FEBRUARY 2015 ISSUE 185 CONTENTS MINING TRUSTS

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1 FEBRUARY 2015 ISSUE 185 CONTENTS COMPANIES Asset for share transactions Venture capital companies: the investors DEDUCTIONS Improvements on Government land GENERAL Conducting farming operations MINING Provision for mining rehabilitation TRUSTS Pitfalls in dealing with trusts SARS NEWS Interpretation notes, media releases and other documents COMPANIES Asset for share transactions The Income Tax Act No. 58 of 1962 (the Act) contains a number of provisions in terms of which assets may be transferred from one taxpayer to another on a tax-free basis, with the tax in relation to such an asset being deferred until the transferee eventually disposes of the asset. One such provision is contained in section 42, dealing with asset-for-share transactions. 1

2 An asset-for-share transaction is essentially a transaction in terms of which a person (the Transferor) disposes of an asset to a company (the Company) in exchange for the issue of shares by the Company, provided the Transferor holds a qualifying interest in the Company at the end of the day of the transaction (broadly speaking, 10% of the equity shares and voting rights in an unlisted company, or any equity shares in a listed company). In addition, certain qualifying debt may be assumed by the Company as part of the asset-for-share transaction, without prejudicing the application of section 42. Broadly speaking, in relation to capital assets, an asset-for-share transaction results in no capital gain for the Transferor with the Company acquiring the asset at the same base cost at which the Transferor held it. The base cost of the asset accordingly rolls over to the Company and the deferred capital gain on the asset is accordingly only triggered when the Company disposes of the asset, unless any relief finds application at such time. In addition, the Transferor acquires the shares in the Company at a base cost equal to the base cost at which it held the asset disposed of to the Company. Section 42(8) provides that a proportionate part of any qualifying debt that was assumed by the Company as part of an asset-for-share transaction will constitute an amount received by or accrued to the Transferor in respect of the disposal of any of the shares in the Company acquired in terms of the asset-for-share transaction, should such shares be disposed of by the Transferor. Essentially, section 42(8) provides that the Transferor will have additional proceeds upon the disposal of the shares equal to a proportional amount of the debt that was assumed by the Company. The reason for this provision appears to be to counteract the base cost allocated to the shares in terms of section 42 where the assets disposed of are geared. For example: Person A borrowed R100 from a bank and utilised the funding to 2

3 acquire an asset. The asset accordingly has a base cost of R100 in the hands of Person A. Assume the asset grows in value to R150. Person A then disposes of the asset to Company B in exchange for the assumption of the R100 debt and the issue of shares in Company B. Simplistically speaking, the value of the shares acquired by Person A in Company B will be R50 (being the net asset value). However, in terms of section 42, the base cost at which Person A will acquire the shares in Company B, will be deemed to be equal to the base cost at which Person A held the asset, i.e. R100. But for the application of section 42(8), if Person A were to dispose of the shares in Company B at their market value (R50), Person A will trigger a capital loss of R50 (R50 proceeds less R100 base cost). However, in terms of section 42(8), Person A will be deemed to have additional proceeds equal to the debt that was assumed by Company B in terms of the asset-for-share transaction, in this case R100. This will result in Person A triggering a capital gain of R50 upon a disposal of the shares (R50 real proceeds plus R100 deemed proceeds, less R100 base cost) which mimics the commercial gain of Person A. Generally, the application of section 42(8) does not place the Transferor in a worse position than would have been the case had it retained the asset and was taxed on the growth in value in the asset. However, the application of section 42(8) could have detrimental consequences in certain instances: Firstly, most of the roll-over relief provisions in the Act do not contain explicit roll-over relief in relation to the deemed additional proceeds triggered in terms of section 42(8). Accordingly, should shares acquired in terms of an asset-for-share transaction be disposed of in terms of another transaction qualifying for corporate roll-over relief, such relief may not cater for a gain which may arise as a result of the application of section 42(8). Furthermore, the roll-over relief provisions may result in a rolled-over base cost for the transferee, despite a capital gain being 3

4 triggered in the hands of the Transferor as a result of the application of section 42(8); Secondly, section 42(8) may give rise to detrimental consequences where the debt that was assumed in terms of the asset-for-share transaction was not applied in order to fund fixed assets (but, for example, to fund working capital in the case of a sale of a business in terms of an asset-forshare transaction). In such an instance, the base cost of the shares will not equate to the debt that was assumed in terms of the asset-for-share transaction, which may result in additional tax in the event of the disposal of the shares. Lastly, it is important to remember that there is no time limitation to the application of section 42(8). In terms of current law, it will continue to find application to a disposal of shares acquired in terms of an asset-for-share transaction, irrespective of the time period that elapses between the asset-forshare transaction and the future disposal of the shares. This is a further aspect which should be borne in mind, inter alia, in determining whether an asset-forshare transaction is an appropriate arrangement in terms of which to implement a disposal. ENSafrica ITA: Section Venture capital companies: the investors (Refer to article 2347 in the October 2014 Issue 181) Introduction This is the second in a series of articles on venture capital companies. This article looks at the conditions relating to the investors. In particular, it looks at the way the investors are permitted to hold their investments in the venture 4

