Vesting of capital gains through a multi-tiered trust structure

Background

Thistle Trust (the “taxpayer/applicant”) is a beneficiary of the Zenprop Group (consisting of 10 vesting trusts). The respondent is the Commissioner for the South African Revenue Service (“SARS”).

In 2014, 2015 and 2016, Zenprop Group disposed of assets and realised capital gains, the proceeds of which were distributed to the taxpayer. The taxpayer further distributed those proceeds to the natural persons who were its beneficiaries (within the same tax years in which they were realised).

Based on legal advice received, Zenprop Group and the taxpayer did not account for the capital gains in their tax returns for the relevant tax years. They had been advised that the amounts were capital gains which, in terms of the common law conduit principle and provisions of the Income Tax Act, 1962 ("ITA"), were taxable as capital gains in the hands of the ultimate beneficiaries.

SARS audited the taxpayer and found the taxpayer liable for the capital gains tax.

SARS’ basis was that liability for the capital gains realised by Zenprop had passed to the taxpayer as the direct beneficiary of Zenprop but did not pass further to the taxpayer’s beneficiaries (as intended).  SARS raised additional assessments claiming capital gains tax from the taxpayer and imposing understatement penalties in respect of the undeclared capital gains tax.

The taxpayer appealed to the Tax Court and the Tax Court upheld its appeal.

SARS’ appealed to the Supreme Court of Appeal ("SCA") and the appeal was upheld on, inter alia, the basis that while the conduit principle was of general application in tax law it ought only to be applied in appropriate circumstances (which was not the case here). The SCA also held that the taxpayer could not be liable for understatement penalties because SARS had conceded that the understatement was a bona fide inadvertent error.

The taxpayer then applied to the Constitutional Court ("CC") for leave to appeal against the decision of the SCA. SARS filed a conditional application for leave to appeal in respect of its understatement penalties.

In the CC the taxpayer argued that:

• liability for capital gains lay with the ultimate beneficiaries in terms of the common law conduit principle (applicable to the taxation of trusts), section 25(B) of the ITA, and paragraph 80(2) of the Eighth Schedule to the ITA;
• in terms of section 25B of the ITA, the capital gain of Zenprop is deemed to be the capital gain of the taxpayer and then deemed to be the capital gain of the ultimate beneficiaries when distributed to them by the taxpayer. This is because section 25B applied to any amount and because section 26A, as the taxing and liability imposing provision, included taxable capital gains in taxable income (whilst paragraph 80(2) merely quantified the amount of the capital gains); and
• paragraph 80(2) entitled the taxpayer not to be taxed on the relevant capital gains because paragraph 80(2) must be read as an attempt to codify the common law conduit principle.

SARS argued that:

• section 25B did not apply to capital gains as section 25B was introduced into the ITA at a time when the concept of capital gains tax did not exist in South Africa;
• paragraph 80(2) contained its own codification of the conduit principle and makes it clear that the conduit principle cannot operate beyond the first beneficiary trust in a multi-tiered trust structure (relying on the 2008 Explanatory Memorandum of amendments effected to paragraph 80(2)); and
• all matters relating to the calculation of a taxable capital gain of a trust should be determined in accordance with paragraph 80(2).

In respect of understatement penalties, the taxpayer argued that it had not made any understatement so there were no understatement penalties to be imposed, and even if its appeal failed, the appeal for understatement penalties must be dismissed because any error in its tax return falls within the category of a bona fide inadvertent error.

SARS, on the other hand, denied that it made the concession attributed to it by the SCA and argued that the taxpayer did not have reasonable grounds for its reliance on its tax position because it intentionally adopted its position and its “error” could not be described as a bona fide inadvertent error.

SARS argued that the taxpayer’s behaviour fell within the category of no reasonable grounds for tax position taken or reasonable care not taken in completing return.

Majority decision

The majority judgment of the CC traced the history of the conduit principle and held that the common law conduit principle was developed to determine two issues where these were not determined directly in the taxing statute, namely:

• which taxpayer (trust or beneficiary) was to be taxed on particular income; and
• whether particular income retained its tax privileged or tax prejudiced status (in accordance with legislative choices made in respect of such income).

The majority held that in this particular case:

• the legislative choice was to tax trusts at twice the rate of individuals; and
• the ITA determined which taxpayer was liable for capital gains tax.

The exercise was therefore one of statutory interpretation.

The majority concluded that the taxation of capital gains in the hands of a trust was governed (not by the more general section 25B) by the more specific paragraph 80(2) because:

• paragraph 80 addressed the conduit principle in respect of capital gains realised by the sale of trust assets;
• paragraph 80 went beyond quantification – it determined whether a beneficiary or a trust was liable for tax;
• paragraph 80(2) identified the trust (determining the capital gain) as the one which disposed of the asset (and not the trust in whose accounts the capital gain was determined);
• this interpretation accorded with the legislative purpose, determined on a linguistic analysis of the provision, to prevent the conduit principle from applying beyond the first beneficiary trust in a multi-tiered trust structure; and
• paragraph 80(2) could not be read as having no purpose and being overridden by section 25B.

The majority cautioned, however, that there is a limit to the weight that can be placed on the explanatory memoranda for statutory interpretation purposes. This is because the rule of law dictates that the law must be clear and predictable (so that individuals can organise their affairs accordingly particularly in the context of tax statues). If the meaning of law depends entirely on historical research, on what was said and not said in an explanatory memoranda (issued decades earlier and not capable of easy identification and location), accessibility of the law would be undermined and the rule of law negatively impacted.

Nevertheless, the majority accepted the invocation of the explanatory memoranda in this case because the practice was well established in the context of interpreting revenue statutes and because both parties invoked it.

In respect of the understatement penalties, the CC refused SARS’ application for leave to appeal on the ground that there had been no judgment by the lower courts on the matter and the CC could not be the court of first and last instance on the issue. Furthermore, SARS did not have a sustainable case for penalties, which militated against entertaining the matter on interest of justice grounds.

The majority held that SARS bears the onus of proving facts that bring the understatement within the categories contended for (and SARS had no reasonable prospects of doing so in this case).

The majority remarked further as follows:

• the fact that a tax position is incorrect did not mean that it was a position that the taxpayer had no reasonable grounds to take (in this case the taxpayer’s position was upheld in the Tax Court in a reasoned judgment); and
• taking reasonable care in completing a tax return does not mean that a person should ignore the advice given to it and follow the stated SARS position (where that advice expressly considered and rejected SARS’ stated position). Such a position would elevate SARS to the status of an authority that can decree the only reasonable interpretation of tax legislation and is therefore clearly untenable.

Significance

The significance of the majority decision is set out below:

• it has highlighted the reasons for the common law conduit principle;
• it has highlighted circumstances in which the common law conduit principle applies (in circumstances where a taxing statute does not directly address liability and/or the tax privileged or tax prejudiced status of particular income as determined by legislative choice); and
• the importance of obtaining and relying upon sound and well-reasoned tax opinions (even if contrary to SARS’ stated position).