loan”) and the interest
earned from time to time on the
outstanding balance of his director’s
loan to his employer, Bowman Gilfillan (“the Bowmans loan”)
for purposes
of s 11(a) of the Income Tax Act (“ITA”).
[2]
[3]
Section 11(a) provides
inter alia
that in the determination of
taxable income, a taxpayer is entitled to the deduction of
expenditure (save for capital expenditure)
actually incurred in the
production of income from any trade.
[4]
In its rule 31 statement SARS also relied on s 23(g) of the ITA
which stipulates that monies outlaid or expended for purposes
other
than trade may not be claimed as a deduction. This reliance was
abandoned at the commencement of proceedings in the Tax Court,
SARS
having conceded that it would be impermissible in terms of rule 31(3)
of the Tax Court rules, given that this did not form
the basis of the
original disallowance.
[5]
The taxpayer was thus not obliged to show that the interest expense
was incurred for the purposes of trade, and thus not prohibited
by
s 23(g).
[6]
In his tax returns for the years in question the taxpayer claimed as
a deduction a portion of the interest expense on the Investec
loan to
the extent that he had to “fund” the Bowmans loan.
[7]
SARS disallowed the deduction essentially on three grounds: First,
SARS practice note 31 (“PN 31”) requires the
underlying
capital to be borrowed and then lent for the interest income to
qualify for purposes of s 11(a). Second, the interest
on the
amount owed under the Investec loan was not incurred in the
production of interest income on the Bowmans loan. Third, the
Bowmans
loan was not sourced from the Investec loan.
[8]
PN 31
[3]
provides as follows:
‘
1.
To qualify as a deduction in terms of section 11(a) of the Income Tax
Act (the Act) expenditure must be incurred in the carrying
on of any
“trade” as defined in section 1 of the Act. In
determining whether a person is carrying on a trade, the Commissioner
must have regard to, inter alia, the intention of the person. Should
a person, therefore, borrow money at a certain rate of interest
with
the specific purpose of making a profit by lending it out at a higher
rate of interest, it may well be that the person has
entered into a
“venture” and is thus carrying on a trade (50 SATC
40). In other words, interest paid on funds
borrowed for purposes of
lending them out at a higher rate of interest will, in terms of
section 11(a) of the Act, constitute an
admissible deduction from the
interest so received by virtue of the fact that this activity
constitutes a profitmaking venture.
2.
While it is evident that a person (not being a moneylender) earning
interest on capital or surplus funds invested does not carry
on a
trade and that any expenditure incurred in the production of such
interest cannot be allowed as a deduction, it is nevertheless
the
practice of Inland Revenue to allow expenditure incurred in the
production of the interest to the extent that it does not exceed
such
income. This practice will also be applied in cases where funds are
borrowed at a certain rate of interest and invested at
a lower rate.
Although, strictly in terms of the law, there is no justification for
the deduction, this practice has developed
over the years and will be
followed by Inland Revenue.’
Background
facts
[9]
The taxpayer is a qualified
solicitor in England and Wales but is not qualified as an attorney in
South Africa. On 8 June 2004
he was offered a position by
attorneys Bowman Gilfillan within its corporate department. Because
he lacked the South African qualification
he was unable to be
appointed as an equity director, but would ‘
carry
the status of and be treated’
[4]
as such. He accepted the offer and took up employment in early
October 2004.
[10]
At all material times it has been a term of his employment contract
that the taxpayer must loan funds to Bowman Gilfillan to
assist with
ongoing working capital requirements (the Bowmans loan). Initially
this loan was funded by crediting his loan account
with 20% of his
annual gross remuneration in 36 equal monthly instalments.
[11]
The taxpayer participated in the profits of Bowman Gilfillan at a
percentage (his participation percentage) that varied marginally
year-on-year. His budgeted profit share for each year was determined
as his participation percentage of the budgeted profits for
that
year. He was entitled to a monthly draw (akin to a salary, including
deductions) which, after expiration of the initial period
referred to
above, was determined as 65% of his budgeted profit share for the
year, spread over 12 months. The remaining 35%
was retained in
part as a margin for any shortfall between actual profit and budgeted
profit, and as an obligatory loan to fund
cash flow. This obligatory
loan constituted the growth in the Bowmans loan, year-on-year.
Interest accrues monthly at prime rate
on the amount standing to the
credit of the Bowmans loan from time to time.
