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[1990] ZASCA 138
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Burman v Commissioner for Inland Revnue (72/89) [1990] ZASCA 138; 1991 (1) SA 482 (AD); [1991] 3 All SA 950 (AD) (23 November 1990)
IN THE
SUPREME COURT OF SOUTH AFRICA
(
APPELLATE DIVISION
)
CASE NO:
72/89
In the
appeal of
DARYL
BURMAN
APPELLANT
and
COMMISSIONER
FOR INLAND REVENUE
RESPONDENT
Coram:
BOTHA, NESTADT et KUMLEBEN JJA; NICHOLAS et GOLDSTONE AJJA.
Date
heard: Friday 7 September 1990 Date delivered: Friday 23 November
1990
2
JUDGMENT
GOLDSTONE JA
:
I
have
had the privilege of reading the judgments of Nestadt JA and Nicholas
AJA. The facts are fully set out in the judgment of Nicholas
AJA and
it is unnecessary to repeat them. As emerges therefrom, the sole
issue in this appeal is whether the losses sustained by
the taxpayer,
Mr Daryl Burman ("Burman"),were of a capital nature. The
conclusion reached by Nestadt JA and Nicholas AJA
is that they were
not of a capital nature and were therefore properly deductible in the
assessment of Burman's taxable income. With
respect,
I
have come to a different conclusion.
In this type of case the
preliminary step is:
3
"to
obtain clarity as to precisely what it is that appellant seeks to
deduct."
per
Corbett AJA in Stone v Secretary for Inland Revenue
1974 (3) SA 584.
(A) at 592H. As it was put in
New State Areas
Ltd v
Commissioner for Inland Revenue
1946 AD 610
at 627, it is
necessary to ascertain the true legal nature of the transactions
which gave rise to the losses.
The
true legal nature of the transactions which gave rise
to
the losses in the present case was that they were a number
of
contracts of loan between Burman and property companies in
the
"Concord Group". The loans were made for the purpose of
financing these companies and enabling them to purchase fixed
property ie. the provision of working capital. What
Burman
seeks to deduct from his taxable income are the losses sustained on
the loans by reason of the insolvency of the
4
companies.
It
was the intention of Burman that as soon as possible his shares and
loan accounts would be sold. The envisaged sale was to a public
company. The purchase consideration would be paid by way of an issue
of shares in the public company to Burman. Although, as pointed
out
by Nicholas AJA, Burman's
evidence lacked
clarity and detail, as
I
understand
his evidence
the shares in the property
company would have been sold at their market value in return for
shares in the public company having a
similar value. The loan
accounts would have been sold for shares in the public company having
a value equal to that of the respective
loan accounts. Burman would
then have sold the shares in the public company on the market and
thereby recouped his expenditure and
realised a profit. It follows
that the anticipated profit would come about by reason of the
difference between the cost to Burman
of his shares,
5 on the one hand, and the
proceeds of the shares in the public company received therefor, on
the other hand. No profit would accrue
to Burman on the sale of the
loan accounts. He would simply recoup his outlay in full. As it was
put by Jennett J in the judgment
of the Special Court:
"The purpose of the loans was
in order to make a profit on the sale of shares."
The judgment in
Stone v
Secretary for Inland Revenue
1974 (3) SA 584
(A) is instructive
in considering the main issue which arises in the present matter. In
that case, it is recorded in the judgment
of Corbett AJA (at 592 F)
that counsel for the taxpayer submitted that:
"In each transaction
appellant's purpose was to lay out the money, or engage his credit by
way of
6
suretyship, in order to have the money returned, or his suretyship
terminated, together with the agreed profit."
Corbett
AJA analysed what it was that the taxpayer sought
to deduct.
At 592
in fine
- 593 C the learned Judge of Appeal
said:
"In
regard to the loan transactions, what it is that the appellant seeks
to deduct is the loss suffered by him by reason of the
fact that the
capital sum loaned to Kasmai proved irrecoverable. As a result of
each loan agreement and of the fact that appellant
had actually
advanced the amount of the loan, appellant became entitled
contractually to receive back from Kasmai the capital sum
lent,
together with the share of profit amounting to 20 per cent of the
capital.
7 The stated case does not reveal
what was to have happened if no profit was realised upon Kasmai's
alleged contracts with the third
parties concerned, or if the profit
realised amounted to less than 20 per cent. Nothing appears to have
been said about this at the
time. Presumably, appellant was confident
that a substantial profit would always be made and did not
contemplate these contingencies.
Be that as it may, Kasmai went
insolvent and the appellant's right to recover the capital lent
proved worthless. In essence, therefore,
these two loans became bad
debts."
The learned judge continued at 593
E - G:
"I
have
been at pains to emphasise what
I
conceive
to be the true nature of the deduction claimed by
8
the appellant because, as
I
have indicated above,
appellant's
counsel tended to found his argument upon the 'expenditure' which it
was said appellant had incurred in making these loans
to Kasmai. But
it is not this 'expenditure' which appellant claims to deduct: it is
the loss of the loan capital by
reason of
it having become irrecoverable. Indeed, were it not for this loss
there would be no question
of any such
deduction. No doubt, in characterising
this
loss regard must be had to the loan transaction
itself;
but that does not detract from the basic proposition that the true
issue in this case is the deductibility of the loss. The
importance
of this analysis becomes apparent when one comes to apply the various
tests relating to the distinction
between
expenditure and losses of a capital nature and those of a non-capital
nature. Without clarity
9 upon this the tests may be
misplaced and false analogies may be drawn."
After considering a number of
authorities, Corbett AJA said (at 594 H):
"It is
sufficient for present purposes to observe that in this case, as far
as the loan transactions were concerned, the irrecoverability
of the
capital loaned constituted a loss in the sense of an invoiuntary
deprivation and, as
I
have
already indicated, it is this loss that is the true substance of the
deduction claimed."
An analysis of the facts of the
present case, in my opinion, will yield a similar conclusion.
Whatever Burman's intention, there is
no question but that the
transactions between Burman
10 and the property companies were
contracts of loan. As between them Burman became contractually
entitled to receive back the capital
sums lent. As in
Stone
's
case, the evidence does not reveal whether Burman or the companies
contemplated what was to happen if the shares and loan accounts
were
not purchased by the public company. In any event, the companies
became insolvent, and apart from small liquidation dividends,
the
loans became bad debts. As in
Stone
's case, section 11 (i) of
the Income Tax Act, 58 of 1962 (the Act), was of no assistance to
Burman as the capital amounts of the
loans had never been included in
Burman's income. Hence, the enquiry as to whether these bad debts are
deductible in terms cf the
provisions of section 11 (a) of the Act.
The next stage of the enquiry was
described as follows by Corbett AJA in
Stone
's case (at 594
in
fine
- 595 B):
11
"The
central issue remains: was this loss of a capital
or
non-capital nature? One way of dealing with this issue - and one that
has to me a logical appeal - is to ask what was it that was
lost? The
answer,
I
think,
is clear: the appellant lost the capital which he had advanced by way
of loan to Kasmai. The next enquiry follows as a natural
corollary;
was the capital lost fixed or floating (circulating) capital? If it
was fixed capital, then the loss was of a capital
nature; if floating
(or circulating)
capital, then it was a
non-capital loss. These conclusions would be in conformity with the
dicta
of
Watermeyer, C.J. - cited above - in which the concept of a 'loss' is
identified with a loss of
floating
capital."
In
New
State Areas Ltd v Commissioner for Inland Revenue
(
supra
)
12
at 620,
Watermeyer CJ said:
"When
the capital employed in a business is frequently changing its form
from money to goods and vice versa (e.g., the purchase
and sale of
stock by a merchant or the purchase of raw material by a manufacturer
for the purpose of conversion to a manufactured
article), and thïs
is done for the purpose of making a profit, then the capital so
employed is floating capital."
In the
present case there was certainly no question of Burman's money
"frequently changïng its form". As far as one
can
glean from the record, loans were made once and for all to the
property companies and they would have remained as such until
purchased by the public company. There was no suggestion that if
recouped the amounts of the loans would be utilised in
13
the making of further loans. It follows, in
my opinion, that the moneys lent by Burman to the property companies
were fixed capital. For this reason
I
cannot agree with the contrary conclusion
reached by Nestadt JA and Nicholas AJA. That conclusion has
insufficient regard
to the absence of any
intention by Burman that there would be any recurrence of
expenditure: see
Atlantic Refining
Company of Africa (Pty) Ltd v Commissioner for Inland Revenue
1957
(2) SA 330
(A) at 336 C - F.
