SYNOPSIS. October Highlights of the Draft Revenue Laws Amendment Bill Advance tax rulings in respect of VAT... 8

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1 SYNOPSIS Highlights of the Draft Revenue Laws Amendment Bill Advance tax rulings in respect of VAT Accrual of income Reportable arrangements revamped Recreational clubs to be partially tax-exempt Fifteen years of VAT in South Africa The new general anti-avoidance provision VAT in Africa

2 Highlights of the Draft Revenue Laws Amendment Bill 2006 The highlights of the statutory amendments foreshadowed by the just-released Draft Revenue Laws Amendment Bill 2006 are set out below. Estate Duty Act The Commissioner is to have to the power to appoint any person to be the agent of any other person in respect of the payment of duty by the latter (proposed section 12A) and will have the same remedies against property vested in or under the control or management of any agent or trustee as the Commissioner would have against the property of the person who is liable for duty or interest (proposed section 12B). Income Tax Act A definition is to be provided of country of residence and foreign business establishment for purposes of the provisions governing controlled foreign companies; (proposed section 9D(1)); New provisions in respect of tax exemption for recreational clubs; (proposed section 10(1)(cO) to dovetail with the new section 30A; New provisions regarding the tax exemption for scholarships or bursaries; (proposed section 10(1)(q) read with the proposed section 30A); Deductions in respect of scientific or technological research and development; (proposed section 11D); A significant expansion of the deductions available to personal services companies or personal service trusts; (proposed section 23(k)(iii)); A new category of public benefit organisation, namely an agency or branch in the Republic of a company or association formed outside the Republic which is exempt from tax in that other country; (proposed section 30(1)(a)); Section 103(1) and (3) are to be deleted and replaced by a proposed new Part IIIA dealing with impermissible tax avoidance arrangements ; Section 76A which deals with reportable arrangements is to be deleted and replaced by Part IIB; There is to be a new definition of personal service company ; (proposed paragraph 1 of the Fourth Schedule); Public benefit organisations are to disregard any capital gain or loss in respect of the disposal of an asset not used for any business undertaking or trading activity or which was used, since the valuation date, in carrying on a public benefit activity; (proposed paragraph 63A of the Eighth Schedule); An expanded provision dealing with the deemed disposal, for capital gains tax purposes, of an asset to the taxpayer s surviving spouse; (proposed paragraph 67(2)(a) of the Eighth Schedule); The introduction of a 10th Schedule to deal with oil and gas activities. Value Added Tax Act The extension of the system of advanced tax rulings to value-added tax (proposed section 41A of the Act). 2

3 The accrual of income Another taxpayer falls into the trap The South African tax landscape is strewn with pitfalls for the unwary taxpayer. A tax consultant earns his or her keep by guiding the client around the traps. Unfortunately, some taxpayers try to economise on professional fees and either manage their own tax affairs (a sure recipe for expensive errors) or else assume that the professionals who draft their contracts are well-versed in the principles of tax (a dangerous assumption). Contracts that make excellent sense and are well-drafted from a commercial perspective may be tax disasters. Woe betide the draftsperson who has the law of contract at his or her fingertips but has never got around to studying income tax. In Case (decided in the Durban Tax Court on 26 May 2006 and not yet reported) the taxpayer was a manufacturing company that sold products to wholesalers. Its standard conditions of sale included a term which stated that Should payment be made by purchaser to seller not later than the 25th day of the month following the month during which delivery takes place, the purchaser shall be entitled to deduct a settlement discount from his payment, in accordance with the seller s discount scheme During the tax year in question, the taxpayer calculated its gross income by deducting the applicable settlement discount, on the assumption that the debtor would pay the account by the 25th of the month. At the end of the 2003 tax year, these discounts totalled just over R4 million. In computing its gross income for tax purposes, the taxpayer deducted the aggregate of such discounts. SARS raised an additional assessment which added that discount to the taxpayer s gross income. The crisp issue before the tax court was whether the so-called settlement discounts formed part of the taxpayer s gross income. This turned on whether the amounts in question had accrued to the taxpayer, even though they had not been received by him, since the Income Tax Act defines gross income as including both receipts and accruals. Citing the well-known cases of Lategan v CIR 1926 CPD 203 and CIR v People s Stores (Walvis Bay) (Pty) Ltd 1990 (2) SA 353 (A) the court held correctly it is submitted that an amount accrues to a taxpayer when he becomes entitled to the amount and that, on the facts of the matter, the taxpayer became entitled to the full selling price. The fact that the taxpayer s accounting system treated the amount due as the selling price less the discount could not (said the court) alter the situation from a tax point of view. The tragedy was that, if the person who drafted the standard contract had been aware of elementary principles of tax law, he or she could have ensured that only the discounted amount accrued to the taxpayer. This could have been achieved by the simple stratagem of making the discounted amount the selling price, and writing a suspensive condition into the contract in terms of which, if the price was not paid by the 25th of the month, a further amount would become payable. It is well established that an amount accrues only if and when the taxpayer acquires an unconditional right to it. The tax consequences of a contract can often be (legally) manipulated in this way. The fundamental principles as to the time when an amount falls to be included in the taxpayer s gross income, and the time when tax-deductible expenditure becomes deductible are based on the legal concepts of the accrual of a right and the incurring of a legal obligation respectively. A taxpayer cannot, merely by drawing up his accounts in a particular way, delay the accrual of income or bring forward the time that an obligation is incurred. 3

