Taxpayer H v CSARS (SARSTC 14213)

Facts

Taxpayer H is a private company that is an investment holding company with assets comprising of unlisted shares in subsidiary entities, loans advanced to the subsidiaries, and cash. Taxpayer H claimed that it conducted a money lending trade with the specific purpose of making a profit from on-lending borrowed funds to its subsidiaries.  Taxpayer H submitted that all money borrowed free of interest was used for share investing activities, while interest-bearing borrowings were applied towards lending to the subsidiaries.  However, the interest rates imposed by Taxpayer H, ranged from 0% to 8.29%, while it borrowed at an interest rate of 8.29%.  The South African Revenue Service (SARS), argued that the interest rates imposed by Taxpayer H had no commercial sagacity, and exposed the appellant’s transactions as nothing more than furthering the group’s interest, by enhancing the earning capacity of the subsidiaries.  Taxpayer H contended that it in fact did have a profit motive, which was already achieved in the 2012 year of assessment.  However, it seems that Taxpayer H included the interest it earned from financial institutions, i.e the bank, and did not only take into account the interest earned from the subsidiaries when it put forth the argument that it is in fact making a profit.  When SARS raised the additional assessment, SARS limited the interest deduction, to the interest earned, based on the long-standing practice as set out in SARS Practice Note 31 (PN 31).  SARS also imposed an understatement penalty as provided for in section 223 of the Tax Administration Act No 28 of 2011 (the TA Act).

Issues

Issue 1: Whether the interest sought to be deducted by Taxpayer H was incurred whilst carrying on a trade;

Issue 2: Whether the interest sought to be deducted by Taxpayer H was incurred in the production of income; and

Issue 3: Whether SARS has successfully discharged the onus resting on it for its imposition of the understatement penalty

Findings

In order to decide on issue 1, the court relied on the guidelines established in Sologlass Finance Co. (Pty) Ltd v CSARS, in order to determine whether Taxpayer H was carrying on a trade as a money lender or banker.  According to Sologlass; lending had to be done on a system or plan which disclosed a degree of continuity in laying out and getting back the capital for further use and which involved a frequent turnover of the capital; even though obtaining security was a usual feature, though not essential, of a loan made in the course of a money lending business; the fact that money had been lent at remunerative rates of interest was not enough to show that the business was of moneylending; and as to the proportion of the income from loans to the total income: the smallest of the proportion could not however be decisive if the other essential elements of a moneylending business existed.  When Taxpayer H was requested to provide proof as to the existence of its money-lending business, it indicated that the loans had no terms, including repayment terms.  Taxpayer H could not provide board minutes, or documents evidencing its lending policy, or that security was provided for the loans.  Taxpayer H also could not provide evidence of a plan of laying out and getting in its money to prove continuity.  SARS also pointed out that on the IT14 submitted by Taxpayer H for the 2011 year of assessment, it answered “NO” where it was asked whether or not it entered into any transaction contemplated in section 24J of the Income Tax Act No 58 of 1962 (the IT Act).  This became important since Taxpayer H underscored the words “all accrual amounts” in section 24J(3) of the IT Act, in order to include the interest accruals from the bank to show a profit.  SARS maintained that there cannot be a profit-making motive if Taxpayer H’s interest expense will be more than its interest income, as a result of Taxpayer H’s own lending policies.  In this regard, SARS was able to provide proof that the interest earned from the bank came from the cash pooling activities of the group. A claim which was not denied by Taxpayer H.  Accordingly, the interest expense could not have been linked to the interest income earned from the bank.

Regarding issue 2, in order to determine whether the expenditure was incurred in the production of income the important and sometimes overriding factor is the purpose for which the expenditure was incurred and what it actually effected.  Taxpayer H argued that the expense was incurred in the production of interest, i.e the interest earned from its subsidiaries, and the fact that the interest expenses were more than the interest income, did not mean that the interest expense was not incurred in the production of income.  According to Taxpayer H, the requirement of section 24J(2) of the IT Act was met.  SARS argued that there was no intention to generate income and that the purpose of this lending arrangement was to further the group’s interest.  The court agreed with SARS since the taxpayer failed to demonstrate that the interest expense was incurred in the production of income.  

When arguments were heard concerning issue 3, Taxpayer H affirmed its position that there was no understatement.  In its view, the interest was fully deductible, and in the event that SARS is of the view that the interest is not deductible, it should be seen as a bona fide inadvertent error.  Here Taxpayer H placed reliance on section 222(1) of the TA Act, which stated that if the understatement resulted from a bona fide inadvertent error, no understatement penalty should be levied.  Taxpayer H argued that it was for SARS to satisfy itself that the understatement did not result in such an error and that this is a jurisdictional fact for SARS to overcome prior to imposing any understatement penalty.  The court did not agree with this argument by Taxpayer H.  The court reminded Taxpayer H, that the burden of proof set out in section 102(2) of the TA Act, cannot be turned on its head, and that the burden still lies with the taxpayer to prove that the interest expense was deductible and that it was up to the taxpayer to provide proof that the understatement was due to an inadvertent bona fide error.  In this case, Taxpayer H did not provide such evidence, and its contention that it relied on expert advice could not be supported.

The appeal was dismissed with cost.

Find a copy of the court case here.

30/05/2022