South African Revenue Services Discussion Paper on Tax Avoidance: hearings

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Finance Standing Committee

30 March 2006
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Meeting report

 

FINANCE PORTFOLIO COMMITTEE
31 March 2006
SOUTH AFRICAN REVENUE SERVICES DISCUSSION PAPER ON TAX AVOIDANCE: HEARINGS

Chairperson:
Mr N Nene (ANC)

Documents handed out:
PricewaterhouseCoopers presentation
Ernst & Young presentation
Mallinicks Attorneys presentation
National Treasury presentation

SUMMARY
The Committee conducted public hearings on the South African Revenue Services’ Discussion Paper on Tax Avoidance. PricewaterhouseCoopers said that the actions of the Revenue Services and their huge collection figures showed that a lot of taxpayers were scared and Section 103 of the Income Tax Act was acting as a deterrent, so it was debatable whether it had to be changed. The Revenue Services’ reason for changing Section 103 was to curb the use of manufactured business schemes in avoiding tax. This amounted to a vote of no confidence in the courts as to their ability to identify these schemes. One of the more worrisome aspects of the section was the ‘objective purpose’ test. The Revenue Services had not indicated how this test was to be applied especially as the ‘purpose’ was to be ‘one of the main purposes.’ For business, the new section created uncertainty and increased complexity. It would also create the perception of Government intervention in the economy which would be bad for foreign investment.

Ernst & Young disagreed with the Revenue Services about where ‘impermissible’ tax avoidance started and stopped. There must not be a situation created where business becomes worried about entering into straight-forward transactions which had favourable commercial and tax consequences. The majority of tax professionals spent the bulk of their time helping clients understand the exceedingly complex provisions of the law and its application to transactions that had already been entered into and were devoid of tax engineering. In analysing the Revenue Services’ new ‘purpose’ test, the test remained partly subjective since the facts and circumstances must include the taxpayer’s stated intention. Thus, the new provision did not add very much. Tax avoidance was legal, and so it was inappropriate to impose penalties where a presumptive test and the burden of proof may place an innocent taxpayer at a considerable disadvantage. At the very least, any penalty decision had to be subject to review and appeal.

Mallinicks Attorneys said that they were concerned that a number of the ‘abnormality’ indicia were present in a number of normal commercial transactions. Also, the mere presence of the indicators may result in overzealous Revenue Services assessors applying the General Anti-avoidance Rule without a proper analysis of the relevant transactions. They had difficulty in understanding why once any one of the indicators was present, a presumption was created. Thus, the burden of proof shifted to the taxpayer. It was interesting that no such presumption was provided for in the foreign jurisdictions referred to in the discussion paper.

The South African Revenue Services’ reaction was to say that the Law Society of South Africa had accused them of importing the ill-defined foreign concept of impermissible tax avoidance. This was wrong. The General Anti-avoidance Rule had been part of South African law since 1941 and there was case law that noted that a transaction could be impermissible in the contest between the taxpayer and the receiver of revenue. It was important to note the impact of the changed environment. There was globalisation, financial deregulation and an increase in the use and sophistication of information technology but the current Rule had kept the same form for over 50 years. The Revenue Services were seriously considering implementing some of the proposals they had received.

National Treasury’s reaction was to say that taxpayers were entitled only to the tax consequences that matched commercial or economic substance. This substance doctrine was no stranger to South Africa having being employed in contract and other business law. The ongoing abundance of schemes showed the need for anti-avoidance rules. While a growing culture of compliance existed, a small but expensive few transactions continued to generate high fees. Further comments were still needed, and the doors for engagement with the Revenue Services were not closed. Most importantly, a detailed description of the facts was needed for corporate finance and Black Economic Empowerment.

MINUTES
PricewaterhouseCoopers Presentation
Mr K Van Wyk said that the actions of the South African Revenue Service (SARS) and their huge collection figures showed that a lot of taxpayers were scared and Section 103 of the Income Tax Act was acting as a deterrent, so it was debatable whether it had to be changed. The rule of law was paramount. Courts first examined the language of the legislation, and only in extreme cases would they try to identify the intention of the legislature. SARS examined international precedent, but in places like Australia and the US, their tax rules were presented as a package of measures. It was important to ensure that South Africa adopted such an approach.

Section 103 had to be broad-based, but it could not operate as a ‘taxing section.’ Commerce and industry would continue to use arbitrage, the different tax rates between taxpayers, and the different treatment of different transactions. SARS needed to keep in touch with the administration and analysis of increased business sophistication. SARS’ reason for changing Section 103 was to curb the use of manufactured business schemes in avoiding tax. This amounted to a vote of no confidence in the courts as to their ability to identify these schemes. Taxpayers needed to be treated consistently, but no single system of rules could treat all transactions the same.

He applauded SARS on the proposal to use Section 103 as an alternative, but was worried that it might be used by assessors on a frivolous basis. Applying the section to any step of a transaction was also a positive move. The Advanced Ruling System (ARS) had to be implemented at the same time that the legislation came into force to ensure a smooth process. Consistency would be created by making SARS’ Practice Notes binding on it, and centralising the administration of the section.

