Liberty Investors Limited (In Members' Voluntary Liquidation) v The Commissioner for the South African Revenue Service

Between March 1995 and August 1996, the appellant company received dividends totaling R156 831 000 from its wholly owned subsidiary, DGI Holdings (Pty) Ltd. This amount was capitalized by transferring some to the appellant's share capital and the rest to its share premium account. The appellant then issued capitalization shares to its shareholders. On 5 July 1999, during the 2000 tax year, the appellant was placed in voluntary liquidation pursuant to a special resolution of its members. On the same date, the appellant declared a dividend to shareholders of approximately R5 565 million in the course of the liquidation. The respondent (SARS) regarded the R156 831 000 as a distribution from revenue reserves and levied secondary tax on companies on the net portion of R148 370 619, resulting in a tax liability of R18 546 327.38.

• Whether dividends received from a subsidiary and subsequently capitalized constitute 'profits of a capital nature' for purposes of exemption from secondary tax on companies under section 64B(5)(c) of the Income Tax Act 58 of 1962
• Whether the capitalization of revenue profits transforms their nature from revenue to capital
• The application and effect of paragraph (i) of the proviso to the definition of 'dividend' in section 1 of the Income Tax Act

The appeal was dismissed with costs, including the costs of two counsel.

Where a company has transferred amounts from reserves or undistributed profits to share capital or share premium account, paragraph (i) of the proviso to the definition of 'dividend' in section 1 of the Income Tax Act operates to deem such amounts to retain their original character. Specifically, under sub-paragraph (bb), amounts that were revenue profits when earned are deemed to remain profits of a revenue nature available for distribution, regardless of their capitalization. Such amounts cannot qualify as 'profits of a capital nature' for purposes of the exemption from secondary tax on companies under section 64B(5)(c), notwithstanding that they have been capitalized through transfer to share capital or share premium accounts. The deeming provision applies regardless of whether the company in fact has any profits available for distribution.

The court made an obiter observation that the case of Commissioner for Inland Revenue v Collins (1923 AD 347) demonstrates the flaw in the Tax Court's reasoning that mere capitalization does not change the nature of profits. This suggests that, apart from the deeming provisions in the proviso, the general principle might support the view that capitalization can effect a transformation from revenue to capital. However, this general principle was ultimately irrelevant given the specific statutory deeming provision. The court also noted, as an aside, that quite apart from the deeming provision, there was a question whether the capitalized amount could correctly be called 'profits' at all, though this point was not developed or decided.

This case is significant in South African tax law as it clarifies that the capitalization of revenue profits does not transform their character into capital profits for purposes of secondary tax on companies. It emphasizes the importance of the deeming provisions in paragraph (i) of the proviso to the definition of 'dividend' in section 1 of the Income Tax Act, which operates to treat capitalized revenue profits as remaining revenue in nature despite their transfer to share capital or share premium accounts. The judgment prevents companies from avoiding secondary tax on companies by the simple expedient of capitalizing revenue reserves before liquidation. It demonstrates that substance prevails over form in tax matters and that statutory deeming provisions must be carefully considered in tax planning and disputes.