South Africa's Constitutional Court Rules Ignorance Does Not Preclude Application of GAAR in Landmark Case

Details of the decision are summarized below.

(a) Facts. The applicants, ABSA Bank Limited (ABSA) and its subsidiary United Towers (Pty) Limited (United Towers), are incorporated and tax-resident in South Africa. References to ABSA include United Towers.

Between 2011 and 2015, the applicants invested approximately ZAR 1.9 billion in preference shares in a special-purpose company, PSIC3. The Macquarie Group (Macquarie) designed the arrangement, which provided the applicants with tax-exempt preference share dividends. Allegedly without ABSA's knowledge, the funds flowed through a complex back-to-back structure: from PSIC3 to PSIC Finance 4 (RF) (Pty) Limited (PSIC4), then to Delta 1 Finance Trust (D1 Trust) and ultimately back to Macquarie Securities South Africa Limited (MSSA).

The D1 Trust lent the funds to MSSA through interest-bearing notes, received interest from MSSA and used that interest to acquire Brazilian government bonds. The trust distributed the resulting income to PSIC4 as non-taxable income under the South Africa–Brazil double tax treaty, after which it was distributed as dividends. In substance, the structure converted what would ordinarily have been taxable interest income into tax-free dividend income through a multi-step arrangement.

On 18 May 2018, the South African Revenue Service (SARS) notified the applicants of an audit under the GAAR provisions of the Income Tax Act 1962 (ITA). The notices primarily referred to PSIC3, the preference shares and the related dividends, but also requested information concerning PSIC4, the D1 Trust and the Brazilian bond transactions. The applicants stated that they were unaware of these downstream entities and transactions and could not address them in their documentation.

Following the audit, SARS issued notices under section 80J of the ITA, which requires the Commissioner to notify taxpayers when GAAR may apply and to set out the reasons. In October 2019, SARS raised additional assessments recharacterizing the tax-exempt dividend income received by the applicants as normal income, on the basis that the scheme constituted an "impermissible avoidance arrangement" designed solely to secure a tax benefit.

The applicants disputed the assessments, arguing that they were only aware of the initial investment and had no knowledge of the downstream steps. They contended that (i) they were not a "party" to any broader tax-avoidance arrangement and (ii) they obtained no tax benefit, as they merely received dividends that were lawfully exempt from tax.

The applicants launched a review application in the High Court, which ruled in their favour and set aside the assessments. SARS appealed to the Supreme Court of Appeal, which overturned the High Court's decision.

(b) Issue. The Constitutional Court faced the following two key questions:

• whether the arrangement constituted an "impermissible avoidance arrangement" and whether the applicants could be regarded as parties to the avoidance arrangement for GAAR purposes despite their alleged lack of knowledge of certain steps; and
• whether the applicants obtained a tax benefit from the arrangement for purposes of GAAR.

(c) Decision. The Constitutional Court allowed the appeal, holding that the matter raised important questions of law of public importance. The majority found as follows:

• GAAR does not require that the same taxpayer who is assessed must personally have avoided tax. It is sufficient that the arrangement produced a tax benefit. In this case, although the immediate tax saving (untaxed interest income) arose in the hands of the D1 Trust or PSIC4, that benefit was passed on to the applicants in the form of enhanced tax-free dividends. But for the tax-avoidant features of the scheme, the applicants' investment return would have been structured as taxable interest income or a loan. 
• Objectively assessed, the applicants derived a tax benefit in the form of a higher after-tax return. GAAR may therefore apply to any party to an arrangement, even if another entity formally enjoyed the tax saving. The Court emphasized that SARS is not limited to targeting shell entities while the true beneficiaries escape liability;
• the arrangement constituted an impermissible tax-avoidance arrangement under GAAR. It lacked any bona fide commercial purpose other than tax avoidance, and its main purpose was to obtain a tax benefit by exploiting the tax-exempt nature of certain payments;
  although the applicants claimed ignorance of the downstream steps, they knowingly took the first critical step by investing in PSIC3 to obtain tax-free returns. When viewed objectively, that step formed part of an arrangement that yielded a tax-avoidance outcome. Participation in a key element of the scheme was sufficient to treat the applicants as parties to the overall arrangement;
• GAAR requires an assessment of substance over form, and taxpayers cannot comparmentalize steps to claim that they only undertook an "innocent" part of a broader scheme. The use of intermediaries or structural complexity does not shield beneficiaries from GAAR. The applicants participated in a pre-planned tax scheme and therefore fell within GAAR's scope; and
• the tax advantage arising from the untaxed interest income ultimately accrued to the applicants in the form of higher dividends. The applicants' ZAR 1.9 billion investment would otherwise have been structured as a taxable loan or would have generated taxable interest income, resulting in a tax liability that was avoided.

The Court rejected the argument that GAAR requires a direct, one-to-one correspondence between the avoided tax and the assessed taxpayer. SARS was entitled, under section 80B of the ITA, to recharacterize the applicants' dividend income as interest and impose tax accordingly. Allowing the applicants to retain the benefit merely because another entity technically avoided the tax would undermine the purpose of GAAR.

The Constitutional Court therefore upheld SARS's assessments and dismissed the applicants' appeal with costs.

Report from our correspondent, Lutando Mvovo, South Africa. Follow our reporting on this via our daily Tax News Service (subscribers only).