One of the more worrisome aspects of the section was the ‘objective purpose’ test. SARS had not indicated how this test was to be applied especially as the ‘purpose’ was to be ‘one of the main purposes.’ Nearly all transactions, including perfectly normal and business ones, would fall under this section which was unfortunate. The codification of factors that indicated abnormality was a poor move on SARS’ part. If a taxpayer undertook a scheme with aspects of it falling outside of those factors, they may get some sympathy from the court. Listing the factors actually narrowed the legislation to an extent. Some of the wording of the legislation was vague, including that concerning penalties.

For business, the new section created uncertainty and increased complexity. It would also create the perception of Government intervention in the economy which would be bad for foreign investment. The self-assessment system for business which was going to be introduced next year would place an added burden on commerce, and the risk of incurring penalties would become substantial.

Tax was not a game for business. It constituted 30% of its income so they would continue to try and reduce their tax burden. On the other hand, the accounting and legal professions had to insist on nothing but full disclosure from their clients.

Ernst & Young Presentation
Mr D Clegg, the National Technical Partner, said that he disagreed with SARS about where ‘impermissible’ tax avoidance starts and stops. A situation should not be created where business becomes worried about entering into straight-forward transactions which had favourable commercial and tax consequences. If SARS drafted the legislation to act as a deterrent rather than a ‘watchdog,’ a situation could arise where taxpayers would pay more than they had to. They would be too scared to pay just the correct amount.

The majority of tax professionals spent the bulk of their time helping clients understand the exceedingly complex provisions of the law and its application to transactions that had already been entered into and were devoid of tax engineering. A healthy tension should exist between SARS and taxpayers in the application of tax laws, since the ascertainment of what tax was properly due was dependent on words crafted by man, and words were blunt instruments. This tension had to be used constructively, and should not be allowed to deteriorate into general or personal attacks by either side.

He was concerned that SARS had not tried to test the section in court to determine its precise effect, its successes and its shortcomings. This reluctance on the part of SARS seemed to be based on the belief that the courts interpreted the law in a manner that did not reflect the intent of Parliament. The courts applied principles of interpretation which were developed over many years, and were applied in relation to all legislation, not just that administered by SARS. It was inappropriate and disrespectful for SARS and Treasury to call these judgements into question. It was not a matter of the rules of statutory interpretation being outmoded, but of a (purported) change in the intent of Parliament since the section was first enacted, which must be remedied if indeed there had been such a change.

He was concerned about how some of the new measures had been crafted. The question of whether a new investment can ever result in the avoidance of an anticipated tax was a strong defence to both the existing and new provision, notwithstanding that it had been raised only once in the courts. It may also be difficult to apply and interpret the ‘one of the main purposes test.’ He was doubtful that a court would be prepared to find that a ‘main’ tax benefit purpose could co-exist with a real and substantial purpose that arose from a single transaction.

In analysing SARS’ new ‘purpose’ test, the test remained partly subjective since the facts and circumstances must include the taxpayer’s stated intention. Thus, the new provision did not add very much. Clarity was needed on the ‘part or thereof’ aspect in the purpose and abnormality requirements. The abnormality requirement remained essentially the same except the presumptive elements, which were SARS’ strongest weapons. Section 103 would not apply if there was a business purpose, and so it was not that different from the existing test. What had to be clarified was when the presumption would take effect. The section said that the presumptions applied in any "proceedings." It must be made clear to assessors that at the level of tax return submission/assessment, no presumption arose.

Tax avoidance was legal, and so it was inappropriate to impose penalties where a presumptive test and burden of proof may place an innocent taxpayer at a considerable disadvantage. At the very least, any penalty decision had to be subject to review and appeal.

Mallinicks Attorneys Presentation
Mr H Bester, a Director in Mallinicks’ Tax Department, said that conceptually there was a large degree of consensus between SARS and the business world. It was in everyone’s interests to have certainty about the law, but it was unfortunate that SARS had not tested Section 103 more in court.

Ms M Naude, a Senior Associate, said that they were concerned that a number of the ‘abnormality’ indicia were present in a number of normal commercial transactions. Also, the mere presence of the indicators may result in overzealous SARS assessors applying the General Anti-avoidance Rule (GAAR) without a proper analysis of the relevant transactions. The ‘abnormality’ test would make the entire test more complex. Courts already had difficulty applying it in its current format. The proposed test provided for specific eventualities, without establishing an underlying general principle such as reasonability.

They had difficulty in understanding why once any one of the indicators was present, a presumption was created. Thus, the burden of proof shifted to the taxpayer. It was interesting that no such presumption was provided for in the foreign jurisdictions referred to in the SARS discussion paper. The ‘sole or main purpose’ requirement was problematic also. The courts had held that ‘main’ meant more than 50%, so it was difficult to conceive how a taxpayer could have more that one ‘main’ purpose.

