Case law gives guidance on the correct values to be used for tax purposes in the event that assets are exchanged for more or less than the market price
Some 3 000 years ago people traded goods and services through barter or exchange. This method was later largely replaced by a medium of exchange such as salt, shells or animal hides and later by money in the form of notes and coins. The Chinese invented paper money around 770BC and the first coins were manufactured on an industrial scale in Europe in 600BC. In the 21st Century we now also have crypto assets as a medium of exchange. However, barter or exchange transactions continue to this day and are a normal part of commercial life. Occasionally, they can produce some strange results when determining capital gains and losses.
References in this article to paragraphs are to paragraphs of the Eighth Schedule to the Income Tax Act 58 of 1962 and to sections are to sections of that Act.
Proceeds under a barter or exchange transaction
The proceeds from the disposal of an asset are determined under paragraph 35 and are equal to the ‘amount’ received or accrued on its disposal. In WH Lategan v CIR,Watermeyer J stated the following on the meaning of ‘amount’:
"In my opinion, the word “amount” must be given a wider meaning and must include not only money but the value of every form of property earned by the taxpayer, whether corporeal or incorporeal, which has a money value."
In CIR v Butcher Bros (Pty) Ltd, the court held that the word ‘amount’ should be taken to mean an amount having an ascertainable money value, as opposed to mere conjectural value. In C: SARS v Brummeria Renaissance (Pty) Ltd & others, the court stated that whether an amount can be turned into money is merely one of the ways to determine whether it has a money value and that:
"it does not follow that if a receipt or accrual cannot be turned into money, it has no money value. The test is objective, not subjective".
Expenditure in a barter or exchange transaction
On the meaning of ‘expenditure’ Harms AP stated the following in C: SARS v Labat Africa Ltd:
"The term “expenditure” is not defined in the Act and since it is an ordinary English word and, unless the context indicates otherwise, this meaning must be attributed to it. Its ordinary meaning refers to the action of spending funds; disbursement or consumption; and hence the amount of money spent. The Afrikaans text, in using the term “onkoste”, endorses this reading. In the context of the Act, it would also include the disbursement of other assets with a monetary value. Expenditure, accordingly, requires a diminution (even if only temporary) or at the very least movement of assets of the person who expends. This does not mean that the taxpayer will, at the end of the day, be poorer because the value of the counter-performance may be the same or even more than the value expended.”
Arm’s length barter or exchange transactions
In South Atlantic Jazz Festival (Pty) Ltd v C: SARS the taxpayer staged annual international jazz festivals. In the course of that enterprise, it concluded sponsorship agreements with various suppliers under which the sponsors provided money and goods and services for the festivals, in return for which the taxpayer provided goods and services to the sponsors in the form of branding and marketing. Binns-Ward J noted that the transactions under the sponsorship agreements were essentially barter transactions, despite their part-cash components. The judge stated the following:
"In consequence, and accepting, as one may, that the transactions were at arms’ length, the value of the goods and services provided by the appellant to the sponsors in each case falls to be taken as the same as that of the counter performance by the relevant sponsor.
In an ordinary arms’ length barter transaction, the value that the parties to it have attributed to the goods or supplies that are exchanged seems to me, in the absence of any contrary indication, to be a reliable indicator of their market value."
From these cases, we can deduce the following principles when X exchanges asset A with Y for asset B:
- X will have proceeds equal to the market value of asset B.
- The base cost of asset B for X is equal to the market value of asset A immediately before the exchange, which represents the amount by which X has been impoverished.
- In an arm’s length transaction, asset A’s market value should be equal to that of asset B.
- Uneven transactions as a result of paragraph 31
The term ‘market value’ is defined in paragraph 1 and means market value contemplated in paragraph 31. Paragraph 31(1)(a) provides that the market value of a financial instrument listed on a recognised exchange for which a price was quoted on that exchange is the ruling price for that financial instrument on that recognised exchange at close of business on the last business day before the specified date.
Sometimes, it can happen that when listed shares are exchanged, their respective ‘market values’ as prescribed in paragraph 31(1)(a) will result in unequal value being exchanged.
