The taxpayer’s contribution to its employee share option scheme is deductible
On 26 November 2018 a full bench of the Western Cape High Court confirmed by majority the decision of the tax court and found in favour of the taxpayer in CSARS v Spur Group (Pty) Ltd A285/2019 (not yet reported in SA Tax Cases). The taxpayer had claimed deductions under section 11(a) of the Income Tax Act (Act) in respect of a contribution totalling some R48,5 million to its employee management incentive scheme trust (Trust) deducted in the 2005 to 2012 years of assessment.
The essence of the argument was whether there was a sufficiently close connection between the expense and the taxpayer’s production of income. A secondary question, that of prescription, would arise should the court find against the taxpayer.
The facts were not in dispute. The taxpayer had implemented the share incentive scheme in 2004, the object being to afford employees the opportunity to participate in the scheme in order to promote the growth and profitability of the group. The selected employees were key managerial staff; the contribution was for the purposes of the scheme; the employees did benefit; the contribution was not capital in nature; the scheme was legitimate and its agreements, implementation and transactions not simulated. On 30 November 2004 the Trust was established. The sole beneficiary was Spur Holdco as to capital, shares and income. The Trust then acquired the share capital of a shelf company, Newco. On 7 December 2004 the taxpayer concluded a contribution agreement with the Trust in terms of which it made the R48,5 million contribution to the Trust. The trustees were obliged to use the contribution to subscribe for preference shares in Newco, redeemable only after five years and carrying a coupon rate equivalent to 75% of SA prime. Newco in turn used the subscription price to purchase 8,2 million shares in Spur Holdco, the listed company of the group. The participating employees were offered ordinary shares in Newco at par in proportions determined by Spur Holdco. They were not entitled to deal in their shares for at least seven years after issue, and the shares of any employee who left within that period were forfeited and used for later allocation to other employees.
Newco made no distributions during the five year term of the preference shares, so the participating employees became entitled to the accumulated growth in the Trust’s holding in Spur Holdco. By the end of the five year period, the trust was entitled to accumulated dividends of R22,5 million. This was settled by transferring to the Trust the equivalent value of Spur Holdco shares. Newco then redeemed the preference shares and disposed of the balance of its Spur Holdco shares. Out of the proceeds Newco paid dividends of R28,2 million and R635 000 to the participating shareholders in 2009 and 2011 respectively.
On 13 December 2010 the scheme was terminated and the participating employees became discretionary dividend beneficiaries of the Trust. The taxpayer’s R48,5 million, not being repayable to the taxpayer, vested in Spur Holdco, as did the preference share dividends of R22,5 million. It appears from the narration, although not expressly stated, that the trustees distributed these two amounts to the vested beneficiary. Thus the scheme came to an end.
In disallowing the deduction, SARS contended that the participating employees had not benefited from the R48,5 million distribution. The only beneficiary was the sole vested beneficiary, Spur Holdco. Only if the participating employees had benefited directly from the contribution could the expense qualify as a deduction under section 11(a) and thus as an expense incurred in the production of income.
The tax partner at Spur Group’s auditors had given evidence to the tax court and explained the rationale behind the scheme as devised. Under cross-examination by counsel for SARS as to why this scheme had been used and not the simpler provision of loans to the participating employees, he explained that loans can be a disincentive if, as often happens, the increase in value of the shares fails to keep pace with the capital amount of the loan and accumulated interest. The employee bore the risk of the share price falling to the point where the loan liability exceeded the amount the employee could obtain from selling the shares. Making the employees, in effect, dividend beneficiaries removed this risk. It seems that what the tax partner was getting at, without expressing it in these terms, was that the whole scheme had to be looked at holistically. The use of the Trust and Newco and Spur Holdco, and the preference share issue, and the acquisition of Spur Holdco shares, were all parts of a scheme designed to provide incentives to participating employees, to the benefit of the taxpayer and the employees, while mitigating the risk of loss to the employees.
The chief financial officer of the Group was one of the participating employees. She explained that, as a service oriented business Spur expected its employees to work irregular hours, not the usual 8 to 5 regime. They needed to be rewarded for this inconvenience. Spur was a very dividend rich company and in order to derive profits it needed an enthusiastic, committed and competent workforce. She affirmed that her participation in the scheme contributed significantly to her desire to remain employed at Spur.