South African Revenue Service Reaction
Mr F Tomasek, Acting General Manager: Tax Legislation began by saying that they were very appreciative of the presentations and the input they had received. Mr E Liptek, a SARS tax specialist, said that Section 103 needed to be strengthened to counter some of the more complicated transactions they came across. It also had to be applicable to steps within a larger transaction. The Law Society of South Africa accused SARS of importing the ill-defined foreign concept of impermissible tax avoidance. This was wrong. The GAAR had been part of South African law since 1941 and there was case law that noted that a transaction could be impermissible in the contest between the taxpayer and the Receiver of Revenue. The SARS analysis had also drawn from many other sources.

There had been strong acknowledgement of SARS’ assertion that Section 103 had not been a consistent deterrent since the Conhage case. It had been stated by the Law Society that the GAAR effectively dealt with film schemes and abusive sale and lease-back schemes. In practice, these were still being marketed and developed, and were becoming increasingly complex. The problem with litigation was that many of these cases were fact-specific and needed a lot of preparation. One such case in the US cost the Internal Revenue Service $2 million. Even if the State was successful in these cases, it provided a road-map for practitioners to follow new schemes.

It was important to note the impact of the changed environment. There was globalisation, financial deregulation and an increase in the use and sophistication of information technology but the current GAAR had kept the same form for over 50 years. The use of penalties was an effective deterrent. The marketing of these schemes by promoters made the problems worse, but they had to be carefully applied to ensure innocent promoters who simply provided advice to their clients were not caught in this net.

SARS was seriously considering implementing some of the proposals they had received. The first was the ARS to give more certainty to the process. They intended to co-ordinate this with the reportable transactions rules. They supported issuing interpretation notes to help explain some of the new rules and how the rules were to be applied. More could be done to warn taxpayers about the existence of certain tax schemes that were inappropriate. Where appropriate, test cases would be brought to court. They had taken great care to retain as much of the current section as possible to ensure an evolutionary, rather than a revolutionary approach. They had to ensure that the GAAR did not affect normal, legitimate transactions. There were only a few aggressive promoters that really had to worry about uncertainty.

Mr Tomasek said that there were measures to combat uncertainty so that some of the problems of the ‘abnormality’ factors would be ameliorated. The two major concerns were that there was the potential for some of them overlapping, they were too vague and they were too broad. They were placed in the section as indicators of abnormality. SARS was trying to attack the roots of the schemes. It also would guide courts as to what was abnormal, which was something that troubled the courts right now.

SARS was considering reducing the number of factors, consolidate the ones that overlapped and refine their scope. This was only a discussion paper so there was room for changes. South Africa was part of the global community and things were naturally complex there. SARS was trying to limit the complexity of the section and the Act as a whole. The presumption of abnormality placed the burden of proving that the transaction was not abnormal because the taxpayer selected the transaction, and they knew all the intimate facts of it. The ‘objective purpose’ test as proposed was in keeping with international best practice. Some commentators said the provisions were vague, and again, since this was only a discussion paper, SARS was in a position to clarify the point further.

South Africa had a dearth of judicial doctrines because there was a GAAR. There was no need for developing precedent when they just relied on the GAAR. South Africa had to develop legislation that looked at the proper economic substance of transactions.

National Treasury Reaction

Mr K Engels said that the debate was about the ‘spirit’ versus the ’letter’ of the law. Taxpayers were entitled only to the tax consequences that matched commercial or economic substance. This substance doctrine was no stranger to South Africa having being employed in contract and other business law. However, it had not been fully imported into tax law other than in the Ladysmith case. South African courts often favoured the ‘letter’ of the law where purposive intent was secondary and explanatory memorandums were ignored. ‘Substance’ was a lot harder to draft than a label-driven form.

The ongoing abundance of schemes showed the need for anti-avoidance rules. While a growing culture of compliance existed, a small but expensive few continued to generate high fees. Aggressive opinions from lawyers were still taken too seriously and some planners even demanded SARS rulings as an endorsement for some of their schemes. The current GAAR did not even apply to the simple "offshore washing machine" structure of 2000.

There was usually a time line that determined when SARS could become involved in these schemes. A scheme would be undertaken; returns would be submitted; an audit risk would be identified; there would be an exchange of documents and information; there would be objection and appeal and hopefully there would be a decision by the court. After this long process, years would have passed and a culture of avoidance would have developed. SARS, Treasury and the GAAR had to stop these schemes at their onset. The indicators of ‘abnormality’ were the key to the new GAAR as they acted as ‘red flags’ for the courts. However, taxpayers feared that these signs can be overstated.

Further comments were still needed, and the doors for engagement with SARS were not closed. Most importantly, a detailed description of the facts was needed for corporate finance and Black Economic Empowerment.

Discussion
Ms J Fubbs (ANC) asked why there was such an aversion to the prevention of problems rather than trying to cure or fix the consequences. Why was there such a clamour for more case law?

Mr Van Wyk replied that all tax planners were in favour of clear articulation of the law. The moment the law became too onerous to follow, commercial activity would be adversely affected.

Mr Clegg replied that there were about 1750 reported tax law cases since 1922 but only 1% of those dealt with tax avoidance. When faced with complex legislation, the usual destination was court. To determine what certain phrases and terms meant, lawyers and taxpayers in general looked at what the courts had decided. There was no point in going to SARS if the planners were unsure about the law on the matter.

The meeting was adjourned.

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