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[1993] ZASCA 160
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Essential Sterolin Products (Pty) Ltd. v Commissioner for Inland Revenue (605/90) [1993] ZASCA 160; 1993 (4) SA 859 (AD); [1993] 2 All SA 632 (A) (30 September 1993)
Case No 605/90
IN THE SUPREME COURT OF SOUTH AFRICA
(
APPELLATE
DIVISION
)
In the matter between:
ESSENTIAL STEROLIN PRODUCTS
(PTY) LIMITED
APPELLANT
and
THE COMMISSIONER FOR INLAND REVENUE
... RESPONDENT
CORAM
: Corbett CJ, Van Heerden, Smalberger, Goldstone, JJA, et
Howie" AJA.
DATE OF HEARING
: 2 September 1993.
DATE OF JUDGMENT
: 30 September 1993
JUDGMENT
CORBETT
CJ:
In about 1968 Mr R W Liebenberg commenced
2
experimenting with certain chemicals for
pharmaceutical purposes. With the assistance of a scientist and researcher, Dr K
Pegel of
the University of Natal, he discovered that two species of the hypoxis
plant contained a substance known as B-Sitosterol-D-Glucoside
(for reasons which
will later emerge I shall refer to this as "the active substance") which proved
very effective in the treatment
of a medical condition known as prostata
hypertrophy.
With a view to exploiting this discovery and in April 1970 Mr Liebenberg
caused to be incorporated a company known as Vivokem (Proprietary)
Limited, in
which he was allotted ninety-five per cent of the shares and Dr Pegel five per
cent. In the following year the name of
this company was changed to Essential
Sterolin Products (Proprietary) Limited. It is the appellant in the present
appeal.
3
In order to market a medicine in a country it is
normally necessary that it be registered by a medicines control authority; and
before
such registration is granted exhaustive tests have to be performed. For
various reasons appellant did not seek registration for its
products in South
Africa but preferred to do so in West Germany. This it did through a West German
corporation known as Hoyer GmbH
and Company ("Hoyer"), which at all times acted
as its distributor in West Germany. In addition, certain West German patents
were
registered to protect the use of the active substance for the treatment of
prostata hypertrophy. The patents did not cover the actual
manufacture of the
active substance since its existence and the process of its manufacture had been
public knowledge for many years.
Initially appellant's business modus operandi
was to manufacture the active substance, dissolve it in a solvent and
precipitate it
onto what is termed "a carrier" in order
4
that it should assume monomolecular form. This was all done in South
Africa. The active substance, in this form, would then be exported
to Hoyer in
West Germany. Hoyer, in turn, would add fillers, put the compound into capsules,
and pack and market them under the registered
trade mark
"Harzol".
In about 1976 a Dr Hans Walker, of West Germany, who had
himself done research on the hypoxia plant for his doctoral thesis, approached
appellant, in the person of Mr Liebenberg, and offered his services in improving
the appellant's turnover in West Germany and placing
its product on other world
markets, in return for a share in the business. His offer was accepted and
acting on his advice, appellant
estblished a so-called "front company"
registered in Switzerland and known as Intermuti Pharma AG, with its head office
in the Zug
canton ("Intermuti Zug") through which to market its product. The
reason given was that as a South African
5
company appellant would have no standing in international markets and its
South African connection might prove to be a negative factor;
whereas
Switzerland was a "neutral" country and was regarded as a very good
pharmaceutical source, in the sense that large pharmaceutical
companies with
good reputations were established there. Dr Walker was given a ten per cent
share holding in Intermuti Zug, the remaining
shares being held by
appellant.
Thereafter appellant's product was supplied to Intermuti Zug which in
turn sold it to Hoyer at a profit. As turnover increased'(which
it did at a
steady rate) the mark-up was increased so that Intermuti Zug could meet its own
expenses, including Dr Walker's salary.
In due course, again on the advice of Dr Walker and in order to
facilitate marketing in West Germany, a company was registered in
West Germany
as a wholly-owned subsidiary of Intermuti Zug. This company, known as
6
Intermuti Pharma GmbH of Eschwege, West Germany ("Intermuti Eschwege"),
was used as the medium for the introduction onto the German
market of a
"generic" or patent medicine which contained the same active substance, but was
sold "over the counter" (Harzol was supplied
on medical prescription) under
different packaging and a different trade mark. This gave a big boost to
appellant's turnover.