5 capital company (VCC) in order to qualify for the tax concessions available to them and with transactions within the VCC. Venture capital companies the investment process The tax treatment of the investors Who are the investors? Investors in VCCs may be individuals or corporate entities. Under certain circumstances, individuals who subscribe for shares in VCCs may consider that investment as part of their retirement planning, particularly in the light of 5

6 forthcoming retirement funding restrictions. Individuals may choose to invest directly in VCCs or through intermediate passive investment holding companies which will benefit from the dividends tax exemption and in certain cases lower rates of corporate income tax at 28% compared to individuals where the highest rate of personal income tax is 40%. However, companies suffer higher rates of capital gains tax compared to individuals: 18.6% compared to 13.3% respectively. Operating companies which invest in VCCs should consider, apart from the tax benefits, whether such investment qualifies for enterprise and social development points in terms of the broad based black economic empowerment codes. Upfront income tax relief VCC investors enjoy an immediate tax deduction equal to 100% of the amount invested with no annual limit or lifetime limit (section 12J of the Income Tax Act No. 58 of 1962 (the Act)). The tax relief is available provided that the VCC investor subscribes for equity shares (as defined in section 1(1) of the Act), as opposed to buying them second hand from other VCC investors. The VCC scheme only applies to VCC shares acquired on or before 30 June The VCC investors must support their claim for a tax deduction with a certificate issued by the VCC stating the amounts invested in the VCC and that the Commissioner approved that VCC. The table below compares the effect of the upfront income tax relief on an individual, trust or company VCC investor. It assumes that the investor subscribes for shares in the VCC in an amount of R100,000. Although individuals are taxed at progressive rates of income tax it is assumed for the purpose of this example that the individual is in the 40% income tax bracket. 6

7 Table 1. The effect of the upfront income tax relief Individual / Company Trust investor investor Cost of the VCC investment Subscription in VCC shares R100,000 R100,000 Income tax rate 40% 28% (Less) tax relief (R40,000) (R28,000) Net cost of the investment R60,000 R72,000 Initial value of the VCC investment Gross subscription by the investor R100,000 R100,000 Issue costs (say 5%) R5,000 R5,000 Initial net asset value R95,000 R95,000 Initial uplift: (Rand) R35,000 R23,000 Initial uplift ( As a percentage of 58% 32% net cost) Taxable recoupment The Act specifically makes taxable any recoupment or recovery of an amount which was allowed to be deducted under the provisions of section 12J. According to the Taxation Laws Amendment Bill there will be no claw back of the upfront income tax relief if the VCC shares are held by the VCC investor for 5 years. VCC shares are not listed Unlike shares in real estate investment trusts there is no statutory requirement for VCC shares to be listed. Thus, VCC shares tend to be highly illiquid. No capital gains tax (CGT) relief 7

8 The investor does not enjoy any VCC-specific CGT exemption on the disposal of the VCC shares. Accordingly, CGT is payable upon the sale of the VCC shares. For individuals the maximum rate of CGT is 13.3%; for companies, 18.6%, and for trusts, 26.6%. Where a VCC investor claims the section 12J tax deduction on the subscription price for the VCC shares then the base cost of the VCC shares will be reduced to zero. As a result the investor will not have any base cost in the VCC shares to shield the subsequent proceeds from CGT. To make the investment in a VCC more attractive, an exemption from CGT on the disposal of the VCC shares would be welcomed. Dividends tax Investors will seek to make a return on their VCC investments either through dividends arising from dividends paid by the underlying companies to the VCC or dividends arising from the VCC disposing of the shares in the underlying companies. Dividends received by the VCC investors in respect of their VCC shares are subject to the 15% dividends tax unless the investor qualifies for an existing dividends tax exemption. SA resident company VCC investors will enjoy the company-to-company dividends tax exemption. However, individual VCC investors remain subject to the 15% dividends tax. No CGT reinvestment relief It is not possible for an investor to defer the gain on another investment by applying the sale proceeds to subscribe for VCC shares. Thus, investors that sell their, say, Sasol or MTN shares in order to reinvest the proceeds in VCC shares will be subject to CGT on the sale of the Sasol or MTN shares. The after-tax proceeds from the sale of those shares may then be invested in VCC shares. No capital loss relief against income 8