There are
two points of distinction between the facts of the present case and
those in
Stone
's case. In the latter case the capital amounts
of the loans were intended to be repaid to the lender directly by the
borrower. In
the present case the intention was that the capital
amounts of the loans would be recouped
14 by
means of payment in shares in the public company and the immediate
resale of those shares on the market and that they would
be repaid as
part of the same transaction in which Burman's shares in the property
company were sold. It appears to be these distinctions
which have led
Nicholas AJA to the conclusion that the loans in a case such as the
present were:
"a
component, together with his shareholding, of the member's interest
in the company."
That
approach, in my respectful opinion, ignores the commercial reality
and legal consequences of the loans made by Burman. There
is no
question here of the loans having been fictitious or disguised
transactions or that the usual consequences of a loan would
not
operate in respect thereof. At all times
15 the
borrowers of the moneys were Burman's debtors and must have been so
regarded by him. When Burman proved his claims against
the estates of
the insolvent property companies it would not have availed the
liquidator to plead that Burman's intention had been
to recover his
loans in a manner other than by direct payments by the borrowers or
that he did not intend to be repaid if he did
not simultaneously sell
his shares.
Nicholas
AJA points to the common practice with small private companies of the
issued share capital being minimal and the operating
capital being
provided by way of shareholders' loans. Insofar as this consideration
is relevant, regard must be had to the reason
for this practice.
Until this year, dividends received from companies by individual
taxpayers attracted liability for income tax.
However, the repayment
of a loan (save perhaps to a money-lender) would constitute a capital
16
repayment and would not attract
liability for income tax. Corporate profits were therefore more
beneficially used in the repayment
of loan accounts than in the
declaration of dividends. In the present case Burman was a minority
shareholder in the property companies.
If the majority, for whatever
reason, had decided to repay the loan accounts in whole or in part,
Burman could not have objected
and such repayments could hardly have
constituted taxable income in Burman's hands.
In short, Burman's intention that
he would be repaid the loans together with a sale of his shares in
the property companies was in
no way inconsistent with the loans
being genuine and their having the legal consequences which usually
flow from contracts of loan.
However Burman regarded his shares and
loan accounts, the fact is that he did indeed hold two different
economic entities. His intention
did not destroy or even mask the
reality that if he made a profit in the manner
17
contemplated by him that profit would have come about only because of
an increase in the market value of his shares. The value
of his loan
account could never have exceeded the capital amounts thereof which
he lent to the property companies. The frustration
of Burman's
intentions in no way prevented the loans from becoming bad debts.
It
follows, in my opinion, that the loans made by Burman constituted
fixed capital and the loss of the capital amounts thereof were
not
deductible in the computation of his taxable income. A similar
conclusion was reached in ITC 1321, reported in (1980) 42 SA Tax
Cases 269. In that case, too, shareholders, including the taxpayer,
advanced funds on loan to six companies. According to the headnote:
"At
all material times the intention of the companies was to resell the
land at a profit. A prospective
18
purchaser
would thus be able either to take transfer of a particular group of
subdivisions or to purchase shares and loan account
of the relevant
company. ... Appellant divested himself of his investment by way of
shares and loan account in four of the companies.
In support
of his appeal it was submitted by appellant that the shares and loan
account in issue were irrevocably linked and that,
since the loss on
the former had been allowed, the loss on the loan account should
likewise be allowed; and also, in effect, that
he should be regarded
as an individual who had purchased land as a profit-making operation
which had resulted in a loss."
In
dismissing the appeal, Milne J said the following:
19
"The
only way in which it would be possible to uphold the appellant's
contentions would be to say that he must be regarded as
being in the
same position as an individual who decided to purchase land and who
made a loss, having purchased such land as a profit-making
operation,
and that the losses must be taken to be incurred in the production of
an income-producing venture. It is however, not
possible to ignore
the existence of the companies. The true position, in fact and in
law, is that the appellant lent the company
money in order to enable
the company to acquire immovable property, and to assist the company
with the running expenses incurred
in respect of that immovable
property. The company was carrying on the business of selling land
for profit, not the appellant. Furthermore,
the appellant concedes
20 that he is not a moneylender,
and once the true position is, as it is in the view of the court,
that this is simply a loan to a
company, which has not been recovered
in full, this is a loss of fixed capital (cf the well-known passage
in the judgment of the
Appellate Division in
Stone v SIR
1974
(3) SA 584
and
36 SATC 117
, and in particular the passage at 130 of
the SATC report, where the distinction between fixed and floating
capital is clearly drawn)."
I
do
not agree with Nestadt JA and Nicholas AJA that ITC 1321 is
distinguishable from the present case. The only point of distinction
is that in ITC 1321, the purchaser apparently paid cash for the
shares and loan account whereas in the present case the shares and
loan accounts were intended to be exchanged for shares in the public
company. That distinction has no effect at all on the nature
of
Burman's loan accounts or on
21
the legal
principles to be applied in the present case.
As appears
from the judgment of Milne J, the taxpayer's argument was,
inter
alia
, that-
"The
disposal of the loan account should be seen as part and parcel of the
shares as they are linked together."
That
argument, (which was advanced on behalf of Burman in the present
case), was rejected by Milne J, in my opinion, correctly.
I
cannot agree with Nicholas AJA that the
similarities between that case and the
present case are "surface
similarities"
or that it differs "
toto caelo
"
from the present
case.
Both
Nestadt JA and Nicholas AJA rely upon ITC 1344 reported
in
(1981) 44 SA Tax Cases 19.
I
agree
with Jennett J that
22
the decision in that case is only
explicable upon the agreed facts which recorded,
inter alia
,
that
"... it was at all relevant
times his intention to sell the said shares and loan account as soon
as the development was completed
with a view to making a profit."
The intention expressed was that
the shares as well as the loan accounts would indeed be sold at a
profit. That is the basis upon
which the case was approached by
Grosskopf J, as appears from the passages of his judgment cited by
Nicholas AJA. There are no facts
which establish that in the present
case.
On the main
issue which arises
I
would
dismiss the appeal.
It was common cause between
counsel that there is an error
23
in the
order made by the Special Court. That order reads as follows:
"In
the final result, however, the appeal is allowed only
to
the
extent that the assessment is set aside
and the matter is remitted to the Commissioner to reassess
appellant's liability for income
tax on the basis that interest on
funds borrowed to finance the purchase of
shares
is deductible from appellant's income."
However,
in terms of an agreement which the parties entered into prior to the
hearing in the Special Court it was agreed that:
"...
interest paid is deductible subject only to an adjustment in terms of
s 19 to the extent that the borrowings funded the
purchase of
shares."
24
The effect of the order of the Special
Court is to allow the deduction only of a small portion of the
interest paid by Burman and
not, as agreed, all of the interest.
I
have difficulty in understanding how the
provisions of section
19 of the Act might
be of application. That notwithstanding,
I
am of the view that the Special Court
should have made an
order which reflected
the parties' agreement.
Mr
Melunsky, on behalf of Burman, submitted that if he failed
on the
main issue then Burman should still be awarded the
costs of
the appeal. He based that submission upon the necessity
of Burman
having to approach this Court for the variation
of the
order made by the Special Court. That order was at
no time
abandoned by the Commissioner. However, that point
was
conceded by the Commissioner's counsel in his heads of
argument
which were filed in this Court on 15 May 1990.
25
In my
opinion, the most that could have been argued on behalf of Burman is
that he was entitled to the costs incurred by him up to
15 May 1990
in consequence of the error in the order. The only relevant
documentation would have been the terms of the agreement
between the
parties and the judgment of the Special Court. The costs in relation
thereto are minimal and, in my opinion, do not justify
a special
order.
The
following order is made:
1. The
order of the Special Court is amended to read as follows:
"The
appeal is allowed only to the extent that the assessment is set aside
and the matter is remitted to the Commissioner to
reassess
appellant's liability for income tax on the basis that the interest
paid by him is deductible subject only to an adjustment
26
in terms
of section 19 of the Income Tax Act No.
