may/june 2011 issn - 1845-5896 · taxtalk may/june 2011 3 welcome back from an extended easter...

The official journal of theSouth African Institute of Tax Practitioners

issue28May/June 2011ISSN - 1845-5896

C M Y CM MY CY CMY K

3TaxTalk May/June 2011

Welcome back from an extended Easter break to all our readers, I trust that all of you had a relaxing time. We hope that our readers have found the first two issues of 2011 to be in-formative.

This issue contains an article on the proposed National Health scheme and some sugges-tions on how the NHI scheme can be fi-nanced. We would welcome any input on this topic from our readers.

We feature the second part of the article ‘The New Economic Substance Doctrine’.

Professor Daniel N Erasmus, one of our regular contributors, recently attended the International Transfer Pricing Summit in London and has provided us with a summary of the conference. Readers who require more information on the discus-sions at the summit are welcome to e-mail Professor Erasmus; his details are at the end of the feature.

Next issue we feature recent changes in trust law, as well as HR and payroll is-sues. Don’t miss our feature ’Women in tax’ as we celebrate Women’s Month in August. Should any of our lady subscribers wish to contribute an article, please contact the editor.

Opinions expressed in this publication are those of the authors and do not necessarily reflect those of this journal, its editor or its publishers, COSA Communications. The mention of specific products in articles or advertisements does not imply that they are endorsed or recommended by this journal or its publishers in preference to others of a similar nature, which are not mentioned or advertised. While every effort is made to ensure accuracy of editorial content, the publishers do not accept responsibility for omissions, errors or any consequences that may arise therefrom. Reliance on any information contained in this publication is at your own risk. The publishers make no representations or warranties, express or implied, as to the correctness or suitability of the informa-tion contained and/or the products advertised in this publication. The publishers shall not be liable for any damages or loss, howsoever arising, incurred by readers of this publication or any other person/s. The publish-ers disclaim all responsibility and liability for any damages, including pure economic loss and any consequential damages, resulting from the use of any service or product advertised in this publication. Readers of this publication indemnify and hold harmless the publishers of this magazine, its officers, employees and servants for any demand, action, application or other proceedings made by any third party and arising out of or in connection with the use of any services and/or pro-ducts or the reliance of any information contained in this publication.

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Dear reaDer

contents

10 Substance over form - nothing new

12 Summary of the two-day international transfer pricing summit in London

14 Does our current tax system really support small business?

18 The long walk to … healthcare – NHI

22 Hidden tax costs of doing business in Africa

24 The ‘new’ economic substance doctrine

28 Multinationals and their legacies: Decimation in those details

37 Business directory

Our annual subscription fee for 2011 is R290.

4 TaxTalk May/June 2011

Company cars – have you considered this?

by hennie van deventer

By now, all employers providing company cars to their employees would have

incorporated the amendments (effective 1 March 2011) to the company

car regime.

We have, however, identified a few things that are of interest in relation to the

following.

• Determinedvalue

•Maintenanceplans

• Tooloftradevehicles

determined value

The determined value in relation to a motor vehicle acquired under a bona fide

sales agreement (or exchange) is said to be the original cost to the employer (im-

portantly it excludes finance charges and interest).

Employers should be aware that the cost referred to above includes value added

tax (VAT) despite the Income Tax Act (the Act) not specifically stating that it does.

The reason being that by implication, VAT is included in the cost to the employer.

reaDer’s ForUM

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and Royalty (Administration) Acts■ Monetary Thresholds■ Tax rates and rebates ■ [NEW] Extracts from Acts: Section 39 of the Taxation Laws

Amendment Act Section 56 & 57 of the Income Tax Act Section 125 of the Revenue Laws

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The Explanatory Memorandum to the Amendment Bill also clari-

fies this, saying the cost must include VAT.

Importantly, employers should be aware that the method in cal-

culating the determined value has changed meaning that the

amendments also apply to vehicles purchased prior to 1 March

2011. Furthermore, the Act states that where the vehicle is not

acquired under a sales agreement or lease, the retail market value

should be used as the determined value. This seems a little harsh

on the employees of motor manufacturers who are provided with

company cars.

The Act does provide for some potential leeway and we suggest

that the subject matter experts are contacted in this regard.

Maintenance plans

The Act allows the fringe benefit rate to be reduced from 3.5%

by a further 0.25% where the cost of the vehicle includes a full

maintenance plan.

Employers should note that a ‘maintenance plan’ means that the

provider of the vehicle has a contractual obligation to underwrite

the maintenance of the vehicle for a period of at least three years

and a distance of not less than 60 000 kilometres.

An interesting point that arises is the reference in the Act to “in the

ordinary course of trade with the general public...” when referring

to the contractual obligation of the provider.

It is not uncommon for employers to lease the vehicles from a

bank and for the bank to provide a maintenance plan in terms of

the lease agreement.

It is submitted that the bank is the provider and has a contractual

obligation to maintain the vehicle. However, is it the bank’s ordi-

nary course of trade with the general public to provide vehicles or

is it simply a place where people deposit money?

Tools of trade

Employees using their vehicles as so-called tools of trade, qualify

for a reduced inclusion of the fringe benefit for employee’s tax pur-

poses in that only 20% of the rate will be taxed on the proviso that

the employer is satisfied that at least 80% of the usage will be for

business purposes (ie a 0.7% inclusion rate).

No guidelines have been given to determine the 80% business

use threshold. But employers making use of tracking systems are

likely to base this determination on the previous year’s business

travel by the particular employee, thereby attempting to satisfy the

South African Revenue Service that the 80% business use thresh-

old would be reached during the current year of assessment.

As always when dealing with tax matters, it is recommended that

employers seek advice in the event of uncertainty.

[email protected]

Philip Kotze

M Com Tax, CA(SA), MTP(SA)Technical Support Executive

[email protected]

Frequently Asked questions Accrual system and marriage out of community of property

Question

My client is married out of community of property with the accrual system. He acquired a property,

registered in his name, after he got married and now wants to sell the property. My client wants

advice with regard to the capital gains tax consequences on the sale of the property. Will he be liable

for 100% of the capital gains tax, or can he apportion it between him and his wife; considering the

marriage was concluded out of community of property with the accrual system, and the property

was acquired after he got married.

