Shares and capital gains tax

A recent case contains guidelines on penalties and interest under the Tax Administration Act – and how to lodge a successful objection.

Shares and capital gains tax
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In November last year, an especially well-reasoned judgement was issued by the Johannesburg Tax Court in Mr Z vs Commissioner SARS (case number 13472). Apart from the decision relating to the main issues in dispute, the judgement contains restatements of principles from older judgements that will be of great value to the reader.

READ:Fewer options on share options

Briefly, the facts are that, acting as agent for his principal, Mr Z sold shares in a company held by the principal to another party. The shares were sold for a substantial sum, but for reasons which need not concern us here, the principal sued the agent for damages, claiming that Mr Z had not informed him adequately of his rights, to his alleged detriment. A large out-of-court settlement was agreed upon.

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At this point, SARS audited Mr Z and assessed him to a large amount of capital gains tax (CGT) on the price of his own shares in the same company, which he had sold to cover the settlement. The settlement was not taken into account by SARS in calculating the CGT. In addition, it levied penalties of 75% plus interest. Hence the appeal to the Tax Court. Here, the judges analysed the provisions of the 8th schedule of the Income Tax Act. Mr Z, the appellant, had relied on these (notably paragraph 35) in seeking to use the out-of-court settlement as a deduction for CGT purposes.

The law recognises that once income accrues, the use to which the income is put does not alter the taxability thereof. Using cases dealing with this as precedent, the judges in Mr Z vs Commissioner SARS followed the same train of thought with regard to CGT. The gain had occurred in a personal share sale. The damages settlement did not qualify as a deduction in the eyes of the court because it was unrelated to the accrual of capital previously enjoyed, even though the sale was made to settle a debt.

Regarding the penalties and interest charged by SARS, the judges held that SARS did not take into account the fact that:
The appellant had sought professional assistance in the filing of the return relating to the CGT; and Although he was unsuccessful in the CGT matter, the understatement was reasonable by virtue of Mr Z having sought professional assistance.
As a result, the penalty was reduced to 10% with interest charged by SARS under Section 89 of the Income Tax Act reduced to nil.

The case contains useful guidelines on when to object to penalties and interest in terms of the Tax Administration Act. Although it would not have had an effect in this case, it occurs to me that shareholder agreements might be tweaked to ensure that if shareholders act as agents for each other and disputes arise, the proceeds must be contractually reduced. In this way, adverse CGT events might be avoided.