9 Losses of a revenue nature can usually be set off against both income and capital gains, while capital losses may only be set off against capital gains. An investor in VCC shares that derives a capital loss (although very unlikely) will not be able to set off that capital loss against its income gains. The investment in the VCC must take the form of equity shares Equity shares are defined more restrictively than shares The section 12J deduction is limited to a subset of shares defined as equity shares. The terms shares and equity shares are used frequently throughout the Act. The equity share incorporates the share definition (equity share means any share) with an important exclusion. Equity shares exclude so-called fixed rate shares. Thus, where a share entitles an investor to a fixed rate dividend it is excluded from the definition of equity share. Debt instruments ineligible Since the tax relief is limited to equity shares, it follows that VCC investors will not qualify for the section 12J tax deduction if they subscribe for debt instruments in the VCC. Hybrid equity instruments and third party backed shares ineligible The VCC scheme also excludes hybrid equity instruments and third-party backed shares as these types of instruments have features in common with debt instruments and are therefore considered safer forms of investment. Can a VCC investor borrow to fund its investment? Although there is no prohibition on VCC investors borrowing funds to acquire VCC shares, the calculation of the section 12J deductible amount is subject to a number of requirements and limiting factors. There are two basic requirements: The first requirement: has the taxpayer used any loan or credit for the payment or financing of the whole or any portion of the VCC shares? 9

10 The second requirement: does the taxpayer owe any portion of the loan or credit at the end of the tax year? If the answers to both requirements are yes, then the taxpayer has cleared the first hurdle. The second hurdle is a limiting factor. The amount which may be taken into account as expenditure that qualifies for a deduction must be limited to the amount for which the taxpayer is deemed to be at risk on the last day of the relevant tax year. A taxpayer is deemed to be at risk to the extent that the incurral of the expenditure to acquire the VCC shares (or the repayment of the loan or credit used by the taxpayer for the payment or the financing of the expenditure to acquire the VCC shares), may result in an economic loss to the taxpayer were no income to be received by or accrue to the taxpayer in future years from the disposal of any VCC shares. A taxpayer is not deemed to be at risk to the extent that the loan or credit is not repayable within a period of 5 years from the date on which the loan or credit was advanced to the taxpayer. A taxpayer is also not deemed to be at risk to the extent that the loan or credit is granted directly or indirectly to the taxpayer by the VCC itself. The exit mechanisms Unlike a real estate investment trust (regulated by section 25BB of the Act), the VCC shares do not have to be listed. This means that there is no ready market for the secondary trade in these VCC shares. It also means that existing investors cannot exit their investments by placing them for sale on the JSE. 10

11 The absence of a secondary market for the trade in VCC shares makes it difficult to understand how the proposal in the 2014 National Budget Review (proposing transferability of tax benefits when investors dispose of their holdings) would be practically implemented. In reality, VCC shares will be illiquid. The VCC will have to offer the investors an exit route. Existing investors will in all likelihood realise value for their investments through: trade sale of investments by the VCC followed by a distribution of cash to the investors; a repurchase of the investors VCC shares by the VCC; or a consolidation and listing of underlying investments and distribution of shares as dividends in specie to the investors. Trade sale of investments by the VCC followed by a distribution of cash to the investors In a trade sale, the VCC sells all of its shares in an investee company to a trade buyer, i.e. a third party often operating in the same industry as the company itself. This method provides a complete and immediate exit from the investment. The VCC will be subject to capital gains tax at the rate of 18.6% on the sale of the shares in the investee companies to the trade buyers. The VCC may distribute the after-cgt cash proceeds it derives from the trade sale to the VCC investors. These distributions may constitute a dividend or a return of capital or a combination of the two. Dividends distributed by the VCC to the VCC investors generally attract dividends tax at the rate of 15%. Certain VCC investors such as resident companies are exempt from dividends tax. Return of capital payments fall under a different system of tax compared to tax on dividends. Return of capital payments are treated as proceeds subject to 11

12 capital gains tax. The main distinction between a dividends versus a return of capital distribution is based on whether the distribution comes from Contributed Tax Capital (CTC). Distributions from CTC qualify as a return of capital while distributions from other sources qualify as dividends. Repurchase of the investors VCC shares by the VCC The investors will be subject to either dividends tax or capital gains tax or a combination of the two on the repurchase of their VCC shares. SA resident corporate investors will enjoy the dividends tax exemption. Thus, only individual investors will be subject to the dividends tax. One method for individual investors to defer the dividends tax is to hold their VCC shares through a passive investment holding company. The dividends paid by the VCC to the passive investment holding company will be exempt from dividends tax. However, the eventual distribution of cash flow from the passive investment holding company to the individual investor will be subject to dividends tax. This structure allows the individual investor to defer - not avoid - dividends tax. On the negative side the passive investment holding company is subject to 18.6% capital gains tax whereas the individual investor is subject to 13.3% capital gains tax. There is no capital gains tax exemption at the investor level on the disposal of VCC shares. The VCC investor whether an individual or juristic entity will be subject to capital gains tax on the repurchase of their shares by the VCC. There is nothing in the present set of rules that prevents a VCC investor selling its shares back to the VCC and using the proceeds to subscribe for another shareholding in the VCC. Although there are no rules that prevent the aforementioned repurchase-followed-by re-subscription scenario there are two rules that lessen the tax benefit for the VCC investors. 12

