Deemed Disposals: Mystery in Double Tax Agreements
The recent judgment of the Supreme Court of Appeal on deemed disposal and its relevance to double tax agreements has left National Treasury and the Minister of Finance marooned and bamboozzled. The Supreme Court of Appeal delivered judgment on 8th May 2012 in the case of the Commissioner for the South African Revenue Service v Tradehold Limited (132/11) (2012) ZASCA 61.
In this case the Commissioner for the South African Revenue Service was an appellant and Tradehold Limited the respondent. Tradehold had initially succeeded in the Cape tax court to have the additional assessment by the South African Revenue Service (“SARS”) set aside. SARS raised an additional assessment on Tradehold based on the deemed disposal by Tradehold of its shares in Tradegro Holdings Limited. The deemed disposal was a result of the application of paragraph 12 of the Eighth Schedule to the Income Tax Act No. 58 of 1962 (“the Act”).
Tradehold is an investment holding company incorporated in South Africa and listed on the Johannesburg Stock Exchange. During the year of assessment ended 28 February 2003, Tradehold’s only relevant asset was its 100% shareholding in Tradegro Holdings which in turn held 100% of the shares in Tradegro Limited, a company incorporated in Guernsey. In turn, Tradegro Limited held 65% of the shares in the UK-based company, Brown & Jackson PLC.
On 2 July 2002, at a meeting of Tradehold’s board of directors in Luxembourg, it was resolved that all further board meetings would be held in Luxembourg. The result of the resolution was that as from 2 July 2002, Tradehold became effectively managed in Luxembourg.
Nevertheless, Tradehold remained a resident of South Africa by reason of its incorporation in the Republic as provided by section 1 of the Act at that time.
The term ‘resident’ was defined in relation to a person (other than natural person) as a person who is incorporated, established or formed or has its place of effective management in the Republic.
Subsequent legislative amendment
With effect from 26 February 2003, the proviso was added to the definition of the term ‘resident’. The effect of the proviso was that a person will not be treated as resident in South Africa if that person is exclusively deemed to be resident of another country for the purpose of double tax agreement with that other country. A double tax agreement (“DTA”) is entered into between countries with the purpose of avoiding the taxation of income by both countries in similar hands.
Subsequent tax treatment by SARS
SARS relied on the provisions of paragraph 12(2)(a) of the Eighth Schedule to the Act and contended that Tradehold is deemed to have disposed of their only relevant asset, i.e 100% shareholding in Tradegro Holdings at the time of its relocation of effective management to Luxembourg on 2 July 2002 or at the time Tradehold ceased to be resident of South Africa on 26 February 2003. Paragraph 12(2)(a) of the Eighth Schedule provides that a person shall be deemed to have disposed of their assets when they cease to be resident of South Africa or when such person can no longer be regarded as resident of South Africa for DTA purposes.
However, assets such as immovable property in SA and any assets attributable to a permanent establishment in SA will be excluded from the deemed disposal provisions and May only be taxable when actual disposal takes place.
Since Tradehold ceased to be resident of South Africa for the purpose of SA domestic tax law effective from 26 February 2003, SARS argued that Tradehold should be deemed to have disposed of their assets on 26th February 2003. Consequently, SARS raised an additional assessment on capital gains in the hands of Tradehold to an amount of R405, 039,083. This type of tax on cessation of residence is colloquially referred to as an ‘exit tax’.
Legal status of double tax agreements
Section 231 of the Constitution of the Republic of South Africa Act No. 108 of 1996 (“the Constitution”) provides that the Republic may enter into international agreements with other countries and such agreements have to comply with the Constitution and be consistent with any relevant Act of parliament. On the other hand, section 108(1) of the Income Tax Act provides for specific types of international agreements to be entered into with the purpose of avoiding the double taxation of income. Section 108(2) of the Act further provides that once a double tax agreement is approved by parliament and published in the Gazette; such an agreement will assume equal status with the Income Tax Act.
For example, SA Government entered into the DTA with the Government of Grand Duchy of Luxembourg on 6 December 2000. The DTA is applicable to SA in respect of the years of assessment commencing on or after 1 January 2001.
Conflict between double tax agreements and the domestic tax law
Corbett JA held in SIR v Downing (1975) (4) (SA 518(A) (37 SATC 249) that in the event of any ambiguity or conflict between the DTA and the provisions of the domestic tax law, the DTA must take preference and its provisions be given effect. For example, prior to 2 July 2002, Tradehold became resident of SA because the company was incorporated in SA and had its place of effective management in SA. From 2 July 2002, Tradehold assumed dual residence when they relocated their board meetings to Luxembourg, thereby moving their place of effective management from SA to Luxembourg.