Answer

The Matrimonial Property Act 88 of 1984 makes the accrual system automatically applicable

to a marriage out of community of property unless its application is specifically excluded in the

antenuptial contract. Under the accrual system, a claim will arise on death or divorce in the hands of

one spouse against the other for the difference in growth of the estates of the spouses. For example,

if the growth in value of spouse A’s estate during the marriage is R100, and the growth in value

of spouse B’s estate is R50, spouse B will have a claim of R25 against spouse A on dissolution of

the marriage. The accrual system does not result in a splitting of capital gains and losses between

spouses. A capital gain or loss on disposal of an asset by a person married out of community of

property must be accounted for by the spouse who owns the asset. A claim under the accrual

system only arises on death or divorce of a spouse or under an order of court. It does not affect the

tax treatment of the spouses during the subsistence of the marriage or even on its termination. This

is a claim for a sum of money, not a pre-existing entitlement to specific assets or income of the other

spouse. The accrual claim is thus contingent on death or divorce and its quantum also depends

FAced by tAx PrActitioners

veriFiAble Articlemin

on the value of the estates of the spouses at the time of those events. It might

happen, for example, that gains accumulated earlier in a marriage are later lost

or expended. It does not, therefore, have any impact on the incidence of an

accrual of an amount of gross income or proceeds on disposal of an asset.

learnership allowance and transfer of learnership contract

Question

Will the ‘completion of learnership’ allowance be available with respect to a

trainee moving to another firm during his third year of the learnership?

Answer

Section 12H(4) of the Income Tax Act No.58 of 1962 prohibits the deduction

of the allowance where -

• anemployerwhichispartytoanexistingregisteredlearnershipagreement

is substituted by another employer (and that employer does not form part of

the same group of companies as that original employer).

Neither the employer nor the substituting employer may claim the allowance in

respect of the completion of the learnership and the substituting employer may

not claim the allowance in respect of entering into the learnership.

e-File returns and signatures

Question

Does an e-File return require a signature from the taxpayer if submitted by a

tax practitioner?

Answer

The e-File return does not require a signature. The tax practitioner must,

however, obtain a power of attorney from the client to act on behalf and

represent the client in the e-Filing process. Alternatively, the tax practitioner can

submit printed hard copy returns signed by the client.

The tax practitioner should also ensure that a formal letter of engagement,

which sets forth the terms and conditions and the nature and scope of services

of the engagement, exists between the tax practitioner and the client.

Provisional tax returns not issued

Question

My client wants to know whether he is still liable for provisional tax, because

the South African Revenue Service (SARS) did not issue him with a provisional

tax return for his most recent provisional tax period.

Answer

The onus is on the taxpayer, assisted by the tax practitioner, to determine

whether the taxpayer is liable for provisional tax and to submit provisional tax

returns. In the past, SARS issued the returns automatically, if the taxpayer

was registered for provisional tax or ought to be registered for provisional tax.

With recent changes, it is now the responsibility of the taxpayer, assisted by

the tax practitioner, to request provisional tax returns. This can be done by

registering for e-Filing, calling the SARS contact centre or visiting the nearest

SARS branch.

SARS Comprehensive Guide to Capital Gains Tax (issue 3), 6 May 2010.SARS Interpretation Note: No.20 (issue 3) Section 12H Learnership allowance, 28 January 2010.

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The importance of good corporate

governance and greater transparency

has been thrown into the spotlight

more than ever before, especially

with stakeholders in companies

demanding better, and more transparent, financial

management of their investments. One of the areas

where companies can potentially control their

expenses is by having proper fleet management

structures in place.

From a moral point of view, companies can

enable themselves to validate their whole fleet’s

travel claims. With the latest SARS legislation,

and the logbook requirement by SARS to validate

your travel claim, it will add to a company’s

credibility to empower their employees to be

compliant with SARS.

In effect, partly because of the latest legislation

with regard to travel claims from SARS – both

for employees driving company-owned vehicles,

as well as the ones who have opted for a travel

allowance, or simply using their private vehicle for

business purposes from time to time – the logbook

issue has now, both directly and indirectly, become

a (potential) liability to the company, and forms

part of their holistic fleet management solution.

Most companies/employees have opted to go

the travel allowance route because of the new

dispensation in terms of the travel tax/allowance

benefits/restrictions on the travel claims legislation

from SARS.

Individuals/employees within the company

environment now face the responsibility of having

to validate any travel claims they submit to SARS.

IntelliDrive has a fleet management solution

with a different approach to any other fleet

management solution currently available in

South Africa. Its solution accommodates the

latest SARS requirements on direct and indirect

fleet management, as well as the traditional fleet

management requirements.

IntelliDrive offers both an off-line (after the fact)

and an online solution.

The off-line solution consists of a GPS-driven data

logging device that is powered by the cigarette

lighter of a vehicle (other power supply options are

also available).

The unit logs all trip data. This data is downloaded

onto a computer via a USB port on a daily,

weekly or monthly basis by either the driver or the

fleet manager.

The tripTrack-powered software translates this data

into SARS-compliant logbook reports. A variety

of detailed reports can also be drawn for fleet

management purposes – all dependent on what

the individual or company’s requirements are.

Driver behaviour can also be easily monitored with

the trip data that is available.

Companies that choose to assist their employees

to comply with the SARS logbook requirements

free up a lot of employees’ wasted time trying

to compile logbooks, and enable them to be

more productive.

In turn, the companies then utilise this as a tool

to monitor their field personnel’s trips. It validates

all trips taken and ensures that drivers and sales

or technical staff members manage their trips

and time more efficiently. This ensures that travel

claims submitted by employees to their respective

companies are validated. The system does not

allow you to add trips that were not driven ... this

alone could potentially save most companies a lot

of money.

The facility also improves a company’s CRM

reportability. All trips can be viewed on a street

map that forms part of the software and these

can be simulated on Google Earth. All of this

is available at a once-off cost – with no monthly

fees payable.

The tripTrack driven once-off solution is a cost-

effective way for smaller companies to manage

their fleet.

For companies with multi-users or larger fleets,

IntelliDrive offers a ‘live’ unit which enables the

user to track a particular vehicle in real-time

on a screen, via a PC, laptop or cellular phone.

Sophisticated add-ons are available on the system,

giving the user access to the latest technology to

control and manage vehicle fleets.

The live system comes at a reasonable up-front

cost and monthly fee to cover data and recovery

costs. In the not-so-distant future, IntelliDrive will

be in a position to offer the service of reporting and

fleet management on behalf of customers.

To find out more about the different options available, or to obtain a tailor-made proposal on what will work best for your particular application,

IntelliDrive can be contacted on 082 415 3536. Alternatively, send an e-mail to [email protected], or visit our website at www.intellidrive.co.za.

Fleet mAnAgement

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management & logbook solution

24/7 access to your own vehicle’s movements etc.Reports include fully comprehensive data on all tripsReports include driver behaviour, e.g. speeding etc.Live tracking at your own disposal 24/7

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control


While the NWK judgement shook

up the tax fraternity when the

Supreme Court of Appeal of

South Africa came down in

favour of SARS late last year,

history shows that this should not have come as such

a surprise to those interested in the case – either from a

corporate or a professional services viewpoint.