13 The first is that the VCC legislation contains a rule that an investor that becomes a connected person in relation to the VCC after the subscription for the VCC shares is not allowed the upfront income tax deduction. However, a corporate investor only becomes a connected person in relation to the VCC if, inter alia, it forms part of the same group of companies as the VCC or if it holds at least 20% of the equity shares or voting rights in the VCC and no other shareholder holds the majority voting rights in the VCC. If a corporate investor keeps its shareholding below these limits and avoids the connected person classification, then it may be able to benefit from this arrangement. The second is that there is presently no capital gains tax exemption for the VCC investor when it disposes of the VCC shares. The VCC investor will have to reduce the base cost of the VCC shares by the amount claimed as an income tax deduction in terms of section 12J. Thus, a VCC investor which subscribes for VCC shares for R and claims that amount as a section 12J tax deduction has a base cost of zero. Consolidation and listing of underlying investments and distribution of shares as dividends in specie to the investors A distribution by the VCC that results in the disposal of shares in the investee companies generates a capital gain or loss for the VCC at market value as if the shares distributed to the VCC investors were sold to the VCC investors at market value. This rule exists as a matter of tax parity within the corporate tax system a straight asset distribution should have the same tax impact as the VCC selling the shares in the investee companies followed by a distribution of after-tax cash proceeds. The tax considerations should accordingly be similar to the tax consequences of the trade sale of investments by the VCC followed by a distribution of cash to the investors which is discussed above. ENSafrica 13

14 ITA: Sections 1(1) definition of equity shares, 12J and 25BB Taxation Laws Amendment Bill 2014 (The Bill was promulgated as an Act on Tuesday, 20 January 2015) DEDUCTIONS Improvements on Government land (Editorial note: Published SARS rulings are necessarily redacted summaries of the facts and circumstances. Consequently, they (and articles discussing them) should be treated with care and not simply relied on as they appear.) On 1 October 2014, the South African Revenue Service (SARS) released Binding Private Ruling 180 (BPR 180) dealing with the question of whether a taxpayer, who is a party to a Public Private Partnership (PPP), would qualify for a deduction under section 12N of the Income Tax Act No. 58 of 1962 (the Act) in respect of improvements effected on land not owned by the taxpayer. In respect of PPP s, Government often undertakes to provide underlying land to a private party for the construction of buildings or the improvement of the land, without parting with ownership of such land. Section 12N allows for private parties to a PPP to claim deductions in respect of improvements effected on land or buildings owned by Government, even though the private party only has a right of use or occupation of the land. To qualify under section 12N, a private party must: hold a right of use or occupation of the land or buildings; effect improvements on the land or buildings in terms of a PPP; 14

15 incur expenditure to effect the improvements; and use or occupy the land or buildings for the production of income, or derive income from the land or buildings. By way of background, a company incorporated in and a resident of South Africa (applicant) and a department of the National Government (department) entered into a PPP in terms of which it was agreed that under the proposed transaction, the applicant would: finance, design, construct, operate and maintain a new serviced head office building for the Department that is to be constructed on land owned by the Government; and assume the financial, technical and operational risk for the project. The applicant would be able to use subcontractors to carry out its obligations for both the construction and the operational phases of the PPP. The PPP provided for a unitary payment to be made by the department to the applicant of the capital amount owed to the applicant, together with interest and service fees. Furthermore, during the construction phase, the applicant would be granted possession of and access to the project site to construct the serviced head office building. The operational phase would commence thereafter. It is important to note that the applicant would not hold any right of use or occupation of the land or the serviced head office building by virtue of any term of the PPP. The applicant would only be given access to the new building exclusively for purposes of providing the services as described in the PPP. The issue under consideration before SARS was whether the applicant qualified for any of the deductions referred to in section 12N in respect of the improvements effected on land not owned by the taxpayer. 15

16 SARS ruled that the applicant did not comply with the requirements of section 12N and therefore did not qualify for any deduction under any provision referred to in section 12N. The Taxation Laws Amendment Bill of 2014 (the Bill) was introduced to Parliament on 22 October The Explanatory Memorandum on the Bill notes that under certain PPP arrangements a private party is not able to meet the criteria of section 12N. Specifically, the private party will not necessarily have the right of use or occupation of the land or buildings. The private party could, for example, only have a right to access the land or building in order to perform under the PPP. As a result, the private party is not able to claim any deduction under section 12N and this has an effect on the overall pricing of the project. The Bill proposes the insertion of section 12NA into the Act, which addresses the above problem and will essentially allow a private party to claim a special capital allowance in respect of improvements to State-owned land and buildings where the Government has the right to use or occupy the land or buildings, and not the private party. In order to claim this special allowance, the private party must: be a party to a PPP agreement with Government; and incur expenditure of a capital nature. The proposed insertion of section 12NA to the Act will come into operation on 1 April 2015 and will apply in respect of expenditure incurred to effect improvements during any year of assessment commencing on or after that date. It is evident that the insertion of section 12NA to the Act will provide relief to those private parties to PPPs, who find themselves in a position similar to the 16

