Tax Avoidance -Simulated transactions

supreme cort of appeal 1In Roshcon (Pty) Ltd v Anchor Auto Body Builders CC [2014] ZASCA 40 (Roshcon) the Supreme Court of Appeal (SCA), in a unanimous judgment drafted by Wallis JA, has clarified the issues caused by its previous decision in SARS v NWK Limited [2011] SA 67 (NWK). Roshcon was not a tax case; it concerned supplier and floor plan agreements relating to the sale of trucks, with a reservation of ownership to a finance house as security until the trucks were fully paid for by the purchaser. On the assumption that NWK had transformed our law in regard to simulated transactions, counsel contended that the agreements in question were a disguise or simulation, amounting in fact to a pledge of the trucks without delivery or possession as required by law. In rejecting this argument, the SCA took great care to reaffirm the well-established principles relating to simulations, and to explain its previous comments in NWK.

NWK was a tax case. It concerned what was essentially a loan of R50 million, but with a range of unrealistic and self-cancelling features added to make it look like a loan of nearly R100 million.  These additional features served no real commercial purpose other than to inflate the deductions that NWK could make against its taxable income. The SCA had no hesitation in declaring the transaction to be a simulation, notwithstanding the fact that the parties intended to take all the unrealistic steps provided for in the contractual documents. Delivering the unanimous judgment of the Court, Lewis JA said the following:

“In my view the test to determine simulation cannot simply be whether there is an intention to give effect to a contract in accordance with its terms. Invariably where parties structure a transaction to achieve an objective other than the one ostensibly achieved they will intend to give effect to the transaction on the terms agreed. The test should thus go further, and require an examination of the commercial sense of the transaction: of its real substance and purpose. If the purpose of the transaction is only to achieve an object that allows the evasion of tax, or of a peremptory law, then it will be regarded as simulated. And the mere fact that parties do perform in terms of the contract does not show that it is not simulated: the charade of performance is generally meant to give credence to their simulation.”

This passage and the underlined sentence in particular, aroused concern amongst tax practitioners and others. It appeared to call into question the long-established principle that parties may genuinely arrange their transactions in such a way as to avoid the imposition of a tax, or to remain outside the provisions of a statute. It suggested that even an honest transaction might be deemed a simulation and in fraudem legis if it lacked a sound commercial purpose. Moreover, it blurred the distinction between motive and intention so carefully drawn by the SCA in the earlier case of  Hippo Quarries (Tvl) (Pty) Ltd v Eardley [1992] SA 867, where the genuineness of a cession was in question: “Motive and purpose differ from intention. If the purpose of the parties is unlawful, immoral or against public policy, the transaction will be ineffectual even if the intention to cede is genuine. That is a principle of law. Conversely, if their intention to cede is not genuine because the real purpose of the parties is something other than cession, their ostensible transaction will likewise be ineffectual. That is because the law disregards simulation.”

In Roshcon, the SCA has now said that these concerns were unfounded: the underlined sentence in the passage from NWK quoted above should be read in the context of the passage as a whole, and the passage itself should be read in the light of the discussion that preceded that. Read in that light it was manifestly not the intention of Lewis JA to upset the established principles regarding simulated transactions.

Those principles were clearly spelled out by Innes CJ in the foundational cases of Zandberg v Van Zyl [1910] AD 302 and Dadoo Ltd v Krugersdorp Municipal Council [1920] AD 530, and elaborated in subsequent cases such as Customs and Excise v Randles, Brothers & Hudson Ltd [1941] 33 SATC 48. They are to the following effect: A simulated transaction is one that is deliberately disguised to conceal its true nature. In essence, it is a dishonest transaction, in as much as the parties to it do not really intend it to have, inter partes, the legal effect that its terms convey to the outside world. The parties have “a real intention, definitely ascertainable, which differs from the simulated intention”. However, a transaction is not necessarily a disguised one merely because it is devised for the purpose of evading a prohibition in a statute or avoiding liability for a tax imposed by the statute; if the parties honestly intend the transaction to have effect according to its tenor, it will be interpreted by the courts according to its tenor; and then the only question is whether, so interpreted, it falls within or outside of the prohibition or the tax.

Accordingly, Wallis JA in Roshcon said: “Whether a particular transaction is a simulated transaction is therefore a question of its genuineness. If it is genuine the court will give effect to it and, if not, the court will give effect to the underlying transaction that it conceals. And whether it is genuine will depend on a consideration of all the facts and circumstances surrounding the transaction.” Those circumstances include the commercial purpose of the transaction, any unusual features of the transaction, and the manner in which the parties intend to implement it. The presence of unusual features which serve no commercial purpose would thus give rise to a suspicion that the transaction was not a genuine one.

In income tax cases such as NWK, explained Wallis JA, parties may seek to take advantage of income tax legislation in order to obtain a reduction in their overall liability for income tax. The various mechanisms for doing this involve taking straightforward commercial transactions and adding complex additional elements solely for the purpose of claiming increased or additional deductions from taxable income, or allowances provided for in the legislation. “The feature of those that have been treated as simulated transactions by the courts is that the additional elements add nothing of value to the underlying transaction and are very often self-cancelling.” This was the case in NWK where a range of unrealistic and self-cancelling features had been included “solely to disguise” the true nature of the loan. The requirement of disguise was therefore met in the NWK case and therefore the simulation principle applied in these circumstances.

The problem the court faced in NWK was that despite the apparent futility in doing so, the parties intended to take all the steps provided for in the contractual documents, “in other words, to jump through the contractual hoops as a matter of form”. It was in this context (i.e. the context of a disguised transaction) that Lewis JA had said that it was not sufficient, when testing for a simulation, to enquire whether there was an intention to give effect to a contract in accordance with its terms; the test had to go further, and require an examination of the commercial sense of the transaction, of its real substance and purpose.

It is therefore now clear that the simulation principle still requires an element of dishonesty, disguise or deception. In the absence thereof, the principle cannot apply. In applying this principle to “genuine” transactions it is therefore not necessary for a court to go further and test whether such transactions have commercial substance and purpose as articulated in the NWK case.

Shongwe JA decided the matter on the basis that, on the facts, the appellant failed to show on a balance of probabilities that the transaction was simulated. The court came to this conclusion without relying on the NWK judgment – probably because the court was not dealing with a matter involving tax avoidance. It is therefore not entirely clear whether the comments made by Wallis JA on the NWK judgment forms part of the ratio decidendi of the court.

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