FEBRUARY 2012 ISSUE 149 CONTENTS INCOME Share scheme ruling TAX ADMINISTRATION VALUE ADDED TAX Imported services SARS NEWS

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1 FEBRUARY 2012 ISSUE 149 CONTENTS COMPANY TAX Mining rehabilitation funds DEDUCTIONS Future expenditure on contracts EMPLOYEES TAX International labour broking FRINGE BENEFITS Residential accommodation INCOME Share scheme ruling TAX ADMINISTRATION Legal professional privilege VALUE ADDED TAX Imported services SARS NEWS Interpretation notes, media releases and other documents COMPANY TAX Mining rehabilitation funds Mining companies are obliged to perform environmental rehabilitation of mining sites upon the decommissioning or termination of mining activities. Section 37A of the Income Tax Act, No. 58 of 1962 (the Act) aligns tax policy with environmental regulation. It regulates mining rehabilitation funds (rehabilitation fund) created with the sole object of applying their property for the environmental rehabilitation of mining areas and grants a tax deduction for payments made to such dedicated rehabilitation funds. Section 37A requires the assets of rehabilitation funds to be strictly utilised in accordance with their objects. What happens though, when the rehabilitation fund is no longer needed, or has fulfilled its purpose and has surplus assets? What are the tax implications of amending or terminating a rehabilitation fund? Section 37A of the Act was introduced in 2006 it grants a deduction to mining companies that pay cash into a rehabilitation fund which complies with section 37A.

2 Section 37A imposes strict rules in respect of rehabilitation funds, for example: the rehabilitation fund may only apply its assets for prescribed rehabilitation purposes; once the rehabilitation has been completed to the satisfaction of the Minister of Minerals and Energy, (the Minister) of the rehabilitation fund is obliged to transfer its assets to a similar company or trust, or to an account of a company or trust prescribed by the Minister and approved by the Commissioner for the South African Revenue Service (the Commissioner); and should the rehabilitation fund meet all its liabilities and have sufficient assets to perform the required rehabilitation, it may transfer any surplus assets to another company or trust approved by the Commissioner. Section 37A does not appear to contemplate a situation where the rehabilitation fund has completed its rehabilitation work and has surplus assets, and the mining company does not have similar funds to which the assets of the rehabilitation fund can be transferred, or where the mining company wants to transfer the assets of the rehabilitation fund to a similar fund, for value. Non-compliance with section 37A carries penalties - income tax is imposed on the mining company and/or the rehabilitation fund, if section 37A is contravened. In some instances, the South African Revenue Service (SARS) has a discretion to reduce the income tax so imposed. If the rehabilitation fund distributes its property for purposes other than the prescribed rehabilitation, section 37A(7) states that an amount equal to the market value of the property that was so distributed, is deemed to be taxable income of the rehabilitation fund for that year of assessment. The inclusion of the market value of the property so distributed is peremptory and SARS has no discretion to waive the inclusion. Section 37A(8) is a catch all provision that applies to any contravention of section 37A. Where section 37A has been contravened in any manner, the Commissioner may include an amount equal to twice the market value of all property held in the rehabilitation fund, on the date of contravention, in the rehabilitation fund s taxable income, and include the amount that the mining company contributed to the rehabilitation fund (and claimed a tax deduction for), in the mining company s income, to the extent that the property in the rehabilitation fund was directly or indirectly derived from cash paid to the rehabilitation fund. Both the rehabilitation fund and the mining company pay tax where section 37A(8) is triggered, but the Commissioner has a discretion to reduce the taxable income as he deems fit. An inclusion in income tax in terms of section 37A(7) is not discretionary, whereas the Commissioner has a discretion in respect of imposition of tax in terms of section 37A(8).