As long ago as March 1996, the first landmark ruling

in favour of SARS with regard to substance over form

was seen in the 1996 case of Erf 3183/1 Ladysmith.

This case saw the Appellate Division of the Supreme

Court finding that a tax exempt entity was used to

absorb the deemed taxable income arising out of a

lessees’ obligation to improve the property concerned.

At that time, the Court drew a distinction between:

• Transactions inwhich thesubstanceand form

coincide – that is, the intended effects of the

transaction are wholly in line with, and fully laid out

in, the documentation; and

• Transactionswhichareneverintendedtohavethe

effect that their documentation purports, or whose

intended effect is different in some material way

than their form would suggest. These are generally

known as sham transactions.

A second ruling that was based on the principle of

substance over form, was a 1997 case of the Supreme

Court of Appeal in favour of SARS against a company

called Brummeria Renaissance. Prior to this ruling,

taxpayers were not concerned that SARS would

impute income on interest-free loans made available

by one person to another. However, the court decided

that the right to use an interest-free loan constituted

gross income which accrued to Brummeria.

In essence, interest-free loans were made available by

different persons to Brummeria in return for so-called

life rights which gave the person the right of life-long

occupation of a residential unit owned by Brummeria.

SARS argued that the right to retain and use the

interest-free loan capital had an ascertainable money

value which accrued to the companies and that

constituted gross income in their hands.

The NWK case in 2010 case saw the Supreme

Court of Appeal expand the accepted interpretation of

substance over form, after NWK entered into a series

of commercial transactions which SARS argued did

not reflect the true substance of the transaction.

“For taxpayers, the ruling sends a clear message

that tax risks should be re-examined and positions

analysed to give effect to the terms of an agreement,

which must have a real commercial purpose. While

the NWK judgement is just one in a series that SARS

has won, SARS is using the basis of the judgment to

broaden the scope of its audits on structured finance

transactions. On 15 February this year, SARS made an

announcement to this effect.

“SARS has encouraged voluntary disclosure by

taxpayers of transactions of this nature (in terms of the

recently effective Voluntary Disclosure Programme) to

regularise their affairs, following which SARS is targeting

specific transactions for audit. How widespread this

will be remains to be seen, however, as organisations

will attempt to differentiate themselves from the facts

in the NWK case while choosing the most tax-effective

substAnce over Formnothing new

Nazrien KaderService Line Leader, Taxation Services

[email protected]

“For taxpayers, the ruling

sends a clear message

that tax risks should be

re-examined and positions

analysed to give effect to

the terms of an agreement,

which must have a real

commercial purpose. While

the NWK judgement is just

one in a series that SARS

has won, SARS is using

the basis of the judgment

to broaden the scope of its

audits on structured finance

transactions.” veriFiAble Articlemin


method of financing as possible,” explained Nazrien

Kader, taxation service line leader at Deloitte.

Billy Joubert, director in charge of transfer pricing at

Deloitte, points out that the principle of substance over

form is important in understanding the significance

of certain changes to the transfer pricing rules, which

take effect from 1 October this year. Transfer pricing

rules apply between group companies which transact

cross-border. They are aimed at preventing groups from

shifting profits to low tax jurisdictions by transacting at

artificial prices which favour the entities in the low tax

country.

The legislation has always focused on whether the

pricing of such transactions is arm’s length. More

specifically, SARS would want to know that by virtue of

the transaction, the SA company has neither overpaid,

nor undercharged, its foreign group company.

The new legislation focuses not so much on the

pricing of the relationship but looks more widely at the

entire nature of the relationship between the parties.

It therefore anticipates that profits may be shifted

artificially not only by means of non-arm’s length

pricing, but in more complex ways. Therefore taxpayers

will be required to show that they have transacted with

foreign-related parties as if they were “independent

persons dealing at arm’s length”.

At first glance, it seems that compliance with this

requirement may, in certain cases, be almost

impossible. This is because there are arrangements

within multinational groups that simply do not occur

between unrelated parties – for example, limited

risk arrangements such as limited risk, or stripped,

distributors.

SARS has yet to provide us with guidance on the

significance of this change. However, it seems unlikely

that SARS will stop recognising such structures

altogether – particularly since they occur widely in

practice within multinationals. Indeed, as the OECD

has pointed out, multinationals exist partly because

they can achieve efficiencies and synergies which are

not available to independent enterprises.

In the absence (at this stage) of guidance from SARS,

by reference to OECD principles it seems that the

significance of the change is that SARS will apply

more of a substance over form approach in evaluating

transfer pricing practices. For example, with limited

risk arrangements, taxpayers will be required to show

not only that the relevant risks are limited contractually.

It will be necessary, in addition, to show that the actual

management of those risks is done by the party which

purports to carry them.

In a transfer pricing context, a written policy can be

regarded as the form of an intra-group arrangement

whereas the actual implementation of that policy is

the substance. In view of the new legislation, it seems

that implementation is going to become increasingly

important.

“The legislation has always

focused on whether the

pricing of such transactions

is arm’s length. More

specifically, SARS would want

to know that by virtue of the

transaction, the SA company

has neither overpaid, nor

undercharged, its foreign

group company.”


Professor daniel N erasmusAdjunct Professor of Law - Thomas Jefferson School of Law, San Diego, California (USA)[email protected]

summAry oF the

dAy one oF the conFerenceMelissa Tatton of HMRC Transfer Pricing desk was

the first person to present at the conference. It is clear

that multi-national co-operation between the various

OECD and observer countries is high on the agenda,

with the UK leading the initiative. This follows the

clear involvement of HMRC Transfer Pricing desk in

training African countries on TP audits. The problem

is that these African countries are cherry picking

issues that suit them in collecting more money, but

they are not acting in a consistent and fair manner

in executing their TP mandates. Examples include

the recent announcement by SARS in South Africa

that they will be removing the thin capitalisation

safe harbour, expecting associated companies to

show comparatives in proving that their interest

charge, or lack thereof, is objectively arm’s length.

The problem is that there is no commercial database

to benchmark and draw comparisons applicable to

Africa. Greater uncertainty is created, leading to

greater potential for conflict and controversy.

Mention was made by other speakers that advance

pricing agreements (APA) should be used as a means

to move away from controversy, as they successfully

do in the US. African countries tend to shy away

from APAs. South Africa is a clear example. So the

opportunity to create certainty in a very uncertain

TP world in Africa is lost.

