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[2002] ZASCA 161
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Commissioner For The South African Revenue Service v Scribante Construction (Pty) Ltd (026/2001) [2002] ZASCA 161; 2002 (4) SA 835 (SCA); 64 SATC 379 (14 May 2002)
IN THE SUPREME
COURT OF APPEAL
OF SOUTH AFRICA
REPORTABLE
Case No: 26/2001
In the matter between:
COMMISSIONER FOR
THE
SOUTH AFRICAN
REVENUE SERVICE
APPELLANT
and
SCRIBANTE
CONSTRUCTION
(PTY)
LTD
RESPONDENT
___________________________________________________________
Coram: HOWIE, SCHUTZ
JJA et HEHER AJA
Heard: 3 MAY 2002
Delivered: 14 MAY 2002
Summary: Income tax –
s s 11(a) and 23(g) of Act 58 of 1962 – dividends declared
by company credited to shareholders’
loan accounts –
interest paid on such loans – whether taxable
______________________________________________________________
J U D G M E N T
HEHER
AJA
/…
HEHER
AJA
:
[1]
The
respondent is a civil engineering construction company the activities
of which are mainly road building and earthmoving. It
has been a
family concern for more than fifty years. Its shareholders are three
family trusts. They have developed a number of
practices designed to
suit both their own interests and those of the company. One such is
to leave dividends “banked”
in the company (which then
credits their loan accounts with an agreed rate of interest) until
more advantageous investment opportunities
arise.
[2]
During 1990 the company declared
dividends of R6 573 076. Of this amount R3 199 834 was allocated to
the shareholders’
loan accounts on the understanding that no
interest would be paid. The balance of R3 373 242 was likewise
credited but on the
basis that it would bear interest at an agreed
rate. No money was moved or changed hands. The arrangements were
effected solely
by book entries. In fact, the cash funds of the
company which were available for the purpose of the distribution
remained in the
interest-bearing call accounts held by the company.
[3]
In its 1991, 1992 and 1993 returns for
income tax the company sought to deduct the interest which it had
credited to its shareholders’
loan accounts in respect of the
dividends as expenditure incurred in the production of income allowed
by s 11(a) of the Income
Tax Act, 58 of 1962. The appellant
disallowed the deductions. In amplification, he informed the
taxpayer that
‘
[t]he
distribution of previously produced income in the form of dividends
can in no way be seen to produce income or increase the
income
producing capacity of an operation. In the case of
Scribante
Construction (Pty) Ltd
it is clear that the
interest was incurred as a result of the dividend declaration and
consequently is not-productive.’
[4]
The company appealed successfully to
the Income Tax Special Court. A further appeal by the Commissioner
to the Full Court of
the Eastern Cape Division was decided in the
taxpayer’s favour by a majority. The matter now comes before
this Court with
special leave granted.
[5]
The only evidence before the Special
Court was that of the company’s auditor, Mr Jacobs. It was
not seriously contested.
Aside from the background which I have
sketched, the salient facts which emerged are set out in the next
paragraph.
[6]
When the company declared the
dividend, the money held in the call accounts was surplus to its
immediate operational requirements
to the extent of R3 373 242, which
is why it was prepared to pay interest on that amount but not beyond
it. During the years 1991,
1992 and 1993 the net current accounts of
the company (excluding cash on hand) were respectively R1 346 996,
R2 984
216 and R1 587 971. If the shareholders had been paid out
instead of lending the money to the company or had withdrawn all the
interest-bearing loans, the company would have been in a solvent
condition with sufficient available cash to meet its day to day
requirements. An important aspect of the company’s business
involved the furnishing of contract guarantees (surety bonds)
for
construction work which it was to undertake. The ability of the
company to reflect a substantial cash reserve in its financial
statements was of material assistance in readily obtaining the issue
of guarantees from financial institutions, thereby sharpening
its
competitive edge when tendering for contracts and increasing its
income potential. The interest earned by the company on
the call
accounts fluctuated. In 1991 the average rate was 16% per annum, in
1992 15.3% and in 1993 11.3%. Although the total
interest on the
loaned funds in the call accounts over the three years amounted to R1
648 216, the amount credited to the shareholders
loan accounts was
only R1 516 108, the company retaining the difference. (The interest
rate which the company had agreed to pay
the shareholders was
apparently less than it in fact earned in each of the first two years
but greater in the third.) The shareholders
disclosed the interest
credited to their loan accounts and were duly assessed on it.