3 So, what needs to be taken into account if a mining company wants to terminate or amend the objects and rules of the rehabilitation fund (for example to allow for the transfer of funds to a fund which is not a section 37A fund)? Firstly, the additional tax that will be triggered by any contravention or non-compliance with section 37A, has to be taken into account. Also, the contents of the constitutional documents of the rehabilitation fund (which is normally a company or a trust) will probably have to be amended. Typically the trust deed or company s articles of association or memorandum of incorporation would have been drafted to comply with section 37A, and these documents may have to be amended to change the objects of the rehabilitation fund and the purpose for which the rehabilitation fund was established. The directors or trustees of a rehabilitation fund are obliged to act in accordance with the constitutional documents in order to legally effect an amendment or termination. If the rehabilitation fund is a trust, for example, the trustees will have to take care to act in terms of the trust deed. This principle was entrenched in the authoritative South African case on the law of trusts, Land and Agricultural Development Bank of SA v Parker and others [2004] 4 All SA 261 (SCA), which provides commentary on the invalidity of trustees actions which are not in line with the provisions of the trust instrument: It [the trust] vests in the trustees, and must be administered by them and it is only through the trustees, specified as in the trust instrument, that the trust can act. Who the trustees are, their number, how they are appointed, and under what circumstances they have power to bind the trust estate are matters defined in the trust deed, which is the trust s constitutive charter. Outside its provisions the trust estate cannot be bound. Since the constitutional documents of the rehabilitation fund would have been drafted to comply with section 37A, it can be assumed that any amendment or termination of the rehabilitation fund needs to be made with the approval of the Commissioner. Questions arise about whether the Commissioner will consent to an amendment of rehabilitation funds. The Commissioner should not be legally precluded from approving such an amendment to the constitutional documents, but this will depend on the facts of every case. Any amendment of the constitutional documents which places the objects and assets outside the ambit of section 37A of the Act, could result in a contravention of sections 37A(3) and (4) (which specify to whom assets can be transferred to upon termination or closure) and the trustees or directors will have to take the tax and/or penalties imposed by section 37A, into account. On a practical level, the following should be taken into account in respect of amendments to section 37A rehabilitation funds: Submissions will have to be made to the Commissioner advancing reasons why the additional tax referred to in section 37A(8) should not be imposed. The Commissioner is obliged to apply his mind and consider any submissions made, fairly and he should take into account the income tax imposed in terms of section 37A(7) as well as the fact that the company had enjoyed the benefit of a tax deduction in terms of section 37A, before exercising his discretion in terms of section 37A(8);

4 Furthermore, it is likely that the Commissioner may request that the assets in the rehabilitation fund be transferred to a similar account specified by the Minister (as contemplated in section 37A(3)(b) of the Act). However, if the mining company is not prepared to agree to such a transfer, it is unlikely that SARS can insist on this. It would be prudent to approach the Commissioner for prior approval to amend the constitutional documents of the rehabilitation fund and for a decision on how he will exercise his discretion in terms of section 37A(8), before making a final decision about the assets in the rehabilitation fund. Bowman Gilfillan IT Act: s 37A DEDUCTIONS Future expenditure on contracts An interesting Binding Private Ruling (BPR) was issued by the South African Revenue Service (SARS) on 19 September 2011 dealing with the application of section 24C of the Income Tax Act No. 58 of 1962 (the Act) to a maintenance trust. In BPR 106, the applicant is a trust that will be set up for the purpose of maintaining the burial grounds of a private cemetery. A separate company will operate the private cemetery for individuals who subscribe to the idea of being at one with nature. Clients of the company will then enter into burial agreements with the company in terms of which they acquire a final resting right, either to be buried or have their ashes scattered on the burial grounds. An amount will be paid by the client to the company for acquisition of the final resting right with another amount being paid by the client to the trust for the maintenance of the burial grounds. SARS ruled that, inter alia, the trust will be entitled to an allowance under section 24C in each year of assessment in which it has an obligation to incur future maintenance expenditure in fulfillment of its maintenance obligations under burial agreements. To put BPR 106 into perspective and why section 24C is so important to the trust, one has to firstly look at the basic "gross income" principles in the Act. The amounts received upfront by the trust will be included in its "gross income" without being necessarily matched by a corresponding deduction in the form of deductible maintenance expenditure. Prior to the introduction of section 24C, taxpayers have on occasion suffered the hardship of paying tax on income received in advance without enjoying any relief for expenditure yet to be incurred. What section 24C provides is an allowance in respect of future expenditure on a contract, provided the income of the taxpayer includes an amount received in terms of that contract which will be utilised in whole or in part to finance that future expenditure to be incurred in the performance of his contractual obligations. The difficulty with section 24C and where many

