Tax Administration – Interpreting statutory provisions

sa courtSARS has investigated, and in many cases raised assessments in respect of, share incentive schemes where the employee had accepted an offer to purchase shares at a fixed price prior to 26 October 2004, subject to delivery and payment taking place at a future date. The law relating to these schemes (known as deferred delivery schemes or DDS schemes) was amended with effect from that date.

The Supreme Court of Appeal has now delivered its judgment in the matter of C: SARS v Bosch [2014] ZASCA 171 (19 November 2014) and provided clear guidance on the application of the Income Tax Act No. 58 of 1962 (the Act) in relation to deferred delivery share incentive schemes, where the employee had exercised the right to acquire the shares prior to 26 October 2004.

SARS had raised assessments on 117 employees of the Foschini Group, against which objection and appeal had been noted, and the cases of Ms Bosch and a fellow employee, Mr McClelland, were test cases in relation to the assessments in question. It is well known that disputes and investigations relating to a number of similar share schemes operated by other employers have been stayed, pending the outcome of this appeal.

The facts  
The employees were employed by the Foschini Group and, in September and December 1998, they were each granted options to acquire shares in Foschini’s listed holding company at the middle market price quoted on the JSE on the date of the notice of grant.

The options had to be exercised within 21 days of the notice, and were duly exercised within that time by both employees.

The scheme provided that the shares would be delivered in three equal tranches on the second, fourth and sixth anniversaries of the notice of grant of the option. The purchase price for the shares was payable on delivery, but the employees could elect that the scheme shares be sold and that the amount remaining after deduction of the purchase consideration and costs of sale be paid to them.

The final tranches fell due on 14 August 2004 and 2 December 2004. Ms Bosch paid for the shares which were delivered to her, and Mr McClelland elected to sell the shares and received a cash payment as described above. In each case, the market value of the shares was considerably higher than the purchase consideration, and SARS sought to impose tax on the benefits derived.

Both of the tranches were the subject of the appeal, as SARS had argued that the tranche that fell due after 26 October 2004 should be taxed on the basis indicated in section 8C (the amendment to the Act), which came into effect from that date.

The law
The statutory provision that applied to the options was section 8A(1)(a) of the Act, which stated:

“There shall be included in the taxpayer’s income for the year of assessment the amount of any gain made by the taxpayer after the first day of June, 1969, by the exercise, cession or release during such year of any right to acquire any marketable security (whether such right be exercised, ceded or released in whole or part), if such right was obtained by the taxpayer before 26 October 2004 as a director or former director of any company or in respect of services rendered or to be rendered by him or her as an employee to an employer.”

The arguments
The contention by SARS was that the right to acquire the marketable security was exercised when the employee became obliged to pay for and take delivery of the shares. The agreements entered into in 1998 were subject to conditions which had the effect that the sale agreement arising from exercise of the option only became enforceable on their fulfilment. On that basis the taxable benefit was the difference between the market value of the shares and the purchase consideration on the date of delivery. In relation to the later delivery, in December 2004, SARS contended that this fell within the ambit of the newly enacted section 8C. In the alternative, SARS alleged that the deferred delivery scheme was a simulated transaction, and the true exercise of the right occurred when the shares were actually acquired.

The employees argued that they had exercised their right to acquire the marketable securities in 1998, at a time when the taxable benefit was an inconsequential amount, and that delivery and payment were deferred. This deferral did not affect the fact that they had an unconditional right to performance in terms of the scheme. They denied that there had been any simulation in the scheme or in the contracts concluded subject to its terms.

The judgment
In a lucid and eloquent judgment, Wallis JA (with whose judgment the full Court concurred) dealt first with the interpretation to be placed on section 8A(1)(a). The Court was called upon to determine the meaning of the term ‘any right to acquire any marketable security’.

Wallis JA affirmed the principles that should be applied to determine the meaning of words used in a statute, at paragraph 9, where he stated:

“The words of the section provide the starting point and are considered in the light of their context, the apparent purpose of the provision and any relevant background material. There may be rare cases where words used in a statute or contract are only capable of bearing a single meaning, but outside of that situation it is pointless to speak of a statutory provision or a clause in a contract as having a plain meaning. One meaning may strike the reader as syntactically and grammatically more plausible than another, but, as soon as more than one possible meaning is available, the determination of the provision’s proper meaning will depend as much on context, purpose and background as on dictionary definitions or what Schreiner JA referred to as ‘excessive peering at the language to be interpreted without sufficient attention to the historical contextual scene’.”

