This is an appeal filed on 3 September 2013 by a registered commercial bank in the High Court in terms of section 65 of the Income Tax Act [Chapter 23:06]. It arises from taxation in the four areas of staff retrenchment costs, Nostro accounts, Nostro charges [non-resident tax on fees] ...
This is an appeal filed on 3 September 2013 by a registered commercial bank in the High Court in terms of section 65 of the Income Tax Act [Chapter 23:06]. It arises from taxation in the four areas of staff retrenchment costs, Nostro accounts, Nostro charges [non-resident tax on fees] and offshore loans.
At the appeal hearing, the appellant called the evidence of 6 witnesses and produced a compendium of documentary exhibits encompassing some 1,207 pages. These documents were contained in 2 large box files, 2 lever files and 1 flat file. In addition, 10 loose leaf documentary exhibits that served as a useful summary to the compendium were produced.
The respondent did not lead any evidence. It was content to rely on the averments made in the 15-paged Commissioner's case and the 76 paged Rule 11 of the Income Tax Rules documents.
On 16 November 2012, the respondent issued to the appellant three amended assessments in respect of income tax for the tax years ending December 2009, 2010 and 2011 [p 1-3 Rule 11 documents], respectively.
The respondent objected to the assessments on 12 December 2012. The objections in respect of the subject matter for which the present appeal is concerned with were disallowed on 15 August 2013 [p 4-7 of Rule 11 documents]. However, on 21 November 2013 the appellant proceeded to issue further amended assessments for the tax year ending 31 December 2010 and 31 December 2011, respectively, after allowing deductions for VAT expenses incurred in the two years in question.
The issues for determination were:
1. Whether the appellant correctly brought the provision for retrenchment costs to account in its income tax return in the 2009 tax year.
2. Whether the respondent was entitled to deem the appellant's offshore Nostro accounts as interest-bearing accounts and the appropriate rate of interest.
3. Whether the respondent was entitled to attribute interest earned by non-resident related parties on loans made to businesses in Zimbabwe to the appellant.
4. Whether bank charges raised by offshore Banks holding the appellant's Nostro accounts amounted to fees under paragraph 1 of the 17th Schedule of the Income Tax Act....,.
NOSTRO ACCOUNTS
The Background
The respondent assessed the appellant for income tax over the 2009, 2010 and 2011 tax years. He observed “huge” balances of non-interest bearing amounts in the Nostro accounts held by the appellant with related parties that were, in his view, in excess of the monthly transactional requirements of the appellant.
Purportedly acting in terms of section 98 of the Income Tax Act [Chapter 23:06] he imputed notional interest income to these accounts at the average local rates prevailing in Zimbabwe at the time.
It was common cause that the rates in Zimbabwe were much higher than the prevailing rates in the jurisdictions in which the Nostro accounts were held. The local interest rates applied were 12.4% for 2009, 11.65% for 2010, and 8.04% for 2011.
Notwithstanding some averments in the respondent's correspondence and Commissioner's case to the contrary, it is clear that the appellant did not actually earn such interest. The respondent deemed the appellant to have earned the ascribed interest income. He wrote back into the gross income of the appellant a total of US$5,392,369=88 for the 2009 tax year, US$11,429,964=09 for the 2010 tax year and US$8,065,117=68 for the 2011 tax year.
The appellant objected. The objection was disallowed, hence the appeal.
The Facts
The appellant relied on the oral evidence of its Head of Corporate Reporting cum Deputy Chief Finance Officer who is also a member of the Bank's Asset and Liability Management Committee. In addition, it relied on the documents in its bundle running from p 536 to 579. The bundle consists of the list of all the Nostro accounts held by the appellant [p 536-538]. Pages 539-579 consists of the transaction report of the debits from and credits to the Rand Nostro account of the appellant for the period 1 January 2009 to 31 December 2012.
The witness is responsible for all the reporting processes in the appellant including tax payments and the filing of tax returns. In that capacity he superintends over tracking balances, quantification, and reconciliation of all the appellant's Nostro accounts. He defined a Nostro account as a current account (also known as a clearing account), which a Bank in one jurisdiction opens in another jurisdiction to facilitate customer transactions in the currency of that jurisdiction. It is thus a current account held by a Bank in the books of a correspondent Bank in another country.