5 taxpayers have fallen short in the courts is that it seemingly does not apply to contingent expenditure. This is confirmed by the conditions and assumptions in BPR 106 where it is stated that the section 24C ruling will not be applicable in relation to expenses of a contingent nature. The issue of utilising section 24C to possibly deduct contingent expenditure has always been contentious, if one has regard to case law on the subject. In ITC 1601 [1995] (58 SATC 172) the taxpayer sought to claim a provision for warranties and rectification, which failed on appeal. The taxpayer carried on the business of process control engineering and sold computer hardware and measuring equipment, among other things. Its standard offer of contract and sale contained a warranty against defective workmanship and materials supplied and it also made it clear that all manufacturers' goods supplied to customers carried the manufacturer's warranty. Even though ITC 1601 was only a review hearing the court made the following statement regarding the legal requirements of section 24C: ''Counsel for the Commissioner, in my view, correctly contended that the Commissioner will not be satisfied that future expenditure will be incurred where there is only a contingent liability. There must be a clear measure of certainty as to whether the expenditure in contention is quantified or quantifiable. Since a deduction is sought, this must arise from an obligation and must be quantifiable.'' One would think that, bearing in mind that section 24C is an allowance for future expenditure to be incurred, i.e. amounts to be laid out in one or more years into the future, one would expect a lesser degree of certainty, precisely because of the lack of precision with which one deals in these circumstances. Criticism has been levied against ITC 1601 on the basis that had expenditure not been contingent in the first place there would be no need for section 24C, based on the fact that the liability will be absolute and thereby qualifying for deduction under section 11(a). In a situation similar to BPR 106, the taxpayer emerged victorious in ITC 1697 [1999] (63 SATC 146), which involved a share-block company operating a timeshare scheme where each member of the scheme was obliged at the beginning of each financial year to contribute a levy to the company, which it applied towards administering the scheme and maintaining the fixed and moveable property. The court held that the company's liability for future expenditure was unconditional, the amounts involved were certain and, therefore, a full benefit under section 24C was available. The answer to the taxpayer's success lay in the procedure adopted in estimating its obligations under the use agreement (the contract for purposes of section 24C). The court stated the following: ''It is not for a rainy day, so to speak, that amounts are included in the annual levies which the directors have to estimate for covering future expenditure. Quite the contrary is the position. Not every item of expenditure is of course an annual requirement, and in each year's budget, which is presented to the annual general meeting, an estimate is made of the necessary expenditure for the following three years for each and every item relating to the administration of the scheme and the maintenance of the taxpayer's fixed and moveable property, whether such item is an annual requirement or not.''

6 In respect of the accuracy of the estimated expenditure, the following was said in ITC 1697: ''The list attached to the budget is of importance. It reflects that, quite apart from the annual items of expenditure, based on the experience and expertise of Mr. C and his firm, it is carefully predicted when and in which year each and every item concerned will become payable, and in the case of assets which will require to be replaced or repaired, when and in which year it will become necessary and what the costs will be. The court agreed that there was a clear measure of certainty that the expenditure will be incurred and accepted the tests laid down in ITC 1601, which worked in favour of the taxpayer. This begs the question that if one should treat section 24C as the exception to the general rule it could possibly be argued that expenditure normally regarded as being contingent, would fall within the scope of section 24C and be deductible. Cliffe Dekker Hofmeyr IT Act: s 11(a), s 24C, BPR 106 EMPLOYEES TAX International labour broking International labour broking came under the tax spotlight recently in the United Kingdom (UK) where the case of Mr Tomislav Kljun v HMRC [TC/2010/04825] was heard in the First-Tier Tribunal. The case has a complicated set of facts but essentially involves Mr Kljun, a Croatian resident, who entered into an employment contract with a company in Cyprus. The company in Cyprus then deployed Mr Kljun, for a fee, to a company resident in the United Kingdom, which operates standby vessels in the oil and gas industry in the UK area of the North Sea continental shelf. Mr Kljun's remuneration was paid by the company in Cyprus, which deducted employees tax in accordance with prevailing tax legislation in the UK. This type of arrangement is generally referred to as the "international hiring out of labour". Mr Kljun argued that because he was not a resident or ordinarily resident in the UK for the 2007 and 2009 tax years, he was entitled to reclaim employees tax deducted, placing reliance on Article 15 of the Double Tax Agreement (DTA) between the UK and Yugoslavia (the Yugoslavia Treaty) dealing with Income from Employment. The DTA between the UK and Yugoslavia also covered Croatia of which Mr Kljun was a resident. The refund claims were rejected by HMRC. The court was required to decide whether there was an entitlement to exemption from UK tax under Article 15 of the Yugoslavia Treaty, which would revolve around the question of which entity was Mr Kljun's 'economic employer' or whether an 'economic employer' was actually present in the current circumstances. If the UK company was found to be his 'economic