Disturbing trends are also being copied by African

TP desks without the sophisticated checks and

balances that tend to exist in some of the OECD

First World countries. Targets with incentives are

created for tax assessors. In any common law

jurisdiction, this will immediately show that a strong

possibility of bias exists, affecting the validity of any

ensuing tax authority decision to raise additional

assessments. The further problem is that TP

advisers from accounting backgrounds, not trained

in administrative law, are oblivious to the fact they

could advise their clients to challenge the unlawful

procedures followed by the tax authorities – resulting

in a quick review of the additional assessment being

set aside – instead of following a long protracted tax

court dispute that could take many years to finalise

(e.g. up to eight years in some African countries).

Bombardier Transportation, in-house TP specialist,

shared with delegates the frustrations of dealing

with the Indian tax authorities. They simply expect

taxpayers to justify any TP question they raise,

ignore the answer in order to raise additional

assessments, and force taxpayers to take the matter

to the next level. India is a common law jurisdiction

with review procedures that would entitle taxpayers

to take on review any such unlawful procedures

followed by the tax authorities. However, in-house

tax advisers there are loath to challenge the tax

authorities in any manner at the assessor level.

They are concerned with the reputational risks and

the possibility of escalated audits.

There are very basic solutions to these bullying

tactics. The majority of TP advisers seem not to be

aware of these. More details on these solutions can

be gleaned from www.taxriskmanagement.com and

through discussions with Prof. Daniel N Erasmus.

Recent case summaries – mainly around thin

capitalisation rules which is a hot topic internationally.

In most instances, taxpayers were unable to justify

an arm’s length approach except in one instance in

India where they convinced the court that the loan

was quasi-equity. In a US case, a twist of events

took place where a judgment against the taxpayer

was reversed when the judges realised on a further

petition from the taxpayers that the regulations from

the IRS were in fact confusing. Lessons for SA –

thin capitalisation rules are changing in October

2011. Taxpayers will have to show why their thin

capitalisation arrangements are arm’s length, so

some of these cases will be very relevant in South

Africa and in Africa.

For a list of these cases and more detail, please

e-mail [email protected].

“The problem is that these African countries are cherry picking issues that suit them in collecting more money, but they are not acting in a consistent and fair manner in executing their TP mandates.”

two-dAy internAtionAl trAnsFer Pricing summit in london, 29 And 30 mArch 2011


dAy two oF the conFerenceThe main challenge for TP specialists remains trying

to negotiate quick settlements because management

tends to want quick certainty. This results in

double taxation to a degree in many TP audits as

TP specialists are compelled to settle quickly with

revenue authorities. Revenue authorities know this

and exploit this through more complex and layered

TP audits. The ultimate result is that too much is

given away in the interest of creating certainty – no

corporation wants to live with surprises. I wonder

how shareholders would feel if they knew to what

extent settlements are being pushed.

APAs and mutual agreement procedures under a

double tax treaty (MAP) are comforting to a small

degree, but tend to take too long – so are often not

used. The average time is about three years, by

which time the tax uncertainty has been reported

and pushed by management to settle more quickly.

So over 30% of these approaches to revenue

authorities are withdrawn; surprising when statistics

show that recently only 1% of MAPs were turned

down. Again there are time constraints in the DTAs

and the length with which some revenue authorities

take to finalise audits causes problems.

There appears to be a general lack of understanding

and knowledge around the domestic specific legal

interpretations to TP in the various countries,

and its integration with procedural law. Clearer

understanding in this arena will result in more ‘wins’

for taxpayers at an early stage as most tax authorities

make many mistakes in leading to concluding the

audit. These mistakes result in the audit result

being unlawful. But as most TP specialists are

not schooled lawyers, these opportunities are lost.

The lack of understanding is written off to the fact

that they don’t want to be too aggressive. But are

these TP specialists doing their jobs properly? If

management doesn’t know that these opportunities

exist, TP specialists may question whether to develop

techniques in this regard. Much schooling and

education needs to be spent in this area now that

many countries have developed administrative law

relief provisions. Many accountants and economists

(who make up the bulk of TP specialists) do not

know this.

Finally, IP is being given a broad brush meaning,

and will cause many problems going forward;

especially where brand development takes place

through extensive marketing in a new territory. The

OECD developments in this area are taking too

long, and are not keeping pace with fast moving IP

development globally. Watch this space. Revenue

authorities will exploit this to their advantage.

For more information, e-mail

[email protected].

in addition to the above, we include an interesting extract from a linkedin Group discussion on transfer pricing and the knowledge of TP specialists in procedural law:

linkedin Groups

Group: Transfer pricing specialistsDiscussion: As a TP specialist, do you believe you know enough about procedural law as it affects interactions with various tax authorities? YES or NO

I used to work in the transfer pricing policy and investigation unit at HM Revenue and Customs and was constantly surprised at how often tax administrations

fail to follow procedural law. It is definitely worth checking that the law has been adhered to if you are dealing with a transfer pricing audit. I have seen

examples where very large transfer pricing adjustments have had to be relinquished by administrations because they have not followed the rules.

While I have experience in a number of jurisdictions, in my experience there is nothing like working together with a local specialist.


Vuyisa Qabaka | [email protected]

example 1.1: An integrated system

(all amounts in Rand)

Taxable income attributable to individual = 100 000

Corporate ‘withholding’ taxes paid = 100 000*0.352 = 35 200

Schedule tax payable on company earnings attribution = 100

000*0.18 = 18 000

Primary rebate = (9 756)

Tax credit = (35 200)

Tax refund = 18 000 – 9 756 – 35 200 = 26 956

Effective tax rate = (35 200 – 26 956)/100 000 = 8.244%

does our current tAx system

reAlly suPPort smAll business?

A tax system which supports small business has always been a

popular cause. National Treasury has recognised this with several

SME tax incentives within s 12E and has previously stated that

“internationally, it is recognised that small and medium enterprises

have an important role in economic development and employment

creation”. In legislating the SME tax incentives, it was hoped that they would

“markedly improve the cash flows of growing small businesses and further

enhance the potential for this sector to create jobs”. While such incentives may

have resulted in some limited relief, it is argued here that the actual structure of

South Africa’s current tax system is so heavily biased against small businesses

that any such relief is negligible.

The cause of this bias is that our current system neglects the fact that the corporate

tax, which is levied on these small businesses, is in fact shouldered by the people

who own these businesses. It makes intuitive sense that there is no real difference

between the single shareholder of the company and the company itself. The more

taxes the company pays, the less is available to the shareholder from which to

live. The profits from the company are, after all, the SME owner’s sole income

stream. The examples below show just how punitive the current system is.

Before turning to the examples, it is proposed here that SMEs should be taxed

similarly to trusts to the extent that the income from the company should be

vested in the shareholder and taxed in his/her personal capacity along with any

other income that he/she may have such as interest. Essentially corporate taxes

are ‘integrated’ with the personal taxes. In this way, the company does not pay

any taxes but rather the income from the company is taxed in the hands of the

shareholder. This mode of taxation recognises that there is no substantive difference

between the company and the shareholder insofar as SMEs are concerned. From

an administrative perspective, the company can withhold the taxes and pay it over

to SARS on the shareholder’s behalf in exactly the same way that employees’ tax is

withheld by the company on behalf of the employee. The shareholder would then

be able to claim a tax credit on the taxes withheld by the company.

