Taxation of illegal pyramid schemebenefits the State

Synopsis June 2007

Tax today*

*connectedthinking

2

In this issue

The taxability of illegal pyramid schemes . . . . . . . . . 2

Cross-border partnerships and double tax agreements. . 4

Impermissable tax avoidance arrangements . . . 7

Rectification of a contract . . 8

SARS to be empowered tooverrule court judgments . . 10

The judgment of the Supreme Court of Appeal, handed down

on 2 May 2007 (and not yet reported) in MP Finance Group CC

(in liquidation) v CSARS [2007] SCA 71 (RSA) concerned the

taxability of amounts received by a pyramid scheme (operated

as a close corporation) which, in the words of the court –

“readily parted greedy or gullible ‘investors’ from their money by

promising irresistible (but unsustainable) returns on various forms of

ostensible investment. It paid for such returns for a while before finally

collapsing – owing many millions – when the predictable happened and

the total amount of supposedly due returns vastly exceeded the total

amount of obtainable investment money.”

The CC’s liquidators contested the assessment

SARS assessed the CC to tax in respect of the 2000 - 2002 tax

years. The liquidators of the CC objected to the assessment,

contending that the amounts received by the close corporation

from investors were not “received” as contemplated in the

definition of “gross income” in section 1 of the Income Tax Act

58 of 1962.

The liquidators’ argument was based on the fact that the

amounts paid to the CC in respect of the scheme were, in terms

The taxability of illegalpyramid schemes

It is disquieting that the taximposed in this caserepresents abenefit to theState at theexpense of the investors, bytaxing moneysstolen fromthem.

3

of the Banks Act and the Consumer Affairs (Unlawful Business

Practices) Act, “illegal and therefore void”. (This was not in

dispute.) Therefore, the argument proceeded –

“the scheme never had the least entitlement to retain investors’ money

[and] the perpetrators of the scheme knew the investments to be illegal.

… Upon receipt of a payment, the scheme was liable promptly to repay it

to the investor who had a claim for it under the condictio ob iniustam

causam [a claim for repayment on the grounds of unjust enrichment].

Instead, it used the money to pay the claims of other investors who had

invested earlier. That was the whole idea of the scheme.”

The Supreme Court of Appeal encapsulated the cc’s argument

thus:

“the scheme was liable in law to refund the deposits, there was no basis

on which it could be said that the deposits were ‘received’ within the

meaning of the Act. They were, it was argued, consequently not liable to

tax.”

The court rejected this argument, holding that, throughout the

tax years in question, the perpetrators of the scheme knew that

it was insolvent, that it was fraudulent, and that it would be

impossible to pay all investors what they had promised.

Consequently, whatever the cc’s intention may have been prior

to 1 March 1999, after that date the pyramid scheme made its

money –

“by swindling the public. It must follow that the amounts [the scheme

was paid] in that period were “received” within the meaning of the Act. It

was for the CC to prove the contrary and that onus was not discharged.”

The court therefore ruled in favour of SARS.

An unsustainable argument?

An unfortunate aspect of this decision is that the CC chose to

base its case on a single narrow point - the meaning of the

term “received” in the definition of “gross income” in the

Income Tax Act.

The argument, in essence, was that, since the pyramid scheme

was illegal, any contracts the scheme promoter had entered

into with investors were illegal and void, and that in law, the

scheme was – on receipt of moneys – under an immediate

obligation to repay it.

In the past, courts have found that for the receipt to be valid

there must be a beneficial receipt. (See Geldenhuys v CIR

1947(3) SA 256(C), 14 SATC 419, COT v G 1981 (4) SA 167

(ZA), 43 SATC 159). In this regard, for there to be a beneficial

receipt, not only must the recipient take the proceeds into his

own patrimony, but the person making the payment must

intend that result as well.