4 Under the new dispensation, recreational clubs are to be subject to a system of partial taxation, and will be tax-exempt only within the confines of the mutuality principle. Change of rules for recreational clubs Clubs to be partially tax-exempt Currently, section 10(1)(d)(iv)(aa) of the Income Tax Act 58 of 1962 grants an exemption from income tax to any company, society or association established to provide social and recreational amenities or facilities for its members. SARS has become concerned that clubs are enjoying this exemption even where they allow their amenities to be used by the general public, and that some clubs are involved in extensive trading activities in order to supplement their membership fees. SARS has also taken note of concerns that the exemption accorded to recreational clubs is anomalous, in that they are currently treated more leniently than public benefit organisations, which have recently been made subject to a system of partial taxation. 4 Under the new dispensation, recreational clubs are to be subject to a system of partial taxation, and will be tax-exempt only within the confines of the mutuality principle that is to say, the principle that where a number of taxpayers join together to provide funds to share the expenses of creating amenities for their common enjoyment (such as the construction of tennis courts, golf courses, swimming pools, club-houses, etc.) they can do so without incurring any tax liability. Tax exemption is to be available only for such cost-sharing situations. Income derived from non-members will not be exempt. A recreational club (as defined in the new section 30A) will be exempt from tax on membership fees and subscriptions paid by members, payments by members for social or recreational facilities (e.g green fees for playing a round of golf), and fund-raising activities of an occasional nature and undertaken substantially on a voluntary basis and without compensation. The first R of other income (for example, investment income and income derived from letting out

5 the club premises to non-members) will be exempt from tax, and the balance will be taxable in the ordinary way. Expenditure in producing exempt income; roll-over of capital gains The club s expenditure incurred in producing tax-exempt income will not be able to be offset against taxable club income. Capital gains on the disposal of club assets (for example, the sub-division and sale of part of the club property) will qualify for roll-over relief, and CGT will be deferred if the club uses the proceeds of the sale to purchase an asset for the club that will produce tax-exempt income. Clubs will have to apply to SARS for exemption Tax exemption for recreational clubs will not be automatic, and they will have to apply to SARS for exemption in much the same way as public benefit organisations. Clubs are to be accorded a lengthy transition period in this regard, and application must be made before 31 March 2011 or the last day of the club s first year of assessment. The Commissioner cannot deny exemption if the statutory conditions are fulfilled, namely that - the club is committed to carrying on its activities solely in a non-profit manner; its surplus funds cannot be distributed, except upon dissolution, in which event, it must transfer its funds an assets to another tax-exempt club or to approved public benefit organisations; it pays only reasonable remuneration; all members are entitled to membership for at least a year (hence, for example, daymembers fees will not be exempt from tax); members cannot sell their membership rights; the club does not knowingly become involved in tax avoidance schemes. Where a club s constitution does not satisfy these requirements, it will suffice if a person in a fiduciary position vis-à-vis the club gives the Commissioner a written undertaking that the club will be administered in compliance with these requirements. Violation of these rules can result in the club s forfeiting its tax-exempt status, but SARS must give the club notice and an opportunity to put its affairs in order within a stipulated period. Once the Commissioner has withdrawn his approval of a recreational club, it must within three months transfer its remaining assets to another approved recreational club or an approved public benefit organisation, other than a connected person vis-à-vis the club. If the club fails so to transfer its assets, or take reasonable steps to do so, then a drastic consequence ensues the market value of the assets not transferred will be deemed to be taxable income accruing to the club in the tax year in which the Commissioner withdrew approval. 5