7 employer', there would be no exemption from tax in the UK. In his grounds of appeal Mr Kljun contended that he was employed by the company in Cyprus throughout (with which he had an employment contract), he had no other employer and that it was in any event illegal to work for two employers at the same time. Mr Kljun averred that there was no 'economic employer' and more specifically, the UK Company, to which he was deployed was not his 'economic employer'. The court then proceeded to dissect Article 15 of the Yugoslavia Treaty and accepted that the commentaries on the Organisation for Economic Co-operation and Development's (OECD) Model Tax Convention, although not binding, would be of assistance in the current case. Before looking into the mechanics of Article 15 of the Yugoslavia Treaty the court dealt with the concept of 'employer' as used in the Treaty, versus the seemingly different concept of a 'person' as used in the Model Tax Convention. HMRC argued that the concept of 'person' was synonymous with that of 'employer' however, the court found the concept of 'person' to be of much wider application. Nonetheless, the court stated that the test remains essentially the same - one needs to determine which entity (person or employer) received the economic benefit of Mr Kljun's work. Because Mr Kljun's employment was physically exercised in the UK, the court accepted that his remuneration had the capacity to be taxed in the United Kingdom under Article 15(1) of the Yugoslavia Treaty. This was in fact the case and UK tax was deducted at source. However, if all the provisions of Article 15(2)(a)-(c) of the Yugoslavia Treaty were met, then Mr Kljun's remuneration would be exempt from tax in the UK. Mr Kljun passed the first hurdle under paragraph (a) in that he was not present in the UK for more than 183 days. The second condition, being Article 15(2)(b) of the Yugoslavia Treaty, is that the remuneration of Mr Kljun must have been paid by, or on behalf of, a person for whose benefit the relevant services were rendered and who was not a resident of the UK. The latter part of the test would be satisfied in that the company in Cyprus was not a UK resident however, the court was not convinced that the company in Cyprus was the person for whose benefit the relevant services were rendered. For reasons set out below the court found the UK company to be Mr Kljun's 'economic employer' for whose benefit the relevant dependent personal services were rendered, thereby precluding him from full tax relief in the United Kingdom. The Court stated that Mr Kljun's "... connection with a company based in Cyprus is tenuous at best..." as throughout his employment the company in Cyprus subcontracted most of its functions in connection with Mr Kljun. Further, Mr Kljun's employment contract was governed by English law, the pension provider was based in the UK and meetings / interviews regarding his employment did not take place at the local offices of his contractual employer. The aforementioned factors prompted the Court to suggest that the link with the company in the UK was greater than the link with the company in Cyprus. On further analysis of Mr Kljun's work schedules, holiday provisions, disciplinary procedures, redundancy terms and various other provisions the Court further suggested that, although the United Kingdom company was not his contractual employer, it was effectively acting as his employer in all but name and it was the person which benefitted from his services and bore the responsibility of risks for the results produced by him.

8 Having regard to the commentaries on the Model Tax Convention, the court stated that, in essence, it means looking at the substance over form and considering whether someone other than Mr Kljun's contractual employer in Cyprus was effectively the employer. In this case the court held that Mr Kljun's 'economic employer' was the UK company as it "... reaps the primary benefit..." of his employment, resulting in a failed attempt in exempting from tax his remuneration earned in the UK. Cliffe Dekker Hofmeyr OECD Model Tax Convention: Article 15(2)(a)-(c) FRINGE BENEFITS Residential accommodation Employers sometimes provide residential accommodation to employees, either because of the nature of an employee s duties or because of the location of an employer s work sites. In terms of the Seventh Schedule to the Income Tax Act No. 58 of 1962 (the Act) a fringe benefit will arise on the provision of accommodation by an employer to an employee unless an exemption applies. The fringe benefit value is the higher of an amount determined in terms of a formula or the actual rental paid. The remuneration paid to an employee is one of the key elements of the formula. The effect of this could be that two employees who are granted the same type of accommodation, but whose remuneration amounts differ, would be taxed on different amounts. The other effect of the formula is that the fringe benefit value is not always commercially realistic. This often occurs in the case of expatriates who earn high salaries but who do not qualify for any of the exemptions provided for. As expatriates are often tax equalised, an increase in their personal tax liability gives rise to an increased cost for the company bearing the expense. In situations where the residential accommodation formula gives rise to unrealistic values, an application can be made to the Commissioner for South African Revenue Service (SARS) for relief. The Commissioner has indicated that he will consider an application in the following circumstances: Where the property is situated in a remote area (e.g. mines) and there is no or a limited choice of accommodation for employees to rent or to buy Where the condition of the residential accommodation will result in a lower market value of the property The employee is forced due to the nature of his/her duties to stay near or on the employer s property The employee is highly paid and the average value of the accommodation in the area where it is situated is much less than the value determined in accordance with the formula.