17 applicant, where they do not have the right of use or occupation of land or buildings owned by the Government and to which improvements have been effected. Cliffe Dekker Hofmeyr BPR: 180 ITA: Sections 12N and 12NA Taxation Laws Amendment Bill of 2014 (The Bill was promulgated as an Act on Tuesday, 20 January 2015) GENERAL Conducting farming operations If only all judgments were formulated with the elegant reasoning and perspicacity of the judgment delivered by Rogers J in the Western Cape Division of the High Court in Kluh Investments (Pty) Ltd v Commissioner for the South African Revenue Service (case number A48/2014, as yet unreported) on 9 September The appeal was against the dismissal of an appeal brought in the tax court against an additional assessment levied by the South African Revenue Service (SARS) in respect of the 2004 year of assessment. SARS added an amount of R110 million to the appellant's taxable income on the basis that the gross income giving rise to such taxable income had accrued to the appellant during its 2004 year of assessment on disposal of a plantation as contemplated in paragraph 14 of the First Schedule to the Income Tax Act No. 58 of 1962 (the Act). 17

18 Section 26(1) of the Act provides that the taxable income of any person carrying on pastoral, agricultural or other farming operations must, to the extent that it is derived from such operations, be determined in accordance with the ordinary provisions of the Act but subject to the special provisions set out in the First Schedule to the Act. The relevant excerpt from paragraph 14 of the First Schedule to the Act states that any amount that accrues to or is received by a farmer (i.e. any person conducting pastoral, agricultural or other farming operations) from the disposal of any plantation, irrespective of whether such plantation is disposed of separately or with the land on which it is growing, shall be deemed not to be capital in nature and shall constitute part of the farmer's gross income. The fact that the appellant had disposed of a plantation during its 2004 year of assessment was undisputed. The nub of the appeal was whether the appellant was conducting farming operations from whence the disposal proceeds emanated the prerequisite for applying the statutory provisions SARS had applied in raising the additional assessment. The facts of the case were as follows: The appellant, a special purpose subsidiary of a Swiss company, had been engaged by Steinhoff Southern Cape (Pty) Ltd (Steinhoff) to assume Steinhoff's place as purchaser of certain land with a timber plantation on it. The rationale behind the appellant's substitution as purchaser was Steinhoff's aversion to owning fixed property in South Africa but still wanting access to the plantation. Steinhoff purchased all the machinery and equipment (including a sawmill) while the appellant acquired the land, the timber plantation and certain other assets. Both transactions were executed in writing in October 2001, back-dated to 29 June 2001, and concluded as going concern acquisitions, ostensibly qualifying for zero rating in terms of 18

19 section 11(1)(e) of the Value-Added Tax Act No.89 of 1991 ( the VAT Act). In May/June 2001 by virtue of the relationship of trust between them, Steinhoff and the appellant agreed orally that Steinhoff would be entitled to conduct the plantation business on the appellant's land for Steinhoff's own profit and loss. Steinhoff was granted access to the land on which the plantation stood and was entitled to harvest the timber for its own account. Steinhoff used its own equipment to conduct the plantation operations, employed employees to work on the plantation and contracted with service providers in relation to the plantation operations. All plantation operational income and expenditure was earned and incurred by Steinhoff and reflected in its accounts. It was not obliged to render reports to the appellant regarding the plantation operations. The appellant owned no equipment and had no employees. It had no expertise in operating plantations. It was common cause that the appellant considered the acquisition of the land and plantation as a strategically advantageous long-term investment. To protect its investment, the appellant and Steinhoff agreed that upon termination of the oral agreement, which was to subsist indefinitely, Steinhoff would ensure that the plantation comprised trees of the same volume and quality as at commencement. The oral arrangement was terminated by agreement in June 2004 when Steinhoff changed its policy, in light of escalating timber prices and the scarcity of timber resources, and became amenable to purchasing fixed property in South Africa. The purchase price was determined by an independent valuer and heads of agreement were concluded in terms of which 'the plantation business' was to be sold by the appellant to Steinhoff as a going concern, zero-rated in terms of section 11(1)(e) of the VAT Act. 19

20 Certain disputes arose between the parties which were duly settled and recorded in a settlement agreement in terms of which the reference to the sale of 'the plantation business' was altered to refer to the sale of immovable property, standing timber, the plantation sale assets, machinery and equipment and plantation contracts. In addition it was recorded that VAT at the standard rate may be payable on the transaction in respect of which the appellant was to issue invoices to Steinhoff. Further it was agreed that the appellant was to pay Steinhoff a 'bonus management fee' for the exemplary manner in which it had looked after the appellant's investment. In its 2004 tax return the appellant treated the disposal proceeds as capital in nature. It declared a capital gain of R45,6 million being the difference between the disposal proceeds of R144,7 million and the CGT valuation of the plantation of R99,1 million as at 1 October 2001 (as opposed to the lesser purchase consideration actually paid as at 29 June 2001). The appellant also claimed a section 11(a) deduction of R12 million in respect of the 'bonus management fee' due to Steinhoff. SARS issued an additional assessment in August 2010 in terms of which it rejected the appellant's treatment of the plantation disposal proceeds as capital in nature. SARS averred that section 26(1) read with paragraph 14 of the First Schedule deemed the disposal proceeds to be part of the appellant's gross income. The appellant objected to the additional assessment. In its grounds of assessment SARS maintained its stance. However, SARS contended in the alternative that if the appellant was correct in treating the disposal proceeds as capital in nature, it had calculated the gain incorrectly. The CGT issue was left over by agreement pending the outcome of the main issue. Before the tax court, SARS had argued that the mere disposal of a plantation was sufficient to trigger the relevant statutory provisions. In effect SARS 20