Prior to 26 February 2003, Tradehold qualified as resident of SA because of its incorporation in SA and also qualified as resident of Luxembourg because of the provisions of the DTA between SA and Luxembourg. Following on the judgment in SIR v Downing (supra), Tradehold’s dual residence status may only be resolved through the provisions of the DTA.
Article 4(3) of the relevant DTA contains the so-called ‘tie-breaker’ provisions and it directs that where a person (other than natural person) qualifies as resident of both Luxembourg and SA, such person shall be deemed to be resident where their place of effective management is situated. Since Tradehold’s place of effective management moved to Luxembourg from 2 July 2002, Tradehold is deemed to be resident of Luxembourg from that date for DTA purposes.
Effects of the Court Judgment
The Supreme Court of Appeal confirmed the judgment of the Cape Tax Court where Tradehold succeeded in their appeal. Tradehold argued that in terms of the DTA, the company was resident of Luxembourg at the time SARS raised an assessment on the capital gains on deemed disposal. Tradehold cited article 13(4) of the DTA where the taxing rights on the alienation of relevant property are given to the resident state of the alienator. SARS argued that article 13(4) did not cover deemed and only covered actual disposal. To this end, SARS cited the dictum in Cronje v Paul Els Investments (Pty) Ltd (1982) (2) SA 179 (T) where the term ‘alienation’ was defined to mean an action of transferring ownership to another.
The court in casu confirmed the judgment of the court a quo and held that ‘alienation’ includes both actual and deemed disposals of property. The Court pointed at the significance of no distinction drawn between actual and deemed disposals by article13 of the DTA. The Court concluded that the contracting states had no intention to restrict ‘alienation’ to actual disposals only. The Court concluded that since 2 July 2002, the DTA gave Luxembourg exclusive taxing rights on any capital gains made by Tradehold.
It would be interesting to consider whether or not the outcome would be different if SARS argued that deemed disposal took place on 1 July 2002 prior to Tradehold moving its place of effective management to Luxembourg. Paragraph 13(1)(g)(i) of the Eighth Schedule to the Act provides that the timing of the deemed disposal under para 12(2)(a) (inter alia) shall be the day prior to the event itself.
However, this argument was not advanced by SARS because they were under the impression that the deemed disposal resulted from the amendment effected on 26 February 2003 to the definition of residence. On 1 July 2002 Tradehold was purely a resident of SA by virtue of incorporation and the location of its place of effective management in SA. Had SARS argued for 1 July 2002 as the date of deemed disposal, Tradehold would have been correctly assessed on the capital gains made from deemed disposal.
The point missed by SARS and National Treasury
The Minister of Finance expressed his disappointment in the outcome of the Tradehold case and the judgment of the Court. The Minister based his disappointment on the fact that the Eighth Schedule to the Act makes provision for a deemed disposal on a person’s cessation of residence in SA and this should have been the case even with Tradehold. However, SARS and National Treasury did not base their argument on the date that was going to result in capital gains being taxable in SA.
On 26 February 2003 Tradehold was a resident of Luxembourg by virtue of their board meetings being held in Luxembourg. However, on 1 July 2002, the date prior to 2 July 2002 and the date on which the resolution was passed to move board meetings to Luxembourg, Tradehold was purely resident of SA. Had SARS invoked the provisions of para 13(1)(g)(i) of the Eighth Schedule to the Act and put 1 July 2002 as the date of the deemed disposal in front of the court, probably the judgment would have been in favour of SARS and not Tradehold. The SCA was not asked to interpret the law, but to decide on who is correct between SARS and Tradehold on their argument of residence on 26 February 2003 and whether or not the provisions of double tax agreements cover both deemed and actual disposals.
With effect from 26 February 2003 National Treasury has attempted to align the definition of residence with international tax law as bicontained in double tax agreements. Since the cessation of residence should take place for such an event to be deemed disposal, SARS may, in some instances, appear to be left with little ground to argue for the taxing rights where SA has entered into the DTA with the country of a person’s new residence, unless the assets involved are those that are excluded from the deeming provisions in SA.
Author: Moraka Joseph Komape CA(SA), Tax Practitioner