6 The new general anti-avoidance provision Part IIA of the Income Tax Act The centerpiece (and the focus of attention in the business press) of the proposed amendments to the Income Tax Act is the new general anti-avoidance provision which is to replace section 103(1). The relatively concise provisions of section 103(1) and (3) are to be replaced by twelve new complex sections, comprising sections 80A L, which together constitute a new Part IIA of the Act entitled impermissible tax avoidance arrangements. Complex and novel features The most striking novel features of the Part IIA are the criterion of commercial substance ; (stated in section 80A(a)(ii) and expanded on in detail in section 80C); the criterion of whether the arrangement in issue would frustrate the purpose of any provision of [the Income Tax] Act (proposed section 80A(c)(ii)); new powers given to the Commissioner in relation to an impermissible avoidance arrangement (section 80B) and to determine whether parties are accommodating or tax indifferent parties and whether there has been a tax benefit (section 80F); a criterion of commercial substance in an arrangement; (section 80C); the concept of accommodating or tax-indifferent parties (section 80E). The three phases of the general anti-avoidance provision This is the third major revamp of section 103(1). In its first phase, section 103(1) lasted from its original enactment in 1978 to its amendment in The pre-1996 format of section 103(1) In its pre-1996 format, section 103(1) distinguished between legitimate and illegitimate tax avoidance on the basis of four criteria, namely (a) the existence of a transaction, operation or scheme ; 6

7 (b) that had the effect of avoiding, postponing or reducing liability for tax; (c) which was entered into in an abnormal means or manner or which created non-arm s length rights or obligations between the parties; and (d) which was entered into for the sole or main purpose of tax avoidance. If all of these elements were simultaneously present, section 103(1) empowered the Commissioner to determine the parties tax liability as though the scheme had not been entered into or carried out, or in such other manner as he deemed appropriate to prevent or diminish the tax avoidance. In terms of section 103(4), if a transaction had the effect of avoiding tax, it was rebuttably presumed that it had been entered into with a sole or main purpose of tax avoidance. There are contested assessments in the pipeline, still to come before the courts, which have to be determined under the pre-1996 format of section 103(1). 2The post-1996 format of section 103(1) The second phase of section 103(1) lasted from its 1996 amendment to the coming into force of the proposed Part IIA. The reason for the 1996 amendment was that, from SARS s perspective, a major weakness of section 103(1) in its pre-1996 format was its abnormality criteria, for it was possible for taxpayers to argue that that it was not abnormal to structure a transaction so as to minimise liability for tax, because it is ordinary business practice to do so. The validity of this argument has never been determined by the courts. The essence of the 1996 amendments to section 103 was as follows: In relation to a transaction, operation or scheme in the context of business, the abnormality criteria were replaced by the criterion of whether the transaction had been entered into or carried out in a manner which would not normally be employed for bona fide business purposes other than the obtaining of a tax benefit. Consequently, a transaction which was not abnormal in its means or manner or in its rights and obligations (and which would therefore have been outside the scope of section 103(1)) in its pre-1996 format) became vulnerable to the section in its post-1996 format if the transaction fell within the scope of this new formula. In relation to a transaction, operation or scheme which was not in the context of business, the Commissioner could invoke section 103(1) where it was entered into by means or in a manner which would not normally be employed in the entering into or carrying out of a transaction, operation or scheme of the nature of the transaction, operation or scheme in question. Transactions which were not in the context of business probably included arrangements such as the creation and operation of family trusts, at least where the trust did not carry on a business. The amended section 103(1) retained, as an alternative, one of the pre-1996 criteria, namely whether the transaction, operation or scheme has created rights or obligations which would not normally be created between persons dealing at arm s length under a transaction, operation or scheme in the nature of the transaction, operation or scheme in question. A new expression tax benefit was introduced into the section and was defined as including any avoidance, postponement or reduction of any tax, duty or levy imposed by the Income Tax Act or any other law administered by the Commissioner. The 1996 amendments did not abolish the requirement that the taxpayer must have entered into the transaction, operation or scheme solely or mainly for the purposes of obtaining (what was now called) a tax benefit, and this requirement remained an overriding condition precedent to the application of s 103(1). A consequence of the way in which the 1996 amendments were drafted 7