Divergent prices may arise because the buyer wishes to incentivise the seller to part with listed shares so that the buyer can obtain a controlling interest. Alternatively, the prices may have been the same when the transaction was announced but by record date they have moved apart. In other situations, the sale may be subject to a suspensive condition, with the quantity of shares to be exchanged fixed under the agreement when the values were equal, but by the time the condition is satisfied, the prices have diverged. The following example illustrates the problem:
Example – Uneven market values
The shares of Company A and Company B are listed on a recognised exchange, with their prices determined under paragraph 31(1)(a).
Jack owns shares in Company A with a base cost and market value of ZAR 100. Jill owns shares in Company B with a base cost and market value of ZAR 110. Jill offers Jack one Company B share in exchange for his Company A share as she needs it to acquire a controlling interest. Jack accepts the offer.
Jack’s proceeds are equal to the market value of the Company B share giving him a capital gain of ZAR 10 (ZAR 110 – ZAR 100), while Jill’s proceeds are ZAR 100, giving her a capital loss of ZAR 10 (ZAR 100 – ZAR 110). Jack’s base cost for the Company B share is ZAR 100 (equal to the amount by which he was impoverished in giving up the Company A share), while Jill’s base cost for the Company A share is ZAR 110, equal to the market value of the Company B share she exchanged. Should they immediately sell their shares, Jack will make a gain of ZAR 10 while Jill will make a loss of ZAR 10. As can be seen, uneven market values lead to the duplication of gains and losses.
A possible solution?
As noted above, the term ‘market value’ is defined in paragraph 1 with reference to the values in paragraph 31. However, the opening words of paragraph 1 state that the definitions apply ‘unless the context otherwise indicates’.
In Canca v Mount Frere Municipality, Davies J stated the following:
"The principle which emerges is that the statutory definition should prevail unless it appears that the Legislature intended otherwise and, in deciding whether the Legislature so intended, the Court has generally asked itself whether the application of the statutory definition would result in such injustice or incongruity or absurdity as to lead to the conclusion that the Legislature could never have intended the statutory definition to apply."
This principle was applied in the context of the equivalent of section 7(2) in CIR v Simpson in which Watermeyer CJ held that the term ‘income’ must be construed as meaning ‘profits and gains’ and not income in the sense of ‘gross income less exempt income’ as defined. This interpretation is still followed today, for example, when attributing ‘income’ to a donor from a trust under section 7(5). If this were not done, gross income would be attributed to the donor and the related expenses would be left behind in the trust.
Logically, Jack’s Company A shares were worth more than their listed price because they were capable of realizing value of ZAR 110 (see the passage cited from the Jazz Festival case in which it was stated that in an arm’s length transaction one would expect the value of the counter-performance to be equal to the value of the goods provided). It is therefore submitted that the actual value Jack received of ZAR 110 should be used to determine the market value of the Company A shares, not their listed price. Since Jack was impoverished by ZAR 110, this will represent the base cost of the Company B shares he acquired. Similar reasoning can be applied to Jill’s Company B shares, which were capable of realizing only ZAR 100, and this should be taken as their market value in the circumstances. If this approach is followed, the problem of double gains and losses is eliminated.
Transactions between connected persons
Paragraph 38 provides that when an asset is disposed of between connected persons at a non-arm’s length price, it must be treated as being disposed of at its market value. In other words, the proceeds would not be equal to the market value of the asset received in exchange but rather the market value of the asset disposed of. Paragraph 38 also applies when the consideration is not measurable in money, such as when a company makes a contribution to an employee share trust and the consideration takes the form of a motivated and contented workforce. Again, the proceeds are equal to the market value of the asset being disposed of.
In GB Mining and Exploration SA (Pty) Ltd v C: SARS the appellant disposed of an interest in one joint venture in exchange for another. The court confirmed that this exchange was a disposal. Strangely, the SCA held that the proceeds were not measurable in money, and hence were equal to the market value of the interest disposed of. Why it was possible to value the interest disposed of but not the interest acquired was not explained.
The principle of barter or exchange plays a critical role in determining the base cost and proceeds on disposal of assets. The illogical results that flow from uneven barter transactions can be resolved if the interpretation suggested in this article is followed. Taxpayers would welcome guidance from SARS in this regard.
Written by Duncan McAllister, Consultant at Webber Wentzel