Reliance on an Opinion to Mitigate Understatement Penalties

Reliance on an Opinion to Mitigate Understatement Penalties

• 05 August 2024
• Corporate Tax
• Adv Christel van Wyk

One of the most daunting questions for a taxpayer who is issued with an understatement penalty assessment, is how to properly respond to this and to come up with compelling arguments to ensure the best possible outcome. There are several categories of understatement penalties that SARS may apply and the basis for successfully disputing them is not a one fit for all. These categories cover instances ranging from a substantial understatement, a taxpayer failing to take reasonable care and to instances where the taxpayer is considered to be grossly negligent.

 On the one hand, SARS is obliged to apply the highest applicable understatement penalty percentage to each shortfall, as defined, in accordance with the understatement penalty percentage table in section 223 of the Tax Administration Act, 28 of 2011 (the Act). On the other hand, the onus is on SARS to prove, on a balance of probabilities, the facts on which it bases the imposition of an understatement penalty. If the error is a bona fide inadvertent error, no understatement penalties may be imposed.

The Act is very specific insofar that, in the case of a substantial understatement penalty, where the taxpayer is in possession of a ‘more-likely-than-not’ opinion by the time the tax return is submitted, SARS is compelled to waive the understatement penalties. From recent case law it appears, however,  that there are circumstances where a taxpayer may rely on an opinion that does not necessarily fit the narrow description of a ‘more-likely-than-not’ opinion as contemplated in section 223(3) of the Act and that such reliance may even be considered quite reasonable.

In Commissioner for the South African Revenue Service v The Thistle Trust [2022] ZASCA 153 (7 November 2022), the first issue was whether the capital gains accrued as a result of the disposal of capital assets by the Tier 1 Trusts were taxable in the hands of the Trust or in the hands of its beneficiaries to whom those gains were distributed.  The Court found that the facts of this case did not support the application of the ‘conduit pipe principle’,  and that the capital gains accrued upon the disposal of assets by the Tier 1 Trusts were taxable in the hands of the Thistle Trust and not its beneficiaries to whom it distributed those gains. In the circumstances, SARS was correct to raise the additional assessment for the relevant tax periods. 

The second issue concerned the imposition of an understatement penalty. The taxpayer relied on a legal opinion and was of the view that the capital gains were taxable in the hands of the beneficiaries. SARS argued that the taxpayer consciously and deliberately adopted a certain position when it elected to distribute capital gains and imposed understatement penalties of 50% for a standard case relates to a taxpayer having ‘no reasonable grounds for the “tax position” taken by the taxpayer’.

The Court held that SARS correctly conceded that the understatement was a ‘bona fide inadvertent error’ as the taxpayer in relying on the opinion believed that the conduit principle applied. As a result SARS was not entitled to impose understatement penalties.

In Commissioner for the South African Revenue Service v Coronation Investment Management SA (Pty) Ltd [2023] ZASCA 10 (SCA) SARS concluded that the ‘controlled foreign entity’ of the taxpayer did not meet the requirements of a ‘foreign business establishment’ and as a result included its net income in the taxable income of the taxpayer. SARS imposed understatement penalties of 10% on the understatement on the basis that there had been a ‘substantial understatement’ resulting in a penalty of 10% of the tax that would otherwise have been paid. The taxpayer relied on a tax opinion procured from a leading tax expert for the tax position adopted but did not disclose the contents thereof or make the opinion available to SARS.  This non-disclosure prompted SARS to draw a negative inference that the tax opinion did not support the taxpayer’s claim for an FBE exemption, and that a deliberate and conscious decision was taken to exclude the net income of the subsidiary, further contending that this was not a ‘bona fide inadvertent error’. The Court held that to speculate that a tax opinion must have gone against the taxpayer merely because it was not produced to SARS, is simply speculative and not sufficient to attribute bad faith on the part of the taxpayer. There is no indication that the opinion relied on fit the description of a ‘more-likely-than-not’ opinion.

On appeal by the taxpayer to the Constitutional Court in Coronation Investment Management SA (Pty) Limited v Commissioner for the South African Revenue Service [2024] ZACC 11, it was held in favor of the taxpayer that the offshore entity had sufficient substance to conclude that its net income should not be included in the taxable income of the taxpayer. The Court found it unnecessary to deal with the counter appeal by SARS as the basis for imposing understatement penalties fell away, but the principle remains that no bad faith could be attributed to the taxpayer for its reliance on an opinion.

From these cases it is apparent that the reliance by a taxpayer on a legal opinion, even if it does not fit the specific requirements of a ‘more-likely-than not opinion’,  may serve to strengthen the basis on which a particular tax position is adopted and such reliance does not in itself point to bad faith on the part of the taxpayer.

Join Adv Christel van Wyk on September 13th where she will host a webinar on "Drafting a Compelling Motivation for the Remission and Reduction of Tax Penalties"

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