[12]
Distributions based on actual
profit and available cash on hand are made periodically (as
determined by the CEO or finance committee
in their sole discretion
on recommendation of the financial director) and, in the case of the
taxpayer, are debited against the
Bowmans loan. The taxpayer also
receives payment of interest accrued on that loan which is treated as
taxable income in his hands.
He cannot demand repayment of the
Bowmans loan for so long as he remains an employee.
[5]
[13]
In August 2005 (i.e. 10 months
after he commenced employment), the taxpayer purchased an immovable
property for residence purposes.
The purchase price was paid with the
proceeds of a loan from Investec Bank (the Investec loan) secured by
way of a mortgage bond
registered against the title deed of that
immovable property. This loan is a so-called access facility.
[6]
By 1 March 2009 the taxpayer had made payments into, and
withdrawals from, the facility to fund a variety of expenses and
continues to do so. The capital balance of the Investec loan, which
thus fluctuates, attracted interest during the relevant period
at the
rate of prime minus 1.85% per annum.
[14]
For the tax years in issue the taxpayer claimed, as a deduction, a
portion of the interest accruing on the Investec loan (“the
interest expense”) against the interest received on the Bowmans
loan (“the interest income”). The interest deduction
claimed was limited in two respects. First, it was calculated on an
amount equivalent to the capital balance of the Bowmans loan.
Second,
it was less than the interest income received on the Bowmans loan due
to the interest rate differential between the two
loans.
[15]
The taxpayer testified that,
had the full amount of the Bowmans loan been repaid in the discretion
of his employer during the 2010
to 2012 tax years, he would have paid
it into the Investec loan.
[7]
This is supported by his conduct, at least from 1 March 2010, in
which each significant distribution from his profit share
resulted in
a deposit of approximately the same amount into his Investec loan.
[8]
[16]
He also testified that,
although clear from the agreement concluded in respect of the
Investec loan that its initial purpose was
to fund the purchase of
his residence,
[9]
if he had no obligation to maintain the Bowmans loan its proceeds
would have been paid into the Investec loan,
[10]
thereby reducing the capital and interest incurred thereon. It was
for these reasons that the taxpayer claimed the deductions in
question, submitting that there was a sufficiently close connection
between the interest income and the interest expense for purposes
of
s 11(a), as read with PN 31.2.
Findings
of the Tax Court
[17]
The Tax Court formulated the issue before it as follows:
‘
The
question… is whether the amount in credit in the appellant’s
loan account constitutes monies borrowed on the basis
of which the
expenditure incurred, in the form of interest paid on the home loan
account,
[is
such as]
to
justify a conclusion that the interest so paid could be said to have
been expended to earn interest income’.
[11]
[18]
It found that from the outset the taxpayer knew that the Bowmans loan
could never be applied to ‘
reduce’
the Investec
loan for so long as he remained employed. This was thus a fact known
to him when he took out the Investec loan. The
taxpayer was not
entitled to the exemption contained in PN 31.2 because it
contemplates interest earned on capital or surplus funds
actually
invested whereas in the taxpayer’s case it was simply interest
income earned on income retained by his employer
in terms of his
contract of employment.
[19]
Moreover, it found that the
interest contemplated in PN 31.2 is that earned on funds first
received and thereafter invested at the
taxpayer’s
election.
[12]
[20]
The Tax Court also placed
reliance on the fact that the taxpayer’s intention in taking
out the Investec loan was to pay for
his residence. It found that
‘
there is no
indication on the record of evidence of a change of intention or, if
his initial intention had changed at some point,
at what point was
there a change of intention’.
It thus found that whatever interest was incurred on the Investec
loan, it was due to the acquisition of a capital asset and the
interest expenditure thus incurred was of a capital nature and was
not actually incurred in the production of income as contemplated
by
s 11(a).
[13]
[21]
It must be mentioned that the
Tax Court appears to have misconstrued the evidence before it in two
material respects. First, it
stated that the periodical distributions
made by the taxpayer’s employer pertained only to interest
accrued on the Bowmans
loan.
[14]
Second, it stated that the Investec loan was initially a “pure”
home loan which was converted at a later stage to an
access
facility.
[15]
The taxpayer’s evidence instead established that distributions
were not limited to the interest component only, and that
the access
facility had been in place from the time that he purchased his
residence.
