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FINANCE PORTFOLIO COMMITTEE
12 September 2006
GENERAL ANTI-AVOIDANCE DRAFT RULES: SARS PROGRESS REPORT
Chairperson: Mr N Nene (ANC)
Documents handed out:
South African Revenue Service Progress Report on the Draft General Anti-avoidance Rules
Draft legislation available on the www.sars.gov.za website later today
The South African Revenue Service gave the Committee a progress report on the Draft General Anti-avoidance Rules. They said that there had to be certainty for bona fide transactions on the one hand, and a stronger, more effective deterrent on the other. To create that greater certainty, changes had been made to the original proposals. The eleven factors in the abnormality requirement were reduced to five and the presumption of abnormality was also removed. The ‘objective’ enquiry was relaxed to allow subjective factors to also have a role in the test, and the “one of the main purposes” test was dropped as well. An explicit notice requirement was introduced where taxpayers would receive written notice up front that Section 103 may be applied to them with reasons provided.
To create a better deterrent, new tests had been developed for the abnormality requirement. There had to be commercial substance (which had five key indicators), and a statutory purpose for the transaction.
The results so far of the reportable arrangements system were very disappointing and this was caused by weaknesses in the legislation. Proposed changes to the system included greater co-ordination with the Draft General Anti-avoidance Rules and the existing trigger would be retained albeit with some additions.
The draft legislation would be published within a matter of days.
Mr Frans Tomasek, the South African Revenue Service (SARS) Assistant General Manager for Legislation, reminded the Committee of the four requirements in section 103 of the Income Tax Act (the General Anti-avoidance Rules [GAAR]) that were the subject of the changes. There had to be an arrangement; a tax benefit; abnormality and a tax avoidance purpose.
SARS’ original proposals were that in assessing abnormality, objective factors were looked at and if they were found, a presumption of abnormality would arise. An objective test was also applied to the purpose requirement and tax avoidance had to be “one of the main purposes” for the provision to apply. SARS wanted the GAAR to apply to steps in a larger arrangement and also wanted it to be used in the alternative.
SARS had published a discussion paper on the 3rd of November 2005 and had accepted public comment until the 28th of February 2006. An interim response was published on the 16th of March. It had been a professional and constructive debate and SARS had also consulted extensively with international experts. A balance had to be stuck between all of the comments. There had to be certainty for bona fide transactions on one hand, and a stronger, more effective deterrent on the other.
Mr Ed Liptak, Legal and Policy Division: SARS, said that to create that greater certainty, SARS made some changes to their original proposals. The 11 factors in the abnormality requirement were reduced to five to remove duplications and to deal with the fact that some were too wide. The presumption of abnormality was also removed as it probably went too far.
In the purpose test, the ‘objective’ enquiry was relaxed to allow subjective factors to also have a role in the test. Here, the subjective intent would be tested against the objective facts and circumstances. He said that this approach would reinforce existing case law and allowed for a balanced approach. The “one of the main purposes” test was dropped as well because it swept too many things into the net.
An explicit notice requirement was introduced where taxpayers would receive written notice up front that the section 103 may be applied to them with reasons provided. The taxpayers would also have the opportunity to respond and provide reasons why it should not apply. This would reduce the length of the whole process and costs as well.
They were also going to simplify and clarify the language of the provisions and create shorter sentences and change their format.
To create a better deterrent, Mr Liptak said that new tests had been developed for the abnormality requirement. There had to be commercial substance, and a statutory purpose for the transaction, as the “sham” transaction doctrine was often not applicable as it was too narrow and “abnormality” as a whole was under pressure from globalisation and financial deregulation.
The new “commercial substance” test would target the problem directly and applied to arrangements that lacked commercial substance in whole or in part. The test’s key features were that it had no substantial effect on a party’s business or commercial risks, net cash flow and beneficial ownership of assets. The five key indicators of the absence of “commercial substance” were that the legal or economic effect/substance of the whole differed from the legal form of the parts; round trip financing; accommodating or tax-indifferent parties; offsetting or self-cancelling and inconsistent characterisation of the transaction by the parties for the tax purposes. The factors had also been revised.
