Buying Peter to offset Paul a tricky matter
THE legal position of a company with an assessed loss acquiring a profitable business whereby the profits will be used to reduce the assessed loss is important to understand. Section 103(2) of the Income Tax Act No 58 of 1962 deals with transactions entered into for the sole or main purpose of avoiding or postponing liability for, or reducing, amounts of tax on income.
In particular, section 103(2) is an anti-tax avoidance provision allowing the Commissioner of the South African Revenue Service to disallow the setting off of an assessed loss or balance of an assessed loss against the company’s income if certain requirements are met.
In circumstances where a company with an assessed loss acquires a profitable business, two main requirements must be met in order for section 103(2) to apply. In particular, that:
An agreement has been entered into which directly or indirectly gave rise to income being received by such company; and
That such agreement has been effected solely or mainly for the purpose of utilising any assessed loss incurred by the company in order to avoid any tax liability, or to reduce any tax liability.
In terms of the first point, there is no limitation on the meaning of an “indirect result”, and the chain of causation may therefore be long and involved, so long as it is not broken. In the case of New Urban Properties Ltd v SIR 1966 (1) SA 215 (A), it was held that it will always be a question of fact whether a company has derived income “directly or indirectly” as a result of the change of shareholding.
In terms of the second point above, section 103(2) can only apply if the agreement was entered into with the sole or main purpose of utilising an assessed loss.
The word “purpose” is not defined in the Income Tax Act, but is generally understood to be “something set up as an object or end to be obtained”, “the reason for which something exists or is done, made, used, etc”.
In ITC 1347 (1981) 44 SATC 33, a taxpayer acquired a company with an assessed loss. Two of the factors considered by the court were that, although it was assumed that the company had an assessed loss, no specific enquiries were made by the taxpayer to determine the extent of such loss and nothing was paid for the acquisition of the assessed loss.
In ITC 983 (1961) 25 SATC 55, the court found that, where a clothing manufacturing company had acquired a subsidiary with a balance of assessed loss and had then introduced income into that subsidiary, the sole or main purpose of the acquisition was not the acquisition of the assessed loss but rather to enable the company to obtain a productive manufacturing unit that could go into immediate operation to supplement its own productive capacity. Section 103(2) was therefore not applicable.
In ITC 989 (1961) 25 SATC 122 the taxpayer company had carried on business for a considerable period as a timber merchant and had incurred trading losses which resulted in an assessed loss. All the shares in the taxpayer company were then offered to and acquired by another company (ie the holding company) in the timber business. This holding company produced items made from wood such as doors which were marketed through a subsidiary company. Prior to the acquisition of the shareholding of taxpayer company the holding company also utilised this subsidiary company to sell timber to builders and tried to utilise it to sell timber to merchants also but experienced difficulties in doing so because the practice of selling direct to builders led to the undercutting of merchants, who consequently refused to buy from the subsidiary.
After the acquisition, the holding company revised its selling arrangements and effected its sales to builders through the taxpayer company. The timber was sold to it at the normal prices charged to merchants and was in turn resold by it to builders at retail prices.
In determining the liability for tax of the taxpayer company for the first year after the sale of its shares, the Commissioner applied s 90(1)(b) of the Act 31 of 1941 (the equivalent of s 103(2)) and disallowed the setoff of the balance of its assessed loss against its income.
The court held that, on the facts, the taxpayer company had shown that neither its sole nor its main purpose was the avoidance of liability for tax. While there was some advantage derived by the holding company in purchasing the shares of the taxpayer company and thus acquiring the benefit of its assessed loss, the holding company was able to show that material benefits accrued to it, for example, benefits flowing from the separation of the wholesale and retail trades.
Accordingly there appeared to be good reason to believe that the purchase of the shares would in fact have been a profitable and advantageous purchase even if there had been no assessed loss. Section 103(2) was therefore not applicable.
In light of the cases set out above, it is therefore a subjective and factual enquiry as to whether the acquisition of a profitable business by a company with an assessed loss is entered into solely or mainly for the purpose of utilising the assessed loss.
In terms of section 103(4) of the Income Tax Act, the taxpayer bears the onus of proving or showing that the transactions were not entered into with the sole or main purpose of utilising an assessed loss.
The reasons for a company with an assessed loss in acquiring a profitable business should therefore be documented. It should be ensured that there are sufficient business related reasons for entering into the transaction, ie that these business reasons constitute the main reason for the transaction.
As a factual matter, it should be ensured that a company with an assessed loss would acquire the profitable business even if it did not have such assessed loss.
Profitable business acquired in order to offset assessed loss at the buyer has tax implications
Peter Dachs and Bernard du Plessis are directors and joint heads of ENSafrica’s tax department.