Submissions
on appeal
[22]
The taxpayer’s principal argument is that there is a direct
causal link between the interest income and the interest
expense,
supported by his uncontested evidence that if the Bowmans loan were
to be repaid to him, such repayment would in fact
be appropriated to
reduce the balance of the Investec loan (and concomitantly the
interest incurred thereon) as evidenced also
by what actually
occurred since at least March 2010. Consequently, the reduction in
the interest accrual brought about by such
repayment directly results
(and would result) in a reduction of the interest expense.
[23]
Put differently, he contends that the portion of the Investec loan
equal to the Bowmans loan represents a loan payable (and
an interest
expense incurred) because the Bowmans loan receivable (upon which the
interest income is earned) has not been paid.
Herein lies the
“sufficiently close connection” and consequently the
interest expense should be deductible to the appropriate
extent.
[24]
He also submits that there is no requirement in PN 31.2 that the
funds invested at interest must first have been “received”
by the taxpayer. Rather, what is required is that there are ‘
capital’
or ‘
surplus’
funds that are invested and earn
interest. There is also no implication that the funds must first have
been borrowed and then invested.
All that is required is that funds
must be borrowed at a certain rate of interest and funds must be lent
at a different rate. Accordingly
there is no “timing”
requirement as was found by the Tax Court.
[25]
On the other hand, SARS contends that the purpose for which the
Investec loan was taken is unrelated to the existence of the
Bowmans
loan and that there is thus no direct causal link between the
interest income on the Bowmans loan and the interest expense
on the
Investec loan.
[26]
It submits that the interest incurred by the taxpayer on the Investec
loan is a private expense ‘
totally unrelated to the income
earning part of his business’
. The taxpayer borrowed the
proceeds of the Investec loan, albeit through an access facility, and
applied such proceeds to a purpose
unproductive of income and not
directly connected with the income earning part of his business.
Therefore the interest expense
cannot be claimed as a deduction
against the interest income.
Discussion
[27]
As a starting point, and
as correctly identified by the Tax Court, SARS did not disallow the
deduction claimed due to the
taxpayer’s failure to comply with
the requirements contained in PN 31.2, but instead those contained in
PN31.1.
[16]
[28]
To my mind, the plain wording
of PN 31 contemplates two distinct scenarios. PN 31.1 provides
that to qualify as a deduction
for purposes of s 11(a) the
expenditure must be incurred in the carrying on of any ‘
trade’
as defined in s 1 of the ITA.
[17]
It stipulates further that in determining whether a person is
carrying on a trade the Commissioner ‘
must
have regard to, inter alia, the intention of the person’.
Such intention appears to relate to the intention in incurring the
expense, because it goes on to say that ‘
(s)hould
a person, therefore, borrow money at a certain rate of interest with
the specific purpose of making a profit by lending
it out at a higher
rate of interest, it may well be that the person has entered into a
“venture” and is thus carrying
on a trade’.
[29]
On the other hand, PN 31.2 commences with the words ‘
(w)hile
it is evident that a person (not being a moneylender) earning
interest on capital or surplus funds invested does not carry
on a
trade and that any expenditure incurred in the production of such
interest cannot be allowed as a deduction, it is nevertheless
the
practice of Inland Revenue to allow expenditure incurred in the
production of the interest to the extent that it does not exceed
such
income’.
[30]
Accordingly, PN 31.1 concerns itself with whether or not a deduction
should be allowed on the basis that the interest expense
was incurred
in the carrying on of a trade, whereas PN 31.2 proceeds from the
premise that the person concerned does not carry
on a trade with
regard to the expense, in which event the deduction is allowed under
certain specified circumstances.
[31]
Although given SARS’ abandonment of its reliance on s 23(g)
the taxpayer was not obliged to show that the interest
expense was
incurred for the purposes of trade, it does not therefore follow that
the taxpayer had himself relied on PN 31.1 in
claiming the deduction.
He has always relied on PN 31.2.
[32]
Accordingly the only question to be answered is whether the interest
expense on the Investec loan (limited in the respects
set out above)
was incurred in the production of the interest income on the Bowmans
loan.
[33]
This in turn requires an
assessment of the closeness of the connection between the income and
the expense. Where there is a ‘
clear
and close causal connection’
this is an important consideration. The causal connection is also not
necessarily established between the raising of the loan and
the
initial use to which the capital raised is put. It is the purpose of
the expenditure (i.e. the purpose in incurring the interest
expense)
that must be considered, together with what that expenditure actually
effects
[18]
(i.e. causes to happen or brings about).