21 submitted that it was not necessary to satisfy section 26(1) as a separate jurisdictional fact before rendering the deeming provision of paragraph 14 of the First Schedule applicable to the plantation disposal proceeds. Plainly put, it was not necessary to first establish whether or not the appellant was conducting farming operations. The mere fact that the appellant sold a plantation was sufficient to render paragraph 14 applicable and deem the plantation disposal proceeds to be part of the appellant's gross income. In the alternative, SARS argued that even if Steinhoff had conducted the plantation operations independently of the appellant, such operations had been physically conducted on the appellant's land, the appellant retained a direct interest in such operations and Steinhoff was required to restore the plantation in the same condition upon termination of the oral agreement as it had stood at commencement. As such SARS argued that there was a sufficiently close connection between the disposal proceeds and the plantation operations during the subsistence of the oral arrangement to render section 26(1) and paragraph 14 of the First Schedule applicable. The tax court found it unnecessary to consider SARS' first argument as it found in SARS' favour on strength of the alternative basis. In so finding, Rogers J concludes that the tax court conflated two distinct issues: "Section 26(1) does not apply merely because there has accrued to the taxpayer income which has 'derived from' farming operations; the section applies to a person carrying on farming operations to the extent that his income is derived from such operations. Two questions must therefore be answered: (i) Was the person whom SARS wishes to tax a person carrying on farming operations during the year of assessment in question? (ii) If so, did the particular item of income in dispute derive from those farming operations?" 21

22 Rogers J then proceeds to review the relevant case law and concludes that a number of tax court decisions 1 have similarly conflated the two questions. In rejecting SARS' first argument he states that the objective of "paragraph 14 is not to define what constitutes the carrying on of farming operations, but to characterise a particular type of accrual as gross income rather than capital." The mere disposal of a plantation previously acquired by a taxpayer is insufficient to constitute the carrying on of farming operations; and the conduct of farming operations is the prerequisite for triggering the paragraph 14 deeming provision. Rogers J concluded in favour of the appellant on the basis it was not conducting farming operations. As section 26(1) was inapplicable, the characterisation of the plantation disposal proceeds fell to be determined in accordance with the normal provisions of the Act. In upholding the appeal, he wryly observes that had SARS' contentions been upheld, a Pandora's Box may have been opened for non-farming taxpayers disposing of pastoral, agricultural or farming assets. Cliffe Dekker Hofmeyr ITA: Section 11(a) and 26(1) and paragraph 14 of the First Schedule VAT Act: Section 11(1)(e) MINING Provision for mining rehabilitation Mining companies generally make financial provision for rehabilitation by way of rehabilitation trusts or financial guarantees through a financial institution or 1 ITC 66 (1930) 5 SATC 85, ITC 1630 (1996) 60 SATC 59 22

23 with insurance policies. Although a deduction can be claimed for contributions to a rehabilitation trust and the income derived by such rehabilitation trust is exempt from tax, cash strapped mining companies in the current economic environment are finding it tough to contribute the required amount of cash to rehabilitation trusts. Insurance policies therefore have become a more lucrative option as it enables mining companies to spread the premiums, and therefore payment burden, over a longer period of time and even led to some mining companies transferring the funds in rehabilitation trusts into the insurance policies. The potential pitfalls of these methods are firstly, the adverse penalties in excess of 200% of the value of the funds in the rehabilitation trust which could be imposed by the South African Revenue Service (SARS) upon the transfer out of rehabilitation trusts and the potential non-deductibility of the premiums paid towards the insurance policies. Mining companies in South Africa are required to make financial provision in terms of the Mineral and Petroleum Resources Development Act No. 28 of 2002 (the MPRDA), read with the National Environmental Management Act No. 107 of 1998 (NEMA), for the rehabilitation of the mining areas on which mining activities are conducted (this will in future solely be governed by NEMA). From an administrative and practical perspective, mining companies are required to re-evaluate their rehabilitation liabilities and ensure that they must be able to provide upfront for any shortfall in the provision for such rehabilitation liabilities. In this regard, the Department of Mineral Resources (the DMR) insists that mining companies must be able to provide upfront for any shortfall in the provision for rehabilitation liabilities. For companies which merely provide for rehabilitation through a rehabilitation trust, this would imply that a cash contribution of the entire shortfall amount would need to be contributed towards the rehabilitation trust. Commercially, many mining companies (especially junior mining companies) are not in a position to make 23