9 The Commissioner has wide discretionary powers in terms of the Act in this regard. Employers often overlook the potential benefit they could derive from applying to the Commissioner to exercise his discretion. This requires an application to the Commissioner motivating (in a prescribed format) why the Commissioner should apply a lower fringe benefit value to the accommodation. Ernst & Young IT Act: Seventh Schedule, par 9 INCOME Share scheme ruling Share schemes, in various forms, have been the subject of a number of Binding Private Rulings (BPR) and Binding Class Rulings (BCR) since inception of the Advance Tax Ruling (ATR) process. This theme is continued with SARS releasing BCR 30 on 9 September 2011, which is sure to force a re-think in the way many current share schemes are structured, especially schemes based on the premise of utilising after tax money for participation. BCR 30 involves the application of section 8C of the Income Tax Act No. 58 of 1962 (the Act) to a Share Value Incentive Plan (SVIP) of a foreign company, registered as an external company in South Africa. The rules of the SVIP make a distinction between Bonus Invested Shares, Invested Shares and Matched Awards. Operation of the schemes is summarised below. Bonus Invested Shares are acquired on behalf of a participant at the current listed price and funded by way of a percentage of his / her after tax annual bonus. It appears from the ruling that the acquisition of Bonus Invested Shares is compulsory for qualifying participants. The shares so acquired are then restricted for a period of three years with typical good and bad leaver scenarios generally found in schemes of this nature. Invested Shares are acquired by a participant on invitation only, at market related prices and funded by way of the remaining portion of his / her annual after tax bonus, after deducting the portion used to acquire the Bonus Invested Shares referred to above. Invested Shares are then restricted for a period of three years with the participant entitled to dividends during that period and enjoying voting rights in relation to the Invested Shares. After acquiring the Invested Shares on behalf of the participant, the remuneration committee will procure a Matched Award based on the value of Invested Shares acquired. On the face of it, it appears that the Invested Shares and Matched Awards are interlinked in that the participant may dispose of the Invested Shares, but in so doing the Matched Awards will correspondingly reduce or be forfeited. Acquisition of the Matched Awards after a period of three years from grant date is contingent upon the happening of certain events which include,

10 inter alia, being in employment and the meeting of certain performance targets. Matched Awards are also subject to various good and bad leaver scenarios and carry no voting or dividend rights. SARS ruled that the Bonus Invested Shares, Invested Shares and Matched Awards constitute "restricted equity instruments" for purposes of section 8C of the Act and any gain would therefore be subject to the deduction of employee's tax upon vesting. SARS also ruled that a deduction would be available for a participant to the extent that a loss arises on vesting, most likely because some, if not all, of the aforementioned schemes could be 'under water' at the time of vesting. There is nothing controversial about allowing the deduction as section 8C(2)(b) of the Act specifically provides for same. However, the issue of whether the use of after tax funds to acquire shares in a scheme falls within section 8C, requires closer scrutiny. Section 8C of the Act governs the taxation of "equity instruments" and is limited to "equity instruments" acquired by a taxpayer: by virtue of employment or the office of director of any company or from any person by arrangement with the taxpayer's employer; by virtue of any restricted equity instrument held by that taxpayer in respect in respect of which section 8C will apply upon vesting thereof; and as a restricted equity instrument during the period of employment by or office of director of any company from that company or an associated institution in relation to that company. In order for the provisions of section 8C of the Act to apply, the taxpayer must acquire the "equity instrument" "by virtue of his or her employment or office of director". If an "equity instrument" is acquired "by virtue of his or her employment or office of continued director" section 8C of the Act will be applicable and the taxpayer will be liable for income tax on the difference between the market value of the "equity instrument" and any consideration given in respect of that "equity instrument". Generally, section 8C of the Act will only be triggered when all the restrictions relating to the "equity instrument" cease to have effect. The crisp issue for consideration in relation to the use of after tax funds to acquire shares is whether the "by virtue of his or her employment" criterion will be met. The phrase 'by virtue of employment' requires a causal connection between the acquisition of the equity instrument and employment. Stated differently, section 8C does not apply to all equity instruments which an employee acquires but only to equity instruments which the employee acquires because he is an employee. The question that one would ask under the SVIP is whether the participants will acquire "equity instruments" because they are employees or because they chose to acquire the shares and pay for them with after tax funds. In Stander v CIR [1997] (59 SATC 212) it was held that the phrase, 'by virtue of any employment' in paragraph (c) of the "gross income" definition in section 1 of the Act means that services rendered or to be rendered must be the causa causans of the amount received and that it was not sufficient if such services were merely the causa sine qua non for the amounts received. The court drew a distinction between an event being a cause-in-fact, (a so-called conditio sine qua non) and a cause in law (legally relevant cause) and how that the mere fact that the recipient

