Tax Avoidance (GAAR) – Real intention of contracting parties

court hoodCIR v Sunnyside Centre (Pty) Ltd [1996] 58 SATC 319 clearly stated that South African taxpayers must sleep in the (contractual) beds they make:

“When a scheme works, no tears are shed for the Commissioner. That is because a taxpayer is entitled to order his affairs so as to pay the minimum of tax. When he arranges them so as to attract more than the minimum he has to grin and bear it.”

There are two sides to this coin (or is it bed?).

Where the South African Revenue Service (SARS) senses that the written agreement between contracting parties does not reflect their true intention, it invokes the ‘substance over form’ doctrine. This would seek to tax the transaction with reference to its ‘substance’, thereby disregarding what was meticulously set out in writing. To achieve this, SARS must show that the parties had “… a real intention, definitely ascertainable, which differs from the simulated intention.” (Zandberg v Van Zyl [1910] AD 302).

A substance attack is appropriate where contracting parties deceive in relation to their real intent, aiming to extract some tax advantage not available to them.

The deception, constitutes,
“… a dishonest transaction: dishonest, in as much as the parties to it do not really intend it to have, inter parties, the legal effect which its terms convey to the outside world … The parties wish to hide the fact that their real agreement or transaction falls within the prohibition or is subject to the tax, and so they dress it up in a guise which conveys the impression that it is outside of the prohibition or not subject to the tax.”(Commissioner of Customs and Excise v Randles Brothers and Hudson Ltd [1941] 33 SATC 48).

In CSARS v NWK Ltd [2011]73 SATC 55the fundamental principle was accepted that a taxpayer is entitled to arrange his affairs as to remain outside of the provisions of a Tax Act. Lewis JA held, however, that a court would not be deceived by the form of a transaction but would examine its true nature and substance. In considering whether simulation was present, “[T]he test should thus go further, and require an examination of the commercial sense of the transaction: of its real substance and purpose.” [Paragraph 55] This required that “… there must be some substance – commercial reason – in the arrangement, not just an intention to achieve a tax benefit or to avoid the application of a law. A Court should not look only to the outward trappings of a contract: it must consider, when simulation is in issue, what the parties really sought to achieve.”

Under the substance doctrine tax consequences attach to a transaction based on the contracting parties’ (unexpressed) ‘real intention’ (NWK case: “what the parties really sought to achieve”) as opposed to the (deceiving) written terms or ‘outward trappings’ of the contract.

Now to the flipside: What is the position where the taxpayer’s written agreement is subsequently found to contain drafting or implementation errors producing unintended adverse tax consequences?  In other words, where the written agreement in fact does not represent the parties’ consensus.

But what if a revenue authority, perhaps opportunistically, attempts to extract tax on the basis of such an incorrectly drafted/poorly implemented agreement?

The above would mean that the parties’ ‘real intention’ counts for little with the badly drafted/implemented agreement becoming the sole basis for a tax assessment. This issue was considered in two Canadian cases (subsequently dealt with in a single judgment by the Supreme Court of Canada (SCC)).

In Quebec (Agence du Revenu) v. Services Environnementaux AES Inc., [2013] SCC 65 (decided on 28 November 2013), the SCC dealt with two appeals where the revenue authority attempted to tax on the basis of written agreements – but where professional advisers had made errors in executing the tax planning documentation. In the one case there was an incorrect valuation; in the other the advisers got the implementation sequence wrong. In both instances there was no dispute regarding what the two sets of transactions set out to achieve and what the original consensus had been.

Both taxpayers used rectification to escape the unanticipated tax consequences.

The SCC (Lebel J.) approached the matter as follows:

  • The parties’ intended that their agreements should have no tax consequences. This was not achieved due to errors made by professional advisors.
  • The two rectification applications were simply for “… the true nature of the agreements to be established and recognised so as to ensure that their declared will, as expressed in their written documents, is consistent with their true intention”.
  • The formation of a contract is “… subject to the principle of consensualism … no particular form is required except where the legislature intervenes to impose one. The common intention of the parties is not equivalent to the expression – oral or written – of their declared will.” According to the SCC “A contract is distinct from its physical medium.” In essence: a written agreement might not be an accurate expression of the parties’ consensus.
  • Where a contract does not reflect the parties’ consensus this can be remedied since “… the contract belongs to the parties.” Consequently “… they are free as between themselves, although this is subject to any rights acquired by third parties, to amend or annul the contract and the documents recording it. This means there is nothing to prevent them from acknowledging the existence of a common error and agreeing to correct it by mutual consent”.
  • In the two cases before it the SCC accepted the parties’ description of their consensus. Such consensus was, however, not reflected in the wording or implementation of the agreements. The parties therefore agreed to take corrective action. This resulted from the actual will of the parties and there was no need to rely on a supposed power to correct based on the implicit powers of the Superior Court.
  • It was accepted that the parties agreed to correct the error by amending the documents that recorded and implemented their agreements, including the necessary tax forms, thereby restoring the integrity of their original agreements.
  • Regarding the revenue authority the question was “… whether they can rely on acquired rights to have an erroneous writing continue to apply even though the existence of an error has been established and it has been shown that the documents filed with the tax authorities are inconsistent with the parties’ true intention.”
  • The SCC held: “Under the civil law itself, the [revenue] agencies can also prove that simulation existed and demonstrate the true nature of the transactions they allege to be shams. In addition, tax legislation may re-characterise contractual or economic transactions for its own purposes by overriding the legal categories established by the common and civil law. With the exception of such situations, however, tax law applies to transactions governed by, and the nature and legal consequences of which are determined by reference to, the common or the civil law.”
  • Because the above-mentioned exceptions did not apply, the SCC held that, in the civil law, the tax authority did not have an acquired right to benefit from an error made by the parties to a contract after the parties had corrected the error by mutual consent.

So, the taxpayers prevailed. Following the retroactive rectification, tax could not be levied on the basis of agreements that were inconsistent with the taxpayers’ intent.

The SCC did sound a warning though: “Taxpayers should not view this recognition of the primacy of the parties’ internal will — or common intention — as an invitation to engage in bold tax planning on the assumption that it will always be possible for them to redo their contracts retroactively should that planning fail.”

The approach of the SCC confirms that a transaction’s tax consequences should be determined with reference to the contracting parties’ real intention. Where the written agreement is inconsistent with the parties’ consensus, rectification should happen, followed by the determination of the tax consequences on the basis of the agreement correctly reflecting the parties’ consensus.

The position in South Africa is similar. In Rane Investment Trust v CSARS [2003] 65 SATC 333,the Supreme Court of Appeal (SCA) dealt with tax consequences of a so-called ‘film scheme’. The SCA pointed out: “… we are not concerned in this matter with a dispute between the parties. It is a third person – the Commissioner – who seeks to place a different interpretation on the agreements.” The SCA held that “… when a third party is questioning the meaning of a contract, regard may be had to the parties’ conduct in executing their obligations.” Despite certain ‘obscure’ clauses in the parties’ contract, the SCA gave effect to the agreement since the parties’ subsequent conduct was aligned with what they really intended to achieve. The tax consequences in Rane Investments followed the tenor of the agreement because the agreement was accepted as evidencing the parties’ real consensus – despite SARS’s misgivings.

The bottom-line, for both revenue authority and taxpayer, is that tax consequences should take their cue from the contracting parties’ ‘real intention’. Where there is deception, SARS can apply the “substance over form” doctrine and ignore the simulation. On the other hand, where the taxpayer’s agreement is inconsistent with the parties’ real intention, rectification should happen, and only thereafter the determination of the tax consequences (if any).