Jacobs testified that the manner of treatment
of the dividends by the
company was a common practice in private companies.
[7]
The issues argued before us were
whether the interest paid by the company to the shareholders for the
years in question was expenditure
incurred in the production of
income as contemplated by s 11(a) of the Act and whether the interest
was laid out or expended by
the company for the purposes of trade
within the meaning of s 23(g).
[8]
The legal principles are
well-established.
‘
In
regard to the general deduction formula, it is settled law that
generally, in order to determine in a particular case whether
moneys
outlaid by the taxpayer constitute “expenditure incurred in the
production of income”, important, sometimes
overriding, factors
are the purpose of the expenditure and what the expenditure actually
effects. And in this connection the
Court has to assess the
closeness of the connection between the expenditure and the
income-earning operations (see
Commissioner
for Inland Revenue
v
Nemojim (Pty) Ltd
1983 (4) SA 935(A)
at 947
G – H and the authorities there cited).’
Commissioner for
Inland Revenue
v
Standard Bank of South Africa
1985 (4)
SA 485
(A) 498 F – G.
As Hefer JA pointed out
in
Ticktin Timbers CC
v
Commissioner for Inland Revenue
1999 (4) SA 939
(SCA) 942 I
‘
There
can be no objection in principle to the deduction of interest on
loans in suitable cases. Loan capital is the lifeblood of
many
businesses but the mere frequency of its occurrence does not bring
about that this type of expenditure requires different
treatment.’
In
Commissioner for Inland Revenue
v
Giuseppe Brollo Properties (Pty) Ltd
[1993] ZASCA 197
;
1994 (2) SA 147
(A) 152 I –
153 G Nicholas AJA said
‘
In a
case concerning the deductibility or otherwise of interest payable on
money borrowed, the enquiry relates primarily to the
purpose for
which the money was borrowed. That is often the “dominant”
or “vital” enquiry, although the
ultimate use of the
borrowed money may sometimes be a relevant factor. Where a
taxpayer’s purpose in borrowing money upon
which it pays
interest is to obtain the means of earning income, the interest paid
on the money so borrowed is prima facie an expenditure
incurred in
the production of income. See
Commissioner
for Inland Revenue
v
Allied Building Society
1963 (4) SA 1
(A) at
13 C – G.’
Counsel for the appellant submitted that, properly
analysed, the loan to the company was merely the means of financing
the dividend.
He argued that there was never any intention of paying
the dividend out to the shareholders. I do not agree. I have
already
referred to the uncontested practice of the shareholders in
using the company as a banker. In that context the crediting of the
loan accounts constituted an actual payment as if the dividends had
been deposited into an account held by a shareholder at a banking
institution. Counsel pointed out that if the funds had been taken
out of the company the acquisition of contract guarantees would
have
been more difficult. That is true, but it is only relevant if one
assumes that the dividend declaration was not what it purported
to
be. On the contrary, Jacobs’s evidence as to what motivated
the company and it shareholders was never put in issue:
the
availability of profits in the form of surplus cash, the desire of
the shareholders to know where they stood financially vis-à-vis
the company and each other, and a perception that changes in the
income tax laws were imminent which would have the effect of
taxing
undistributed profits in the hands of the company. Of these
considerations the existence of the surplus is the decisive
factor in
the present context. It serves to distinguish the authorities relied
on by counsel for the appellant in which, in all
the cases, the
taxpayer was unable to pay a dividend from its own funds:
Guiseppe
Brollo Properties
at 150 I , 154 H;
Ticktin Timbers
at
943 D – E, 944 I – 945 C;
Commissioner for Inland
Revenue v Elma Investments CC
58 SATC 295
(1996) at 297
in
fine
. The evidence was that the cash generated in the course of
the company’s business would have been sufficient for its
operating
requirements even if the dividends had not been lent to it.
