This bulletin was prepared by partner Conor McFadden and candidate attorney Johan Coertze.
In the recent matter of The Commissioner for the South African Revenue Service v Spur Group (Pty) Ltd (unreported case number: A285/2019) a full bench of the Western Cape High Court had to determine whether a contribution made by an employer to a trust, which only beneficiary was that employer’s holding company, in order to facilitate an employee share incentive scheme is deductible in terms of section 11(a) of the Income Tax Act 58 of 1962 (the "ITA").
The facts can be summarised as follows. Spur Group SA (Pty) Ltd ("Spur") contributed an amount of R48 million to the Spur Management Share Trust (the "Trust") which was established in order to implement a share incentive scheme (the "Scheme") (the "Contribution"). The Spur Corporation Ltd ("Spur HoldCo"), which held shares in Spur was the only capital and income beneficiary of the Trust. Senior management employees of Spur were allowed to participate in the scheme in order to promote the growth and profitability of the Spur group of companies. The Scheme enabled the participating employees to purchase ordinary shares in a shelf company ("NewCo") which, after the Trust had acquired preference shares in NewCo by utilising the Contribution, could acquire shares in Spur Holdco. The employees benefited from the value created in NewCo by the appreciation of the Spur HoldCo shares held by NewCo. On the subsequent redemption of the preference shares by the Trust, through the transfer of the equivalent value of Spur HoldCo shares from NewCo to the Trust, a dividend of R28 627 000 was declared by NewCo to the participants of the Scheme. NewCo thereafter disposed of the shares held in Spur HoldCo and paid further dividends of R28 627 000 and R635 000 to the participants of the Scheme. The Contribution in effect moved from Spur to Spur HoldCo and never left the Spur group of companies.
Spur claimed the Contribution amount of R48 million over a period of 7 years in terms of section 11(a) of the ITA. The South African Revenue Service (the "SARS") initially allowed the deductions but issued additional assessments in terms of which it disallowed them based on the view that, since the employees, who were to be incentivised by the Contribution, were not connected to the Trust, there existed no direct causal link between the payment and the production of Spur’s income. The SARS was of the view that Spur could only claim the deduction if the payment was made directly for the benefit of the participating employees. The SARS only relied on section 11(a) of the ITA and did not rely on the negative test in section 23(g) of the ITA.
In the Tax Court, Spur led evidence that the purpose of the Scheme was to incentivise employees to participate in the growth of the Spur group of companies and that such schemes function to attract and retain highly qualified people to the company. An employee of Spur who participated in the Scheme further confirmed the effectiveness of the Scheme in incentivising employees to contribute to and remain in the employ of Spur. The SARS contended that Spur chose this structure because it enabled the company to deduct such amount, whilst a loan from Spur to the Trust would have achieved the same purpose without enabling Spur to deduct the Contribution. The Tax Court accepted Spur’s evidence and found that Spur had established a sufficiently close connection between the expenditure and its income earning operations and accordingly allowed the deduction.
The basis of the Appeal to the Full bench of the High Court was that Spur had failed to show that the purpose of the Scheme was to incentivise the participating employees and accordingly that there was not a sufficiently close causal nexus between the expenditure and the production of Spur’s income. In reaching its decision, Ndita J, writing for the majority of the court, confirmed that based on the evidence before the Tax Court, it had been proven that the object and purpose of the Scheme was to incentivise the participating employees. The Court further aligned with the view of the Tax Court that ‘a taxpayer may organise its financial affairs in such a way as to pay the least tax permissible’ and that the fact that Spur chose the particular structure of the Scheme instead of a loan which could have reached a similar result does not detract from the actual purpose of the Scheme – which was to incentivise the participating employees. The Court further held that although the bulk of the benefit of the Scheme inures to the Spur Group, this does not invalidate the actual purpose of the Scheme. The costs of facilitating the Scheme, therefore formed part of the income producing activities of the employer (Spur). The majority of the Court accordingly allowed the deduction and concluded that:
the money was disbursed in order indirectly to facilitate the carrying on of the taxpayer’s trade. Even if the contribution did not directly benefit the employees, the overwhelming evidence supports the fact that it incentivised and motivated the participating employees, as I have said, albeit indirectly. I also do not understand it to be a requirement that employees benefit directly from the contribution. What seems to be paramount, at least in my view, is the purpose of the expenditure and what it affects.
In his dissenting judgment, Salie-Hlophe J came to a contrary conclusion and found that the amount of R48 million did not leave the hands of the Spur group and the amount was accordingly not spent in the production of income. His view was that the Contribution could not qualify for the deduction in section 11(a) of the ITA as the amount was not expenditure which was spent, but was rather held in trust for the taxpayer. This, however, seems to be conflating two separate parts of the general deduction formula. It was common cause between Spur and the SARS that the amount of R48 million qualified as expenditure and accordingly the only relevant determination which remained for the court, as correctly addresses in the majority judgement, was whether there is a close enough connection between the expenditure and the production of the income of the taxpayer (Spur).
The majority decision is good news for taxpayer’s intending to implement employee share schemes in order to incentivise their employees. Such employers would be allowed to deduct, for income tax purposes, contributions made in order to implement or facilitate an employee share scheme irrespective as to whether the direct benefit from such contribution inures to the employees or whether the employees own any shares in the employer directly. This judgment also confirms the wide scope of allowable deductions for taxpayers as the court again emphasised that the purpose of any expenditure is a paramount consideration in determining whether expenditure is deductible irrespective of the ultimate recipient of the benefits of such expenditure. It is however unsure whether reliance on the negative test of the general deduction formula in section 23(g) of the ITA by the SARS would have affected the decision of the court and care must accordingly be taken to ensure that any contribution to an employee share scheme forms part of the employer’s trade.