58 of 1962
to the extent that the borrowings funded
the
purchase of shares."
2. Save as
aforesaid the appeal is dismissed with costs.
GOLDSTONE
JA BOTHA JA ) CONCUR KUMLEBEN JA )
CASE NO
72/89
/CCC
IN THE
SUPRERME COURT OF SOUTH AFRICA
(APPELLATE DIVISION)
In the
matter between:
DARYL
BURMAN
APPELLANT
and
COMMISSIONER
FOR INLAND REVENUE
RESPONDENT
CORAM
:
BOTHA, NESTADT, KUMLEB5N, JJA et NICHOLAS,
GOLDSTONE
AJJA
DATE HEARD
: 7 SEPTEMBER 1990
DATE DELIVERED
: 23
NOVEMBER 1990
JUDGMENT
N
Ë
STADT JA
:
There is
no dispute that the amount in question, viz, R76 398,00 represents
losses incurred in the production of income. What is in
issue is
whether
2/
2.
appellant
established that they were not of a capital nature (within the
meaning of sec 11(a)).
I
assume,
despite the wording of the agreement
between the parties,
that appellant also
had to show that the deduction sought
to be
made was wholly laid out for the purposes of trade
(within
the meaning of sec 23(g)).
I
think
he did both.
In my view therefore the
amount should have been allowed as
a
deduction from appellant's income.
If
the loss in respect of the loans is
deductible,
so too is that resulting from appellant's
liability
under the suretyships. They share the same fate.
I
therefore confine my attention to the
loans.
There is no reason in principle why,
even though appellant
was not a
money-lender, they should not qualify as
expenditure
of a non-capital nature.
Stone's
case is not
contrary to this approach. The
business of money-lending
is given (at 597
G) only as an example of a loan being
3/
3.
circulating or floating capital. But there are other situations where
this may be the case and where the loss resulting from the
irrecoverability of the loan would accordingly be an allowable
deduction. A number of reported judgments in both the United Kingdom
and South Africa illustrate this (see
Whiteman and Wheatcroft on
Income Tax
, 2nd ed, para 8-67;
Silke on South African
Income Tax
, vol 1, llth ed, para 7.43;
Meyerowitz and
Spiro,
Income Tax in South Africa
, paras 715-7). Many of the cases
relate to loans between inter-connected companies; some to loans made
by a trader for the purpose
of obtaining business; and others to loan
accounts of a shareholder in a private company to finance its
activities. It would seem
that what has to be determined is whether
the loan was made in order to earn income apart from interest on the
loan (
Meyerowitz and Spiro
, para 715). But no precise formula
for doing this emerges. In these
4/
4.
circumstances the guidelines laid down for distinguishing between
capital and revenue expenditure (as to which see
New State Areas
Ltd vs Commissioner for Inland Revenue
,
1946 AD 610)
have to be
applied. Accordingly, the true nature of the transaction must be
examined. One has to assess the closeness of the connection
between
the expenditure and the income-earning operations having regard to
the purpose of the loan and to what it actually effects.
In a case
such as the present this involves taking account
inter alia
of
the nature of the lender's business; the relationship between him and
the company; the terms of the loan; its purpose; and its
effect.
In a
number of respects appellant's evidence lacks clarity. It does,
however, establish that his acquisition of an interest in the
companies was in furtherance of a scheme of profit-making. The idea
(the Warren Street concept) was that he would, in exchange for
5/
5.
his shareholdings and loan
accounts, acquire shares in the
public company which it was
contemplated would be formed.
These would then be sold as soon
as a stock exchange
listing was obtained. When this
scheme miscarried, a
different
modus operandi
was evolved. This was the
Concord project. But the principle
of "quick profits"
remained. Appellant's testimony in
this regard was:
"If
I
can summarise, the intention throughout the
property investment was in fact not investment or a rental dividend
return but really
was a speculative interest in property, interest
acquired from the resale at a
profit. Yes,
that is correct, my lord."
In these circumstances the
following finding of the special
court was fully justified:
"It may be accepted that at
all material times, commencing with the Warren Street concept, the
intention of appellant with regard
to his shares in the various
companies was such that the proceeds received on any sale thereof
would have been in the nature of revenue
income. After the Warren
Street phase appellant also at all material times intended and saw
himself as divesting himself completely
of his interests in
6/
6.
the companies...."
But the crucial
issue concerns the status of the loans. They were made (by appellant
as well as his co-shareholders) to provide the
companies with working
capital.
I
understand
this to mean that the companies would thus have the finance to be
able to pay for the properties which were being purchased
by each of
them. In these circumstances they were
prima
facie
capital payments (cf
Milnes
(H.M. Inspector of Taxes) vs J Beam Group Ltd
50 T C 675
at 687 E) and the onus resting on appellant to show that
they were revenue transactions may be said to be a heavy one. More
especially
is this so when it is borne in mind that the loans, unlike
the shares, would not ordinarily be able to be sold, ie ceded, at a
profit.
On the other hand, however, appellant with justification
regarded his shares and loan accounts as one indivisible economic
unit or
asset. The acquisition of the shares
7/
7.
took place when the loans were
made and depended on them.
According to appellant:
" (E) very
share you wanted, you had to lend so much money.
I
don't know whether that is called a premium
on shares but it was a condition initially, that if you took up three
or four percent
shareholding, then for each share you had to lend so
much money..."
His further evidence as to how he
understood his interest
in the companies. would be
realised is also significant.
Having explained that there was no
agreement as to
repayment of the loans by the
companies and that there was
no provision for the payment of
interest, he said:
"So you just saw yourself
selling both shares and loan accounts ultimately? -- That is correct,
my lord... And (the shares and
loan accounts were) virtually a
package which you saw of yourself as selling. -- That is correct, my
lord... Do you understand a
loan to mean something that would be
repaid
I
understand that, yes. But as
I
say
in my
particular case it was not an investment in a company, it was only
because
I
was
told there was a profit that
I
put
the money in, so whether it was shares or loans, it was part of the
speculation just to get out again... (Y)ou felt that you might
have
been repaid loan accounts. --
6/
8.
No, not repaid
loan account, paid for my loan account.
I
couldn't have been repaid loan account, we
were going to sell out ...(T)he presentation to you, was that your
interests both shares
and loans, would ultimately be consolidated in
shares which you could sell for a profit?
â
Yes, that is this deal to Warren Street. Right."
It is true that appellant made a
claim against the
companies in liquidation for, so
it would seem, repayment
of his loan accounts (and in fact
received a small
liquidation dividend). But that
cannot detract from the
overriding intention that the
loans were not to be repaid
by the companies as borrowers. As
indicated, recoupment
would occur as part and parcel of
the eventual realisation
of the shares. That this is so,
appears further from a
passage in a letter of a
Johannesburg firm of attorneys who
were to handle the proposed public
flotation. It is
recorded that appellant and his
associates intended that
"(t)he shareholders of Warren
will sell their shares and
the claims on loan account against
Warren to the public
9/
9. company
in exchange for shares in the public company and a certain amount of
cash." Presumably the loan capital of each of
the particular
companies would first be converted into share capital. The resultant
increased number of shares would entitle appellant
to an allotment of
shares in the proposed public company. These shares would then be
sold at a profit which no doubt would have formed
part of appellant's
taxable income.
What
has been stated shows, to my mind, that
appellant
was engaged, besides his profession, in another
income-earning
operation or business. His shares were his
trading
stock. And the money he outlaid for the loans,
though
his capital, was his floating capital. It was not
invested
in the ordinary sense. It was capital employed
in
his other business. To regard it otherwise would,
I
venture to suggest, be artificial. Nor were
the loans, as
was argued on behalf of
respondent, made to preserve a
10/
10.
capital
asset. They were a
sine qua non
to appellant acquiring the
shares which would enable him to earn a profit. This involves taking
account of the function of the loans.
It is legitimate to do this
(
Plate Glass and
Shatterprufe Industries Finance Co (Pty)
Ltd vs Secretary
for Inland Revenue
1979(3) S A 1124(T) at
1132A).
In the
result, therefore, expenditure was incurred on acquiring an asset
(the shares and loan accounts) which appellant hoped would
be sold at
a profit. However, the asset turned out to be substantially
valueless. The consequential loss was, accordingly, of a non-capital
nature. And the money expended in order to make the loans was laid
out wholly for the purposes of trade. This was appellant's trade.