8 Advance tax rulings in respect of VAT In terms of the Draft Revenue Laws Amendment Bill 2006, the provisions contained in Part IA of chapter III of the Income Tax Act in relation to advanced tax rulings are to be made applicable, mutatis mutandis, to the Value Added Tax Act 89 of Any procedures and guidelines issues by the Commissioner in terms of section 76S of the Income Tax Act for the implementation and operation of the advanced tax ruling system are to apply, mutatis mutandis, to VAT. The new anti-avoidance provision was that a taxpayer could, with impunity, enter into a transaction that was (objectively) abnormal, so long as he did not have a (subjective) sole or main purpose of tax avoidance. Conversely, a taxpayer could with impunity enter into a transaction with the (subjective) sole or main purpose of tax avoidance as long as it was not (objectively) abnormal. This meant that if two taxpayers, A and B, entered into exactly the same type of transaction, which involved an abnormal means or manner or abnormal rights and obligations, the result could be that section 103(1) applied to A, but not to B, because A had a sole or main purpose of tax avoidance, but B did not. Indeed, this could happen even if A and B had entered into the particular scheme with one other, with the result that the Commissioner could invoke his draconian powers in relation to one, but not the other! There are many disputed assessments, still to be heard by the courts, involving section 103(1) in its post-1996 format. 3Phase three Part IIA of the Income Tax Act It is proposed that Part IIA of the Income Tax will come into force with effect from the commencement of years of assessment ending on or after 1 January An unwelcome aspect of the introduction of Part IIA is that it will take many years perhaps decades for the High Court and the Supreme Court of Appeal to rule on the interpretation of these new provisions, and the novel concepts such as a lack of commercial substance, and whether a particular tax scheme would frustrate the purpose of any provision of the Income Tax Act. In the meantime, the business community and their professional tax advisers will have to endure prolonged uncertainty as to whether or not a proposed arrangement, or an arrangement which they have in fact entered into, will be found to have infringed Part IIA. This uncertainty will be particularly acute in relation to innovative methods of financing business deals, for it may be very difficult to determine whether or not a particular arrangement lacks commercial substance (as contemplated in section 80C) or involves round trip financing (as contemplated in section 80D). One way for businesspeople to deal with this uncertainty would be to write into the contract that particular contractual provisions will change, or will be unwound, if SARS succeeds in invoking Part IIA, or even if SARS merely gives notice in terms of section 80J that it may do so. Such a contractual provision is not void or impermissible it merely makes the contract a reportable arrangement in terms of the proposed Part IIB of the Act. But it may be preferable for the parties to a tax scheme to decide for themselves, at the outset, how to unwind the scheme if it is attacked by SARS, rather than to leave themselves at the mercy of SARS s extensive new statutory powers to, inter alia, re-allocate gross income or recharacterise expenditure in terms of section 80B. 8