11 would not have received the amount had he not been an employee was not sufficient to establish the causal link required for purposes of paragraph (c). In other words, the fact that employee's employment is the conditio sine qua non for the receipt of an amount does not necessarily mean that the amount is received in respect of services rendered. That will only be the case if the services constitute any causa causans (that is the real or proximate cause) of the receipt. With regard to the participants in BCR 30, their employment with the applicant or its subsidiaries is certainly the factual cause of the acquisition of the shares. For instance, when applying the "but for" test one would ask, but for the participants employment with the applicant, would he or she have acquired the shares? The answer is most likely no and the basic causal nexus may not exist. One could certainly advance the argument that in schemes of the nature in BCR 30, i.e. acquisition of shares with after tax money, the participant's employment is merely the causa sine qua non for the acquisition of the "equity instruments". In other words, something more is required in order to establish whether their employment is in fact the real or proximate cause or the causa causans for acquiring the shares. The following practical example can be used to illustrate the absurd result that may arise if one accepts the basis that a participant acquires the "equity instrument" as a result of his employment. For instance, if an employee uses his bonus to buy a car instead of shares, would anybody contend that he obtained the car by virtue of his employment relationship? One would argue that surely this cannot be the case, as every single thing that an employee buys with his salary and bonus are things which he would not have had but for the fact that he was employed (i.e. merely the causa sine qua non of the acquisition of the equity instrument). Given the possibly wide ramifications to similar share schemes currently being implemented, or already implemented that look to circumvent the application of section 8C of the Act, it is crucial that the terms of those schemes be scrutinised and possibly restructured. Cliffe Dekker Hofmeyr IT Act: s 1, definition of Gross Income, par c, s 8C, s 8C(2)(b) BCR 30 TAX ADMINISTRATION Legal professional privilege The issue of legal professional privilege arises in many circumstances. For instance, the South African Revenue Service (SARS), when asking for information from a taxpayer, usually requires such information in terms of section 74 and section 74A of the Income Tax Act No. 58 of 1962 (the Act). In these requests they sometimes ask for, amongst other things, all tax opinions relating to a particular transaction.

12 The Tax Administration Bill will, once it comes into effect, replace the provisions of section 74A of the Act and will set out the information which must be provided by a taxpayer on request from SARS. One of the few circumstances where documents do not have to be provided to SARS is where such documents are subject to legal professional privilege. Clause 64 of the Tax Administration Bill also recognizes legal professional privilege and sets out circumstances for determining whether such privilege applies to documents requested by SARS. In the recent UK case of Prudential PLC and Prudential (Gibraltar) Limited v Special Commissioner of Income Tax and Philip Pandolfo (HM Inspector of Taxes) [2010] EWCA Ci 1094, Prudential attempted to extend the existing rule of legal professional privilege to advice on tax law given by accountants. The court of appeal unanimously confirmed that legal professional privilege did not apply to any other professionals except solicitors and barristers. This matter is now on its second appeal and Prudential is again seeking to extend legal professional privilege beyond the legal profession. This article provides some background to legal professional privilege in SA and its importance in respect of tax disputes with SARS. The rationale of this privilege is that it promotes the public interest because it assists and enhances the administration of justice by facilitating the representation of clients by legal advisers. It encourages people to seek and obtain legal advice to ensure that the law is applied and that litigation is properly conducted. Lawyers are regarded as part of the system of administration of justice, and for that system to be able to function properly people must be able to obtain legal advice and representation, secure in the knowledge that what they disclose to their lawyers will remain confidential and be protected against public disclosure. Legal privilege applies to communications (written or oral) in the following two situations: Communications between a legal adviser and his client made for the purpose of obtaining or giving legal advice. Communications between legal adviser and client, or between either of them and a third party, for the purpose of preparing for litigation. The communication must have been made in confidence. The privilege is a right of the client, and has to be claimed. It can be waived, expressly or by implication. It does not apply when the advice is sought for a criminal or fraudulent purpose. The advice must have been sought and given in a professional capacity. Originally, legal professional privilege was restricted to barristers and solicitors (advocates and attorneys) as officers of the court, in independent practice, and subject to the ethics and discipline of their professions.

