The general anti-avoidance rules (GAAR) in sections 80A to 80L of the Income Tax Act 58 of 1962 (the Income Tax Act) have featured in several recent judgments. The Constitutional Court has now delivered its judgment on two legal questions raised in the ABSA case.

Background to the review application

The judgment did not arrive at the Constitutional Court through the normal objection and appeal route. SARS applied the GAAR to ABSA and, as part of that process, issued a section 80J notice. ABSA took the view that the notice was legally flawed. It approached the High Court for review to set the notice aside. The application was later amended to also set aside the assessments that flowed from the notice. The High Court ruled in ABSA’s favour. The Supreme Court of Appeal held that the High Court should not have entertained the review at all.

The Constitutional Cour, found that the High Court did have jurisdiction. The present judgment is the Constitutional Court’s substantive decision on the two legal errors that ABSA raised. The judgments refer to a Rule 31 statement and disputes relating to penalties. This suggests to me that a separate Chapter 9 dispute may be pending or running in parallel.

The transaction

ABSA subscribed for preference shares in PSIC3. PSIC3 used those funds to subscribe for preference shares in PSIC4. PSIC4 made a capital contribution to an offshore trust, the D1 Trust. The D1 Trust on-lent the funds to MSSA, a South African entity in the Macquarie Group. The judgments record that the preference share product was introduced to ABSA by the Macquarie group.

The interest payment from MSSA to the D1 Trust was exempt in the hands of the non-resident trust under section 10(1)(h). If, however, that interest had vested in PSIC4 as the resident capital beneficiary, the exemption would likely not have survived under the conduit principle or section 25B(2A). Within the trust, it appears that the interest received from MSSA was swapped for interest on Brazilian government bonds, which appeared to qualify for an exemption under the relevant double tax agreement, although the judgments leave room for debate on whether that exemption truly applied. Because interest on Brazilian government bonds vesting in a resident would still be exempt, the swap seems to have converted income that would otherwise have been taxable in the hands of PSIC4 into exempt income.

Stepping back, my impression of the overall effect is that a South African entity claimed an interest deduction, while the same economic return flowed back to South Africa, and ultimately to ABSA, in the form of exempt preference dividends.

Was ABSA a party to the arrangement?

ABSA argued that it subscribed for the preference shares on the understanding that the funds would reach MSSA. It was unaware of the intermediate steps. The first legal question for the court was therefore whether ABSA was a party to the avoidance arrangement at all.

The majority judgment by Majiedt J held that the term “party” must be interpreted broadly. Objectively, it is any person who forms part of the chain of transactions that constitutes the arrangement. This is the case whether or not that person knew about every step. The court reasoned that a narrower interpretation would allow parties to deliberately remain ignorant of the intervening steps and so escape the consequences of the GAAR.

The minority judgment by Rogers J approached the question differently. The starting point should have been to identify what the arrangement was and why it was impermissible, and then to ask to which arrangement ABSA was a party. On that approach, ABSA was a party to the first step and the last step. If it did not know about the steps in between, it could not have been a party to them.

The concept of an “arrangement” is wide enough to include ordinary commercial dealings. However, the GAAR is only concerned with those arrangements that are avoidance arrangements. I would perhaps have expected more debate as to which arrangement(s) constitutes the avoidance arrangement, and only then whether ABSA was a party to that.

Did ABSA derive a tax benefit?

ABSA argued that what it received was a preference dividend that would have been exempt in any event. The tax benefit from the arrangement accrued to another party further along the chain.

Section 80B

The majority drew attention to the wording of section 80B, which empowers SARS to determine the tax consequences for any party to an impermissible avoidance arrangement. On that reading, the party whose tax position is adjusted need not be the party that received the tax benefit. In my view, this is a significant statement of principle. It, however, recedes in the rest of the analysis, because the majority concluded that ABSA itself derived a tax benefit. Rogers J, in the minority judgment, expressed the view that only the party that obtained the tax benefit should have its tax position adjusted under section 80B.

Meaning of tax benefit

The majority reasoned that the arrangement must be stripped of its avoidance features to establish whether a tax benefit exists. The majority concluded that the exempt preference dividends received by ABSA were functionally or in substance equivalent to taxable interest. They concluded that that this was where ABSA’s tax benefit lay. The benefit took the form either of what should have been taxable interest, or of a smaller exempt dividend if PSIC4 had paid tax on the interest before it was distributed up the chain.

The minority arguably adopted a narrower interpretation. A tax benefit is a defined term referring to a liability for tax under the Act that has been reduced. The “but for” test calls for a comparison between what actually happened and a plausible counterfactual. The plausibly different step is the swap of the MSSA interest for the Brazilian government bond interest. On that analysis, the parties whose tax liability would have been higher are the D1 Trust or PSIC4, not ABSA. ABSA’s benefit was economic rather than a tax benefit. The preference dividends it received would have been exempt either way.

The reasoning that an exempt preference dividend is functionally equivalent to taxable interest sits, in my view, uncomfortably alongside the specific anti-avoidance rules in sections 8E and 8EA of the Income Tax Act, which target preference shares with the characteristics of debt. One possible reading of the majority judgment is that preference shares falling outside sections 8E and 8EA could still come under pressure from the GAAR on the basis that the dividend is in substance interest, despite not falling within the ambit of these sections. In my opinion, the thread in the majority’s reasoning that ABSA’s tax benefit was in the form of receiving a larger exempt dividend than it would have received had PSIC4 paid tax on the interest, perhaps fits more comfortably with the overall logic of the judgment.

Take-home message

The judgment opens interpretations that may widens the practical reach of the GAAR in several respects. Firstly, the concept of “party” extends to any person in the chain of transactions. This is irrespective of knowledge of the intervening steps. Secondly, the party whose tax position is adjusted under section 80B need not be the party that obtained the tax benefit. Lastly, the concept of tax benefit requires a purposive reading. It should take into account the benefits derived by each party in the chain. This judgment warrants that taxpayers approach any arrangement with a flavour of a tax avoidance scheme or product with extreme caution.