Tax consequencies of carrying on business through an agent

agent 2A decision in the Tax Court in the Western Cape (Case No. 13002) related to the question whether a company was carrying on farming.

The company (Company A) had acquired a piece of land on which there were substantial plantations. Company A itself did not wish to exploit the plantations commercially, but wished to ensure their preservation. It therefore entered into an arrangement with a second company (Company B), in terms of which Company B had the right to exploit the timber, but was obliged to maintain the rotation by planting trees to replace those that were cut. Company B was entitled to all proceeds from the exploitation and was obliged to meet its own costs and to keep the plantations insured against fire.

Subsequently Company A reached an agreement with Company B that it would sell the land together with the plantations to Company B. As part of the negotiation, the amount payable by Company B was effectively reduced by what was referred to as a “bonus management fee” for its management of the plantation.

Company A declared a capital gain in respect of the sale of the land. SARS, however, relying on a provision of the First Schedule to the Income Tax Act No. 58 of 1962 (the Act), included the proceeds from the disposal of the plantation in gross income, alleging that Company A was carrying on farming operations.

The Tax Court held that Company A was indeed carrying on farming operations. Davis J, delivering the judgment of the Court, relied heavily on references in the agreements to a “forestry business”, to the payment of a management fee and to the references in the annual financial statements of Company A reflecting the plantations as inventory and the growing of timber as a main objective of the company. Thus he concluded:
“When the objective evidence, particularly the range of documents to which I have references, including contracts and financial statements are considered. They all indicate in the direction that appellant was conducting a business of plantation farming.”

Recent decisions in the Supreme Court of Appeal
The decision should be considered critically in light of two judgments of the Supreme Court of Appeal delivered in 2010 and 2011.

In CSARS v Foskor (Pty) Ltd [2010] 72 SATC 174, the taxpayer owned rights to mine for a particular mineral (foskorite) on a specified property. Another company had rights to mine for copper on the same property, and it was agreed that the other company would conduct the excavation and, in the course of such excavation would excavate and deliver the foskorite to the taxpayer, and be compensated for the cost of excavation and delivery. This agreement bore the marks of a contract mining arrangement. In short, the other company extracted foskorite (to which the taxpayer alone was entitled) from the soil, delivered it to the taxpayer and was reimbursed for the costs that it incurred in so doing.

The Supreme Court of Appeal found that the taxpayer was not carrying on mining operations. It held that the arrangement was for the delivery of the foskorite as a by-product of the mining operations of the other company.

The construction company
A similar result emerged in the case of CSARS v SA Custodial Services (Pty) Ltd [2011] 74 SATC 61. The taxpayer company entered into an agreement with the government to erect a prison and operate the prison for a period of years as agent for the government, for which it received a fee. It was obliged to deliver occupation of the prison to the government at the end of the management contract. In law, the prison became the property of the state when it was constructed. The taxpayer engaged a sub-contractor who was required, as its agent, to erect the structure and to comply with the requirements of the main contract as to quality, materials, etc. The taxpayer claimed that, as the principal contractor, it was carrying on a trade; that the expenditure that it incurred in remunerating the sub-contractor was deductible expenditure and the prison building was trading stock until it was finally delivered to the government.

In the court below, the issue had been dealt with in the following terms:
“The second question is the submission by the Respondent that because it operated through sub-contractors it was itself not really trading as such and therefore could not become a trader as per the definition thereof in the Act. There is no merit in this argument either: “Qui facit per alium, facit per se.” This principle is part of our law. It simply means that he who acts through agents, acts himself. It is thus clear that whatever the Applicant really is and however it might have operated whatever it did, it did by and through itself. Therefore all the definitions regarding trader and trading stock, etc. must be viewed in the light that they apply to the Appellant directly and not to any of its sub-contractors.”

The Supreme Court of Appeal, however, found that there was no sub-contract, and that the arrangement between the taxpayer and the sub-contractor was not a sub-contract, but a principal contract. Therefore the sub-contractor provided all the materials that were used in construction and did not do so as agent of the taxpayer. It followed that the taxpayer was not carrying on the construction activity and could not claim the necessary deductions.

Thus, the SCA has held in two separate judgments that unless a person carries on the activities relating to a trade personally and directly, that person is not carrying on that trade.

Can these decisions be reconciled with Case No. 13002?
It is noteworthy that, in the two matters determined in the SCA, the taxpayer engaged the services of another person to perform certain operations on its behalf. The benefit of the exertions of the agent in each case accrued to the taxpayer. Notwithstanding that the benefit accrued to the taxpayer and the sub-contractor was merely an agency to enable that benefit to be derived, the Court held that the taxpayer was not carrying on the trade that it claimed to be carrying on and that the trade was being carried on instead by the sub-contractor.

In Case No. 13002, the Court appears to have adopted a view that is diametrically opposed to that in the SCA decisions. Here, the benefit of the farming operations, namely the revenue from the harvesting of the timber was not derived by the taxpayer, but by Company B. It had the right to use the land and exploit the timber for the duration of the agreement with Company A, subject to returning the plantations to Company A in like condition on termination of the agreement. Yet, Company A was found in this instance to be carrying on farming operations.

It is disturbing that these decisions cannot be reconciled. Stripped down to their bare essentials, all three cases go to the question of identifying the person who was carrying on the specified trade.

  • In the SCA cases, all benefit and profit went to the principal, yet the principal was found not to be conducting the relevant activity, because it did not directly carry on the physical activity.
  • In Case No.13002, the owner did not derive the benefit of the farming activities and did not directly conduct the physical activity, and yet was found to be carrying on farming operations. Even if it can be accepted that a benefit was derived by the owner by reason that the value of the plantations was not diminished, the owner did not directly carry on the physical activity.

It is to be hoped that some consistency will be applied if this matter should be referred to the Supreme Court of Appeal.

(Editorial comment: It is clear from the case 13002 that none of the parties argued the CSARS v Foskor (Pty) Ltd [2010] 72 SATC 174 and CSARS v SA Custodial Services (Pty) Ltd [2011] 74 SATC 61 principles.  In addition the court considers every evidence presented and if there are contradictions there is a risk  that the is likely to decide in favour of the tax authority in line with the provisions of section 102(1) of the Tax Administration Act No 28 of 2011.)

ITA: Second schedule