Even where this intention is present, the amount does not

necessarily represent gross income – for instance, where the

amount represents a contribution to share capital of a

company, in exchange for the allotment and issue of shares. It

appears from the judgment that this was what the swindlers

represented the payments were for, although the documentation

“evidencing” the contribution was fraudulent. It is submitted

that the Court should have given greater weight to the intention

of the investors in the scheme. This was considered

paramount in COT v G (supra), and, it is submitted, this is the

approach that should apply in all cases of theft or fraud. The

thief takes something which is not his, and is aware that he has

no lawful right to do so, by reason of the dishonest action.

Can the Court be faulted for giving judgment in respect only of

the argument put forward by the taxpayer? It is not, after all,

the task of the Court to consider what other arguments the

taxpayer could have presented, and then give judgment on

those arguments as well. Nevertheless in the broader context of

what constitutes “receipt”, it is difficult to reconcile the decision

in principle.

A disquieting result

Many may find it disquieting that the tax imposed on the CC

represents a benefit to the State at the expense of the

investors, by taxing moneys stolen from them.

It is not the task of the Court to consider what other arguments the taxpayer could have presented,and then give judgment on those arguments as well.

4

The taxpayer in question, an attorney,

resided in South Africa. He was entitled to

practise both in South Africa and in

Lesotho. He was a partner of a firm of

attorneys in South Africa, and also a

partner in a firm located in Lesotho. The

Lesotho-based firm did business only in

Lesotho from a permanent establishment

in that country. When rendering

professional services, the members of the

firm did not do so individually, but acted

on behalf of the firm, which billed the

client and received payment. Profits of the

partnership so derived were shared

equally by the partners.

The Lesotho-based firm was a registered

taxpayer in Lesotho, where it filed

partnership returns. The taxpayer’s profits,

earned in Lesotho as a partner of that firm,

were taxed in Lesotho.

SARS assessed the taxpayer totax but allowed him a credit fortax paid in Lesotho

SARS included those profits in the

taxpayer’s gross income as taxable in

South Africa, but credited him with the

amounts of tax he had paid on them in

Lesotho. In so doing, SARS relied on

article 22 of South Africa’s double tax

agreement with Lesotho.

The taxpayer argued that his share of

profits from the Lesotho practice was

taxable only in Lesotho, and that these

amounts were exempt from tax in South

Africa.

In giving judgment, the court took as its

starting point that South Africa has a

residence-based income tax system;

hence a resident of South Africa is taxable

(subject to such relief as may be available

under double tax agreements) on his or

her world-wide income.

South Africa’s double tax agreement with

Lesotho provides for the avoidance of

double tax in respect, inter alia, of

business profits and income from personal

services.

The court noted that in terms of article 1,

the DTA applies only to persons who are

residents of one or both of the contracting

states, namely South Africa and Lesotho.

The crucial terms in the DTA, “enterprise

of a Contracting State” and “enterprise of

the other Contracting State”, are defined

to mean, respectively, an enterprise

carried on by a resident of a contracting

state and an enterprise carried on by a

resident of the other contracting state.

The DTA defines “resident of a

Contracting State” as meaning a person

who, under the laws of the Republic or of

Lesotho, as the case may be, is liable to

tax in that state by reason of his

residence, place of management or any

similar criterion.

The court said it was clear that the

taxpayer in the present case was resident

in South Africa, and that it was

unnecessary to consider what the position

would have been had he been resident in

both South Africa and Lesotho.

There are few reportedjudgments of our courts on the interpretation of thiscountry’s double taxagreements. Consequently, the recent decision of theBloemfontein tax court(case number 12158; 22March 2007, not yetreported) will be of wideinterest, particularly to themany attorneys and otherprofessionals who havepractices both in theRepublic and inneighbouring countries.

Cross-border partnerships anddouble tax agreements

5

Profits of an enterprise or profits fromprofessional services

The DTA draws a distinction between “profits of an

enterprise”, which are governed by article 7, and income

derived “in respect of professional services or other

activities of an independent character”, which are

governed by article 14.

The interest of the judgment lies in the issue of whether

the taxpayer’s income from the Lesotho-based practice

in which he was a partner fell under article 7 or article 14.