It
is this factor that distinguishes the present matter from cases such
as ITC 1321
(1980) 42 SATC 269
and ITC 1327
(1981) 43 SATC 47.
On the
other hand, this case does not differ substantially
11/
11.
from that
of ITC 1344
(1981) 44 SATC 19
in which a similar deduction was
allowed.
I
accordingly agree with NICHOLAS AJA that
the appeal be allowed in the terms suggested by him.
NESTADT,
JA
IN THE SUPREME COURT OF SOUTH
AFRICA
(
APPELLATE DIVISION
)
In the matter between:
DARYL BURMAN
Appellant
and
THE COMMISSIONER FOR INLAND
REVENUE
Respondent
CORAM
: BOTHA, NESTADT,
KUMLEBEN, JJA, NICHOLAS et GOLDSTONE AJJA.
DATE OF HEARING
: 7
September 1990
DATE OF JUDGMENT
: 23
November 1990
JUDGMENT
NICHOLAS
AJA:
This appeal from the Eastern Cape
Income
Tax
Special Court relates to the
disallowance by
the
Commissioner for Inland Revenue
("the Commissioner")
of
deductions claimed by Mr Daryl
Burman ("Burman") in
his
2
return of
income for the year of assessment ended 28 February 1983: namely the
losses arising from loans to certain property companies;
the amounts
paid in terms of suretyships for the obligations of the said
companies; and interest on money borrowed on overdraft to
finance the
purchase of shares in the said companies and to enable Burman to
satisfy the suretyship obligations.
The
facts
In the
Special Court, over which Jennett J pre-sided, the only witness was
Burman himself, who is an attor-ney. His evidence was not
seriously
challenged by the Commissioner's representative, and the Special
Court found no reason to doubt his veracity. His account
of the
circum-stances which gave rise to his claim for the deductions was,
it is true, general in its nature and it tended to be
vague and to
lack detail and documentary support. That was
3
possibly
due to the fact that Burman was at,the beginning of the relevant
period a tyro in matters of business, having spent the whole
of his
working life in the State Attorney's office, more particularly in the
conveyancing department; that he was not himself actively
involved in
the transactions concerned but played a minor and relatively passive
part, and was not concerned in the day to day management
of the
companies; and that the relevant events occurred over a period of
years from 1965 to 1982. Nevertheless, the Special Court
was able to
make clear findings (not challenged by the Commissioner) in regard to
the material facts, so that the questions for decision
are
essentially questions of law.
Burman's
story had its beginning in May 1965. He had recently resigned from
the Civil Service because he wished to return to Cape
Town, where had
had lived most of his life, and the Department of Justice had refused
to grant
4 him a transfer. He had obtained
employment in Cape Town when a University contemporary, Mr Aaronson,
who was also an attorney, persuaded
Burman to run the conveyancing
department of Aaronson's firm in Port Elizabeth. Aaronson held out
the prospect of a partnership at
the end of the then current
financial year.
In Port Elizabeth he found that
the partners in the firm engaged in property speculation, something
which increased in 1967 when the
firm was joined by Mr Harold
Blumberg, whom Burman described as a "wheeler dealer in
property". To judge by Blumberg's
subsequent activities, that
expression, as described in the American Dictionary of Slang ("an
adroit, quick-witted scheming
person"), aptly described him.
When Burman came to Port Elizabeth
his financial resources amounted to no more than R2 000 in total
which he used for the deposit
on a house which he bought and for
5 transf
er costs. At the end of the 1966 f inancial year he was offered a 20%
interest in the practice. A goodwill of some thousands
of rands was
required and this was obtained by way of an overdraft from Nedbank
which his partners arranged for him.
Burman
became interested in property speculation after Blumberg came on the
scene. The latter got together a group of people, each
of whom
contributed R10 a month for this purpose and a company named Dolphin
Trust was formed. Por various reasons Burman was not
happy in Port
Elizabeth, and he was anxious to go back to Cape Town. Blumberg told
him that with property dealing he could make a
quick profit within a
short time and pay his debts and get out. He let Burman have "a
very minimal interest" in some of
the schemes he was putting
together, and so Burman became involved.
Burman's
first substantial investment was made in 1967 in a company named
Louise Michael Development (Pty)
6 Ltd. This company had acquired a
township in Port Elizabeth called Lovemore Heights. Burman was led to
believe that within a reasonably
short time all the 131 erven which
had been opened up would be sold. He was called upon to put in R6 500
which he raised by increasing
his overdraft with Nedbank to R10 000.
There was a vigorous advertising campaign, and at a one-day sale
about 100 erven were sold.
But the resulting state of euphoria was of
short duration. For various reasons the whole operation turned sour
and many buyers withdrew
from their contracts. The venture at that
stage was a failure. Burman's financial situation was now parlous.
The amount of his overdraft
exceeded his annual income which was then
about R8 000, and he could not afford to pay the interest on the
overdraft. Seduced by
the lure of quick profits with which he could
retrieve his position, however, he continued to participate in
Blumberg's schemes.
7
Blumberg's
general
modus operandi
was to f orm syndicates composed of
various members which would acquire properties and put them into
companies, in which the members
took shares and to which they
advanced loans to be used as operating capital. Burman said:
"The
way it was done was every share you wanted, you had to lend so much
money.... it was a condition initially that if you took
up three or
four per cent shareholding, then for each share you had to lend so
much money plus, of course, you had to put in your
proportion of any
costs at that stage."
The object
of the loan money was to develop the property concerned, to keep it
running and to cover the day to day expenses of the
company. There
was no agreement that the companies would pay interest on the loans
(although it appears that, unbeknown to Burman,
insignificant amounts
of interest were at a later stage credited to his account) nor
8
was there
any agreement in regard to the terms of repayment of the loans.
Operating capital was also obtained by way of facilities
afforded to
the company concerned by a bank or building society, which facilities
were guaranteed in terms of sureties furnished
by the shareholders.
The main
vehicle for the speculative operations was a company named Concord
Development Holdings (Pty) Ltd into which most of the
properties were
put. As at 1982 this company owed Burman R36 774,36 on loan account,
The so-called "Concord Group" played
an important part in
the operations after 1970. Burman said that ultimately everything he
owned, with cme or two minor exceptions,
was in Concord Development
Holdings.
In about
1969 Blumberg devised what was called the Warren street concept, with
which it was intended to exploit the then buoyant state
of the stock
and share market. The idea was to put Concord into a company named
Warren Street
9
Investments (Pty) Ltd which also acquired, provisionally, a number of
trading companies with a profits record. There was then to
be created
a public holding company which would issue shares
inter alios
to the shareholders in Concord and other companies, and would obtain
a Stock Exchange listing. On the day of flotation, it was envisaged,
the shares would be sold by Blumberg and his associates (including
Burman) who would recoup, with a profit, what they had put into
the
companies.
This
concept was not realised. As Burman put it in his evidence, that
South Sea Bubble burst, the whole exercise was one of futility
because the Stock Exchange clamped down on this sort of flotation and
"we had missed the boat".
The next
scheme was a pure property portfolio put together in the Concord
group which was to be sold "lock stock and barrel"
to "one
of these blossoming new generation
10
wonderboys,
the Corlett Drive Estates, Tuckers, Mondeor, those Johannesburg
companies". Burman said that he was now (1970-1971)
absolutely
desperajbe financially (his overdraft had increased to about R25 000)
and he pinned all his hopes on a sale taking place.
One offer was
received, but it involved payment in shares and it was refused. The
purpose was to realise the interest in cash, and
shares were of no
use.
After
the failure of this scheme, Burman said,
this
was a very difficult period of his life, but he
accepted
that "the only way out of this was to have this
package
that could be marketed" and so they kept going, "but
it
never came to fruition and all that happened was that
I
kept on borrowing more and more money to
put in".
Ultimately
in November 1982 he became obliged to liquidate Concord Development
and other smaller companies.
With
liquidation, Burman said,
"I
no
longer had any
11
assets".
His overdraft was called up and he was called upon to meet his
suretyship obligations.
The
Special Court Hearing and Judgment
.