In his analysis, Wallis JA dealt first with the syntax and grammar, observing at paragraph 10 that:

“The section refers to the exercise by the taxpayer of a right to acquire any marketable security. It does not refer to the acquisition of a marketable security. That suggests that it is concerned with something prior to the actual acquisition of ownership, which is effected by transfer of the marketable security to the taxpayer.”

After examining the difference between an option and an offer to sell and identifying circumstances in which a right to acquire a marketable security might otherwise arise, Wallis JA concluded at paragraph 12 that:

“The characteristic of each of those situations is that they do not necessarily mean that the exercise of the right brings about the immediate acquisition of the marketable security in the sense of title to it as an asset. When that occurs will depend upon the terms of the contract that results from the taxpayer’s exercise of the right.”

After considering SARS’s argument that the ordinary legal meaning of the word ‘acquire’ is to acquire ownership, and the authority cited in support thereof, Wallis JA found at paragraph 13 that:

“…[All] that those cases demonstrate is that whether this is the correct meaning is always dependent upon context and that the word may have a broader meaning of the acquisition of the right to acquire ownership …”

This, in turn, led him to find that:

“There is nothing to indicate that section 8A(1)(a) was directed at performance of the contract resulting from a prior exercise of rights, as opposed to the exercise of a right leading in due course, in accordance with the applicable contractual provisions, to the acquisition of ownership of a marketable security.”

Turning next to the context, Wallis JA observed that since 1969 it had been accepted that the right to acquire a marketable security was intended to deal with the situation in which an option is exercised, and related to the exercise of the option.

This principle had been extended in the matter of SIR v Kirsch [1978] 40 SATC 95 to the acceptance of an offer to allot shares, which was found to be no different than the exercise of an option to acquire shares. It was conceded that Kirsch’s case did not deal with the exercise of a right giving rise to a contract of purchase and sale, subject to delayed performance. Wallis JA nevertheless found at paragraph 15 that:
“It did, however, recognise that the allotment of shares would not occur simultaneously with the acceptance of the offer to allot shares and cited the example of a rights offer where the acceptance and performance of the resulting contract occur at different times. Nonetheless it identified the acceptance of the offer and the conclusion of the contract as the event that attracted liability to tax under section 8A.”

An internal memorandum in SARS, prepared in 1996 in respect of deferred delivery schemes, had not suggested the approach that SARS had adopted in raising the assessments, but had instead recommended amendment of the law to deal with the taxation of benefits under deferred delivery schemes.

However, amending legislation was not enacted until 2004. In addition, the practice of SARS, prior to the issue of the assessments that were before the Court in this appeal, was that the acceptance of the option under a deferred delivery scheme was the time of exercise of a right to acquire the shares.

Looking at the conduct of SARS in administering the section, Wallis JA found at paragraph 17:

“The conduct of those who administer the legislation provides clear evidence of how reasonable persons in their position would understand and construe the provision in question. As such it may be a valuable pointer to the correct interpretation. In the present case the clear evidence that for at least eight years the revenue authorities accepted that in a DDS scheme the exercise of the option and not the delivery of the shares was the taxable event, fortifies the taxpayers’ contentions.”

Finally, Wallis JA considered that the amendment of the law in 2004 also provided context in relation to the operation and interpretation of section 8A. After explaining the effect of the amendment, he stated:

“As explained in the Explanatory Memorandum accompanying the amending legislation when it was placed before Parliament, the existing provisions of section 8A(1)(a) ‘fail to fully capture all the appreciation associated with the marketable security as ordinary income’. That not only identifies the purpose of the amendment, but is also a permissible guide to Parliament’s understanding of the existing section.”

As a result, Wallis JA concluded at paragraph 19:

“Weighing all relevant contextual and background material it points consistently in favour of the construction of the section in the manner for which the taxpayers contend. That reinforces the linguistic analysis. I conclude that when the section speaks of the exercise of a right to acquire a marketable security it is concerned with the action by the taxpayer that gives rise to a binding contract under which the taxpayer will be entitled, subject to compliance with the terms of the contract, to acquire the marketable security, whether the acquisition by transfer to the taxpayer occurs immediately or is postponed to a future date. The contrary contention by the Commissioner must therefore be rejected.”