The court said that, in the statement of agreed facts

drawn up by the parties prior to the hearing, SARS had

admitted that what the taxpayer had derived from the

Lesotho-based practice was “a share of the profits”. The

court said that this admission was clearly correct, and

that the taxpayer’s share of such profits –

“did not involve individual fees of the [taxpayer]. I therefore find

that article 14 of the DTA is not applicable to this case …”

Consequently, said the court, article 7 of the DTA, which

deals with “the profits of an enterprise” was applicable,

and not article 14 which applies to income from

professional services. It was held that, in terms of article

7, the profits of that enterprise carried on by the

taxpayer were taxable in Lesotho, but the taxes so paid

should be deducted from the tax due by the taxpayer to

SARS in terms of article 22 of the double tax agreement.

Therefore, said the court, the assessment of the

taxpayer was correct, and could not be disturbed.

continued on page 6

In giving judgment, the court took as its starting point that South Africa has a residence-basedincome tax system.

6

A partnership is not a legal person, nor is

it a taxable entity in its own right.

Partnership income is taxed in the hands

of the partners, their respective shares in

such income being determined by the

terms of the partnership agreement.

In essence, the court in this case held

that a partner’s income is not derived

from his individual fees, but is a share of

the profits of the enterprise.

The court cited no authority for this

proposition, and was apparently

unaware that this issue has been

considered by our courts and by

overseas jurisdictions.

In essence, the issue is whether a

partner’s income is, for purposes of tax

law, regarded as being income from the

services that he has rendered, or as

income derived from his rights as a

partner under the partnership

agreement. As was noted above, the

court decided that the latter was the

correct position, in other words, that his

income was derived from the carrying on

of an enterprise.

This is a proposition that has been

accepted in Australia.

In FCT v Everett (1980) 10 ATR 608 the

Full High Court of Australia held (at

615–616) that, in the case of a sole

trader operating a business or a

professional person in business for his

own account, his income is the product

of his personal exertion, and went on to

say –

“But this is not true of partners in general or of

the respondent as a partner in this case. The

respondent’s entitlement under the partnership

agreement was to a proportionate share of the

partnership profits as disclosed by the

partnership accounts. The relevant proportion

of the partnership profits was payable to the

respondent because he was a partner and the

owner of a share in the partnership. The

respondent was therefore entitled . . . to his

proportionate share of the partnership profits,

however much or however little energy he

devoted to the practice, so long as the

partnership remained on foot. Accordingly, it is

a misnomer to speak of the respondent’s share

of the income as having been gained by

personal exertion”.

However, the South African courts have

rejected this proposition and have taken

a different view. In CIR v Epstein 1954 (3)

SA 689 (A), 19 SATC 221 the Appellate

Division in essence laid down the

principle that that income derived from

the carrying on of a partnership business

has its source in the respective business

activities of the partners, in other words,

that a partner’s share of the profits is

income derived from the rendering of

services.

Thus, the court said (at 699C) that –

“the income which the partner who carries on

his business activities in the Union receives is

the quid pro quo for the services he renders in

the Union to the partnership”.

In Lever Bros 1946 AD 441 at 459

Schreiner JA said that –

“No-one would speak of the purchase of [a

shareholder’s] shares as the source of his

income any more than one would speak of the

partnership agreement as the source of the

income of a partner.”

In short, the Appellate Division, which

was the highest court in South Africa,

has held that a partner’s income is

derived from the services that he has

rendered, and this principle is therefore

absolutely binding on all lower courts.

It follows that the tax court in the

judgment under discussion in this note

erred in its finding that, as a matter of

law, the taxpayer’s income from the

partnership was derived from “the

enterprise” and not from his “services”,

for the contrary principle.

Critical analysis

7

A New Zealand case rules onan “arrangement”

This was a central issue in the recentNew Zealand case of Petersen vCommissioner of Inland Revenue [2006]3 NZLR 433. The case involvedsyndicates of taxpayers who acquiredthe screenplay for films, and thencommissioned a production company to produce the film for a fixed price, with aview to making a profit by putting thefinished film on the commercial circuit.