24 such contributions as this would lead to cash flow constraints for the already cash strapped mining companies. As alluded to earlier, section 37A of the Income Tax Act No. 58 of 1962 (the Act) provides for the deduction for income tax purposes of contributions made to a qualifying rehabilitation trust. This deduction would not necessarily benefit mining companies which are not in a tax paying position. Instead, additional funding would need to be obtained to firstly fund the operations and secondly to fund the rehabilitation trust. As a result, mining companies have opted to provide for rehabilitation expenses through the various insurance products which are currently in the market (and have been for quite some time) as this is regarded by the mining companies as a more effective method to manage the cash flow constraints and provide the DMR with the required guarantee(s) for the future rehabilitation liabilities. The benefit of these insurance products is that although the guarantee is received upfront, the mining companies have a longer period during which the actual premiums can be paid as the insurance policies typically extend over 3 years (which could be extended further), thereby easing the cash flow constraints. Due to the use of the funds contributed to a rehabilitation trust being restricted and which can only be withdrawn for rehabilitation purposes (or used for purposes set out in section 37A), many mining companies have opted to provide for rehabilitation solely through insurance policies rather than to establish rehabilitation trusts (i.e. mining companies regard insurance products to be a more effective method to provide for future rehabilitation expenditure). In some instances, mining companies have gone so far as to transfer funds out of already established rehabilitation trusts into the aforementioned insurance policies. SARS does not favour such transfers and has indicated that the application of the penalty provisions provided for in section 37A (which would lead to a penalty in excess of 200% of the value of the funds in the rehabilitation trust) 24

25 would be strictly applied to any transfer which contravenes the provisions of section 37A. From an insurance policy perspective, National Treasury has inserted section 23L into the Act which came into effect on 31 March In essence, the purpose of section 23L is to disallow the deduction of any premiums incurred by a taxpayer on short-term insurance policies, unless the required criteria are met. The required criteria include, inter alia, recognising the insurance premiums as an expense in the financial statements (and not capitalise the expense as many mining companies would typically do). In this regard, the question which should be considered by taxpayers is whether the specific insurance policy which has been entered into to provide for future rehabilitation expenditure would be regarded as a short-term insurance policy as envisaged in section 23L of the Act and, if so, would the criteria be met so as not to fall within the ambit of section 23L. It is recommended that careful consideration be given and advice sought from tax advisors who also understand and are knowledgeable as to the requirements of the MPRDA and NEMA before a taxpayer opts to transfer any funds out of an established rehabilitation trust into any other fund or policy not specifically mentioned in section 37A. This is to ensure that the adverse (and arguably draconian) penalty provisions contained in section 37A are not triggered. It is further advisable that tax advice be sought before any mining rehabilitation insurance policy is entered into by a mining company in order to ascertain whether there is not a more efficient manner in which the policy could be structured, thereby not falling within the ambit of section 23L. It would be interesting to see how the Davis Committee will approach the current tax incentives for mining rehabilitation and whether, going forward, insurance policies of the nature discussed above would be recognised by the 25

26 Davis Committee and adequate provision be made in the Act for the treatment of insurance premiums paid on such insurance policies. ENSafrica ITA: Sections 23L and 37A Mineral and Petroleum Resources Development Act No. 28 of 2002 National Environmental Management Act No. 107 of 1998 TRUSTS Pitfalls in dealing with trusts In two fairly recent cases, the Supreme Court of Appeal (SCA) has gone out of its way to warn about some of the legal dangers facing people who transact with trusts. These dangers relate mainly to the capacity of the trust to conclude the transaction and the authority of a trustee to bind the trust. In Nieuwoudt & Another NNO v Vrystaat Mielies (Edms) Bpk [2004] 3 SA 486 N and his wife W were the sole trustees of the family trust, through which they conducted their farming business. Purporting to act on behalf of the trust, N concluded a forward sale of the following year s mealie crop at a price of R785 per ton. A year later, when the price of mealies had risen to R1 239 per ton, he denied the validity of the sale on the grounds that his fellow trustee W had not consented to or signed the deed of sale. The SCA accepted that the trustees had to act jointly in order to bind the trust, but referred the matter for the hearing of oral evidence on the question whether the trustees, acting jointly, had authorised N to conclude the transaction on behalf of the trust, as their agent. 26