At about the time of the negotiations with Dr Walker a Mr Morris Joffe
joined appellant as its managing director. He was of the view
that the
arrangements with Hoyer should be placed on a more formal basis and pursuant
thereto a written contract ("the Distribution
Agreement") regulating the supply
of appellant's product (referred to in the contract as "the active substance")
to Hoyer was concluded
on 5 April 1977. In terms of this contract, which was to
endure for 15 years (with the possibility of a two-year extension), Intermuti
Zug
7
agreed to sell the active substance to Hoyer "on an exclusive basis" for
distribution in West Germany and West Berlin for the treatment
of "prostata
adenom"; and Hoyer agreed to purchase all its requirements of the active
substance exclusively from Intermuti Zug. The
Distribution Agreement further
regulated the purchase price of the active substance, the place and method of
payment thereof, Hoyer's
obligations in regard to the marketing and distribution
thereof, the use of the Harzol trade mark and other related matters. In
particular,
Hoyer acknowledged that it had no proprietary or other rights in the
relevant patents and appellant and Intermuti Zug warranted that
they were the
"beneficial owners" of the patents; Hoyer was obligated not to manufacture, sell
or distribute during the currency
of the Distribution Agreement and one year
thereafter any product which competed with the product distributed by Hoyer
under the
distribution agreement. And Hoyer
8
acknowledged that the "confidential information" received from appellant
and/or Intermuti Zug was "proprietary to" appellant and/or
Intermuti Zug and
gave certain undertakings of non-disclosure in regard thereto. The agreement
contained a definition of "confidential
information" from which it appears that
it related to "valuable secret and confidential experience information and
know-how" developed
by and belonging to appellant and/or Intermuti Zug and
relating to the active substance.
The Distribution Agreement also dealt with the sale of the active
substance in its generic form and in this regard provided that Hoyer
appointed
Intermuti Exchwege as its commission agent to distribute the same -
".... so as to ensure that interested parties do not become aware that
Hoyer is selling a generic product in addition to
9
Harzol for the treatment of prostata adenom".
In December 1977 appellant caused to be incorporated in the Netherlands
Antilles a company known as Roecar Holdings (Netherlands Antilles)
NV ("Roecar")
in order that this company should hold the patents then registered in
appellant's name. This was done to avoid having
the patents registered in the
name of a South African company. Ten per cent of the shares in Roecar were
issued to Dr Walker and
the balance to appellant. Roecar subsequently
established a number of wholly-owned subsidiaries in Holland, West Germany, the
United
States of America and Switzerland in order to develop markets outside
West Germany. These included Interbio Pharma AG of Zug, Switzerland
("Interbio
Zug), which was run by a Dr Max Ehrbar, who held two per cent shareholdings in
Interbio Zug and Roecar.
10
In mid-1982 Mr Joffe resigned from appellant. Since Mr Liebenberg had by
then withdrawn from active participation in the affairs of
appellant and as far
as appellant was concerned was in "semi-retirement" Mr Joffe's resignation gave
rise to management problems.
Mr Liebenberg went to Europe to discuss the matter
with Dr Walker, Dr Ehrbar and Mr Jurgen Hoyer of Hoyer. By this stage the
marketing
of Harzol and the patent medicine equivalent had become about fifty
per cent of the business done by Hoyer. Mr Hoyer indicated that
his company
would like to participate in appellant's international activities and to acquire
a shareholding in the international
group. As a result of these discussions and
on 9 September a written agreement ("the Sale and Manufacturing Agreement") was
entered
into in Dusseldorf, West Germany between appellant and Hoyer in terms
whereof Hoyer would acquire all the issued shares in Intermuti
Zug and
thirty-nine per cent shareholdings
11
in Roecar and Interbio Zug for a total
consideration of DM16 750 000. A clause relating to the payment of the
consideration (which
was spread over a period of 3 years) contained the
following provision (clause 4.2):
"The consideration of DM 16 750 000
includes an amount of DM 4 000 000 due in terms of the AGREEMENT TO ALLOW
MANUFACTURE IN THE EVENT OF INABILITY, and no additional
amount may be claimed
under that agreement."
In another clause appellant undertook to assign or cause to be assigned
to Roecar all registered patents not already held in that
company's
name.
The Agreement to Allow Manufacture in the Event of Inability ("the
Inability Agreement") referred to in the above-quoted clause 4.2,
was signed by
one of the parties in Amsterdam on 10 September 1982 and by the others in
Dusseldorf on 9 September 1982. The parties
thereto were appellant, Interbio
Zug, Roecar and Hoyer.