The film in question actually cost $x toproduce, but the investors were falselyled to believe that it would cost $x + y.The investors signed a productioncontract to pay the production company $x + y to make the film, which theinvestors paid as to $x out of their ownresources, and as to $y by way ofmoneys borrowed from a lenderconnected with the productioncompany. The project was highlygeared, with $y representing more thanhalf of the investors’ total investment.

What then actually transpired was that$x was paid to the production companyand used in the production of the film,but $y was immediately recycled to thelender.

The taxpayer in question claimed as a

deduction from his income tax his full

contribution to the film project, namely

his share of $x + y. The Commissioner

disallowed the deduction to the extent

that it represented his share of $y, on

the basis that these borrowed moneys

were “tax avoidance arrangements”,

which fell foul of the general anti-

avoidance provision in New Zealand’s

Income Tax Act.

Defeat in the High Court, butvictory on appeal

The New Zealand High Court held in

favour of the Commissioner, finding that

the inflated cost of making the film was

an “arrangement” within the scope of

that anti-avoidance provision, and that

the Commissioner was entitled to make

a consequential downward adjustment

in the deduction claimed by the taxpayer.

On appeal, it was held that an

“arrangement” did not require a meeting

of the minds, and it was therefore

irrelevant that the taxpayer did not know

about the dishonest inflating of the cost

of the film.

However, on further appeal, the Privy

Council held that that the taxpayer,

nonetheless, had in fact “incurred” the

expenditure in question and was

therefore entitled to the tax deduction.

The false inflating of the cost of

producing the film, the use of borrowed

moneys, and the recycling of the loan

portion of the loan to the lender did not

alter the fact that the taxpayer had

incurred the expenditure entailed in his

investment in the project, and he was

entitled to a tax deduction for his outlay.

In hindsight, this may seen a

straightforward conclusion, but the

taxpayer’s ultimate victory was

achieved only after litigation through the

New Zealand equivalent of our tax

court, the New Zealand High Court, the

New Zealand Court of Appeal and,

finally, the Privy Council.

Impermissible tax avoidancearrangements

What is an “arrangement”?

Section 103(1) of theIncome Tax Act (thenotorious generalanti-avoidance provisionof the Act) was repealedwith effect from2 November 2006 andreplaced by the new,much more detailed PartIIA of the Act, which isaimed at “impermissibleavoidance arrangements”.

For all the detail in the new legislation, key conceptsremain unclear. What, forexample, does the word“arrangement” mean? And can the new anti-avoidance provisions beapplied where there was atax avoidance“arrangement”, but thetaxpayer was not a partyto that arrangement?

8

Once parties have entered into a contract, they are usually locked into its tax consequences.

The law reports are replete with instances where people have

entered into contracts without giving sufficient thought – or any

thought – to the tax consequences of what they were doing.

At some later stage – often years later, when they receive an

unexpected assessment from SARS – it dawns on them that

the contract has adverse tax consequences. It may also dawn

on them that, in hindsight, those adverse consequences could

have been avoided if the contract had been drafted differently.

The accrual and incurral of contractual rightsand obligations

The difficulty in trying to remedy this commonplace scenario is

that income tax is highly legalistic, both on the incoming side

and on the expenditure side.

Thus, an amount is included in a taxpayer’s gross income

immediately it “accrues” to the taxpayer, and the courts have

declared that an amount accrues to a taxpayer when he

acquires a legal right to it. (See Lategan v CIR 1926 CPD 203, 2

SATC 16; CIR v People’s Stores (Walvis Bay) (Pty) Ltd 1990 (2)

SA 353 (A), (1990) 52 SATC 9.)

On the outgoings side, expenditure is deductible as soon as it

has been “incurred”, in the sense that the taxpayer has come

under an unconditional legal obligation, except in the few

instances where the Income Tax Act lays down that the

expenditure is deductible only when it has actually been paid.

