The main purpose of the current understatement penalty regime administered by the South African Revenue Service (Sars) is to encourage voluntary compliance and deter unwanted behaviour by taxpayers, including, non-compliance with their reporting obligations. A taxpayer's reporting obligations include not only the direct reporting of the actual tax chargeable through the submission of tax returns, but also, the indirect reporting of matters that affect the tax chargeable through the completion of specific information requested in the tax returns.

In accordance with and to give effect to the main purpose of the understatement penalty regime, the triggers for the imposition of an understatement penalty by Sars are actions, or inactions, by a taxpayer that cause or result in prejudice to Sars or the fiscus. Each 'trigger' that causes any prejudice to Sars or the fiscus will be an understatement and a taxpayer will incur an understatement penalty.

In the recent Supreme Court of Appeal (SCA) judgment of Purlish Holdings vs. The Commissioner for the South African Revenue Service (76/18) [2019] ZASCA 04 (Purlish), the SCA concluded that prejudice to Sars, in the context of understatement penalties, is not only determinable in financial terms but, that - in the specific circumstances of the case - additional resources allocated to and time spent by Sars' employees to understand the affairs of a taxpayer constituted prejudice to Sars and, therefore, triggered an understatement penalty.

In this case, the Taxpayer appealed against the decision of the Tax Court and asked the SCA to decide whether Sars had proven that it was entitled to impose understatement penalties in terms of section 222 of the Tax Administration Act, 28 of 2011 (TAA) for the 2011, 2012, 2013, and 2014 years of assessment (Relevant Period). Every tax return submitted by the Taxpayer during the Relevant Period was a so-called "nil return" (a return that reflects that a taxpayer had neither received income nor incurred expenses). However, at the time of the rendition of the ‘nil returns’, the Taxpayer had already paid provisional tax of approximately R13 million. The Taxpayer’s submission of ‘nil returns’, if properly assessed as such, would have resulted in a refund to the Taxpayer.

A representative of the Taxpayer, accordingly, sought a refund of the provisional tax paid on the basis that the Taxpayer had not traded during the tax years in question. However, despite the information in the returns indicating that the Taxpayer was not a party to a contract to conduct any activity, it was discovered by Sars that the Taxpayer had concluded consultancy agreements in terms of which it had earned substantial income during the Relevant Period. However, despite earning this income, the Taxpayer had filed ‘nil returns’. Furthermore, despite the consultancy agreements clearly stipulating that the fees payable to the Taxpayer were inclusive of value-added tax (VAT), Sars discovered that the Taxpayer had not rendered any VAT returns for the Relevant Period. Sars accordingly levied understatement penalties in respect of corporate income tax and VAT.

The first issue in Purlish, and the only one considered in this article, relates to whether or not Sars has proven that it is entitled to impose understatement penalties in terms of section 222 of the TAA. In this regard, section 221 of the TAA defines the term "understatement" as:

"any prejudice to Sars or the fiscus in respect of a tax period as a result of ─
(a) a default in rendering a return;
(b) an omission from a return;
(c) an incorrect statement in a return; or
(d) if no return is required, the failure to pay the correct amount of tax." [own emphasis]

Section 222(1) of the TAA, in turn, reads as follows:

"In the event of an “understatement” by a taxpayer, the taxpayer must pay, in addition to the 'tax' payable for the relevant tax period, the understatement penalty determined under subsection (2) unless the 'understatement' results from a bona fide inadvertent error."

The SCA held that the submission of incorrect information in returns falls squarely within the provisions of item (c) of the definition of ‘understatement’. In addition, the SCA also held that Sars must prove that the Taxpayer committed the conduct set out in items (a) to (d) of the definition of ‘understatement’ in section 221 of the TAA and that such conduct caused it (Sars) or the fiscus to suffer prejudice.

To this end, Sars submitted that it would have suffered substantial financial loss if it had acceded to the Taxpayer’s request for a refund without conducting an audit, which was prompted by the amount of the refund claimed by the Taxpayer's representative.

The SCA agreed with Sars' submission and held that it is "… clear that had it not been for the audit, the [Taxpayer]’s liability to pay VAT would not have been exposed, as it had not registered for VAT".

Sars also submitted that:

"… the resource allocation in the form of additional time and human capital necessitated by the extensive audit also constituted prejudice to Sars, as such resources could have utilised for other matters".

It is in this context in which the SCA concluded that, "[g]iven the circumstances of this matter, … the use of additional Sars resources for purposes of auditing the [Taxpayer]’s tax affairs indeed prejudiced Sars" [own emphasis]. What is important to note is that this judgment must be read within its proper context, since it is the use of additional resources by Sars to conduct an extensive audit within the circumstances of this matter that that constituted prejudice to Sars. The circumstances of this matter was a fraudulent attempt to claim a refund from Sars and, because of both an incorrect statement in a return and such fraudulent attempt, the use of additional Sars resources prejudiced Sars.

In other words, not every resource allocation in the form of time and human capital by Sars can constitute prejudice in the context of the definition of "understatement" as defined in section 221 of the TAA. In conclusion, Sars cannot be too sensitive and claim that every general resource allocation, in the form of time and human capital, constitutes prejudice, in the sense of damage, to it.

Written By Dr. Johannes Jacobus van der Walt, Associate Designate, Baker McKenzie Johannesburg