A recent court decision has come as big blow to Telkom. A judgment handed down on March 25 by the Supreme Court of Appeal (SCA) held that a R3.9 billion foreign exchange loss and a R136 million incentive bonus were not deductible.
This meant the tax liability of R875 million raised by the tax commissioner for the 2012 tax year will now stand, and Telkom will also have to pay the costs of the commissioner’s three counsel.
During May 2007, Telkom International, a wholly-owned subsidiary of Telkom SA, acquired 75% of the issued share capital in Multi-links Telecommunications, based in Nigeria. Telkom acquired the remaining share capital the following year.
Telkom also made various US dollar-denominated loans to Multi-links, which by October 2011, amounted to $877 022 900.86. Of this, $346 million was converted into preference share equity, and the remaining $531 022 900.86 was reflected on the loan account.
Multi-links was struggling, and the prospects of the loans being repaid were slim. No matter, Telkom continued advancing loans to Multi-links until October 2011, when Telkom sold its equity interests in Multi-links to Hip Oils Topco, an unrelated third party. The loan to Multi-links was included in the sale, and was priced at $100.
Accounting and tax treatment
For accounting purposes, Telkom reported a foreign exchange gain of R247 million on the realisation of the loan. For tax purposes, Telkom claimed a foreign exchange loss of R3.9 billion in terms of Section 24I of the Income Tax Act. Telkom also claimed a deduction for a cash incentive bonus paid of R136 million.
The commissioner however disallowed both deductions, raised a tax liability of R875 million, and imposed an understatement penalty of R91 million.
Legal arguments (in brief)
Telkom argued that the R3.9 billion foreign exchange loss reflected the commercial reality of the transaction, whereas the commissioner argued that the transaction resulted in a foreign exchange gain of R267 million.
Telkom submitted that the commissioner’s interpretation produced a result that was removed from commercial reality, was not sensible or businesslike, undermined the purpose of Section 24I of the act, and was “unjust, inequitable or unreasonable”.
The commissioner rejected Telkom’s contention that “rate” can mean an absolute amount, such as the $100, and that the “exchange difference” can only be calculated by comparing the difference between the rate on the realisation date, and the “spot rate” on the transaction or translation date.
The SCA agreed with the Tax Court that foreign currency amounts should be converted into rand “at a defined exchange rate”, and that the “consideration for the loan of $100 was agreed by reference only to the perceived value of the loan”.
The SCA, in rejecting Telkom’s argument, held that Section 24I of the act “is not intended to deal with the tax consequences of commercial losses”.
“Its operation is limited to gains and losses arising out of currency fluctuations,” it said.
The SCA upheld the commissioner’s argument that Telkom could not generate a tax deduction based on the quality of foreign currency-denominated debt by applying a tax provision that dealt exclusively with gains and losses as a result of exchange rate differences. The SCA further ruled that the R91 million understatement penalty raised by the South African Revenue Service (Sars) should be set aside.
Impact on Telkom
Telkom, in its annual report dated March 31, 2019, stated: “As noted in the prior year consolidated annual financial statements, the tax treatment of the loss that arose in the 2012 and 2014 financial years on the sale of foreign subsidiaries is based on a specific set of circumstances and a complex legislative environment. The 2012 matter was heard in the Tax Court in August 2018 and an appeal has been filed against the Tax Court judgment received, and as such, the dispute with Sars remains unresolved. The tax refund received, relating to the 2012 sale, therefore remains contingent and will only be recognised once the matter has been resolved.”
Telkom did not make any provision for a possible contingent liability as “the possibility of a loss arising is considered remote”.
Now that the SCA has denied the deduction, Telkom may rue not making a provision.
At the end of March 2019, Telkom had cash and cash equivalents of only R1.4 billion.
It will now have to pay a tax liability of over R500 million, which will include a substantial amount of interest. This will severely impact its cash position.