At the
start of the hearing in the Special Court there was handed in by
consent a document reading as follows:
"The
appeal concerns the deduction of certain losses relating to interests
in a property group and interest on loans raised to
make such
investments and to fund payments under suretyships related thereto.
It is agreed that the only matter to be resolved is
whether the
losses in question represent expenditure incurred in the production
of income not of a capital nature for the purpose
of s.11(a). It is
agreed that the expenditure and losses were actually incurred in the
Republic. It is also agreed that interest
paid is deductible subject
only to an adjustment in terms of s.19 to the extent that the
borrowings funded the purchase of
12 shares."
S.11(a) of the Income Tax Act 1962
("the Act") provides:
11. For the purpose of determining
the taxable income derived by any person from carrying on any trade
within the Republic, there
shall be allowed as deductions from the
income of such person so derived -
(a) expenditure and losses
actually incurred in the Republic in the production of the income,
provided such expenditure and losses
are not of a capital nature."
By reason of the agreement, the
only questions in issue were whether the losses claimed as deductions
were losses actual-ly incurred
in the production of income, and
whether the losses were of a capital nature. The possibility
mentioned in passing by Jennett J in
the judgment of the Special
Court that the deduction was hit by s.23(g) of the Act because the
13
loans as
loans were not "laid out wholly and exclusively for the purposes
of trade" accordingly did not arise. Nor does
the contention now
raised in the heads of argument submitted by counsel for the
Commissioner that the losses were
"nie
geheel en al of uitsluitlik vir bedryfs-doeleindes bestee of uitgegee
nie en nie gemik op die voortbring van inkomste nie."
There was
no issue between the parties as to the quantum of the losses and of
the amount of the interest. These had been set out in
Burman's return
of income:
"1.
Verlies op leningsrekeninge en borgskappe verloor in Maatskappye van
die sg 'Concord' groep, betrokke by spekulasie in eiendomme
en
dorpsontwikkeling:-
Leningsrekeninge
60 249,31
Borgskappe
(i)
Nedbank 5 467,33
rente tot
op
28/2/83
206,71
5 674,04
(ii)
Barclays .. 1 074,58
- 1/4
rente
tot op
28/2/83
27,20
1 101,78
1 4
(iii)
Trust Bank...7 285,44
rente tot
op
28/2/83
294,21
7 579,65
(iv)
Boedel Hayward,1 678,57 1/4 rente tot op 28/2/83....
82,87
1
761,44
(v)
OPBV ... 642,77
rente tot
op
28/2/83
28,21 670,98
Verlies
vorentoe gedra 26 310,20 (
sic
(2) Rente
op oortrokke bankrekeninge,
welke
skuld aangegaan is om lenings in maatskappye, betrokke by spekulasie
in eiendomme en dorpsontwikkeling te finan-sier
1.3.82 -
28.2.83
Nedbank
R3
617 31
Barclays
1
258 14 R 4 875,45
R31
185,65
The
Special Court held by a majority (consisting
of
the learned President and the commercial member) that the
losses
were of a capital nature. The
accountant
member took
a different
view. An order was made as follows:
"The
appeal is allowed only to the extent that the assessment is set aside
and the matter is remitted to the Commissioner to
reassess
appellant's liability for income tax
15
on the basis that interest on
funds borrowed to finance the purchase of shares is deductible from
appellant's income".
In the judgment of the Special
Court Jennett J said:
"It may be accepted that at
all material times, commencing with the Warren Street concept, the
intention of appellant with regard
to his shares in the various
companies was such that the proceeds received on any sale thereof
would have been in the nature of revenue
income. After the Warren
Street phase appellant also at all material times intended and saw
himself as divesting himself completely
of his interests in the
companies i e his shares and his loan accounts, by selling them as a
parcel. What this meant was that he
wouid sell his shares and cede
his loan account to a purchaser."
The court accepted that the loans
were made in order to provide the companies with working capital, and
that "the purpose of
the loans was in order to make a profit on
the
16
sale of
shares".
The
majority distinguished, however, between a sale of shares and a sale
of a loan account. Having ac-cepted that the shares were
stock-in-trade, Jennett J said:
"Quite
plainly the appellant's loan accounts
can, in my view, never be
equated with his
stock-in-trade which were his shares even if
it
were intended that they be sold
together "
and that
". .
. . it was never suggested that they (i e the loans) could ever have
been disposed of at a premium so that any prof it that
the appellant
might have hoped to derive on the loans would have had to have been
achieved on the sale of shares."
On the
basis that the loans were an entity separate from the
shares,
Jennett J proceeded to consider whether the capital
used to
make the loans was fixed capital or circulating
17
capital, and concluded that it was fixed capital.
The
accountant member, on the other hand, did not accept that there was a
dichotomy between the shares and the loan accounts. He considered
that Burman's trading stock comprised the shares and the loan
accounts together.
The narrow
issue to be decided in this appeal is which view was correct.
Discussion
It is not
unusual with small private companies for the issued share capital to
be minimal and the operating capital to be provided
by way of
shareholders' loans. In such a case a shareholder's interest in the
company has two components: his shares and his loan
account. It may
be objected that a shareholder's loan account as such is not an
interest in the company. In its literal meaning a
loan account is the
formal record in the company's ledger of
18
credits and debits relating to
moneys lent to the company; but in its usual business connotation it
is the shareholder's claim against
the company for the amount
standing to his credit on loan account. Hence the shareholder is a
creditor of the company. Ordinarily
speaking, a creditor does not as
such have an interest in the debtor company; what he has is a claim
against
the company for the amount of the debt. A shareholder
with a loan account, however, is in a special position
vis
-á-
vis
the company. The loan is advanced for the purpose of enhancing
his interest in the company and he is subject to restraints against
getting repayment of the loan which are no less real for being
unexpressed. In the ordinary case no interest or other consideration
is payable by the Company for the loan, and nothing is said regarding
terms and conditions of repayment. In theory, the loan would
be
repayable on demand, but in practice no demand is likely to
19 be made so long as the company
is in
esse
, unless it can obtain operating capital from
somewhere else, for the obvious reason that the calling-up of a
shareholder's loan is
likely to drain the company of its life blood
and thereby put its continued existence at risk. Even though it is
not permanent capital,
a member's loan is therefore a contribution to
the capital of the company, and in a real, economic sense such loan
is a component,
together with his shareholding, of the member's
interest in the company. Shares and loan accounts go in double
harness, and a sale
of shares by a shareholder in a private company
is usually (one might almost say invariably) accompanied by a sale
simul ac semel
of any loan account owned by the seller. The
reason is self-evident: the seller does not wish to leave his capital
lying, unproductively
from his point of view, in a company in which
he has no interest; and the buyer does not wish to acquire shares in
a company whose
20
capital structure is vulnerable to
attack by a stranger.
On the evidence given in the
Special Court Burman's operations followed the usual pattern: he
acquired shares in property companies;
he advanced monies on loan
account to be used for operating capital; and it was his intention
throughout that when he came to realise
his interests, the shares and
loan account would be sold as a single economic unit.
In my view therefore the majority
of the Special Court erred in considering that when shares and a loan
account in a company are sold
there is a sale of separate entities
and not a sale of a single interest in the company. What Burman had
in contemplation was the
sale, for one consideration, of his whole
interest in each of the companies, not separate sales of shares and
loan accounts. His
stock-in-trade was not shares alone but interests
in companies each comprising shares and loan accounts. There
21
is in my
opinion no warrant for dividing the single price which it was
contemplated would be obtained upon the sale of the single
economic
unit of shares and loan account between a price for the loan account
(being its face value) and a price for the shares (being
the
balance).
The
question to be decided turns on whether Burman's investment in each
company (consisting of the shares and the loan account) was
of the
nature of fixed capital, or of floating (or circulating) capital.