12
In clause 2 of the Inability Agreement it is recorded, inter alia, that
appellant has the sole right to manufacture and to supply
Interbio Zug with the
active substance; and that Interbio Zug will supply the active substance to
Hoyer for use in pharmaceutical
products. Clause 3, headed "INABILITY TO
DELIVER", reads as follows (appellant being referred to therein as
ESSPROD):
"Should INTERBIO ZUG through the inability of ESSPROD to supply the
ACTIVE SUBSTANCE to it, be unable to supply the ACTIVE SUBSTANCE
to HOYER and/or
any other distributors supplied by INTERBIO ZUG, then in such event but not
otherwise ESSPROD grants to HOYER a sub-licence
to manufacture the ACTIVE
SUBSTANCE exclusively for supply to INTERBIO ZUG, and for no other purpose.
ROECAR and INTERBIO ZUG hereby
consent to the granting of such sub-licence to
HOYER. HOYER shall, however, not be entitled to grant further
sub-licences.
13
Should INTERBIO ZUG be unable to deliver the ACTIVE SUBSTANCE as
aforesaid, it shall be presumed to be caused by the inability of
ESSPROD to
supply, unless the contrary is proved. HOYER will supply the ACTIVE SUBSTANCE to
INTERBIO ZUG at the same price and on
the same terms at which ESSPROD were
supplying the ACTIVE SUBSTANCE immediately prior to its inability to deliver.
ESSPROD assures
that, at date hereof, this will be economically
possible.
ESSPROD will lodge a full description of the manufacturing process of the
ACTIVE SUBSTANCE with the Swiss notary, Dr. A. Renggli of
Baarestrasse 10, 6300
Zug, who will be authorised to release such description to HOYER, should HOYER's
right . to manufacture come
into operation.
In consideration for the rights granted in terms hereof, HOYER shall pay
to ESSPROD the sum of DM 4 000 000."
14
Clause 4 specifies, in effect, when Interbio Zug
should be considered to be unable to deliver the active substance to Hoyer.
Clause
5 is headed END OF INABILITY TO DELIVER and reads:
"Should the inability of ESSPROD to deliver the ACTIVE SUBSTANCE to
INTERBIO ZUG come to an end, then ESSPROD shall notify INTERBIO
ZUG who shall
notify HOYER accordingly, and then, as from a date one year after receipt of
HOYER of such notification, the licence
and authority given to HOYER by ESSPROD
in terms of 3 and as a result of such inability, shall lapse."
On 27 October 1982 two additional written agreements were entered into in
order further to give effect to the whole transaction. The
first of these was an
agreement between appellant and Interbio Zug in terms of which appellant agreed
to sell the active substance
on
15
an exclusive basis to Interbio Zug for distribution; and Interbio Zug
agreed to purchase all its requirements of the active substance
exclusively from
appellant and undertook that it (Interbio Zug) would not manufacture or cause to
be manufactured (except by appellant)
the active substance or any other
substance or product covered by the patents. The second agreement generally
substituted Interbio
Zug for Intermuti Zug in the various agreements governing
the marketing of the products containing the active substance.
These agreements were duly implemented. During the year of assessment
which ended on 28 February 1983 appellant was paid the consideration
which had
become due in terms of each of them. This included the DM 4 000 000 payable
under the Inability Agreement and referred
to in the Sale and Manufacturing
Agreement. In a revised assessment issued early in 1986 respondent, the
Commissioner for Inland
Revenue, included in appellant's
16
taxable income the DM 4 000 000 paid in accordance with the Inability
Agreement, which when converted to rands at the exchange rate
obtaining on 9
September 1982 amounted to R1 847 148. For convenience I shall henceforth refer
to this as the "inability consideration".
Appellant objected to this inclusion
and, its objection having been disallowed by respondent, appealed to the Special
Court.
The appeal was heard in the Transvaal Income Tax Special
Court, presided over by Goldstein J. The Court dismissed the appeal and
confirmed
the assessment. The necessary leave having been granted in terms of
sec 86 A (5) of the Income Tax Act 58 of 1962 ("the Act"), appellant
appeals
direct to this Court.
In the Court below and in this Court three main issues were raised, viz
-
17
(1) whether the inability consideration constituted in appellant's hands a
capital or revenue receipt;
(2) whether or not the inability consideration constituted in appellant's
hands a receipt in terms of par (g)(iii) of the definition
of "gross income" in
sec 1 of the Act, as being a premium or like consideration for the use or the
right to use a process; and
(3) whether or not appellant received the inability consideration from a
source within or deemed to be within the Republic of South
Africa.