[19]
[34]
The taxpayer’s essential
contention is that the purpose of maintaining the relevant portion of
the Investec loan was to allow
him to facilitate the Bowmans loan,
which generated interest income for him. Therefore, the purpose of
the incurral of the interest
expense, to that degree, was to produce
such interest income and it also had that effect.
[20]
[35]
He relies mainly on
CIR
v Smith
.
[21]
There the taxpayer was one of two partners in a practice. They had
previously each loaned the partnership monies to purchase fixed
assets and float working capital. It was agreed that their respective
capital contributions would not be left in the partnership
permanently but would be repaid if and when the partnership was able
to do so.
[36]
A point was reached at which such repayment could be made, but both
knew that capital contributions in essentially the same
amounts would
again be required in the near future. The taxpayer was repaid his
loan and used the proceeds to settle the balance
owing under a
mortgage bond registered against the title deed of his matrimonial
home (which was registered in his wife’s
name). He then took a
bank loan, secured by the same bond, and in turn advanced the
proceeds to the partnership.
[37]
As in the present matter, there was no dispute that the funds made
available by the taxpayer to the partnership were necessary
for its
business operations and to enable it to earn an income from its
business activities. Similarly, if capital had not been
made
available from this source, it would have had to be obtained from
another.
[38]
It was found that the fact that the partners previously funded the
practice from their own resources did not mean that they
were obliged
to do so in the future. They were free to obtain funds from another
source which would charge interest, and that interest
was, at least
on the face of it, expenditure incurred in the production of income.
It was held that:
‘
In
applying
[the]
test
the first point to note is that the expenditure in the present case
is the interest paid on the loan. The purpose of that expenditure
was
to ensure that the financial institution would lend the money to the
respondent in order that he could in turn lend it to the
partnership.
The fundamental purpose of the loan was therefore to provide the
capital which the partnership needed. This was also
the effect of the
loan, the present being a case where there is no difference between
the purpose and the effect of the expenditure
which it is claimed
should be deducted.’
[22]
[39]
What played an important role
in the Court reaching its decision was the agreement between the
partners that their capital accounts
would not remain in the
partnership permanently but would be repaid if and when it was able
to do so. This rendered the facts distinguishable
from those in
ITC
1583
(1993) 57 SATC 58
[23]
where the taxpayer, an attorney, withdrew the full amount of his loan
account from which he settled the bond over his matrimonial
home registered in his wife’s name. In terms of a prior
arrangement with the loan creditor, funds were thereupon re-advanced
in the same amount (to his wife) and the taxpayer in turn paid them
into his loan account the following day. The taxpayer’s
withdrawal of the full amount of his loan account, although with the
agreement of his partners, was on the express condition that
he
immediately repay it. At all relevant times the partnership required
the loan capital, and it was not a case of the partnership
being in a
financial position to repay the loan.
[40]
The Court found that:
‘
It
has been emphasised in cases such as Commissioner for Inland Revenue
v RB Saner
1927 TPD 162
at 172, that it is the substance and not
the form that must be looked at. In this regard it might well have
been said that the
scheme resorted to by the appellant in ITC 1583
had been artificial. To say, in the instant case however, that there
was essentially
no difference between the position before the scheme
had been embarked upon and the position after it had been
implemented, ignores
two relevant matters relating to the taxpayer’s
partnership. It ignores firstly that it had been agreed that the
partners’
capital contributions would not remain in the
partnership permanently but would be repaid if and when the
partnership was able
to make repayment. It ignores secondly the fact
that at the relevant time the partnership could in fact have
continued operating
for some weeks without the partners first
repaying their capital contributions. It is of course true that
taxpayer
in the instant case had planned the whole scheme in advance…
Despite all of these facts, the features which…
distinguish
the instant case from the facts in ITC 1583 are in our view
sufficient to show that the scheme was not artificial.
Indeed they
show that it was not just in form but also in substance that the loan
on 1 March had been raised and therefore that
it was in the
production of income that the interest thereon was paid.’
[24]
[41]
In the present matter the taxpayer falls somewhere between the facts
in these two cases. On the one hand, he cannot demand
repayment of
the Bowmans loan for so long as he remains employed. This not only
applies to the full amount of the loan, but also
to any portion
thereof (I am not referring here to the interest earned on the
Bowmans loan). On the other hand, as a fact, he received
payment of
distributions which were debited against his Bowmans loan.