“Round trip financing” replaced the concept of “circular flow of funds.” The three key features were the transfer of funds between or among parties, the creation of a tax benefit and which reduced risk significantly. These features would help to guide the courts. The manner and means used were irrelevant.
To identify accommodating or tax-indifferent parties, functional approach would be used. There could be the shifting of income or deductions to non-taxable entities; the conversion of revenue to capital; taxable to exempt; non-deductible to deductible or the absorption of pre or accelerated payments. Two instances could be used by taxpayers to escape application of this provision: if they were subject to comparable foreign tax or they were engaged in an ongoing substantive business activity.
Common devices designed to make transactions as complex as possible included accommodating or tax-indifferent parties and connected persons. These were dealt with by giving SARS the authority to disregard accommodating or tax-indifferent parties and combine the connected parties.
He said that the “statutory purpose” was a new test developed for those schemes that attempted to frustrate the purpose of the tax laws. It applied to any arrangement and reinforced the “modern” approach to taxation. It applied explicitly to the GAAR and additional guidance was given in section 103 to give certainty to bona fide transactions. However, it was inevitable that some people would try to abuse the system.
He said that some practitioners had found a loophole in the definition of “tax benefit,” but SARS had since closed it. The remedies had also been strengthened and clarified. Section 103 would still apply to all steps in or parts of an arrangement and could be used in the alternative as per the original proposals.
Mr Tomasek said that since last year SARS had begun a reportable arrangements system where certain (questionable) transactions had to be reported to SARS. The results so far were very disappointing as only 55 arrangements had been reported (compared with over 1000 in the UK in their first year). This was caused by weaknesses in the legislation. There was a very narrow trigger, that is, transactions where the fees charged could change if the transaction was challenged and had a threshold of at least R5 million had to be reported. However, there were arguments about the definition of “tax benefit” and on the issue of penalties. There was also some resistance by the financial services industry to the reportable arrangements system.
Proposed changes to the system included greater co-ordination with the GAAR and the existing trigger would be retained albeit with some additions. The lack of “commercial substance” indicators and a lack of pre-tax profit or an insignificant pre-tax profit would also be reported on and there was a new definition of “tax benefit.” Substantial monetary penalties could be imposed for non-compliance but these could be reduced if there were extenuating circumstances or the penalty was disproportionate to the tax benefit. There were also reduced initial reporting requirements. SARS was still looking into the issue of promoter penalties.
He said that there was a cause of concern as new aggressive schemes were being imported into South Africa from the USA and the UK. There were also foreign tax credit schemes; film schemes; cross-border financing and intangible property schemes; derivative financial instrument schemes and abuses of corporate rules.
The draft legislation would be published within a matter of days and it would include a set of better balances. Once the legislation was put in place, SARS would monitor behaviour and work closer with other revenue authorities and international organisations. They would litigate appropriate cases to create the needed precedents so they were going to settle fewer cases out of court. Refinements to the legislation would be based on feedback and results.
The Chairperson asked at what stage the draft legislation was.
Mr Tomasek said that hopefully it would be ready by the end of the week.
Mr B Mnguni (ANC) asked if the relaxations SARS had made were due to pressure from the public or from their consultations with foreign experts.
Mr Tomasek replied that they were due to public comment weighed up against SARS’ own thinking and the input from the international experts, that is, the changes made sense, but if more changes needed to be made, they would be.
Mr K Moloto (ANC) asked how tax shelters were going to be dealt with. Were uniform accounting standards and definitions going to be applied to settle the issue of the characterisation of the transactions?
Mr Tomasek replied that SARS often received useful information about things that were going on and the reportable arrangements legislation should help them as well so it was important to get it working properly to find out about emerging schemes. On the issue of characterisations, he said that things such as debt equity were difficult and had different legal classifications. The starting point for the enquiry was: could a genuine commercial transaction be made evident once the abnormality was removed?
Mr Y Bhamjee (ANC) said that settlements out of court were mutual decisions. Maybe SARS settled out of fear of losing?
Mr Tomasek replied that many of the settlements were ones that SARS could win with about 70% - 80% certainty but the taxpayers offered to pay 100% of the tax in exchange for not having to pay interest or penalties. SARS now had to decide whether they wanted to make a statement to other taxpayers by taking some cases to court.
The meeting was adjourned.