The two systems – our current system and the integrated one – can now be

compared by way of an example. To simplify things, the examples below assume

the corporation to have a taxable income of R100 000, one shareholder who does

not earn any other income other than from the company and that the company

distributes all of its after-tax profits. Because the company makes this distribution

to which STC is applied, the effective rate of 35.2% is applicable and not 28% .

Example 1.1 gives the tax consequences under an integrated system. As can be

seen, the R100 000 is attributable to the shareholder who pays schedule tax on

it at 18%. From this is deducted the primary rebate as well as the corporation

withholding tax of R35 200 which was levied at the company level but is incurred

at the individual level. The overall position is that the shareholder will receive a

tax refund of R26 956 with the company paying R35 200 on his/her behalf. The

overall position is an effective tax rate of 8.244% which is exactly what it would

have been had the income been subject to schedule tax only, for example if it

were a salary earned.


When the two approaches are juxtaposed like this, the inequity of the

current system is glaring. It is unfair on several levels. Firstly, it is regressive

taxation of the worst kind. A person such as this hypothetical taxpayer

earning R100 000 should be in the lowest income tax bracket with an

effective rate of 8.2% but is actually subject to a tax rate of 35.2%. Based

on the 2010 personal tax tables, this is the rate at which a salary earner of

R1 400 000 pays. One way of defining the extent of the overpayment is

to simply take the difference in the two rates being 27% (35.2% – 8.2%).

To emphasis the regressive nature of this taxation, if the same exercise is

undertaken for a higher income of R600 000 instead of R100 000 the

overpayment, as measured by the difference in effective tax rates under

the two systems, is only 6.3%. The excess burden is clearly greater for the

lower income individual. That is, less the small business owner makes, the

more he/she is overtaxed.

Secondly, the current system discriminates against those people who earn

their income from business rather than employment. The integrated system

achieves the same result regardless. This accords, not just with fairness,

but common sense in that the same income of two individuals should be

taxed equally regardless of the source. A strong case could even be argued

that if equity is to be affirmed, it would actually mean taxing the business

owner at a lower rate than the employee. The reason being that, despite

equal incomes, the business owner has assumed far greater risk than

has his salaried counterpart. Calculated risk taking, as exemplified by the

small business, is something that government should seek to foster and

support rather than undermine and inhibit. One of the central motivations

for establishing the close corporation was to provide smaller undertakings

with corporate status in an effort to support this sector. It begs the question

why government would then undermine its own efforts by choosing to

tax them as companies and not trusts where it allows for the benefits of

corporate status with integration. In this way, government has forgone the

opportunity to provide real support to smaller enterprises in the form of

financial assistance and fairer treatment via the tax system.

A rebuttal by National Treasury to the above would submit that avenues

of relief are available to the shareholder. For instance, the person should

rather operate as a sole-proprietor or partnership and avoid the situation

altogether. However, this misses the point; there are significant benefits

to operating as a company, especially limited liability and perpetual

succession. It is also a means of allowing the business owner to formally

structure the operations and lay the groundwork for future stakeholders.

Furthermore, it was even emphasised in South Africa’s Margo Report of

1986, that the tax asymmetry between companies and individuals “has

in practice had a significant impact on the choice of the form in which

entrepreneurs carry on their business activities”.

A further rebuttal by National Treasury to the deleterious consequences

above would be to claim that they are mitigated via the tax breaks granted

Example 1.2 shows the taxes payable under South Africa’s current tax

code. The company is taxed on its R100 000 earnings as though it is truly

a separate person from its shareholder yielding taxes payable of R35 200

with an effective rate of 35.2%.

example 1.2: Current system

(all amounts in Rand)

Company taxable income = 100 000

Corporate tax payable = 100 000*0.352 = 35 200

Tax applicable at the shareholder level = N/A

Effective tax rate = 35 200/100 000 = 35.2%

to small businesses in terms of s 12E and the turnover tax. While relief is

granted in theory, the criteria to qualify for a small business corporation, as

defined in s 12E, are so stringent that it would not be easy for a company

to qualify. For instance, the company would be disqualified from s 12E,

if the shareholder happened to hold shares in other non-listed companies

(this is particularly realistic for the entrepreneur who may float several

small companies owing to the diverse nature of the businesses he/she is

involved with) or a company is above the qualifying revenue threshold but

is in operational difficulty such that the taxable income is low despite a

relatively high gross income. The turnover tax is similarly restrictive and

in any event targeted more toward micro-enterprises than SMEs. As can

be seen, the limited nature of s 12E and turnover tax is not sufficient in

redressing the problems cited above, this is especially so given that s

12E only became relevant, to all intents and purposes, in 2006 with the

increase in the qualifying threshold despite the fact that the above scenario

has been in existence for decades.

As an aside, the examples above make a broader point: corporate taxes must

eventually be borne by individuals. Of course, where larger corporations

are concerned, the link is not as clear-cut and who the individuals are, is

uncertain but the principle still remains. It should be emphasised that the

Taxpayers’ Foundation is in no way against corporate taxation. We support

it, but it should just be recognised that it is eventually a tax paid by actual

people and not by the ‘legal fiction’ of the corporation.

Overall, it is quite clear that our current system is biased against one of

the most important sectors in the economy being small businesses. At a

time where it is difficult for people to gain employment, they should be

encouraged to start their own ventures and not be punished when they

do. These ventures are critical in growing the economy and for them to

become future employers. Addressing this tax problem should be a priority

for National Treasury. The solution is simple: just tax SMEs as though the

shareholder is a sole proprietor with all the income being vested in his/

her hands.

Vuyisa is a man with a mission; an entrepreneur who was thrust into the

limelight when Finance Minister Pravin Gordhan singled him out in the

2010 Budget speech for one of his ‘tips for Pravin’. Vuyisa’s belief that

the country needs a larger budget for youth development and his initiative

to launch an online social platform called Student Enterprises, to support

youth job creation and entrepreneurship, won him the recognition.

With a BCom (financial accounting) and specialist qualifications in

property, Vuyisa is studying entrepreneurship, too. His experience covers

the property industry, business development and communications. He is

a director of the South African Black Entrepreneurs Forum (SABEF). Not

content to watch things happening around him, he sets out to make them

happen and to change the world for the better. He is determined to give

South African taxpayers a voice and work to improve the efficiency of

government expenditure.

