A realisation company is generally formed in order to facilitate the sale of property. From a property tax perspective, the proceeds derived from the property sale need to be classified as either capital or revenue in nature.
The advantage of disposing assets through a realisation company is that the proceeds may be treated as a capital gain. This gain is then taxable at an effective 14%, rather than the fully taxable proceeds of trading stock at 28%.
SARS tend to view realisation companies with suspicion, as they’re weary of taxpayers classifying their assets as capital when, in fact, these should be declared as trading stock. Where realisation companies do more than just realise the sale of the capital asset, their profits are regarded as gross income.
Evaluating the nature of the proceeds for tax purposes is usually based on the intention of the company. In other words, has the company sold property in a scheme of profit making, or has it merely sold assets to its best advantage?
In light of a judgment recently delivered by the Supreme Court of Appeal in a case between SARS and Founders Hill (AECI), the court took a different approach in determining whether the realisation company would maintain the intention of realising capital assets, or whether the taxpayer would be seen as trading such properties.
AECI originally acquired vast tracts of land in Modderfontein in Gauteng’s East Rand to be used for the manufacture of explosives. The bulk of the land was used as a buffer between the production plant and surrounding commercial and residential nodes. As technology and processes improved, the extent of these buffer zones could be reduced.
AECI formed a company called Founders Hill with a view to sell off the excess land - which was to be subdivided and developed for commercial and residential use.
Since Founders Hill had only one existing shareholder (AECI), the Court found that such a shareholder could have satisfactorily realised the land itself. The court found that Founders Hill had acquired the land with the purpose of both sale and development, and so regarded it as a trading company subject to income tax in respect of its activities.
This judgment changed the perception regarding realisation companies. The Supreme Court of Appeal has now ruled that the case law sets out special circumstances in which a realisation company would be recognised, rather than a general rule.
The advice to taxpayers is that without a compelling argument for using a realisation company, you may not be allowed to transform gross profits into capital gain.
In some cases, a real justification exists for a realisation company. For example, if there are numerous beneficiaries of a deceased estate, getting all the parties to agree and sign documentation would be practically impossible. A realisation company, on the other hand, allows the property to be transferred and a board to be appointed in order to manage the disposal to its ‘best advantage’, taxable at 14%.