Ogilvie Thompson JA observed in
Secretary for Inland Revenue v
Cadac
Enqineering Works (Pty) Ltd
1965 (2) SA 511
(A) at
521 G -522 B that expenditure "of a capital nature" eludes
precise and comprehensive definition, but considered
that the most
useful general guide in determining what is almost invariably a
somewhat evenly balanced and difficult problem
22
remains
Watermeyer CJ's well-known, and often cited, summary of the
authorities in
New State Areas Limited v Commissioner
for
Inland Revenue
1946 AD 610
at 627 :
"The
conclusion to be drawn from all of these cases, seems to be that the
true nature of each transaction must be enquired into
in order to
determine whether the expenditure attached to it is capital or
revenue expenditure. Its true nature is a matter of fact
and the
purpose of the expenditure is an important factor: if it is incurred
for the purpose of acquiring a capital asset for the
business it is
capital expenditure, even if it is paid in annual instalments; if, on
the other hand, it is in truth no more than
part of the cost
incidental to the performance of the income-producing operations, as
distinguished from the equipment of the income-producing
machine,
then it is revenue expenditure, even if it is paid in a lump sum."
23
In support of the finding that the
capital used to make the loans was fixed capital, Jennett J relied on
the judgment in
Stone v Secretary for Inland Revenue
1974 (3)
SA 584
(A). In that judgment Corbett AJA referred to the delineation
of the distinction between fixed and floating capital and said (at
595 G - 596 H):
"Applying the distinction,
thus described, to the ordinary case of a loan of money, there is no
doubt, in my opinion, that the
capital lent constitutes fixed
capital. Such capital is not consumed in the very process of income
production: it does not disappear
to be replaced by something which
/ when received....
24
when received by the taxpayer
forms part of his income. It is true that the lender does not retain
ownership in the actual money which
passes but, in an economic and
accounting sense, it remains his capital and upon the termination of
the loan (all being well) it
returns to him intact. In the process
wealth may be produced for the lender but this takes the form of a
consideration, usually in
the f orm of interest, paid by the borrower
for the use of the capital; it does not consist of the augmented
proceeds of the capital,
which itself has disappeared in the
process."
He then referred to a number of
decided cases in which it was accepted that
" where the taxpayer can
show that he
has been carrying on the business
of banking or money-lending, then losses incurred by him as a result
of loans, made in the course
of his business, becoming irrecoverable
are losses of a non-capital nature and deductible."
25
and went on to say -
"The
rationale of these decisions appears to be that the capital used by a
money-lender to make loans constitutes his circulating
capital and
that consequently losses of such capital are on revenue account.
I
shall accept, for the purposes of this
case, that these decisions are correct, provided that the business is
purely that of money-lender
and the loans are not made in order to
acquire an asset or advantage calculated to promote the interests and
profits of some other
business conducted by the taxpayer (cf.
Atlantic Refininq Company of Africa
(Pty.) Ltd. v. C.I.R
., 1957(2) S.A. 330
(A.D.) ) . There is, however, in my view, no warrant for extending
this principle to loans by persons who are
not conducting a
money-lending business."
The learned judge did not here
decide that losses incurred as a result of loans are deductible only
in the case of a banker or money-lender.
That appears from a passage
later
26.
in the judgment (p 597 G) where he
refers to "the conclusion that a loss of capital loaned would be
deductible only if it was
circulating capital, as in the case of a
money-lending business". In other words the case of the
money-lender is merely one
example, and the question in every case is
whether the loss is a loss of fixed capital or floating capital.
In my view
Stone
's case is
not decisive in the present matter. For the reasons given above, this
was not "the ordinary case of a loan of money".
According
to Burman's evidence, which was accepted by the Special Court, it was
not intended that the loan should be repaid by the
company. The
intention was that Burman should recoup his expenditure as a result
of a sale, at a profit, of the shares and loan account
together. They
were made, not for the purpose of acquiring a capital asset, but for
the purpose of acquiring stock-in-trade (i e
interests in
27 companies) which was to be
realised at a profit.
In my opinion, ITC 1344, a
decision of the Cape
Special Court, reported in (1982)
44 SA Tax Cases 19, is
directly in point. There the
Secretary for Inland Revenue
had disallowed the deduction of a
loss on the sale of a
shareholder's loan account. At the
hearing of the appeal
the facts were agreed by the
parties. So far as they are
relevant for present purposes,
they appear from paragraphs 7
to 12 of the agreement, namely,
"7. In toto, appellant
advanced to the Companies on Loan Account, the sum of R196 723,00
(appellant's total Loan Account).
In October/November 1974... the
parties, including appellant, sold their shares and Loan Accounts in
A and B to C (Proprietary)
Limited.
Appellant's total Loan Account
was sold at a loss of R147 301,00.
28
Appellant
is not a moneylender.
Where
persons acquire immovable property through private Companies owned
by them, it is accepted common commercial practice for
the shares of
the Companies concerned to be nominal and to provide the finance
required by the Companies by way of loans to the
Companies by the
shareholders, proportionate to their shareholding.
12. When
appellant took up his shares in A and B and advanced his moneys on
Loan Account to the said Companies, it was at all relevant
times his
intention to sell the said shares and Loan Accounts as soon as the
development was completed with a view to making a profit.
The
learned President of the court (Grosskopf J) said at 24 in fin - 25:
"It
is clear on the agreed f acts that the shares and loan accounts were
acquired by the appellant for the purpose of resale
at a
29
profit. The appellant was
consequently, in our view, engaged in an operation of business in a
scheme of profitmaking, viz to sell
the shares and loan accounts at a
profit. In fact the scheme produced a loss and not a profit. In our
view such a loss was properly
deductible".
And in regard to
Stone
, he
said:
"
Stone
's case dealt
with loans which were intended to be repaid by the borrower to the
lender and in respect of which the borrower was to
pay interest or
some other consideration for the use of the capital borrowed. The
present case concerns loans which were intended
to be sold by the
lender to a third party. The benefit which the lender hoped to derive
from his loan was not the return of his capital
with interest, but a
profit on the sale and cession of the loan. The
ratio
for
holding that, in loans of the former type, the capital lent
constitutes fixed capital does not, in our view, apply to loans of
the latter type (vide
Stone
' s case (
supra
) at 595-6
(SALR) and 130 (SATC) )."
30
I
respectfully
agree.
In my view there is no valid
ground for distinguishing ITC 1344 from the present case. It is true
that here there was no agreement
or evidence in regard to the
"accepted common commercial practice" referred to in para
11 of the agreement in that case.
It is possible that the practice
referred to is so notorious that an income tax special court would be
entitled to take judicial
notice of it. But however that may be, it
does not appear f rom Grosskopf J's judgment that the existence of
this practice f ormed
part of the
ratio decidendi
. In this
case it is clear from the evidence that the shares and loan accounts
were acquired by the appellant for the purpose of resale
together at
a profit. It is clear also that when Burman acquired his shares and
advanced moneys on loan account to the companies
concerned, it was at
all relevant times his intention to sell the shares and loan accounts
together, in
31
order to make á profit,
when that was judged to be
opportune. Burman's unchallenged
evidence was that he did not expect to get the loans repaid by the
debtor company: he would just
sell shares and loan accounts. The
intention throughout was that he was not to get a "rental
dividend return" but a "speculative
interest in property,
interest acquired from the resale at a profit"; the properties
were in companies in which Burman had shares
and loan accounts, and
this was virtually a package which he saw himself as selling.
ITC 1321,
decided in the Natal Special Court and reported in
(1980) 42 SATC
269
, does not support the Commissioner in the present case. There the
appellant sought to deduct aloss
incurred
upon the realisation of his shares and loan account in A (Pty) Ltd.
This was a managing company for five companies whose
object was to
sell land at a prof it. The appellant had been obliged to advance
funds to the managing company from time to time to
32
enable the
associated companies to finance the cost of
purchasing
immovable properties and to provide the running expenses of the
companies. In the 1976-7 tax year the appellant had disposed
of his
investment in A (Pty) Ltd consisting of shares and loan account at a
loss of Rl 415,00. For reasons which are not germane
to the present
enquiry, the Natal Special Court dismissed an appeal against the
disallowance by the Commissioner of an objection
to the inclusion of
the amount of the loss in the appellant's taxable income.
Notwithstanding some surface similarities on the facts,
ITC 1321
differs
toto caelo
from the present. It was not the case of
the appellant there that he had acquired the shares and loan account
in A (Pty) Ltd as stock-in-trade
for disposal at a profit; his
purpose was to make a capital investment in order to derive profits
from the sales of land by the associated
companies.
