Sale of shares by special purpose vehicle

sharesAuthor: Heinrich Louw – DLA Cliffe Dekker Hofmeyr Author page Ľ Judgment was handed down by a full bench of the High Court, Western Cape Division, in the matter of Capstone 556 (Pty) Ltd v Commissioner for the South African Revenue Service, on 26 August 2014. The matter was on appeal from the Tax Court (ITC 1867 75 SATC 273), on which we reported in our Tax Alert of 5 July 2013.


Profurn was a listed company and by 2001 it had run up a bank debt of nearly R900 million.

R600 million of the debt was subsequently converted into equity, after which the bank held approximately 78% of the shares in Profurn.

JDG, another company in the same industry, was introduced, along with Jooste (an intermediary), and Daun (a German businessman).

JDG agreed to take over Profurn in exchange for issuing JDG shares to the bank.

The bank received the JDG shares in April 2003, and then sold nearly all of these JDG shares, in equal parts, to the taxpayer, and a German company Daun et Cie (being one of Daunís companies).

The taxpayer acquired its JDG shares on 5 December 2003, and funded the acquisition of the JDG shares through the issue of preference shares to the bank and borrowing money from shareholders.

By April 2004, 5 months after the taxpayer acquired the JDG shares, it sold the shares to a purchaser.

Capital or revenue?

In respect of the taxpayer’s 2005 year of assessment, the taxpayer accounted for the proceeds on the disposal of the JDG shares as being capital nature. However, the South African Revenue Service (SARS) assessed the taxpayer on the basis that the proceeds on the sale constituted gross income.

The Tax Court agreed with SARS, reasoning that Jooste was the ‘controlling mind’ behind the taxpayer, and on the objective facts Joosteís intention was clearly to make profi t at the time of the sale, even if there was previously a mixed intention.

The High Court took the approach that, despite the objective facts pointing to the taxpayer having sold the JDG shares shortly after acquiring them, and by making use of short-term finance, ďthe taxpayerís explanation of the events, including his or her intention in respect of the transaction in question, is Ö relevant and must be tested in the light of all the other circumstancesÖit would be an over-simplifi cation to focus too closely on the bare factsÖin drawing an inference as to the intention of the taxpayerĒ.

The court found that the purpose of the entire scheme was a rescue operation, and not a profi t-making scheme. On the broader evidence, such rescue operation would take between 3 and 5 years, and the parties involved could not be said to have a short-term intention. The taxpayerís intention was to make a ‘strategic investment’ in the relevant industry and to hold the shares until the rescue was successful.

Also, the taxpayer did not have to prove that it bought the shares as a long-term investment, but only that it did not buy the shares as trading stock as part of a profit-making scheme.

As for the intention of the taxpayer at the time of selling the shares, the court found that it was really Daun who controlled the decision to sell, and not Jooste as shareholder of the taxpayer. Jooste, and thus the taxpayer, were obliged to go along with Daunís decision as the main partner in the consortium. Thus there was no actual decision by the taxpayer other than to follow Daun.

Additionally, the court noted the following factors regarding the taxpayer, being a special purpose vehicle, that convinced it that the shares were acquired and held as capital assets:

as a special purpose vehicle, the taxpayer was contractually precluded from doing anything other than acquiring and holding the shares Ė it could not trade with the shares;
the taxpayerís financial statements refl ected the shares as ‘non-current’ assets; and
no trade was conducted by the taxpayer, and the taxpayer did not hold any board meetings.
The taxpayerís appeal, on this point, was accordingly upheld.

Equity kicker

In the Tax Court, the taxpayer sought to claim a deduction for payment of a so-called ‘equity kicker’ in circumstances where the proceeds on disposal of the JDG shares were found to constitute gross income. However, on the finding of the High Court that the proceeds did not, the question was whether the equity kicker could be included in the base cost of the JDG shares.

The taxpayer was partially funded by a loan from its shareholder BVI, which was in turn funded by a loan from its shareholder Gensec.

BVI and Gensec agreed that in addition to BVI having to pay back its loan to Gensec, it also had to pay an ‘equity kicker’, being an amount representing a portion of the growth in the value of the JDG shares, calculated by means of a formula. The taxpayer was not formally party to that agreement, and on the face of it had no unconditional liability to pay the ‘equity kicker’ to anyone. However, the taxpayer actually paid the equity kicker.

The Tax Court found that the equity kicker was deductible by the taxpayer because in substance, the amount was incurred by it. The High Court agreed that the amount was actually incurred by the taxpayer, also for capital gains tax purposes. However, the High Court found that the equity kicker constituted ‘borrowing costs’, which is generally excluded from being added to an assetís base cost. However, an exception exists where the asset is a listed share, such as the JDG shares were, allowing for a third of certain borrowing costs to be taken into account for purposes of determining the base cost of the shares.

The High Court therefore allowed one third of the equity kicker to be included in the base cost of the JDG shares.

Indemnity payments

In the Tax Court, the taxpayer also sought to deduct an amount paid to Daun et Cie in respect of an indemnity that Daun et Cie had provided to the bank. The amount was payable to Daun et Cie irrespective of whether any actual liability arose under the indemnity. SARS argued that no amount had actually been expended by the taxpayer during the 2005 year of assessment, but the Tax Court concluded that, on the evidence, the amount had actually been incurred in July 2004, and thus fell within the 2005 year of assessment.

The High Court noted that the decision by the taxpayer to pay Daun et Cie effectively converted a contingent liability, in respect of the acquisition of the shares, into an unconditional liability, only much later. The High Court found that, if anything, the amount paid constituted a cost of disposal, but not a cost of acquisition, and could therefore not be included in the base cost of the shares.


The High Court provisionally ordered SARS to pay 80% of the taxpayerís cost of appeal.