Please note that the full article has footnotes. To acquire the footnotes, please

contact the editor

“Overall, it is quite clear that our current system is biased against one of the most important sectors in the economy being small businesses. At a time where it is difficult for people to gain employment, they should be encouraged to start their own ventures and not be punished when they do.”

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1. background

Following on from the efforts of his predecessor, the Minister of Finance,

Mr Pravin Gordhan, once again, delivered a reasonable Budget on 23

February 2011.

However, much has been deferred until the 2012 Budget and with good

reason. Making major proposals to changes in our tax system at a time of

such economic uncertainty warranted a budget which erred, if anything,

on the side of caution.

It is noteworthy that when the 2012 Budget is delivered, our Income

Tax Act will effectively turn 50. The fact that our country has changed so

significantly since the Katz Commission, it is now well and truly time for

our tax system to be reviewed and appropriately consolidated.

Notwithstanding this, the National Health Insurance (NHI) should not be

delayed until any such tax consolidation takes place.

The NHI has been spoken and written about for some time now and it has

been stated, announcements about specific funding instruments will be

made in the 2012 Budget.

Inextricably linked to the NHI are the current complex income tax provisions

relating to the tax deduction for medical expenses. It was announced in

the 2011 Budget that medical expense deductions (as contemplated in

section 18 of the Act) will be converted into tax credits, effective 1 March

2012. It was noted that a discussion paper regarding the conversion

would be issued by the end of March 2011. At the time of writing, the

discussion paper has not yet been published and I am unable to express

an opinion.

The purpose of this article is to highlight what I believe are some of the

macro issues which could be considered in order to create better healthcare

for the majority of South Africans. I make these respectful submissions in

my capacity as a specialist tax law adviser in the area of healthcare and

am in no way privy to any plans which the government may, or may not,

have regarding financing the NHI.

Furthermore, as an independent tax law adviser, I am an entirely neutral

commentator. Any opinions, suggestions, ideas and observations expressed

are solely mine and made in the hope that South Africa can create a viable,

sustainable and successful State healthcare system for the benefit of all

South Africans.

It is clear that the government is not promising South Africans an

overnight fix to our State healthcare which is desperately in need of

immediate antidotes. Haste, however, will not achieve the intended

results. The government’s pragmatic and conservative approach is thus

commendable.

Government is expecting to phase in the NHI over 14 years. Such period

may seem a long-time to many commentators and, more appropriately, to

the millions of South Africans who are in desperate need and deserving of

better healthcare.

Realism, however, has to be the order of the day as South Africa has a

considerable way to go in achieving a well financed, sustainable and good

healthcare system.

Even the most developed countries around the world have grappled, at

pains, with healthcare reforms. As the title of this article alludes, South

Africa’s position is considerably different to that of America, the United

Kingdom and France, for example. Accordingly, any comparison to the

healthcare systems and any reforms made (or proposed) in those countries

are considered inappropriate in the South African context. This in no

way suggests that South Africa cannot learn from healthcare systems

around the world, however, our continued emergence from the dark days

of apartheid places South Africa at the other end of the spectrum when

dealing with State healthcare, among many other issues (such as job

creation, education, housing).

2. Financing the Nhi

Addressing some specifics about financing the NHI, government is

contemplating an increase in the rate of VAT to partially fund the NHI. Such

an increase would be counter-productive. This is because any increase is

likely to affect those most in need of health care. For this reason, I have not

assessed what percentage increase in VAT would be required in any event

to make a significant contribution to the financing of the NHI.

The precise mechanism for raising finance and adequately allocating

expenditure which the government has in mind is unclear. An NHI fund

should be introduced onto our statute books as soon as possible.

eugene bendel | [email protected]

the long wAlk to…heAlthcAre – nhi


2.1 Public-private partnership

Any successful NHI fund will require a public-private partnership. In

this context, contributors to the NHI should include private hospitals,

pharmaceutical companies and suppliers to the healthcare industry.

Possibly by an indirect tax based on a predetermined percentage of

turnover, or any other more appropriate measure.

Notwithstanding the fact that such indirect taxation would appear to be

detrimental to the various sectors of the healthcare fraternity, the salient

benefits are noteworthy of comment.

Once the NHI is adequately funded, State patients (or those patients not

covered by medical schemes) should be able to receive medical care in

private hospitals, paid for out of the NHI fund, where no suitable State

healthcare facility is available or provided.

For the pharmaceutical and medical supply industries, any increase in

investment, with the concomitant increase and improvement in the State

healthcare system should have a positive impact on their businesses. It

stands to reason that the demand from the State will increase exponentially

for their product offerings.

2.2 increased funding for the Road Accident Fund

The first area of consolidation (bearing in mind the stated requirement for

tax consolidation referred to in point 1 above) is the amalgamation of the

Road Accident Fund (RAF) into the NHI fund.

A considerable amount of the State’s healthcare costs is expended on road

accidents – it is understood that the RAF is inadequately funded. Such

position is, wholly unsurprising as the financial contributor to the fund is

the fuel levy. When reflecting on the sources and causes of road accidents,

there are many other sectors of the economy which should be contributors

to the fund. These include (but are not limited to): motor manufacturers,

motor dealers, suppliers to the motor industry, car rental companies,

vehicle financiers, motor vehicle insurers, construction companies and the

alcohol industry (notwithstanding the considerable efforts that companies

like SAB Miller make in discouraging drinking and driving, the sad reality

is that many road accidents are caused by drivers who are under the

influence of alcohol).

2.3 Tax incentives

Two additional but significant financing instruments could include

incentivised savings.

Firstly, it is recognised that historically disadvantaged

individuals (HDI) are not saving sufficiently for their

futures. Viewed in isolation, such position will create

a substantial social security burden on our State

for future generations. It is, therefore, submitted

that an incentive that could be considered.

For example; for every R100 which an HDI

invests in the NHI fund will be supplemented

by, say R5, by the government. Time limits as

to investments (and early withdrawal issues) in

the NHI fund and the definition of a HDI would

need to be carefully considered.

The second incentive could be for a further tax-

free interest exemption to be made available for

funds invested in the NHI fund. Probably more

beneficial for the country, as a whole, would

be converting the current interest exemption for

savings only made in the NHI fund – the current exemption

could also be increased. It is clearly envisaged that interest paid on any

savings made in the NHI would be at market-related interest rates, or

slightly higher in order to attract sufficient investments.

An initial public bond offering in this regard could also be considered. This

should provide the NHI with the proverbial shot-in-the-arm so as to allow

government to make some relatively short-term decisions (and funding

allocations) for the benefit of a much improved State healthcare system.

3. summary

I have set out a limited number of my submissions and potential ideas

which could be considered in relation to creating a successful NHI. Many

of the ideas and submissions made above may be unworkable, unpractical

or plain and simply inappropriate. In any event, each and every one of

them will require substantial thought and consideration.

