Sale of shares – capital v revenue

Background

ITC 13003 [2013] involved the disposal of shares by a taxpayer and whether the proceeds realised constituted gross income and were of a revenue nature. The taxpayer happened to be a Special Purpose Vehicle and it was argued that the proceeds of the sale of shares were of a capital nature. There were also additional costs incurred which were closely associated with the acquisition of the shares in question. These costs incurred were the so-called ’equity-kicker’ and ‘indemnity costs’.

The taxpayer essentially acquired the shares from the bank. The bank disposed of the shares as part of restructuring a furniture business, M Ltd, which was experiencing serious financial difficulties. M Ltd was ultimately merged with the FG Group and the taxpayer bought shares in this merged business. The taxpayer funded the acquisition of shares by issuing preference shares to the bank and ordinary shares to its holding company. When the funding was raised, it was agreed that the preference shares were to be redeemed after three years. The court also had to consider how the ‘equity- kicker’ was going to be funded.

Witnesses and their roles

Key to this case is gaining an understanding of the roles of the major witnesses.

  • The key witnesses in this case were Mr Y, Mr O, Mr J, and Mr Z. Mr Z was invited by the bank to turn the business around. In approaching Mr Z, the Bank used Mr Y as an intermediary. Mr Z who had previously invested in the SA furniture industry was approached with a view to convince him to invest fresh capital. Mr Z agreed to be part of the deal on certain conditions which allowed him some element of control. Amongst these conditions was that ABC must agree to provide funding to the proposed transaction by way of preference shares that would be redeemable after three years-and-one-day.
  • Mr Y was involved in the structuring of the transaction including the funding of the acquisition of shares.
  • Mr O was seen by Mr Z as someone who had the necessary skills to turn the ship around. He led the consortium that acquired shares in FG Group. Mr O was the chairman of FG Group.
  • Mr J represented the buyer and facilitated the implementation of the book building exercise.

Important dates

  • Although the memorandum of understanding, which gave rise to a binding commitment and the passing of ‘risks and rewards’ was signed on 26 June 2002, a written sale and subscription agreement for the sale of shares by the bank to the taxpayer was concluded in May 2003.
  • Other changes were made to the agreements in May 2003 and the addendum was concluded and implemented in December 2003.
  • Another interesting aspect was the meeting between Mr Y and Mr J in November 2003 to discuss the so-called ’book building exercise’.

This book building concept was explained by Mr J in court as the sale of shares to the institutional market (which in this case was a global audience of institutional investors). Its purpose was to avoid a situation where the market came to the assumption that there was an overhang in the shares.

  • In February 2004 Mr Y approached Mr J suggesting that he may wish to submit a proposal in relation to the book building exercise. This was now explained to Mr Z as well.
  • In March 2004 a decision was made to proceed with the sale of shares.
  • The sale and purchase agreement was concluded on 21 April 2004 by the taxpayer and E Group (the buyer).

Evidence presented by witnesses

The witnesses provided the following evidence:

  • Mr O testified that he together with Mr Y met Mr Z at a point when the turnaround transaction had met considerable success. Mr O told the court that in this meeting Mr Z had asked them, given what had transpired and what they had achieved, how they felt about Mr Z disposing of his stake. Mr O also testified that in the course of that time they were boastful and in high spirits and had no objections whatsoever. These discussions took place in April 2004 while certain aspects of the agreement were concluded in December 2003.
  • Mr Z’s evidence was that his decision to sell was based on overexposure to the South African market and that the appellant had no say in the decision, other than to follow Mr Z and dispose of his shares. Mr Z also testified that he was free to take his money out by disposing of the shares and that his wife was concerned that he had all his eggs in one basket (invested solely in South Africa).
  • Mr Y was cross-examined regarding the sources of funding available to the appellant and his approach to selling. With regards to the funding, Mr Y told the court that the parties were looking for a five-year finance plan even though three years was regarded as the maximum for such a loan. Mr Y also testified that he did not discuss the sale of FG Group shares with Mr J, but rather raised the question of whether or not secondary shares could be sold by way of a book building exercise. However, when pressed about the content of the meeting he conceded that he could not deny discussing the FG Group shares.
  • Mr J’s evidence involved the book building exercise and their discussions with Mr Y. In his evidence he mentioned that Mr Y gave him the name of the company in enquiring about the book building exercise and enquired as to whether this could be replicated for a parcel of existing shares, these being secondary shares.