13 In modern times, when more lawyers are employed by large corporations, institutions and governments to provide in-house legal advice and services, the question has arisen whether legal professional privilege attaches to communications between them and their employers. In particular the issue arises whether legal professional privilege also applies to in-house counsel. In the UK case of Alfred Compton Amusement Machines Ltd v Commissioner of Customs and Excise (No.2),[1972] (2 QB 102) Lord Denning in the Court of Appeal expressed the view that legal professional privilege extends also to such in-house salaried legal advisers. In his view they were in the same legal position as lawyers who practised on their own account, the only difference being that they acted for one client rather than for many. A contrary view was expressed by the European Court of Justice in AM & S Europe Ltd v Commission of the European Communities [1982] E. Comm Ct. J. Rep (Case 153/79)on the grounds that in-house lawyers lack the independence to justify making their advice privileged, an independent lawyer being one who is not bound to his client by a relationship of employment. In SA the question of the extension of the privilege to salaried in-house legal advisers has yet to be definitively pronounced upon by the Supreme Court of Appeal, but at High Court level Lord Denning s view has been approved. In Mohamed v The President of the Republic of SA, [2001] ((2) SA 1145(C))Judge Hoffmann, after considering the matter in some detail, concluded as that to limit the scope of legal professional privilege to clients and lawyers in private practice is not, in my view, justified in law. Academic writers in SA tend to regard the question of the extension of the privilege to salaried legal advisers as being still an open one, but the weight of opinion seems now to be shifting in favour of such an extension. In the light of developments in the common law world and of the decision of the Cape High Court in Mahomed s case, it is considered that when it is finally seized of the matter, the Supreme Court of Appeal may well extend the privilege to salaried legal advisors. However, as in the UK Prudential case, it is unlikely that legal privilege will be extended to accountants providing tax advice. Edward Nathan Sonnenbergs [This article was first published in the Business Law Tax Review in October 2011]. IT Act: s 74, s 74A TAB: c 64 VALUE-ADDED TAX Imported services

14 In XYZ Co v The Commissioner for the South African Revenue Service (VAT 382) (Not yet reported), the Tax Court held that advisory services acquired from a foreign supplier in relation to an offer which unit holders in XYZ Co had received to eliminate their interests in the company, do not comprise imported services for Value-Added Tax (VAT) purposes. The Tax Court further held that the VAT incurred on local services acquired from legal and financial advisors in relation to the transaction, is not deductible as input tax. The trading activities of XYZ Co involved the mining and selling of diamonds from South Africa. It received a proposal from three of its main shareholders as a consortium to acquire the interests of the remaining shareholders in the company. The company appointed an independent foreign financial advisor to advise its board of directors as to whether the consortium s offer was fair and reasonable. The company also appointed certain local financial and legal advisors in relation to the offer and to implement the transaction. After being advised that the offer was fair and reasonable, the transaction was implemented through a scheme of arrangement pursuant to section 311 of the Companies Act No. 61 of The scheme in effect involved a buy-back of certain of the shares of linked unit holders in the company and a cancellation of the balance of the remaining shares, in return for the payment of cash and shares in a subsidiary company. The board of directors of the company which was listed on the Johannesburg, London and Swiss securities exchanges, was legally obliged to obtain proper advice on the offer and to provide the information to the holders of its linked units to enable them to reach an informed decision on the merits of the offer made by the consortium. The South African Revenue Service (SARS) assessed the company on the services it acquired from the foreign financial advisor, and disallowed the VAT it claimed as input tax on the local suppliers services. A legal obligation was imposed upon the board of directors of the company to obtain the services of an independent financial advisor to inform the holders of the linked units in the company of the fairness of the consortium s offer. The Tax Court therefore considered the cost in this regard to comprise an overhead cost of the company, which was acquired for the purpose of its diamond mining and selling enterprise. The Tax Court held that the definition of enterprise in the VAT Act should not be limited to apply exclusively to assets which are used directly in the making of taxable supplies, and found that the services did not comprise imported services because they were used and consumed by the company for the making of taxable supplies and in the course or furtherance of the company s enterprise of mining and selling diamonds. Unfortunately, the Tax Court did not consider the question as to the location where the services were consumed or utilised, as only services consumed or utilised in South Africa comprise imported services. The Tax Court differentiated the local services from the foreign services because it considered them to be incurred mainly to ensure the maximum transfer of shares and cash to unit holders,