Counsel
for the Commissioner put forward another
33
ground for
contending that the losses were not losses of
floating
or circulating capital. He quoted a number of extracts from Burman's
evidence which, he said, showed that although it was
originally his
object to make a quick profit out of the sale of his interest in
property companies, this object disappeared in the
course of time and
he exerted himself and bought further shares and made loans only in
order to rescue the companies from shipwreck
and bankruptcy. He
referred to the case of
Sub-Niqel Ltd v CIR
1948 (4) SA 580
(A) at 599 where reference was made to the principle that expenditure
incurred to preserve a capital asset is expenditure of a capital
nature and not deductible. In this case, however, the expenditure to
which Burman referred was incurred to preserve his stock-in-trade
or
floating capital, and hence was deductible.
The losses
sustained in respect of the suretyship transactions stand on the same
footing as the loans. What
34
Burman did
by entering into these transactions was to
"pledge
or lend his credit" so as to enable the companies concerned to
obtain finance for the carrying on of their operations.
The
liabilities accrued and Burman had to pay them in accordance with the
suretýships. Like the losses on the loans, these
losses were
losses of floating capital. (Cf
Stone
(
supra
) at 598.)
Conclusion
In
my opinion the losses claimed in Burman's
return
of income were properly deductible.
I
would
make an
order allowing the appeal with
costs, and ordering that the order of the Special Court be set aside
and that there be
substituted therefor the
following:
"The
assessment is set aside and the matter referred back to the
Commissioner for reassessment on the basis that the deductions
claimed by the taxpayer be allowed."
H
C
NICHOLAS
LL
Case
No 282/1989
IN THE SUPREME COURT OF SOUTH
AFRICA APPELLATE DIVISION
In the matter between:
TAYLOR & HORN (PROPRIETARY)
LIMITED
Appellant
and
DENTALL (PROPRIETARY)
LIMIED
Respondent
CORAM
:
JOUBERT
ACJ, VAN HEERDEN, E M GROSSKOPF,
NIENABER JJA et NICHOLAS AJA
HEARD
:
2
NOVEMBER 1990
DELIVERED
: 23 NOVEMBER 1990
JUDGMENT
VAN HEERDEN JA
:
2.
The appellant carries on business
as an importer, supplier and distributor of consumable dental
material and equipment. It has some
1 800 customers including
individual dentists, clinics, dental institutions and hospitals.
During 1974 the appellant and a West German
corporation ("ESPE")
concluded an oral agreement. In terms thereof the appellant was
granted the exclusive rights to market
and distribute in the Republic
products developed and manufactured by ESPE. The agreement was later
reduced to writing and was still
extant when the appellant initiated
the undermentioned proceedings against the respondent.
Two of the
products covered by the agreement are Impregum and its successor,
Impregum F, which are patented rubber denture materials
developed and
manufactured by ESPE. (For convenience
I
shall refer to both products as Impregum.)
The substance is used for making impressions for dentures, removable
prostheses and full
crowns, and permits a dentist to
3.
obtain an accurate impression in a
single procedure.
The appellant has been
distributing Impregum in the Republic since 1974. As a result of the
appellant's efforts in promoting Impregum
it has become the móst
used dental impression material in the country. It is also the most
important product marketed by the
appellant, its sales representing -
at least until 1987 - 18% of the appellant's total sales. The growth
in the popularity of Impregum
is demonstrated by the appellant's
sales of the material during the period 1974 to 1986. In 1974 total
sales of Impregum amounted
to some R140 000; in 1986 the
corresponding amount was nearly R770 000.
During 1987 the appellant
experienced a marked drop in the volume of sales of Impregum. It then
discovered that the respondent - which
is also a local supplier of
consumable dental material and equipment - was distributing Impregum
in the Republic. The product was
being sold in the original packaging
in
4.
which it had been placed by ESPE
before distribution to its various agents. The respondent merely
affixed to the outside of the packaging
a sticker proclaiming that it
(the respondent) was the supplier thereof. The respondent did,
however, disseminate advertising material
favourably contrasting its
prices for Impregum with so-called regular (and higher) prices.
When the respondent refused to
give an undertaking to desist from supplying Impregum, the appellant
initiated motion proceedings in
the Witwatersrand Local Division. The
main relief sought by it was an order restraining the respondent from
distributing Impregum
for so long as the appellant enjoyed the
exclusive distributorship rights in respect of the product in the
Republic. The application
was opposed by the respondent and a number
of factual disputes arose. Since the appellant did not apply for an
order referring such
disputes for the hearing of oral evidence,
nothing more need be said about them.
5.
The respondent did not seriously
contest the
appellant's averments that from
1974 it had sought to
extensively promote the use of
Impregum in the Repub-
lic; that the appellant alone had
devoted time, money
and effort in promoting the sale
of the product, and
that through the appellant's
efforts local demand for
Impregum had developed. As regards
the respondent's
intrusion into the market the
appellant alleged:
"... the Respondent has not
purchased its supplies of IMPREGUM from ESPE .... It is ... plain
that the Respondent procures its
supplies of IMPREGUM from
distributors in Europe or elsewhere other than ESPE, and that by
recourse to "grey marketeering",
it is able to sell
IMPREGUM in the Republic at prices lower than that customarily
offered by the Applicant [appellant]."
In support of the above
allegations the
appellant filed supporting
affidavits made by one
Skogstad, the managing director of
ESPE. These related
to the distribution network of
ESPE and to restrictions
imposed on the sale of products by
exclusive
distributors in various parts of
the world. For
6.
reasons
which will appear,
I
do
not find it necessary to particularise Skogstad's averments.
In its opposing affidavit the
respondent stated that it had been distributing Impregum in South
Africa for a period of some three
years, but that for reasons which
had nothing to do with the launching of the proceedings it was not
then doing so. The respondent
furthermore said that the Impregum
distributed by it had been purchased "from distributors in
Europe who in turn procure[d]
it from ESPE or its agents". It
was also made clear that in the future the respondent might resume
supplying Impregum obtained
from such distributors.
The court a
quo
found that
at all material times the respondent knew i) that for many years the
appellant had been the largest, if not the sole,
distributor of
Impregum in the Republic; ii) that the appellant's supplies from ESPE
stemmed from a contractual relationship with
ESPE and iii) that the
7.
appellant had actively promoted
the use of Impregum.
The court also found that in
essence only the appellant
had spent time, money and effort
in creating a market
for Impregum. It rejected,
however, the appellant's
contention that the respondent had
engaged in unlawful
competition with the appellant.
The gist of the
court's reasoning appears from the
following extract
from the judgment:
"I
see
no reason to extend the
lex Aquilia
to this case so that it may be used to prevent the importation into
this country of goods already being sold here in competition
with the
manufacturer's appointed distributor of those goods in this country
and at prices sharply competitive with those of the
appointed
distributor. In my view, as well, the public has a considerable and
positive interest in the activity of any businessman
who is able by
the exercise of his own ingenuity and knowledge of the market to
supply the same product honestly at sharply competitive
prices. The
action is not available for the purpose of enforcing or establishing
a monopoly, for it would otherwise amount to saying
that anybody who
by expenditure of time and trouble and money has established a market
for himself in goods f or which he has been
appointed the sole
distributor ... should for the foreseeable
8.
future be entitled to regard that
market as his personal prerogative untrammelled by competition from
any outside source."
In the result the court a
quo
dismissed the application with costs, but subsequently granted the
appellant leave to appeal to this court.
In order to obtain the order
sought by it, the appellant had to prove
inter alia
that the
respondent's distribution of Impregum was unlawful vis-á-vis
the appellant; i e, that it infringed a right of the
appellant.
Notwithstanding the paucity of the respondent's averments as to its
sources of supply, counsel for the appellant conceded,
rightly in my
view, that it does not appear from the papers that the respondent
acted unlawfully in obtaining its supplies of Impregum.