The Minister of Finance said, when delivering his Budget on 23 February

2011, that the Treasury would carefully consider the pros and cons of

each of their ideas regarding the NHI. As with any major changes in tax

law, there will be winners and losers.

I am aware that many of the submissions made above raise cons, such

as any perceived negative impact the indirect tax could have on the

construction industry. But the salient features do need to be considered

when making assessments as the construction industry will benefit

from greater investment in building hospitals and/or improving existing

healthcare facilities.

I am also acutely aware that the road to a good State healthcare system

will, out of necessity, be a long and winding one. Time will tell as to how

the government approaches the matter and the Minister’s 2012 Budget

will no doubt come under close scrutiny, quite aside from it being a

50th anniversary Budget – I believe we can expect no gifts in the 2012

Budget.

Each and every issue, view, opinion, submission or any other matter

expressed in the article above are solely those of the author. The author

accepts no responsibility of whatever nature for any action which any party

may take pursuant to the publication of the said article.


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Fieta slendebroek | Director Africa Tax at Webber Wentzel

[email protected]

South African companies doing business

in Africa should be aware of the fact that

this may result in considerable tax costs

for the South African company. This

could especially be the case where an

SA company provides services, either management

or technical services, to its African group companies.

Under the South African tax rules, the company

should charge its group companies a market-related

fee for those services. In many cases, the services are

provided electronically or by phone; in other words,

the services are physically provided from South Africa

and that is where the problems come in.

Most African countries have withholding taxes on

fees paid from their country ranging from 10–24%

on the gross amount of the payments and most South

African tax payers simply claim the full withholding

tax against their SA income tax liability. However, this

is not correct.

The South African recipient of technical and

management fees should include the gross amount

of the fees in their income (that is, before deduction

of the withholding taxes), which could potentially

lead to double tax. To avoid, SA legislation provides

that a tax credit may be claimed for the withholding

Where South Africa has concluded a tax treaty with

the African country, help may be at hand. In some

treaties, there is a deeming provision which states

that service fees are deemed to arise in the country

where the payor is residing. This deeming provision

would override the SA domestic legislation as a result

of which service fees paid from a treaty country with

such a provision will always qualify as foreign source

income with the possibility to claim a tax credit.

It should be noted that since SARS released its

Interpretation Note on the subject in 2009, tax credit

calculations of South African tax payers have become

more of a focus area for them. It would therefore be

worthwhile (to avoid interest and penalties) to have

a close look at the methodologies used to calculate

your tax credits.

taxes paid on the fees, provided the source of the fee

income is outside South Africa. In order for the fees to

be considered foreign source, the services underlying

those fees should physically be rendered outside its

borders. Therefore, if the services are provided from

South Africa, it will in principle not be possible to

claim a credit for the withholding taxes. However, the

taxes may be deducted as a cost.

The situation becomes more complicated if services

are provided both inside and outside South Africa

and one fee is charged for both. How would you

then attribute the fee between South African and

foreign source? Do you use time spent in and outside

the country or dominant sources of income as an

allocation key? There is no hard and fast rule to deal

with those questions. Each situation should be looked

at separately to determine the right key.

hidden tAx costs oF doing business in AFricA

min

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the ‘new’ economic substAnce doctrine:

The Three Cs: Consistency, Clarification

and Claws

TeCh TAlK


The economic substance doctrine

In the beginning of this article, I said that economic

substance is a judicially created doctrine. Remember

in Gregory, supra, the form of the transaction, to wit,

the reorganisation, literally satisfied every element of

the applicable statute. One would have concluded,

therefore, and certainly the taxpayer must have

thought, that such transaction if challenged by the

taxing authority would have passed statutory muster.

Nonetheless, the court in determining whether the

reorganisation should be respected did not turn on

the ‘form’ of the transaction. Rather, the validity of the

reorganisation turned on whether its ‘substance’ was

consistent with its form which, in my opinion, turned

on the intent of the legislature for the enactment of the

statute. Taken in such light, the economic substance

doctrine could be viewed as a judicial instrument or

tool utilised by courts to determine whether or not

certain commercial arrangements, when juxtaposed

with governmental intent, survive judicial scrutiny.

I would now like to turn to the test applied to economic

substance. Courts have applied a two-prong test for

determining economic substance: (a) the subjective

component; and (b) the objective component. The

subjective component of the economic substance test

looks to business purpose, while the objective prong

asks whether the transaction in question has any

practical economic effects other than the creation of

income tax losses.

Shriver v. CIR is a case where the subjective

component of the economic substance doctrine was

addressed.

Summary of the pertinent facts:

James A Shriver (Petitioner) entered into an investment

strategy involving a complicated set of arranged sale

and leaseback transactions of leveraged computer

equipment. After Petitioner reported net losses for a

number of years from the equipment purchase and

leaseback transactions, the Commissioner disregarded

those losses on the ground that Petitioner’s investment

was a tax-avoidance scheme devoid of economic

substance.

The primary issue before the court was whether the

transaction consummated by Petitioner was done

with the intent to commit capital for purposes of tax

avoidance or tax minimisation or whether a non-tax,

legitimate profit motive, was intended.

In determining Petitioner’s intent, the Court

considered, inter alia, the following: (i) whether a

profit was even possible; (ii) whether Petitioner had a

non-tax business reason to engage in the transaction;

(iii) whether Petitioner really committed capital to the

transaction; (iv) whether the entities involved in the

transaction were entities separate and apart from

Petitioner and engaging in legitimate business before

and after the transaction; and (v) whether all the

purported steps were engaged in at arms-length with

the parties doing what the parties intended to do.

In this case, the court held that Petitioner had not

manifested a subjective business purpose with

respect to the investment. The court determined

that no realistic opportunity of profit exclusive of tax

benefits existed at the time of entry into the transaction

because no prudent investor would have expected the

investment’s projected residual value and useful life

for the equipment. In conclusion, the court entered

a decision in favor of the Commissioner, which such

decision was upheld by the 8th Circuit.

The other side of the equation dealing with economic

substance is the objective component. This prong

was addressed in ACM Partnership v. CIR.

Summary of the pertinent facts:

ACM Partnership (Petitioner) performed a series of

financial transactions and created a partnership,

for the purposes of generating capital losses that

Petitioner would use to offset previous capital gains

for tax purposes. The Commissioner claimed that

the financial transactions were a sham because

they were created solely for tax-motivated purposes

without any realistic expectations of profit. The

Commissioner therefore disallowed the capital loss

deduction.

With respect to the objective component, the issue

before the Court was whether the transactions and

creation of the partnership engineered by Petitioner

resulted in a meaningful and appreciable enhancement

in the net economic position of Petitioner other than

tax diminution.