Nostro accounts facilitate trade and transactions between countries of varied currencies. He produced the list of all the 22 Nostro accounts, exhibit 3 and pages 536-538 of the bundle, held by the appellant throughout the world. The appellant holds Nostro accounts with other Banks of the same name worldwide (related parties) and other Banks not related to it (unrelated parties). Ten (10) of the accounts were held with related parties. The Nostro accounts, whether with related or unrelated parties, are all held at arm's length.
The witness stated that the most active Nostro accounts for the appellant were the Rand account held in Johannesburg South Africa with an unrelated party and the United States dollar account held in New York with a related party. He stated that the deposits into the Nostro accounts are made by customers and not by the appellant. The money is deposited directly into the customer's account and reflected in the Nostro account simply because the appellant is the banker to the customer.
The witness testified that Nostro accounts do not earn interest; a fact confirmed by his Chief Finance Officer on p30 of the Rule 11 documents.
It was evident from the evidence of the Head of Corporate Reporting that the appellant did not earn any interest on the deposits in the Nostro accounts. He produced a letter, exhibit 5, from the Director Global Head of USD Clearing Product Management, Americas, dated 2 September 2014, in response to a query raised on interest rates on clearing accounts. The letter reads:
“We are writing to you in response to your recent enquiries with regard to the non-payment of interest on your clearing account held with us.
As you will be aware, the global economy entered a recession (the Great Recession) in 2009, which had significant implications on the banking sector. The Federal Reserve took extraordinary actions in response to the financial crisis to help stabilize the US economy and financial system.
The actions included reducing the level of short-term interest rates to near zero. The Federal Fund's average rate since 2009 has been about 13bps (0.13%) whereas the average yields for three month US Treasury Bills since 2009 has been 8bps (0.08%) (refer to appendix to this letter) [produced as exh 4].
As a result of such low yields, interest rates on deposits placed in banks in the United States were significantly impacted, with many banks paying very little or no interest on deposits. We are aware that in some cases some of our competitor banks would in fact charge to hold customer deposits - resulting in 'negative interest' to their customers. The low interest environment continues to persist to date.
[Related Bank] NY, in general, pays no interest on the majority of the clearing accounts held for our clients, regardless of whether they are from [related Bank group] or from external parties.
We therefore confirm that the non-payment of interest on your clearing accounts with us has been, and remains, in line with market practice.”
Exhibit 5 confirmed that the appellant did not earn interest income on deposits in its United States dollar Nostro account resident in New York in the United States of America. The witness also produced exhibit 4, the Bloomberg US Generic Government 3 months' bond yield for any placement funds for the period 2 January 2009 to 14 October 2011. The average interest earned during that period was 0.08%. He confirmed his Chief Finance Officer's observation that call accounts earn the highest rate in those foreign jurisdictions.
The witness indicated that the appellant could only earn interest on transfer of the deposits from the Nostro account to an investment account such as a call account. The Bank also earns interest from buying Treasury Bills or other interest-bearing instruments. Interest was paid on the placement funds and accounted for in the respective tax years.
In 2012, a directive from the Reserve Bank of Zimbabwe stopped the offshore investment of funds from Nostro accounts.
It was common cause that interest rates offered internationally on placement funds were low as exemplified by the declared income earned on those accounts.
He disputed the averment that the Bank did not earn interest on Nostro accounts in order to avoid paying tax and averred that the Bank was in the business to earn income. He denied that the Bank entered into transactional operation schemes with Nostro banks to deliberately forego interest in order to postpone and avoid paying interest. He stated that the appellant Bank operated Nostro accounts, not as a vehicle to avoid, postpone, or reduce its tax obligations but as an objective banking necessity; as would any other Bank worldwide.