In particular
it was conceded that it does not appear that the respondent procured
or induced a breach of contract on the part of
its suppliers. It was
also not disputed that the respondent became the rightful owner of
the Impregum purchased by it. But,
9. contended counsel for the
appellant, by virtue of the appellant's exclusive distribution rights
the respondent could not dispose
of its supplies in competition with
the appellant. In this regard it was argued that one and the same act
may be lawful if performed
by a member of the public but unlawful if
carried out by a competitor of the person harmed by the act. In
support of this proposition
counsel relied upon a
dictum
in
the judgment of the U S Supreme Court (per Mr Justice Pitney) in
International News Service v The Associated Press
[1918] USSC 194
;
248 US 215.
In that case A gathered news as a
result of organisation and the expenditure of labour, skill and
money. Such news was telegraphed
daily to A's members throughout the
United States. B made a practice of obtaining the news through
inter
alia
early publica-tions in newspapers of A's members and of
sending it telegraphically to its own customers who then also
published the
news in their newspapers. The court
10.
held, by a majority, that B's
conduct constituted
unlawful competition. B contended
that once the news
had been published by A's members,
A no longer had the
right to control the use to be
made of it; that it
became the common possession of
all to whom it was
accessible, and that any purchaser
of a newspaper has
the right to communicate the
intelligence which it
contains to anybody and for any
purpose. With
reference to these contentions Mr
Justice Pitney said
at p 239 (and this is the passage
upon which counsel
for the appellant relied):
"The fault in the reasoning
lies in applying as a test the right of the complainant [A] as
against the public, instead of considering
the rights of complainant
and defendant [B], competitors in business, as between themselves.
The right of a purchaser of a single
newspaper to spread knowledge of
its contents gratuitously, for any legitimate purpose not
unreasonably interfering with complainant's
rights to make
merchandise of it, may be admitted; but to transmit that news for
commercial use, in competition with the complainant
- which is what
defendant has done and seeks to justify - is a very different
matter."
n .
This passage must, however, be
read in con-
text for Mr Justice Pitney
immediately went on to say:
"In doing this defendant, by
its very act, admits that it is taking material that has been
acquired by complainant as a result
of organization and the
expenditure of labor, skill and money, and that defendant in
appropriating it and selling it as his own is
endeavoring to reap
where it has not sown, and by disposing of it to newspapers that are
competitors of complainant's members is
appropriating to itself the
harvest of those who have sown."
It is clear, therefore, that in
the view of Mr Justice Pitney the nub of B's objectionable conduct
lay in the misappropriation of
a product of A's in the competitive
struggle. B did nothing to gather the news save for parasitically
copying A's product, i e, the
intelligence gathered by A and
transmitted to its members. Hence the dissemination of the news by B
was not based upon any constructive
effort on his part (cf Callmann,
The Law of Unfair Competition Trademarks and
-
Monopolies
,
4th ed, vol 2, chap 15, p 2).
A similar situation obtained in
Schultz v
12.
Butt
1986 (3) SA 667
(A). With reference to
inter alia International News Servic
é
this court held that B had engaged in unlawful competition with A by
using one of A's hulls - evolved over a long period with
consider-able
expenditure of time, labour and money - to form a mould
with which to make boats in competition with A.
It will be observed that in both
the above cases B competed with A by, in a very real sense, selling
A's product as if it were its
own product. Because this amounted to
the filching of the fruits of another's skill, labour, etc, it was
held to be unlawful competition.
In casu
there is no
question of a copying or appropriation of a product of the
appellant's by the respondent. Impregum is manufactured by
ESPE; the
appellant merely has an exclusive right - vis-á-vis ESPE - to
sell Impregum in the Republic. True, the respondent
sold the same
product as the appellant, but it did not acquire its commodities by
utilising the
13. appellant's product or
business values. Indeed, apart from the fact that the supplies sold
by the parties were all manufactured
by ESPE, the respondent's
activities in procuring and selling Impregum were completely divorced
from the corresponding activities
of the appellant. It is clear,
therefore, that the above cases do not assist the appellant.
I
agree
with the court a
quo
that the real grievance of the appellant appears to be that the
respondent has been capitalising on the market for Impregum built
up
as a result of the appellant's expenditure of effort and money. The
question then arises whether a mere utilisation of a market
built up
by a competitor - without any form of adoption of his product or
performance - is unlawful.
It has often been said that
competition is the life blood of commerce. It is the availability of
the same, or similar, products from
more than one source that results
in the public paying a reasonable
14. price therefor. Hence
competition as such cannot be unlawful, no matter to what extent it
injures the custom built up by a trader
who first marketed a
particular product or first ventured into a particular sphere of
commerce. But, as was said in
Dun and Bradstreet (Pty) Ltd v S A
Merchants Combined Credit Bureau (Cape) (Pty) Ltd
1968 (1) SA 209
(C) 216, competition may be rendered unlawful by the manner in which
a competitor conducts his trade etc.
As far as
I
am aware, it has never been suggested that
the exploitation of a market established by a competitor for a
particular product, or type
of product, is in itself a form of
unlawful competition. On the contrary, it appears to be generally
accepted that, in the absence
of statutory protection, the published
idea or concept of a trader on which his product is based, may be
freely taken over by a competitor
even if the trader has already
through his efforts built up a demand for his product. (Cf
Cadbury
15.
Schweppes
Pty Ltd and Others v Pub Squash Co Pty Ltd
(1981
)
1 All E R 213
, 218
I.)
Take
the case where a manufacturer was the f irst to conceive the idea of
marketing beer in cans. His brand of beer so marketed proved
to be
immensely popular with the result that his competitor also began
marketing his own beer in cans. It can surely not be contended
that
the competitor acted unlawfully merely because of his exploitation of
a demand created by the manufacturer's efforts and originality.
(Cf
Adcock-Ingram Products Ltd v Beecham S A
(Pty) Ltd
1977 (4) SA 434
(W) 437 F-G;
Agriplas (Pty) Ltd and Others v Andrag
and Sons (Pty) Ltd
1981 (4) SA 873
(C)
878, and Callmann, og.
cit
.,
vol 2, chap 15, pp 63-64.)
To revert to the facts of this
appeal, let us assume that the agreement between ESPE and the
appellant did not confer upon the latter
a
sole
agency, but
that until the respondent began distributing Impregum the appellant
de
facto
was the sole agent of
16.
ESPE in the
Republic. Also assume that the respondent obtained its supplies from
ESPE because of the conclusion of a second, non-exclusive,
agency
agreement.
I
fail
to see how, in the postulated case, it can possibly be said that
the respondent acted unlawfully merely because it
reaped the fruits of a market for Impregum created by the appellant's
prior efforts.
Exploitation of an existing market can therefore not
be equated with the copying or appropriation of another's product or
performance.
In the result it seems clear that
the appellant must stand or fall by the contention that because of
the existence of the exclusive
supply agreement between it and ESPE,
nobody may lawfully market Impregum in the Republic in competition
with the appellant. Acceptance
of this contention would certainly
lead to startling consequences. It would mean that for as long as the
sole agency endures the
appellant would enjoy a monopoly, akin to
that derived
17.
from a
patent, in regard to the commercial distribution
of
Impregum in this country. It would also mean that
the
agreement which created purely contractual rights
between
the parties thereto, would in effect bind
would-be
competitors no matter from what source or how-
ever
honestly they obtained supplies of Impregum. A
further
result would be to impose an unwarranted re-
striction
on the right of ownership of a person who le-
gitimately
acquired supplies of Impregum (cf
Consumers
Distributinq
Co Ltd v Seiko Time Canada Ltd
10 DLR
(4th) 161,
174). It is therefore not surprising that
Callmann,
op.
cit
., vol 2, chap 9, pp 6-7, remarks:
"If a
dealer purchases the manufacturer's goods from a seller who is under
no contractual obligation and then sells in the exclusive
area
without misleading the public, there is little likelihood that action
against the dealer, either by the manufacturer or his
exclusive
distributor, would succeed. Such an interference with the
manufacturer's contractual arrangement with his exclusive distributor
would be incidental to, and the normal consequence of competition."
18.
In
Schultz
(at p 679) this court held that fairness and honesty are relevaht
criteria in deciding whether competition is unlawful, and that
in
judging of fairness and honesty regard is to be had to
boni
mores
and the general sense of justice
of the community. Applying these criteria in the light of the above
considerations
I
do
not think that the respondent's intrusion into the market for
Impregum - albeit created by the appellant's efforts as the sole
local distributor of ESPE - would be condemned by the community as
unfair or unjust in a legal sense.
The appeal is dismissed with
costs, including the costs of two counsel.
H.J.O. VAN HEERDEN JA
JOUBERT ACJ
E M GROSSKOPF JA
CONCUR
NIENABER JA
NICHOLAS AJA