The Special Court held that the
inability consideration fell within par (g)(iii) and that it was derived from a
source within the
Republic. The Court consequently found it unnecessary to deal
with the capital or revenue issue.
18
In my view the issue as to source is decisive of this appeal and I
accordingly turn immediately to that.
It is not suggested that any
of the provisions in the Act relating to deemed source is applicable.
Consequently the limited (but by
no means simple) issue is whether or not the
inability consideration was received by appellant from a source within the
Republic.
The only evidence placed before the Court a quo was that
of Mr Liebenberg, who was called to testify on behalf of the appellant. The
aforegoing recital of the essential facts is gleaned from his evidence and the
various contracts referred to by him. In his judgment
the President of the
Special Court stated that Mr Liebenberg impressed him as an "honest and reliable
witness" and I deduce that
he accepted his evidence in its entirety. Certain
aspects of the evidence, not hitherto noted, call for comment.
19
In recounting how the total consideration of DM
16 750 000 payable to appellant in terms of the Sale and Manufacturing Agreement
and
the Inability Agreement came to be determined Mr Liebenberg stated in
evidence that he calculated the net asset value of Intermuti
Zug at DM 12 750
000 and the interest in the goodwill attaching to the shares sold in Interbio
Zug, which was to become the selling
company in the place of the Intermuti
companies, at DM 4 000 000. At the suggestion of Hoyer's legal adviser, a Dr
Bohme, however,
the DM4m was, as it were, allocated to the conditional right to
manufacture granted to Hoyer in terms of clause 3 of the Inability
Agreement. It
appears that this arrangement held out certain tax advantages to Hoyer. Mr
Liebenberg stated, quite frankly, that the
possibility of an inability on the
part of appellant to manufacture and supply the active substance had never
entered his mind and
"would also never arise". The amount of the active
20
compound in a shipment of 50 kilograms was 250
grams. It was cheap and easy to produce. According to him, the first
precipitation
of the active substance onto the carrier was performed in his
kitchen. In the unlikely event of his having to leave South Africa
he could, as
he put it -
".... in my suitcase take out enough
supply of this active compound to see me through for two or three years
and start manufacturing at a different site, taking one key
personnel with me to
set up a new manufacturing unit...." -
Asked about the references to confidential information concerning the"
active substance in the Distribution Agreement and in par 3
of the Inability
Agreement, Mr Liebenberg said:
"Our know-how and our knowledge was merely the fact that we had developed
B-Sitosterol Glucoside and we thought - and we still think
so - that putting it
onto a
21
carrier in monomolecular form is of most importance when it comes to its
effectivity when being used by a patient. It gives better
absorption."
He further emphasized that the active substance was of no use or value to
appellant unless it could be sold as a medicine; and this
could only occur in
West Germany where the necessary registration had been obtained. Accordingly,
the active substance had no value
whatever in South Africa. In West Germany,
moreover, appellant was protected by patent from competition in the marketing of
products
containing the active substance for use as a medicine in the treatment
of prostata hypertrophy.
Despite Mr Liebenberg's evidence, appellant's counsel assured the Court a
quo that the Disability Agreement was not "a sham" and must
be taken at its face
value. That was appellant's attitude on appeal as well. It seems to me that that
is the only proper approach.
22
One cannot go behind the clear provisions of the contract. Similarly, I
think that the confidential information referred to in the
agreements must be
treated as a reality.
The legal principles to be applied in determining whether or not an
amount was received from a source within the Republic have been
stated in a
number of decisions of this Court, more particularly in
Commissioner for
Inland Revenue v Lever Bros and Another
1946 AD 441
;
Commissioner for
Inland Revenue v Epstein
1954 (3) SA 689
(A);
Commissioner for Inland
Revenue v Black
1957 (3) SA 536
(A) . These authorities point out that the
Legislature, probably aware of the difficulty of doing so, has not attempted to
define
the phrase "source... within the Republic" and has left it to Courts to
decide on the particular facts of each case whether an amount
was or was not
received from such a source. As
23
was stated by Watermeyer CJ in the
Lever
Bros
case, supra (at 450) -
".... the source of receipts, received as income, is not the quarter
whence they come, but the originating cause of their
being received as income, and this
originating cause is the work which the taxpayer does to earn them, the
quid pro quo which he gives in return for which he receives
them. The work which
he does may be a business which he carries on, or an enterprise which he
undertakes, or an activity -in which
he engages and it may take the form of
personal exertion, mental or physical, or it may take the form of employment of
capital either
by using it to earn income or by letting its use to someone else.