[42]
Assuming in his favour that the
funds standing to the credit of the Bowmans loan
[25]
from time to time are ‘
capital’
or ‘
surplus’
funds, any distributions made are nevertheless entirely within the
discretion of his employer. Put differently, he cannot rely
on the
existence of any anticipated distribution. It is also a term of his
employment contract that a certain amount must at all
times be
retained in the Bowmans loan for his employer to fund working capital
requirements. Potentially therefore, and depending
upon actual profit
and available cash on hand, he might not receive any distribution
(other than interest earned) at all. To my
mind, that he in fact
received such periodic distributions during the relevant period
should not be conflated with any entitlement
or potential entitlement
to receive them.
[43]
That he intended to pay, and did pay, those distributions he received
into the Investec loan does not necessarily mean, that
without them,
he was unable to reduce the balance on the Investec loan. There is no
evidence to suggest that he was solely reliant
on those distributions
for this purpose. In my view, this is where the taxpayer’s
argument breaks down.
[44]
The chronology shows that the Investec loan, albeit an access
facility from inception, was only acquired some 10 months after
he
became employed, at a time when he well knew that he could not place
any reliance upon receipt of either the full payment, or
partial
repayment, of the Bowmans loan. The distributions he received were to
all intents and purposes fortuitous, being dependent
upon extraneous
factors.
[45]
Had the taxpayer not received the distributions he would still have
had to maintain the Investec loan in order to benefit from
the access
facility. He has in fact maintained the Investec loan and therefore
must have done so from resources other than the
distributions alone,
whether from income or other capital injections. While his evidence
that he would have repaid the Investec
loan had he received repayment
of the Bowmans loan must be accepted, the purpose of the Investec
loan, during the relevant periods,
was to provide him with an access
facility and not to maintain, as he submits, the Bowmans loan. Nor
did the interest expense on
the Investec loan bring about the
interest income on the Bowmans loan. That interest income accrued to
him irrespective of the
existence of the Investec loan.
[46]
It is for these reasons (albeit
different to those of the Tax Court) that I am persuaded that the
appeal must fail. The Tax Court
made no order as to costs. There is
no cross-appeal against that order, and in any event SARS did not
seek costs in the event of
it succeeding in this appeal.
[26]
[47]
The following order is thus made:
‘
The
appeal is dismissed with no order as to costs.’
_______________
CLOETE J
I
agree.
_______________
ALLIE
J
I
agree.
_______________
NUKU
J
[1]
No 28 of 2011.
[2]
No. 58 of 1962
[3]
Dated 3 October 1994.
[4]
Record Vol 1 pp27-36, i.e. other than a salaried
director.
[5]
Record Vol 4 p296.
[6]
It was initially structured as two loans and
consolidated into one loan in August 2011.
[7]
Record Vol 4 pp296-297, 329 and 346.
[8]
Record Vol 3 pp269-270.
[9]
Record Vol 4 p369.
[10]
Record Vol 4 pp371-372.
[11]
Judgment para [4], Record Vol 5 p383.
[12]
Judgment paras [13] to [14], Record Vol 5 p388.
[13]
Judgment para [24], Record Vol 5 p393.
[14]
Judgment para [2], Record Vol 5 p381.
[15]
Judgment para [3], Record Vol 5 pp381-382.
[16]
Judgment para [15], Record Vol 5 p389.
[17]
‘
Trade’
is defined as including every profession, trade, business,
employment, calling, occupation or venture, including the letting
of
any property and the use of or the grant of permission to use any
patent as defined in the Patents Act or any design as defined
in the
Designs Act or any trade mark as defined in the Trade Marks Act or
any copyright as defined in the Copyright Act or any
other property
which is of a similar nature. It thus bears the widest possible
meaning.
[18]
CIR v Standard Bank
of SA Ltd
1985 (4) SA 485
(AD) esp at 500H-501F.
[19]
‘
(E)ffects’
as defined in the Concise Oxford English Dictionary.
[20]
Appellant’s heads of argument para 37.
[21]
60 SATC 397
, a Full Bench decision of the then Natal
Provincial Division.
[22]
At p402.
[23]
A decision of the Cape Special Court.
[24]
At p404.
[25]
Excluding interest earned thereon.
[26]
Judgment para [29], Record Vol 5 p396, respondent’s
heads of argument para 85.