27 Similarly, in Land and Agricultural Bank of SA v Parker and Others [2005] (2) SA 77 P and his wife W conducted their farming business through a family trust, with themselves and their attorney as trustees. When the trust defaulted on loan obligations (in excess of R16 million) owed to the Land Bank, the bank successfully applied to the High Court for the sequestration of the trust and its founder, P. On appeal, counsel for the trust argued that the loans were invalid because at the time when they were entered into there were only two trustees in office (the attorney having earlier resigned as trustee), and the trust deed required a minimum of three trustees. The SCA agreed with this contention, but dismissed the appeal nonetheless, on similar grounds: upon his sequestration P was disqualified from acting as trustee, and there being a sub-minimum number of trustees in office, the trust lacked the capacity to prosecute the appeal. Legal capacity of a trust Unlike a company, a trust is not a legal person. The assets of the trust vest in the body of trustees whose powers to deal with the assets are determined by the provisions of the trust deed the constitutive charter of the trust, as Cameron JA described it in Parker s case. Any action taken by the trustees outside the scope of their powers is null and void. Thus it is vitally important for anybody contracting with a trust to have sight of the relevant trust deed in order to ascertain not only the identity of the trustees but also the limits of their powers, and the minimum number of trustees required to enable the trust to act. As Parker s case shows, if the number falls below the minimum prescribed by the trust deed, the remaining trustees will be incapable of binding the trust and the trust will lack the capacity to act until further trustees are appointed. Moreover, it is a fundamental rule of trust law, confirmed by the two cases above, that unless the trust deed provides otherwise, the trustees must act jointly if the trust is to be bound by their acts. Thus, even if a majority of trustees agrees to and signs the contract, the contract will not be binding upon the trust. 27

28 This goes to trust capacity: the majority of trustees in question is not the body of trustees empowered by the trust deed to act. If the trust deed provides for decisions to be taken by majority vote, the majority cannot act without consulting the minority; the trustees as a group must consider the matter and if there is disagreement the majority view will then prevail. Authority of trustee to bind the trust Even if a trustee has been properly appointed in terms of the trust deed, or by the court in terms of general trust law, he or she may not act on behalf of the trust until authorised to do so by the Master. Any such act performed by a trustee prior to receiving Letters of Authority from the Master will be null and void and incapable of ratification. Such authorisation by the Master must be clearly distinguished from an authority granted to an individual trustee by the board of trustees to perform some act on its behalf. The fact that trustees have to act jointly does not preclude them from expressly or impliedly authorising someone to act on their behalf, and that person may be one of the trustees. Thus, acting jointly, they may delegate certain functions to one of their number, or even to an outsider, whilst retaining responsibility for the actions taken on their behalf. This brings the law of agency into play. In accordance with general principles of agency, when a trustee purports to contract on behalf of the trust, the trust will be bound only if the board of trustees had conferred upon the trustee the requisite authority so to act. The granting of such authority may be express or implied. If the contract fails because the trustee lacked authority, an action for damages will lie against the trustee for breach of warranty of authority, but this may be of little solace in the circumstances. 28

29 The trust will be bound despite the trustee s lack of authority if: the board of trustees subsequently ratifies the actions taken on its behalf, or if the trustee had ostensible authority to bind the trust; that is, if the board of trustees created the impression that the trustee had the necessary authority to represent them, and the other party reasonably relied on that representation. In such circumstances the board would be precluded (i.e. estopped ) from denying the existence of the authority. Ratification is not possible in circumstances where the agent is required by statute to obtain authorisation from the principal before entering into the transaction. On this ground a sale of land was declared invalid in Thorpe and Others v Trittenwein and Another [2007] 2 SA 172 SCA. The deed of sale had been signed on behalf of a trust by a single trustee whose conduct was thereafter ratified by the remaining trustees. The court held that such ratification could not save the transaction because section 2(1) of the Alienation of Land Act No.68 of 1981 requires prior written authorisation of the agent. What if it is clear from the trust deed that an individual trustee can be authorised to represent the trust provided that certain internal formal or procedural requirements have been met, for example, that the body of trustees has resolved to delegate to the trustee the power to sign contracts on its behalf? In those circumstances, must a third party dealing with the trustee check that the requirements have been met, or is it entitled to assume that all is regular? That depends on whether or not the so-called Turquand Rule of company law applies to trusts too. The Turquand Rule: applicable to trusts? 29

30 The Turquand Rule is part of the common law relating to companies, and derives from the famous English case of Royal British Bank v Turquand [1856] 6 E&B 327, where it was held that Persons contracting with a company and dealing in good faith may assume that acts within its constitution and powers have been properly and duly performed, and are not bound to enquire whether acts of internal management have been regular. A statutory version of the rule is now to be found in section 20(7) of the Companies Act No. 71 of 2008: A person dealing with a company in good faith is entitled to presume that the company, in making any decision in the exercise of its powers, has complied with all of the formal and procedural requirements in terms of this Act, its Memorandum of Incorporation and any rules of the company, unless, in the circumstances, the person knew or ought reasonably to have known of any failure by the company to comply with any such requirement. Thus, for example, if a company s Memorandum of Incorporation provides that the managing director can conclude contracts on behalf of the company, provided the board has delegated such power to the director, a third person dealing with the company would generally be entitled to presume, when its managing director signs the contract on behalf of the company, that the necessary delegation has occurred. The effect of the rule is that the company will be bound even if the director lacked authority because the internal requirement of delegation had not been met. Whether the Turquand Rule should be made applicable also to trusts is somewhat controversial, and the issue was expressly left open by the Supreme 30