In assessing the objective component of economic

substance, the Courts can examine whether the

particular transaction has any practical economic

effects other than the creation of income tax losses

and have refused to recognise the tax consequences

of transactions that were devoid of non-tax substance


Part Two

“With respect to the objective component, the issue before the Court was whether the transactions and creation of the partnership engineered by Petitioner resulted in a meaningful and appreciable enhancement in the net economic position of Petitioner other than tax diminution.”

Terrence H Fraser, JD, LLM, is an estate tax attorney for the United States Department of the Treasury and member of the United States Tax Court. The author also is a

JSD (candidate) International Tax at Thomas Jefferson School of Law. This article is solely the work of the author in his individual capacity. The information in this article

does not represent any position taken by, or presented on behalf of, the government of the United States.


because they did not appreciably affect the taxpayer’s

beneficial interest except to reduce his tax.

In this case, on appeal, the Court held that Petitioner

was not entitled to recognise a phantom loss from a

transaction that lacked economic substance separate

and distinct from economic benefit achieved solely by

tax deduction.

As observed above, the economic substance doctrine

has both an objective and subjective component. A

minority of circuits apply one or the other component.

This is referred to as the disjunctive application of the

economic substance doctrine. A majority of circuits,

however, apply both the objective and subjective

components. This is referred to as the conjunctive

application of the economic substance doctrine. A

transaction would be respected for legitimate income

tax purposes under the conjunctive application if such

“transaction has economic substance (i.e. objective

component) compelled by business or regulatory

realities (i.e. subjective component), is imbued with

tax-independent considerations, and is not shaped

totally by tax-avoidance features”.

In addition, the circuit courts have disagreed in their

application of whether a transaction must have

profit potential to be respected under the economic

substance. Here is what a few apparent savants in

economic substance doctrine theory say about the

conflicts:

“Even among the courts that have required there to

be a profit potential, some of these courts applying

the economic substance doctrine have disallowed

the resulting tax benefits if the profit potential and

attendant economic risks were insignificant when

compared with the purported US Federal Income Tax

benefits, while other courts have found a nominal

amount of pre-tax profit to be sufficient. As a result, the

case law was often confusing as to whether a profit

potential was required under the economic substance

doctrine, and if so, what amount of pre-tax profit

was required. The Act [Health Care and Education

Reconciliation Act of 2010, Pub L. No.111-152,

§1409(a) (2010), which includes ‘new’ IRC section

7701(o)] now clarifies that neither a profit potential

nor a minimum return is required for a transaction to

have economic substance. Nevertheless, a taxpayer

may still rely on a profit potential to demonstrate its

transaction has ‘economic substance’ as long as the

present value of the reasonably expected pre-tax profit

is substantial in relation to the present value of the

expected net US Federal Income Tax benefits of the

transaction.”

Notwithstanding the various labels given to the

doctrine and the disagreements, disharmony, and

the lack of uniformity between and among the circuit

courts regarding the appropriate test of the economic

substance doctrine, the application of the doctrine

by the courts has worked fairly well. So the question

is why was codification of the economic substance

doctrine necessary? The answer to this question lies

ahead.

Codification of the economic substance doctrine

As stated earlier, throughout history the common

law doctrine of economic substance has been

used by courts to not respect structures where the

main purpose was to seek tax advantage that was

inconsistent with congressional intent relative to

an applicable statute. As demonstrated above and

reiterated by experts in this area, courts have over the

years articulated different standards for determining

whether or not economic substance exists. Some

circuit courts have utilised the disjunctive component,

while the majority of circuit courts have employed the

conjunctive component. This disjunctive or conjunctive

application to economic substance has led to many

conflicts between and among the circuits. To bring

the circuits into harmony and to achieve consistent

application of economic substance, Congress, under

section 7701(o) of the Internal Revenue Code has

codified the economic substance doctrine by saying,

inter alia, that the conjunctive inquiry will be the test

to apply to transactions consummated after 30 March

2010 in determining whether or not a transaction has

economic substance.

Pursuant to section 7701(o) of the Internal Revenue

Code, a transaction will be considered to have

economic substance only if the transaction satisfies

both the objective component, that is, the transaction

must change the taxpayer’s economic position in a

meaningful way independent of any income tax effects


TeCh TAlK


AND the transaction also must satisfy the subjective

component, meaning that taxpayer must have a

substantial business purpose uninfluenced by income

tax advantage for entering into such transaction.

As previously stated, the conjunctive test has been

applied over the years by a majority of circuit courts.

So this is nothing new to the majority. But that is

not to say, however, that codification is unnecessary,

because it is. Because it brings the minority courts in

line with the majority and, thus, creates uniformity in

judicial application of the doctrine.

Under the separation of powers provisions in the

US Constitution the doctrine as codified, of course,

cannot and does not empower the legislature to

decide whether or not a transaction has economic

substance. Such a determination remains within the

exclusive authority of the judiciary if and when such

issue is brought before its body, in a tax controversy

dispute between a taxpayer(s) and the taxing authority.

Therefore, courts will continue to apply and decide

the economic substance question the same way prior

to the enactment of Code sec. 7701(o); but in so

doing, all circuit courts will now be required to apply

the conjunctive test to determine whether or not the

substance of a transaction comports with legislative

intent.

The seriousness of Code sec. 7701(a) is the claw

or teeth which has been given to it as is evidenced

by additional imposition of penalties for transactions

lacking in economic substance. If after applying

the conjunctive test, the courts should find that a

transaction lacks economic substance, a 20%

penalty will apply if the transaction is disclosed on the

taxpayer’s return. If the transaction is not disclosed, a

40% penalty will be assessed. There appears to be

no defense to such penalties as this is a strict liability

imposition.

Among the reasons for passage of the Healthcare and

Education Reconciliation Act of 2010 and codification

of the economic substance doctrine in IRC §7701(o)

is to raise revenues for the government in a time

when revenues are needed the most, not only to

help close the vast tax gap, but also to advance the

economic health and well-being of our country and

our people. Equally important is the fact that many

of our wealthy taxpayers whose riches were obtained,

due to the enormous opportunities given them in this

country, while at the same time contributing greatly

to the tax gap by engineering all sorts of financial

plans, including abusive tax shelters, both here and

abroad mainly to achieve tax advantage, has to be

stopped. For too long, the Treasury and taxpayers

have been playing cowboys and robbers with the

peoples’ money. Over many years, said taxpayers

have learned and have been willing to play the audit

game and to take chances with the Treasury. The

consensus were that these taxpayers would embark

upon transactions solely for tax advantage, file (and

in many cases not file) their tax returns and wait to

hear from the Treasury either by way of a tax closing

letter or an invitation for an audit. If the

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