(See Port Elizabeth Electric Tramway Co Ltd v CIR 1936 CPD

241, 8 SATC 13; Caltex Oil (SA) Pty Ltd v SIR 1975 (1) SA 665

(A), 37 SATC 1.)

Consequently, where a contract is entered into, the amounts

payable under that contract “accrue” immediately, and

expenditure that is to take place in terms of the contract is

“incurred” immediately. In short, once parties have entered into

a contract, they are usually locked into its tax consequences.

No quick fix

Rectification of a contract

If the parties were to subsequently attempt to amend the

contract purely to achieve a better tax result, it is likely that

SARS would invoke the general anti-avoidance provisions of

the Income Tax Act to nullify the tax benefit of the amended

contract.

The possibility of rectification of the contract

There is, however, one avenue open to the parties in this

situation, and that is for them to attempt to rectify the contract.

“Rectification” of a contract (as distinct from amendment of the

contract) is a process whereby one or all of the parties to a

written contract contend that the contract, as it is written, does

not correctly reflect their true intention, and that the contract

must therefore be rectified so that it does.

SARS may well refuse to recognise the rectified contract, and

may assess the parties to tax on the basis of the original

contract. In this event, the parties can object to the

assessment, but they then bear the onus of proving that the

original contract did not correctly reflect their true intention.

What must be proven for a written contract to be rectified?

There have been several recent judgments that lay down what

must be proven before a contract can be rectified. In Jointwo

Holdings (Pty) Ltd v Old Mutual Life Assurance Co (SA) Ltd

[2007] SCA 5 (RSA) (22 February 2007; not yet reported) the

Supreme Court of Appeal ruled that –

“for rectification [of a contract] to be granted, it must be established that

the written instrument did not correctly reflect what the parties had

intended to set out therein.”

In other words, for a contract to be rectified, the parties must

not only prove that their written agreement does not accurately

reflect their true agreement, but also that they had intended

that the point in question should be reduced to writing and

included in the written agreement.

And, of course, just because the parties say that they had

indeed so intended is not the end of the matter. If the case

goes to court, they can expect to be closely cross-examined by

SARS’s counsel, and the court may well hold that the parties

are not telling the truth or, at least, that they have not

discharged the onus of proof resting on them.

In Propfocus 49 (Pty) Ltd v Wenhandel 4 (Pty) Ltd [2007] SCA

15 (RSA) the Supreme Court of Appeal held that, in order to

succeed in a claim for rectification, the party seeking

rectification had to prove –

· that an agreement had been concluded between the parties

and reduced to writing;

· that the written agreement does not reflect the true intention

of the parties, and that this requires that the common

continuing intention of the parties, as it existed at the time

when the agreement was reduced to writing be established;

· an intention by the both parties to reduce the agreement to

writing;

· a mistake in drafting the document, which could have been

the result of an intentional act of the other party or a bona

fide common error; and

· the actual wording of the true agreement.

These factors may be formidably difficult to prove, in particular

the “common continuing intention of the parties as it existed at

the time the agreement was reduced to writing”.

It would not suffice to prove that the parties, in hindsight,

wished that the contract had been differently expressed. It is

necessary to prove that the rectified agreement reflects the true

intention, not merely of one or some of the parties, but the

intention held in common by all of them at the time the original

contract was entered into, and (as the above judgment makes

clear) “the actual wording of the true agreement” must also be

proved.

“Rectification” of a contract (as distinct from amendment of the contract) is a process whereby oneor all of the parties to a written contract contend that the contract, as it is written, does not correctly reflect their true intention, and that the contract must therefore be rectified so that it does.

10

As section 79 is currently worded, SARS

cannot raise an additional assessment in

respect of any amount, if any previous

assessment has, in respect of that

amount, been amended or reduced

pursuant to –

“((aa) any decision made by the Tax Board …

(bb) any order made by the Tax Court, unless it

has been referred back to that court for

decision;

….