These paragraphs in the judgment provide a master class in how the language of a statute should be interpreted by having regard not only to syntax and grammar but also to the context and history in order to identify a single universal interpretation.

Was the contract conditional?
SARS had not risked everything on the interpretation of section 8A(1)(a), however, and fired its second salvo. Even if the trigger event was the exercise of the option, it said, the right was inoperative until delivery and payment fell due. In effect, the rights and obligations under the contract were suspended and only became operable when delivery was required to be made. It relied on conditions in the scheme that cancelled the contract on the happening of certain events which might occur prior to the date of delivery.

The approach adopted by Wallis JA was to examine the terms of the scheme. In order for the SARS’ argument to succeed, it had to be shown that the scheme incorporated a condition that suspended the operation of the contract until the happening of a future uncertain event. After discussing the terms of the notice of the option and its acceptance, and evaluating the scheme itself, Wallis JA stated at paragraph 25:

“The scheme itself contained no clause that could, even remotely, be construed as a suspensive condition. Clause 7.3 which provided for the postponed delivery dates did not purport to suspend the operation of the contract until those dates.”

Further, the learned Justice of Appeal found that the existence of a condition could not be inferred by way of a tacit term. SARS argued that the suspensive condition could be inferred because the participants in the scheme could not take delivery unless on due date for delivery they were in the employ of the employer. However, it was found that a condition of this nature could not be universally applied.

Instead, after his analysis of the terms of the scheme, Wallis JA found at paragraph 30:

“A wide variety of circumstances would entitle the participant to receive the shares notwithstanding the fact that they did not remain in the employ of the company for the full period.”

In addition, it was found that the inference of a condition would deprive the share trust of rights under the contract, and that it was unlikely that it would have inferred the existence of the condition. It was therefore held that the condition suggested by SARS could not be inferred. The terms of the scheme were intended to operate in the manner set out in the scheme rules for good practical and commercial reasons.

SARS then sought to assert that there was a fiscal conditionality that the taxpayers should be subject to tax on the de facto gain that they had derived from the scheme. Wallis JA was unpersuaded, and responded that this was not the outcome provided in the Act at paragraph 34:

“Once the section was held to apply by virtue of the exercise of an option bringing into existence a contract of purchase and sale, the tax consequences followed from the language of the section itself. Any gain realised by the taxpayer in the year in which the right was exercised was to be included in the taxpayer’s income for that year.”

The gain had therefore been determined in 1998 in the manner provided in section 8A. Authority cited by SARS in support of its contentions was held to have no relevance to the issue.

SARS’s final argument that the contract was conditional as it required reciprocal performance by the parties, failing which it could not be completed, was also rejected.

Substance and form
The final throw of the dice was a submission that the form that the contract took was different than its substance, and that the deferred delivery mechanism was a simulation.

Wallis JA distinguished between simulation, which may amount to tax evasion, on the one hand, and arranging one’s affairs so as to pay the least amount of tax (tax avoidance) on the other, confirming that there is nothing impermissible in tax avoidance, and dealt with SARS’s argument at paragraph 41:
“Once that is appreciated the argument based on simulation must fail. For it to succeed, it required the participants in the scheme to have intended, when exercising their options to enter into agreements of purchase and sale of shares, to do so on terms other than those set out in the scheme. That is manifestly implausible and was not suggested to either Ms Bosch or Mr McClelland in evidence. Their approach was simply that they were being offered an opportunity to acquire shares on the terms of the scheme and they accepted those offers. … [In] this case there was no advantage to the parties in entering into a conditional contract of purchase and sale when they were free to enter into an unconditional contract and postpone performance of the obligation to pay the purchase price and deliver the shares. The Commissioner’s contentions based on the notion of substance over form must be rejected.”

The judgment will bring to finality a number of unresolved disputes between SARS and employers and their employees in respect of the exercise prior to 26 October 2004 of a right to acquire shares in terms of deferred delivery schemes. It is considered that SARS will be obliged to close audits, allow objections, concede appeals and issue reduced assessments. In this regard the decision may be seen as the final chapter in the history of the now defunct section 8A of the Act.

However, the practical exposition of the methodology to be applied to interpret a statutory provision will serve as a model for many for years to come.

ITA: Sections 8A and 8C