9 Reportable arrangements revamped Currently, section 76A of the Income Tax Act provides for the obligatory reporting to SARS of two types of arrangement, namely those that result in a tax benefit and are subject to an agreement that provides for the variation of interest, fees, etc. if the actual tax benefits of the arrangement deviate from the envisaged tax benefit; those falling within a special inclusion list, which currently deals with hybrid debt and equity instruments. The purpose of making such arrangements reportable is to give SARS early warning of arrangements that may fall foul of the general anti-avoidance provision of the Act or in respect of which SARS may take action under other statutory provisions or the common law. In its brief existence scarcely 18 months section 76A has yielded disappointing results for SARS. Fewer disclosures have been made than were expected, and some taxpayers have raised technical arguments that their arrangements did not require to be disclosed because they fell outside the scope of the section. The proposed Part IIB It is proposed that the present (fairly concise) section 76A be deleted in its entirety and replaced by a new Part IIB, spanning section 80M Q which will deal exclusively and in detail with reportable arrangements. Section 80A will significantly expand the definition of reportable arrangement and will dovetail with section 80C(2) (which forms part of the new Part IIA and sets out the characteristics of an avoidance arrangement which has a lack of commercial substance). Subject to specified exceptions (set out in section 80N) the obligation to report will generally be triggered by an arrangement which provides for interest, finance costs, fees or other charges which are partly or wholly dependent on New Part IIB raises the stakes 9

10 assumptions relating to the tax treatment of the arrangement; (e.g where the contract provides that the interest, finance costs, fees, etc, will be varied if they do not qualify as tax deductions); has any of the characteristics of a lack of commercial substance in terms of the proposed general anti-avoidance provisions contained in the new Part IIA; will be disclosed by any participant as a loan or financial liability for the purposes of Generally Accepted Accounting Practice but not for income tax purposes; does not result in a reasonable expectation of a pre-tax profit for any participant; or results in a reasonable expectation of a pre-tax profit for any participant that is less than the value of those tax benefits to that participant on a present value basis. Hazards for adventurous draftspersons It is likely that some draftspersons will continue to try, as they did with section 76A, to draw contracts for themselves or their clients in such a way as not to fall within the scope of the new Part IIB of the Act, so as not to trigger the obligatory reporting. This will be an even more hazardous exercise than before. Under the old section 76A, the consequence of not reporting a reportable arrangement was that the taxpayer would be required to pay, in addition to the ordinary amount of tax, an amount equivalent to the tax benefit derived from that arrangement. The new Part IIB raises the stakes considerably, and failing to report a reportable arrangement will incur a penalty of up to R1 million. (No provision is made for the forfeiture of any legitimate tax benefit achieved by the arrangement.) The penalty is incurred even if there was nothing illegal about the arrangement, and even if it does not in fact infringe the new general anti-avoidance provisions. The penalty is imposed simply for failure to report a reportable arrangement. The Commissioner is given power to reduce the penalty if there are extenuating circumstances and the participant remedies the non-disclosure within a reasonable time, or if the penalty is disproportionate to the envisaged tax benefit. The obligation to report a reportable arrangement The obligation to report a reportable arrangement is to fall on the promoter of the arrangement defined as any person who is principally responsible for organising, designing, selling, financing or managing that reportable arrangement. This wide-ranging obligation which will alarm accountants, attorneys, consultants and financial institutions countrywide represents a radical change from section 76A, in terms of which the obligation to report fell only on the taxpayer. Conceivably, in relation to a single reportable arrangement adopted by a particular taxpayer, the obligation to report to SARS (and the concomitant penalty for failing to report) could fall simultaneously on a host of people other than the taxpayer, since it is possible that a number of individuals or institutions could be principally responsible for each of the stipulated facets of the arrangement, namely organising, designing, selling, financing or managing it. 10

