The Constitutional Court (CC) handed down judgement on The Thistle Trust v Commissioner for South African Revenue Service CCT 337/22 on 2 October 2023.

The facts of the dispute were common causes. The Thistle Trust (Trust) received distributions of capital gains from Zenprop, which is a group of trusts. The Trust then distributed the capital gains to its beneficiaries and the capital gains were taxed in the hands of the beneficiaries. 

The judgement dealt with whether the conduit principle in section 25B of the Income Tax Act 58 of 1962 (ITA) would apply to the capital gains distributed by the Trust to its beneficiaries, or whether paragraph 80(2) of the Eighth Schedule to the ITA would apply to the distributions.

Essentially, the Trust argued that the conduit principle applied to the distributions and the distributions of capital gains were correctly taxed in the hands of the beneficiaries. SARS disagreed and argued that paragraph 80(2) codified the conduit principle only where there was a distribution of capital gains for a trust where the trust had disposed of the assets giving rise to the capital gains. 

Paragraph 80 applied to the distributions

There were majority and dissenting judgements. Both were very well-written and reasoned and contributed manifold to the constitutional jurisprudence of tax disputes.

The majority held that there are clear indications that the conduit principle on the taxation of capital gains in the hands of trusts and beneficiaries is governed not by section 25B but by paragraph 80.

Paragraph 80 governs how the conduit principle is to be applied to establish which taxpayer is liable for taxation on the capital gains realised by the sale of assets by a trust. Paragraph 80 goes beyond quantification of taxable capital gains. Paragraph 80 "seeks to identify the taxpayer who is liable for capital gains tax on a capital gain realised by the disposal of an asset by a trust and distributed to a beneficiary in the same year of assessment in which the disposal took place."

Paragraph 80(2) as it read in the 2014 to 2018 years of assessment, provides for the conduit principle to apply to a trust where the trust vests the capital gain derived from the disposal of an asset to the beneficiaries of the trust. 

The Trust did not derive the capital gain from a disposal of an asset it owned. The Trust received the distributions of capital gains from Zenprop where Zenprop had disposed of the assets. Zenprop was the only trust that could be "the trust" contemplated in paragraph 80(2)(a). Therefore, the conduit principle could only apply to Zenprop and not to the Trust. 

The capital gains received from Zenprop which is distributed by the Trust should thus be taxed in the trust (with the tax rate of 45% * 80% = 36%) and not in the hands of its beneficiaries (with the highest effective tax rate for individuals of 18% being 45% * 40%).

Trust acted reasonably on legal advice

On the question of the meaning of "bona fide inadvertent error", the CC held that the issue raises an arguable point of law of public importance because it will affect how SARS and the courts approach the imposition of understatement penalties in thousands of future tax cases. It will also affect the attitude that SARS takes to individual taxpayers who understate their income in even more cases that do not reach the level of disputes before the Tax Court. 

However, despite the public importance, it is not in the interests of justice to grant leave to appeal as the CC would have to determine the meaning sitting as the court of first and last instance in relation to this issue. This is because the Tax Court in this case upheld the appeal on the merits, and the SCA did not reach the issue of penalties because SARS did not argue the issue and was understood to have conceded the issue. 

We hoped that the CC would have taken the opportunity to pen a few paragraphs in obiter to clarify the meaning of "bona fide inadvertent errors" which prevent the imposition of understatement penalties (USP). However, we appreciate the CC's reasoning not to do so. Nevertheless, the CC's dismissal of the SARS cross-appeal to impose USP is most welcomed. 

The Trust had adopted the tax position taken in the return based on legal advice from senior counsel. Despite the existence of legal advice, SARS was of the view that there should be USP based on no reasonable grounds for the tax position taken; or reasonable care not taken in completing return. (These are behaviours (iii) and (ii) in the USP percentage table of section 223 of the Tax Administration Act 28 of 2011.)

Importantly, the CC confirmed that SARS bears the onus of proving the facts that would bring the understatement of the Trust within either of these categories. 

The CC held that the Trust had reasonable grounds to adopt the tax position taken as it had relied on legal advice. Further, the tax position adopted was upheld by the Tax Court in a reasoned judgement that engaged with the conduit principle and the relevant provisions of the Income Tax Act. Therefore, the SARS argument that the Trust had no reasonable grounds for the tax position taken, must fail. 

SARS further argued that if the Trust had taken reasonable care in completing its returns, it would have ignored the legal advice given to it and followed the stated SARS position which that advice expressly considered and rejected. The CC rejected the SARS position. The CC observed that the SARS argument is based on the "proposition that no taxpayer can act reasonably on advice that differs from SARS’ statements of its interpretation of tax legislation. The argument would elevate SARS to the status of an authority that can decree the only reasonable interpretations of tax legislation. It is an untenable argument." (Our emphasis.)

Call a friend, your legal (or professional) adviser

There is a long list of cases where taxpayers who relied on legal advice was held to have acted reasonably. It is reassuring that the CC as the highest court of the land, has reconfirmed this position in this case. 

Tax has become a complex, high-risk specialist field that taxpayers inevitably must rely on legal advice or professional advice from experts for guidance to ensure they act within the confines of the law. We submit that to impose USP on taxpayers when they have done their best to remain compliant would be unduly punitive on them.

Written by Joon Chong, Partner at Webber Wentzel