The court proceeded to traverse the familiar principles from case law relating to deduction of expenditure, beginning with the locus classicus, Port Elizabeth Electric Tramway Co Ltd v CIR [1936] 8 SATC 13 CPD. The question is twofold: (a) whether the act to which the expenditure is attached is performed in the production of income; and (b) whether the expenditure is linked to it closely enough. The learned judge, Watermeyer J as he then was, went further to point out that the expenditure itself need not be necessary in order to earn income; the purpose of the act entailing the expenditure must be looked to. If it is performed for the purpose of earning income, then the attendant expenditure is deductible. The learned judge concluded: “all expenses attached to the performance of a business operation bona fide performed for the purpose of earning income are deductible whether such expenses are necessary for its performance or attached to it by chance or are bona fide incurred for the more efficient performance of such operation”.
In CIR v Genn & Co (Pty) Ltd v CIR [1955] 20 SATC 113 AD, the Appellate Division referred with approval to Port Elizabeth Tramway and introduced “the closeness of the connection between the expenditure and the income earning operations” as a means of applying the test.
More recently, in CIR v Pick ‘n Pay Employee Share Purchase Trust [1992 65 SATC 346 AD the court stated that in a tax case one is not concerned with what possibilities the taxpayer foresaw and with which he reconciled himself. “One is concerned with his object, his aim, his actual purpose”.
This succinct summary was quoted with approval in Warner Lambert SA (Pty) Ltd v CSARS [2003] 65 SATC 271 SCA, a case that the tax court used extensively.in the present matter. Warner Lambert was the South African subsidiary of the US pharmaceutical giant. In terms of the Sullivan Code principles developed during the apartheid era, local operations of US companies had to permit no discrimination in the workplace and had to incur significant expenditure on social responsibility (SR) projects. The case revolved around whether the SR expenditure was deductible. The court found that it was incurred for the purposes of trade and for no other, because without access to the products and formulas of the US parent its income would have dried up. The SR expenditure had not added to the subsidiary’s income earning structure, which was complete. The SR expenditure had been incurred in order to protect its earnings. The SCA regarded these payments as similar to insurance premiums.
The tax court found that, on the evidence, the dominant purpose of the scheme “was to protect and enhance the business of the taxpayer and its income by motivating its key staff to be efficient and productive and remain in the taxpayer’s employ”. The taxpayer had incurred the expenditure for the purpose of earning income. The majority of the High Court fully aligned itself with these remarks. It acknowledged that the bulk of the benefit inured to the Spur Group, but that did not detract from the actual purpose of the expenditure as affirmed in the evidence. “It, in fact, is quite clear that maintaining a contented and motivated workforce forms part of the costs of performing the income producing operations and is crucial to the Spur Group’s commercial success and profitability”.
Perhaps unconsciously, the court was echoing a 1978 decision of the Swaziland Court of Appeal in COT v Swaziland Ranches Ltd [1978] 40 SATC 232 SwCA, where the court had to interpret the meaning of “buildings used in connection with farming operations” as provided for in the Swazi tax legislation. The majority of the court found that the expenditure incurred in erecting a school solely for the use of the children of employees and two beerhalls for employees was incurred to achieve a happy and contented workforce. As a result, the buildings were used in connection with farming operations.
There is thus strong argument that, on the correct facts, expenditure incurred to motivate and achieve a satisfied workforce can meet the general deduction formula test. The judgment also validates the use of employee incentive schemes, provided they are properly established and operated.
It is necessary to add a note of caution. Salie-Hlophe J issued a strong minority judgment, finding for SARS, fundamentally on the basis that the R48,5 million had not been incurred as contemplated in section 11(a) but had merely flowed through the Group as a vehicle through which to create the dividends, which in turn were the incentive. Because of her view, the learned judge was obliged to consider the prescription question. She stated that she would have found that there had been misrepresentation of material facts in the tax returns in that Spur had answered “no” to certain questions. The judgment does not indicate which these questions were. The fact that the financial statements had accompanied the tax return did not avail the taxpayer. Therefore, she would have found that the three year prescription period provided for in section 99 of the Tax Administration Act did not apply.
Given the strong minority judgment, and the amounts involved, SARS might well launch a further appeal to the Supreme Court of Appeal.