11 Fifteen years of VAT in South Africa It was supposed to be a simple tax. An in and out. Some hoped, forlornly, that it was a passing fad and wouldn t last long. Well 15 years on, Value Added Tax in South Africa is going strong, being responsible for consuming (excuse the pun) thousands of hours of government, South African Revenues Services, business and consultants time. Why, you ask, is so much time now devoted to administering and managing this tax? The answer is simple, consumption taxes notably VAT, GST and customs duties and excise are assuming ever-greater importance as a revenue-collection tool across the globe. They are also, by some distance, the most cost effective taxes to collect, since the taxpayer does all the work. In 2002, consumption taxes comprised approximately 30% of total taxation revenue in OECD countries. Such a large amount of money requires proper Government attention to ensure collections are maximised and leakage is kept under control. The flip side of having a consumption tax system is that, from a governmental perspective, the use of VAT and other consumption taxes to raise revenue is politically unpopular as they are viewed as regressive taxes, i.e they take no account of the ability to pay. Further, there is thought to be a negative impact on GDP and international competition for foreign direct investment as cross-border businesses seek tax-friendly environments with low rates and a minimum of red tape. Businesses across the globe, continent and country are giving increased attention to their strategy regarding indirect tax management. It is now more necessary than ever to ensure compliance and, where necessary, have arguments ready to defend business and tax decisions from over-zealous tax officials. SARS has access to increasingly sophisticated people (CAs, MBAs, economists) and tools (data mining and benchmarking software) to monitor and enforce tax compliance, particularly on the part of large corporations. It is also happily agreeing protocols with like-minded tax jurisdictions, of which there are many, for the exchange of information. All this activity takes place within the context of the constant tension between the need to keep the tax as straightforward as possible using initiatives such as e-filing, and the need for complex legislation to counter tax avoidance. Going forward, National Treasury will try to keep tax legislation as simple as possible without creating too many escape hatches for the taxpayer. SARS will continue to collect tax as aggressively (and hopefully fairly) as possible. Our guess is that as SARS continues to raise its game it will be the simple things that catch taxpayers out like inadequate documentation and VAT treatment issues that one thought had long since been resolved. 11

12 VAT in Africa In the last 15 years, many African countries have implemented VAT systems and have adapted their VAT models to suit unique local circumstances, particularly to lessen the impact of the regressive nature of the tax by creating extensive categories of exemptions and zero-rating. Botswana introduced VAT in 2002 as a replacement for sales tax at a rate of 10%, which is applicable to all supplies that are not exempt or zero-rated. Exempt supplies include financial services (but VAT is charged on any fee rendered for a transaction), educational services and medical services. Kenya introduced VAT in 1990 to replace sales tax. The standard rate of VAT is 16%, and a 14% rate applies to hotel and restaurant services. Mozambique introduced VAT in 1999, with a rate of 17%. Transactions within the country involving staple foods such as maize flour, rice, bread and wheat are fully exempted. Namibia introduced VAT in 2000, with a standard rate of 15%. Non-residents qualify for a refund of VAT on exported goods. Services to non-residents directly in connection with land and buildings are subject to VAT. The sale of a business as a going concern is not zero-rated. South Africa introduced VAT in 1991 with a standard rate of 14%. There is no reduced VAT rate, except for zero-rated supplies. The supply of certain goods and services is exempt, including certain financial services, residential accommodation in a dwelling and educational services. Certain supplies are zero-rated, including the supply of an enterprise as a going concern. Tanzania introduced VAT in 1998 with a standard rate of 20%, and no reduced rate except the zero rate. Uganda introduced VAT in 1996 at a standard rate of 18%. The supply of goods which are exported from Uganda are zero-rated. Zimbabwe introduced VAT in 2003 with three different VAT rates a standard rate of 15% (since increased to 17.5%), a special rate of 22% for cellular telecommunication services, and a zero rate. Editor: Ian Wilson Written by R C (Bob) Williams Sub-editor and layout: Carol Penny Distribution: Elizabeth Ndlangamandla Tel (011) Fax (011) This publication is provided by PricewaterhouseCoopers Inc. for information only, and does not constitute the provision of professional advice of any kind. The information provided herein should not be used as a substitute for consultation with professional advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all the pertinent facts relevant to your particular situation. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the author, copyright owner or publisher. Copyright 2006 PricewaterhouseCoopers Inc. All rights reserved. PricewaterhouseCoopers refers to PricewaterhouseCoopers Inc (a South African incorporated entity) or, as the context requires, the network of member firms of PricewaterhouseCoopers 12 International Limited, each of which is a separate and independent legal entity. Regional offices Bloemfontein (051) Cape Town (021) Durban (031) East London (043) Johannesburg (011) Port Elizabeth (041) Pretoria (012)