The business rescue provisions of the new Companies Act 71 of 2008 have generated much discussion in commercial and legal circles. However, the fiscal aspects of a business rescue plan have seldom been debated.
For this reason, the recent decision of the Cape Town Tax Court per Davis J in A (Pty) Ltd v CSARS (case number 13003, not yet reported) in which judgment was handed down on 13 June 2013 merits close study.
This case concerned the fiscal aftermath of an apparently successful attempt to rescue a financially struggling and heavily-indebted company, not under the business rescue provisions of the Companies Act 2008, but in terms of a strategy devised by entrepreneurs who seem to have neglected to include a tax professional in their team.
Two issues came up for consideration, namely whether the proceeds on disposal of shares were of a capital nature, and whether an “equity kicker” related to the acquisition of the shares and the associated financing arrangements was deductible.
The facts showed that a rescue operation for an ailing listed company was put in place in 2002, with the financing for the taxpayer’s participation being made by way of a three-year loan at interest, with an “equity kicker” equivalent to a portion of the profit on ultimate sale of the shares in the rescue vehicle. The shares were realised by A (Pty) Ltd at a substantial profit early in 2004.
The central characters in the transactions were Y, who was the promoter of the transaction, Z, a non-resident, who was the principal shareholder and a director of A (Pty) Ltd and O, also a director of the A (Pty) Ltd, who was the turnaround expert.
A (Pty) Ltd argued that the shares had been acquired for the long-term and that the intervention of E Ltd had been a fortuitous and unforeseen event. It was argued, citing the testimony of Z, that the decision by A (Pty) Ltd to sell the shares was “an opportunistic decision” that could not have been contemplated when the shares were acquired by the company in 2002.
Giving judgment in the Tax Court, Davis J held (at para ) that the evidence, as a whole, suggested that the investment in the shares by A (Pty) Ltd was to last for a period of at least three years, and perhaps slightly longer, depending on the success of the venture.
A constant theme running through Z’s testimony was that he wanted to have the freedom to deal with “his” investment as he saw fit. There were no significant restrictions on O and Y insofar as the shares were concerned, save that the shares would remain invested until the transaction had “been bedded down”. It was also significant that, whatever Y’s long-term intentions may have been, he had attempted to raise money for the transaction for a maximum of a three to five year period.
Davis J said (at para ) that the nature of the “equity kicker” supported the argument that there was an intention to fund the loan repayments by way of a sale of the shares, because the amount of the equity kicker was fixed as a proportion of the gain realised by A (Pty) Ltd on the shares that had been acquired with the loan, and that the equity kicker would be paid from the funds derived from the sale of the shares.
The evidence did not establish, on the probabilities that the shares were to be a long-term investment; and if that was indeed the purpose, there was no clear proof that it was the dominant purpose. Within a very short period, the sale of the shares had been on the agenda, initiated by Y and explored further by Z.
Davis J concluded in this regard that, in relation to the present case –
“When both the purpose at the time of acquisition and sale are considered, it cannot be concluded, on the probabilities, that a long term investment was realised to best advantage. To the contrary, the mixed intention had converted into a clear purpose of selling to ‘cash’ in on the profit.”
The deductibility of the equity kicker
As regards the deductibility of the so-called “equity kicker”, Davis J said (at para ) that, from the point of view of the taxpayer, A (Pty) Ltd, its liability to pay this amount was a real cost in acquiring the shares since it became payable once a profit was made on the sale of the shares.
Davis J said that there was nothing to gainsay the argument that A (Pty) Ltd had acted in good faith in declaring the amount in question as a capital gain in its 2005 tax return, and he ordered that the interest on the additional tax that was now found to be payable by A (Pty) Ltd was to be remitted.
This matter again highlights the extent to which the surrounding circumstances will influence a Court in deciding on the extent to which it will place reliance on the assertions of the witnesses. In the final analysis, the witnesses’ evidence was not conclusive as to a long-term intention to hold the assets, primarily because a three-year term loan with a sweetener linked to the disposal of the shares formed the basis of the financing. Thus the surrounding circumstances caused doubt in the mind of the Court.