The argument that the company could not actually afford to divest
itself of the dividends which it declared and therefore they were
effectively retained by it was therefore misplaced. A company
is not
to be criticized for declaring and distributing dividends simply
because it might otherwise put the funds to use profitably.
The
declaration of a dividend is a commercial decision regulated by the
terms of the company’s statutes and the rules
which have been
developed in practice: see the authorities referred to in
Commissioner for Inland Revenue
v
Dirmeik
1996 (2) SA
736
(C) at 740 C – I. I find nothing in the evidence to
suggest that the declaration and distribution concerned in this case
were motivated by anything but bona fide commercial considerations.
[9]
The same can be said of the crediting
of the loan accounts. The shareholders were under no apparent
compulsion, commercial or
otherwise, in agreeing to lend the money to
the company. Each remained free to withdraw his loan at the
discretion of the directors.
The reliance by the appellant on the
Guiseppe
Brollo Properties
case
supra
at 153 F –
G and
Commissioner for Inland Revenue
v
Elma Investments CC
at 297 was ill-founded: once the declaration of the dividend is not
part of a broader scheme but is an independent commercial
decision
taken in the context of a company which has the resources available
for distribution as a dividend, it becomes inapposite
to compare the
financial strength of the company before the declaration with the
position after it borrowed the money in order
to determine whether an
additional expense or added burden has resulted. In fact the company
was not poorer. As a result of the
arrangement it benefited by the
loan as it could not have done if the shareholders had used the money
or invested it elsewhere
as they were fully entitled to do.
[10]
There is no doubt that the interest
paid by the company enabled it to secure (even if only temporarily)
the shareholders funds
which could otherwise have been moved
elsewhere. Equally it is certain that the availability to the
company of the funds substantially
increased its competitiveness and,
temporarily, its income in the form of the interest which it
retained. Those two considerations
simply stated provide the
sufficiently close link between the expenditure and the income
earning operations having regard to the
purpose of the expenditure
and what it actually effects,
Commissioner for Inland Revenue
v
Genn
&
Co (Pty) Ltd
1955 (3) SA 293
(A) at 299 G.
The fact that the company could have operated quite adequately
without the funds is not the only pertinent factor.
It was enough
that they served for the more efficient performance of its
operations:
Port Elizabeth Electric Tramway Co
v
Commissioner
for Inland Revenue
1936 CPD 241
at 246. The interest paid to the
shareholders on their loan accounts was plainly an actual expense
which enabled the company to
produce income both in the form of its
allocation of the interest earned and through the commercial
advantages which possession
of the loan funds generated. Section
11(a) was thereby satisfied.
[11]
Seen from the perspective of the
company, the only purpose of paying interest on the loan accounts was
to secure for the company
the benefit of the continued availability
of the funds for use in its trading activities. In addition,
borrowing money and re-lending
it at a higher rate of interest,
thereby making a profit, constitutes the carrying on of a trade:
Burgess v Commissioner for Inland Revenue
[1993] ZASCA 88
;
1993 (4) SA 161
(A).
That is analogous to the way in which the company managed the loan
funds, at least during 1991 and 1992. It follows that
the deductions
which the company claimed were not struck by s 23 (g).
[12]
The appeal is dismissed with costs.
J
A HEHER
ACTING JUDGE
OF APPEAL
CONCUR
:
HOWIE JA
SCHUTZ JA