 Taxpayer’s argument

From the facts of the case, counsel for the taxpayer argued that the proceeds were capital in nature because the intention of buying shares was to hold them as capital assets, and such intention did not change until the shares were disposed of. In supporting this argument the following were the main points raised:

  • If the appellant’s intention had to be determined with reference to that of Mr Y, then at no material time did Mr Y contemplate or intend the sale of the FG Group shares. The evidence suggested that Mr Y was opposed to the decision of Mr Z to sell the FG Group shares.
  • The controlling mind of the appellant had to be determined with reference to the intention of Mr Z as Mr Z was the ‘captain of the ship’ with sole power to make key decisions.
  • With regard to the acquisition of shares in December 2003 and their disposal in April 2004, it was argued that the period was insufficient to determine whether the investment was short-term or speculative. The ‘risks and reward date’ was the effective date under the memorandum of understanding signed in June 2002.
  • It was the approach by E Group that triggered Mr Z’s decision to sell the shares.

Decision of the court

The court decided that the sale of shares should be subject to normal tax on the basis that the proceeds constituted gross income. In coming to this conclusion the court took the following into consideration:

  • Whatever the taxpayer had to tell the court had to be analysed through the prism of the objective facts presented to the court. When the evidence of the relevant persons testifying on behalf of the taxpayer were analysed through the prism of objective facts, then the intention of the taxpayer, both at the time of acquiring assets and at the time of the sale were of decisive importance.
  • A true picture of the appellant appeared to be that Mr Y was, for all purposes the organiser of the appellant, responsible for the financing of the appellant, and hence the ‘brains’ of the company.
  • The objective evidence suggested that the investment in the FG Group shares was to last for a period of at least three years, arguably slightly longer, depending upon the success of the venture.
  • A constant theme running through Mr Z’s evidence was that he wanted to have the freedom to deal with his ‘investment’ as he saw fit. There were no significant restrictions imposed upon Mr O and Mr Y insofar as the FG Group shares were concerned, save that they would remain invested until the M Ltd transaction was ‘bedded down’.
  • Whatever Mr Y’s evidence with regard to his long term intentions, he had attempted to raise money for the FG Group transaction for a maximum of a three- to a 5-year period.
  • 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 ‘equity kicker’ was clearly calculated to constitute a portion of the gain realised by the borrower on the assets acquired with the loan.
  • The loan agreement made it clear that the envisaged source of funds would be the proceeds of the FG shares, the cash from which had to come to KL through a declaration of a dividend by the appellant.
  • Mr Y initiated a discussion with Mr J as to whether shares could be sold by way of a book building exercise in November 2003, less than a month before the ultimate acquisition of the shares. It appeared that Mr Y disclosed the name of the FG Group, the size of the stake he had in mind as well as Mr O’s involvement.
  • In the present case, these shares were not part of an investment portfolio which might need more rapid responses to protect the overall investment but a once off transaction.
  • The evidence suggested that Mr Z was not a reluctant seller. He and the appellant through Mr Y realised that they could take advantage of a transaction which had turned significantly in their favour. The possibilities of a sale had always been in their minds from the commencement of the transaction as is evidenced by the nature of the financing, the discussions between Mr J and Mr Y about the book building exercise and the expedition in the actual sale of shares.
  • The question was not if, but when the sale would occur.

The provisions of section 9C are not considered in this case, as this section was introduced after 2005. From the decision reached in this case, it is clear that SPV companies should do some soul-searching before they dispose of their investments.

(Editorial comment: An interesting by-product of the judgment was that the court rejected the time-honoured test of holding an asset “for keeps” as an indicator of a capital intention.  In the current investment environment, the idea of holding an asset permanently is unrealistic.)

Sizwe Ntsaluba Gobodo TC 759

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