A unanimous decision of our Supreme Court of Appeal recently landed a hook to the chin of structured finance.
In 1998, NWK Ltd applied to FNB for a simple R50m loan and received a 5‐year facility for R96,415,776 with a few whistles and bells: (i) FNB created a subsidiary company (SPV); (ii) the SPV lent R96,415,776 (which it did not have) to NWK ‐ interest totalling R74,686,861 was evidenced by promissory notes, and the R96,415,776 capital amount was repayable by delivery of 109,315 tons of maize; (iii) the SPV sold to FNB the interest promissory notes for R50m and the right to receive the maize for R46,415,776m; and (iv) NWK purchased from FNB 109,315 tons of maize deliverable in 5‐years' time for R46,415,776. On the fifth anniversary, FNB, NWK and a notary were to meet to circulate 109,315 tons of maize from FNB to NWK and back to FNB around the table.
Basically, R50m was lent by FNB via the SPV to NWK, and R46.4m circulated from FNB to the SPV to NWK and back to FNB on the same day.
With a few tweaks, NWK managed to obtain tax deductions for both the R50m loan capital and the R24.7m interest payments.
Although this transaction may appear odd, this and many similar transactions are normal in the land of structured fantasy, where washing machines (i.e. circulatory payments), tailwinds (inflated capital amounts), mayflies (SPVs with only a momentary existence), and caterpillars (i.e. interest promissory notes that metamorphose into trading stock) are as unexceptional as green eggs and ham in Whoville.
After all these years of living in a fantasy world, the extraordinary became ordinary, and residents grew immune to what was obvious to people looking in. Structures became silly, but SARS was as oblivious as Mr Plod.
It mattered not how artificial a structure became. As long as all the boxes in our Tax Act were ticked, SARS gave you a ticket to ride. So what if a cube did not tick all the boxes? Just squeeze it into a corset and force it into the shape you need. But did this change the nature of the cube? Clearly, to Danie Kruger and Iaan Bossert at SARS and our Supreme Court, it did not ‐ our Sancho Panzas of the tax world, who saw the windmills as just boring old windmills, jolting us back to reality.
Basked in clinical sunlight, companies with an "ephemeral existence" appear queer; sequential transactions where the second step must by necessity precede the first are strangely impossible; perfectly circular flows of large amounts of money raise eyebrows; and series of transactions that cancel each other out battle the same incredulity as the concept of antimatter.
As with may others in the structured finance game, FNB and NWK dismissed the doctrine of substance over form as a blunt tool in SARS' armoury. Ignoring it, they went to extreme lengths to tick all the boxes and join all the dots. But their efforts became self‐defeating, prompting our Supreme Court to comment that "the charade of performance is generally meant to give credence to their simulation … The reader might well say "What a charade"."
The concept of substance over form has finally trumped. No matter how clever one is in dressing a horse up as a cow and calling it a cow, it remains a horse. This is an obstacle that many historical structured finance transactions will be unable to overcome ‐ ticking all the boxes no longer shields the transaction from attack by SARS.
But spare a thought for NWK. Lulled by an opinion from senior counsel, NWK was encouraged by FNB to conclude and defend the transaction. And, our Supreme Court fired a volley of difficult, probing questions: "Was there any purpose or commercial sense ‐ other than creating a tax advantage to NWK ‐ for the loan by Slab to NWK to be structured in the way it was? Was there any genuine intention to deliver maize to Slab or a cessionary?" But, when it came to defend the transaction, only Mr Barnard (the CFO of NWK) took the stand ‐ the head chef ran and left the customer to explain how dinner was made. It is clear that Mr Barnard had no idea how the transaction worked, and his isolated stand against SARS' expert witnesses was mismatched, costing him reputation and credibility.
The Supreme Court concluded that the transaction was fraudulent. SARS was entitled to repayment of deductions previously claimed, interest at 15% pa, compounded, and 100% penalties. If there is any silver lining for NWK it is that the finding of fraud releases it from indemnities it may have given FNB. A round of reprisals against persons involved in marketing and implementing this scheme may be in the offing. And, what happened to all those promissory notes? Ironically, if discounted to an untaxed policyholder’s fund or a Mauritian subsidiary, FNB could have generated a significant profit from the transaction and walked away the ultimate winner.
Articles: Structured finance