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The sale of a capital asset via a realization company or trust may result in an unnecessary income tax liability.

Realisation companies and realization trusts - an important new judgment by the Supreme Court of Appeal.

Since 1 October 2001, South Africa has had a capital gains tax in addition to income tax. Consequently, all revenue gains or capital gains are now subject either to income tax or to capital gains tax, unless the gain is of a kind specifically exempted by legislation.

However, capital gains tax is imposed at a significantly lower rate than income tax. Consequently, it is still advantageous for taxpayers to arrange their affairs - if they can - so as to receive their gains in the form of capital, rather than income.

Where a taxpayer holds a capital asset and chooses to realize it - that is to say, to convert its value to cash, usually by way of sale - the general principle is that the proceeds of the realization take on the character of the asset itself, and are therefore capital, not income.

Hitherto, it has been generally believed that the proceeds of such a realization of a capital asset remain capital if the realization was undertaken, not by the taxpayer, but by a realization company or a realization trust formed for that purpose by the taxpayer.

In other words, the general understanding has been that if a taxpayer holds a capital asset, and if he forms a "realization company" or a "realization trust" - that is to say, a company or trust established specifically to undertake the realization of the asset in the most advantageous way - and if he transfers the asset in question to that company or trust for the purposes of the realization - the proceeds of that realization will be capital in the hands of that company or trust, and consequently not subject to income tax.

The prime authority for that interpretation of the law was the decision of the Appellate Division in Berea West Estates (Pty) Ltd v Secretary for Inland Revenue 1976 (2) SA 614 (A).

That interpretation has now been refuted by the decision of the Supreme Court of Appeal in CSARS v Founders Hill (Pty) Ltd [2011] ZASCA 66, in which judgment was handed down on 10 May 2011.

Lewis JA, giving the judgment of the court, pointed out that merely calling an entity a "realization company" (or realization trust) and restricting its selling activities in respect of assets transferred to it-

"is not itself a magical act that inevitably makes the profits derived from the sale of the assets of a capital nature".

This, said the judge, flows from the principle that-

"when an entity is formed for the sole purpose of realizing property, profits achieved [by such realization] amount to income made from trading".

A realization company or trust is, of course, precisely such an entity - that is to say, it is an entity established for the purpose of realizing property.

Consequently, said Lewis JA,

"an interposed realization company (or other entity) will stand in the shoes of the entity that has transferred assets to it and hold them in turn as capital assets only in special circumstances "

Those "special circumstances", it seems, will be where there was a substantial commercial reason for the interposition of a realization company or trust. For example, in Berea West Estates the properties in question were jointly owned by several persons, and would be far more easily saleable if ownership were consolidated into a single realization company.

It seems from the judgment that where the property in question was owned by one person, there will seldom if ever be sufficient justification for that person to sell the property via a realization company or trust and, in these circumstances, the proceeds of the sale by that entity will be income, not capital.

The decision in Founders Hill affirms the importance of tax planning through all stages of the ownership of a capital asset, from the pre-acquisition phase through to eventual sale. That advice must, moreover, take full account of changes in legislation as well as changes in the judicial interpretation of tax principles

It is clear from the judgment in Founders Hill that the taxpayer in that case did take legal advice in regard to selling the asset in question via a realization company, and was presumably told that, from a tax point of view, it was safe to do so.

It may well be that such legal advice accorded with a view generally prevailing amongst tax professionals at the time. Unfortunately for the taxpayer, tax law is in a constant state of flux, not only in the sense that amending tax legislation is enacted every year, but also in the sense that the interpretation of tax principles by the courts is evolutionary, and not static.

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