15 both activities of which do not comprise enterprise activities as defined in the VAT Act. It accepted that certain of the local legal services related to the statutory obligation to provide information and advice to its linked unit holders, but it could not determine the portion that related to this obligation. The Court held that the VAT incurred on the local services did not comprise input tax and is therefore not deductible as such, save insofar as a certain portion of the local legal services are concerned. The Tax Court agreed with SARS counsel that the zero rating provisions of section 11(2) and the exemption provisions of section 12(a) only apply to supplies which would, in the absence of sections 11 and 12, have been subject to VAT at the standard rate, i.e. supplies in the course of an enterprise. The investment in its subsidiary company, which was distributed as part of the implementation scheme, did not comprise an enterprise activity and therefore fell outside the scope of VAT and is not zero rated, even though it may have been supplied to a non-resident. The VAT on the local legal expenses, where the services related to fulfilling the statutory obligation and those relating to the non-taxable activities could not be determined and was referred back to SARS for reassessment. It is understood that both parties have appealed the judgment. Vendors should, nevertheless, carefully consider the VAT implications of the services they acquire from foreign suppliers and local suppliers in relation to investment activities in view of the judgment. Edward Nathan Sonnenbergs VAT Act: s 11, s 11(2), s 12, s 12(a) Companies Act: s 311 SARS AND NEWS Interpretation notes, media releases and other documents Readers are reminded that the latest developments at SARS can be accessed on their website Legal and Policy Income Tax Act, 1962 Tax Information Exchange Agreement between South Africa and San Marino Legal and Policy Income Tax Act, Guide on Income Tax and the Individual (2010/2011) Legal and Policy Income Tax Act, 1964 Notice of withdrawal of Practice Notes with effect from 1 January 2012 (Practice Notes 8 of 1988 and 16 of 1993 were withdrawn) Legal and Policy Publications Tax Guide for Small Businesses 2011/2012 Legal and Policy Publications Guide for Tax Rates/Duties/Levies (Issue 8) Legal and Policy Publications Tax Brochure for Non-Residents

16 Legal and Policy Customs and Excise Act, 1964 Draft forms relating to MIDP, i.t.o. rebate item due date for comments is extended to 31 January 2012 Legal and Policy Income Tax Act, Draft Interpretation Note on Connected Persons comments due by 29 February 2012 Legal and Policy Guide on Taxation of Foreigners working in South Africa (2010/2011) Legal and Policy - Taxation Laws Amendment Act, 2011 (Act No. 24) Legal and Policy - International Treaties and Agreements - Double Taxation Agreements and TIEAs and MAA Agreements updated. Legal and Policy Schedules to the Customs and Excise Act, 1964 (Tariff Book) updated. Editor: Mr M E Hassan Editorial Panel: Mr KG Karro (Chairman), Dr BJ Croome, Mr MA Khan, Prof KI Mitchell, Prof L Olivier, Prof JJ Roeleveld, Prof PG Surtees. The Integritax Newsletter is published as a service to members and associates of The South African Institute of Chartered Accountants (SAICA) and includes items selected from the newsletters of firms in public practice and commerce and industry, as well as other contributors. The information contained herein is for general guidance only and should not be used as a basis for action without further research or specialist advice. The views of the authors are not necessarily the views of SAICA. All rights reserved. No part of this Newsletter covered by copyright may be reproduced or copied in any form or by any means (including graphic, electronic or mechanical, photocopying, recording, recorded, taping or retrieval information systems) without written permission of the copyright holders.