“(ee) the settlement of a dispute in terms of Part

IIIA of Chapter III of this Act, [italics added]

unless the Commissioner is satisfied that the

decision, order, concession or resolution of the

dispute or settlement in question was obtained

by fraud or misrepresentation or non-disclosure

of material facts …”

The Taxation Laws Second Amendment

Bill of 2007, released on 13 June 2007,

foreshadows that the italicised words are

to be moved to a separate line, so that

they henceforth qualify all the preceding

subparagraphs and not only

subparagraph (ee).

Once this amendment is law, SARS will

be empowered to issue an additional

assessment even in respect of an

assessment that has been amended or

reduced by order of the Tax Board or the

Tax Court, if SARS is of the view that the

decision of that court “was obtained by

fraud or misrepresentation or

non-disclosure of material facts”.

In effect, SARS will have the power –

quite outside of any judicial process – to

unilaterally overrule the judgment if, for

example, SARS considers that it was

obtained as a result of testimony by a

witness that was deliberately dishonest

or which misrepresented or concealed

material facts.

This is surely extraordinary. The court

will, after all, have decided whether the

witnesses who testified in the case were

telling the truth and the whole truth. For

SARS to have the power to override the

court by issuing an additional

assessment that flies in the face of the

court’s decision in this regard is

astonishing.

The taxpayer would then have to object

to the additional assessment and take it

before the Tax Board or the Tax Court all

over again. And it seems as though the

whole process could then be repeated.

For SARS to have the power to override the court by issuing an additionalassessment that flies in the face of the court’s decision is astonishing.

SARS to be empowered to unilaterallyoverrule judgment of Tax Board or Tax Court

One of the most importantfunctions of the courts, intax cases no less thanother cases, is to bringfinality to a dispute, subject only to the possibility of anappeal to a higher court.

From a taxpayer’s point ofview, one of the mostworrisome aspects oftrying to get finality inregard to tax liability is thepower given to SARS, interms of section 79 of theIncome Tax Act 58 of1962, to issue an additional assessment.

11

Shifting the balanceThe evolution of indirect taxesVAT and GST are two of the fastest growing taxes globally, with over 141

countries worldwide now operating such systems. The 'Shifting the

balance' report offers an insight into the growth of indirect taxes around the

world and focuses on a number of key themes such as the shift from direct

to indirect taxes, barriers to business and the need for reform, litigation, and

the use of technology in indirect tax compliance.

Drawing on data gathered from across the PricewaterhouseCoopers global

indirect tax network, the report provides an overview of the status of

indirect taxes by presenting information on key regions and countries. In

reviewing and comparing systems on an international basis, it is evident

that no system is without its flaws and that countries with more established

VAT/GST systems can learn from the successes of those with more recently

implemented systems. A need for synchronisation and convergence in

indirect tax legislation also emerges in the report, which examines the

progress being made by the European Commission and the OECD in

addressing this issue.

Please contact Sonja Nel at sonja.nel@za.pwc.com if you would like to

receive a copy of the publication.

12

• Editor: Ian Wilson • Written by R C (Bob) Williams • Sub-editor and lay out: Carol Penny, Tax Services Johannesburg

• Dis tri bu tion: Elizabeth Ndlangamandla •Tel (011) 797-5835 • Fax (011) 209-5835 • www.pwc.com/za

This publication is provided by PricewaterhouseCoopers Inc. for information only, and does not constitute the provision of professional advice of any kind. The information

provided herein should not be used as a substitute for consultation with professional advisers. Before making any decision or taking any action, you should consult a

professional adviser who has been provided with all the pertinent facts relevant to your particular situation. No responsibility for loss occasioned to any person acting or

refraining from action as a result of any material in this publication can be accepted by the author, copyright owner or publisher.

© 2007 PricewaterhouseCoopers Inc. All rights reserved. PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International Limited,

each of which is a separate and independent legal entity. PricewaterhouseCoopers Inc is an authorised financial services provider.

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