Often the work is some combination of these."
(See also
Epstein
's case, supra, at 698 E;
Black
's case,
supra, at 541.) In a particular case there may be a number of causal factors
relevant to the ascertainment
24
of source and, here it would seem, it is
appropriate to
weigh these factors in order to determine the dominant or
main or substantial or real and basic cause of the
receipt (
Black
's case, supra, at 543 A - C). In a
number of cases in our Courts reference has been made (in
various forms) to the following remarks of Isaacs J
delivering the judgment of the High Court of Australia in
the case of
Nathan v Federal Commissioner of Taxation
[1918] HCA 45
;
(1918) 25 CLR 183
, at 189 - 90:
"The Legislature in using the word 'source' meant, not a legal concept,
but something which a practical man would
regard,as a real source of income
(T)he ascertainment of the actual source of a given income is a
practical, hard matter of fact."
(See
Rhodesia Metals Ltd (In Liquidation) v Commissioner of Taxes
1938 AD 282
, at 300;
1940 AD 432
, at 436; '
Lever Bros
case, supra, at
454.)
25
In applying these general principles, the Courts have adopted certain
rules and criteria for locating the source of particular types
of accrual or
receipt, such as dividends, annuities, director's fees, interest, payment for
services, rent, royalties and so on.
None of these would seem to have relevance
to the somewhat unusual character of the inability consideration. In seeking the
originating
cause of this amount one must, in my view, have regard to the
factual matrix underlying and giving rise to the agreement in terms
of which it
became payable and then apply thereto the basic principles outlined
above.
Of fundamental importance in this case is that at the time when the Sale
and Manufacturing Agreement and the Inability Agreement were
entered into the
business operations from which appellant derived its income were conducted
predominantly outside South Africa. This
was so of necessity because there was
no market whatsoever
26
for appellant's product in South Africa. Indeed the only country where it
could be sold was West Germany. Moreover, because of the
patents and trade marks
registered there West Germany was the only country where there was, for the time
being, protection against
competitors marketing products containing the active
substance for the treatment of prostata hypertrophy and using the trade marks.
The distributor for and part manufacturer of these products was a West German
corporation, Hoyer; and Hoyer was bound by means of
contracts entered into in
Europe to purchase all its supplies of the active substance from appellant's
Swiss and German subsidiaries;
to manufacture the final product and distribute
it in West Germany; and to refrain from manufacturing, selling or distributing
any
competing product. In short, the whole foundation of appellant's business
rested upon the rights flowing from registration, the patent
and trade mark
rights and the
27
contractual rights vis-a-vis Hoyer, all of which were acquired and
exercised in West Germany.
It is true that the active substance was
manufactured by appellant itself in South Africa and exported to West Germany
(via one of
appellant's European subsidiaries) in its monomolecular form. But
that is the only South African connection, apart from appellant
itself being
located here. Moreover, that was only part of the process of manufacture. The
product could not be marketed in the form
received in West Germany by Hoyer.
Hoyer still had to add fillers, put the compound into capsules and package them
before placing
the product on the West German market.
The inability consideration was an ingredient of the reorganization of
the business and the grant to Hoyer of a substantial interest
therein. By that
stage the marketing of the products containing the active substance had become a
major segment of Hoyer's business
28
and, of course, Hoyer was paying a large sum of
money for the acquisition of this interest. The purpose of the Inability
Agreement
was to ensure that Hoyer always had a supply of the active substance
giving it the right and know-how to manufacture it in the event
of appellant
being unable to do so; and the purpose of the inability consideration was to
compensate appellant for this potential
deprivation of the exclusive right, as
between itself and Hoyer, to manufacture the active substance. This all arose
from the reorganization
of a business predominantly conducted in Europe by
European subsidiaries of the appellant. And finally the inability consideration
was linked not merely to an inability to supply the active substance from South
Africa, but to an inability to supply it from anywhere
in the world.
In all the circumstances I am of the opinion that the originating cause
of the receipt of the
29
inability consideration, and therefore the source
thereof,
was not within South Africa.
The appeal is allowed with costs, including the
costs of two counsel, and the order of the Special Court
is altered to read -
"The appeal is allowed. Appellant's revised assessment for the tax year
ended 28 February 1983 is set aside and the matter is referred
back to the
Commissioner for such reassessment as may be necessary."
M M CORBETT
VAN HEERDEN JA) SMALBERGER JA) GOLDSTONE JA) CONCUR HOWIE AJA)