His testimony on the prevailing local position, before RTGS was introduced, tallied with the response of the appellant's Chief Finance Officer to the respondent of 10 December 2012 [p 30-33 of Rule 11 documents].The Chief Finance Officer indicated that in 2009 and 2010, before RTGS was introduced, the only option for local Banks was to hold foreign balances either as cash or Nostro balances. All Banks, including the Central Bank, opened correspondent bank relationships and used Nostro accounts to hold such funds in foreign Banks. The entire Zimbabwe National Payment System in this period was conducted through Nostro accounts and the level of balances was high for all Banks reflecting the size of clients for each Bank. He set out four reasons for Nostro accounts. These were;
(i) To ensure Bank liquidity to curtail a run on the Bank;
(ii) To maintain minimum liquidity levels set at the time by the Reserve Bank of Zimbabwe at 25% of customers deposits;
(iii) To safeguard depositor funds by diligent, prudential lending and thorough risk assessments of prospective clients; and
(iv) To support prompt settlement of customers' transactions.
When he was cross examined, he failed to state the balances sitting in the NY Nostro account at the end of 2009, 2010 and 2011 respectively. He did not dispute the averment that the balance in the New York Nostro account at the end of 2009 was US$10.4 million. He, also, did not dispute that the average monthly amounts held over the three years in issue in that Nostro account was US$18 million of which US$2 million routinely catered for the transactional requirements of customers leaving US$16 million idle. He maintained that the primary purpose of maintaining a Nostro account was to conduct customer business transactions. The witness maintained that the Bank was not obliged to lend money to earn income.
He revealed that the decision to move money from Nostro to RTGS to cash depended on the risk appetite and assessed needs of the Bank. He maintained that at the commencement of the multi-currency regime the Bank adopted a low asset to deposit ratio as it needed to fully understand the risk factors bedevilling the local economy.
In my view, the witness acquitted himself very well in respect of the Nostro accounts. He could not term the balances in the Nostro accounts huge.
The respondent averred, in the letter of 15 August 2013, disallowing the objection, that the justifications for the balances of liquidity risk management, safeguarding customers deposits, and prompt customer transaction settlement support did not eclipse the high balances that remained after these reasons had been taken into account. The magnitude of the balances, as disclosed in the cross-examination of the Head of Corporate Reporting, of US$16 million, was not disputed.
Counsel for the respondent suggested to the witness that the average monthly transactions were in the sum of US$2 million and US$16 million remained idle in the Nostro accounts and that this pattern characterised the period from 2009 to April 2012.
While the witness disputed they were huge, his immediate supervisor, the Chief Finance Officer, conceded they were huge.
I am satisfied that, in the context of the operational requirements, the balances were indeed huge.
The letter disallowing the objection further discloses that the respondent accepted that Nostro accounts did not create an entitlement to interest regardless of whether they were held with related or unrelated parties. It invoked section 98 of the Income Tax Act because the balances went beyond meeting liquidity and transaction purposes.
It was unclear why local rates were preferred to call rates prevailing in the jurisdiction of the correspondent Nostro bank. It was also unclear whether the proposal for the appellant to suggest other interest rates was limited to local interest rates or not.
Paragraph 14 of the respondent's case seems to concede that the computation of applicable interest could be extended to the foreign jurisdiction in which the deposits were made. That attitude is confirmed by the acceptance of the interest income declared on call funds invested in those jurisdictions. The view of the appellant was simply that the respondent had no legal right to intrude into its operational space in the absence of a local law that required it to move funds from the Nostro accounts into Zimbabwe to lend at the prevailing local interest rates.
The Legal Arguments
The basis for determining this issue lies in the provisions of section 98 of the Income Tax Act [Chapter 23:06]. It reads:
“98 Tax Avoidance Generally
Where any transaction, operation or scheme (including a transaction, operation or scheme involving the alienation of property) has been entered into or carried out, which has the effect of avoiding or postponing liability for any tax or of reducing the amount of such liability, and which in the opinion of the Commissioner, having regard to the circumstances under which the transaction, operation or scheme was entered into or carried out —
(a) Was entered into or carried out by means or in a manner which would not normally be employed in the entering into or carrying out of a transaction, operation or scheme of the nature of the transaction, operation or scheme in question; or
(b) Has created rights or obligations which would not normally be created between persons dealing at arm's length under a transaction, operation or scheme of the nature of the transaction, operation or scheme in question;
and the Commissioner is of the opinion that the avoidance or postponement of such liability or the reduction of the amount of such liability was the sole purpose or one of the main purposes of the transaction, operation or scheme, the Commissioner shall determine the liability for any tax and the amount thereof as if the transaction, operation or scheme had not been entered into or carried out, or in such manner as in the circumstances of the case he considers appropriate for the prevention or diminution of such avoidance, postponement or reduction.”
Counsel for the appellant submitted that there was no legal obligation for the appellant to have brought those funds onshore, earn interest, and avoid the 2009 loss. He further submitted that the respondent had no legal duty to direct how the appellant should run its business affairs.
He relied on the sentiments of WATERMEYER CJ in dealing with a provision in the South African tax legislation equivalent to our section 98 in Commissioner for Inland Revenue v IHB and AH King 1947 (2) SA 196 (A) at 207-208; (1947) 14 SATC 184 (A) at 190-191.
The essence of the sentiments being that section 98 cannot be invoked against a taxpayer who abstains from earning income by closing his business or resigning from employment or taking a lower paying job. The learned CHIEF JUSTICE listed several circumstances in which the equivalent to our section 98 would be inapplicable. He stated…,:
“These two types of cases may be uncommon but there are many other ordinary and legitimate transactions and operations which, if a taxpayer carries them out, would have the effect of reducing the amount of his income to something less than it was in the past, or of freeing himself from taxation on some part of his future income.
For example, a man can sell investments which produce income subject to tax, and, in their place, make no investments at all, or he can spend the proceeds in buying a house to live in, or in buying shares which produce no income but may increase in value, or he may invest the proceeds outside of the Union, or make investments which produce income not subject to normal tax in his hands, e.g. Union Loan Certificates, deposits in the Post Office Savings Bank or shares in public companies. He can also sell shares in private companies, the holding of which may subject him to heavy taxation in his hands although he does not receive the income which is taxed, or he can sell shares in companies which pay high dividends and invest in securities which return him a lower but safer and more certain income. He might even have conceived such a dislike for the taxation under the Act that he sells all his investments and lives on his capital or gives it away to the poor in order not to have to pay such taxation.
If he is a professional man he may reduce his fees or work for nothing, if he is a trader he may reduce his rate of profit or sell his goods at a loss in order to earn a smaller income. He can also secure deductions from the amount of his gross income, for example by insuring his life. He can carry out such operations for the avowed purpose of reducing the amount of tax he has to pay; yet, it cannot be imagined that Parliament intended, by the provisions of sec. 90, to do such an absurd thing as to levy a tax upon persons who carry out such operations as if they had not carried them out.
Moreover, the problem of deciding what the income of such persons for the tax year would have been if they had not carried out such operations would appear to be insoluble in some cases, if the countless possibilities of what they might otherwise have done with their capital or their labour are borne in mind.”
At p 210 he distinguished two meanings to which the term could apply and settled for the latter. He held:
“In order to answer these questions it should be realised that there is a real distinction between:
(i) The case of a man who so orders his affairs that he has no income which would expose him to liability for income tax; and
(ii) The case of a man who so orders his affairs that he escapes from liability for taxation which he ought to pay upon the income which is in reality his.
Similarly, there is a distinction between:
(i) Reducing the amount of tax from what it would have been if he had not entered into the transaction; and
(ii) Reducing the amount of tax from what it ought to be in the tax year under consideration.”
He held, at 210-11, that:
“If the words 'avoiding liability' and 'reducing the amount' are given the former meanings [(i) above] in sec. 90, then absurd results such as those mentioned above will follow; but, if the words be given the latter meanings [(ii) above], though some difficulties will still occur, absurd results are on the whole eliminated. The provision contained in sec. 90, that the taxpayer shall be taxed as if the transaction had not taken place, which suggests that he has escaped from a liability to which he ought to have been subject, strongly supports the view that the expression 'avoiding liability' and 'reducing the amount' should be given the latter meanings, and those are the meanings which should be given to them.”
In the present matter, the appellant did not earn any income from the Nostro accounts. Exhibit 5 demonstrates beyond a shadow of doubt that it was not possible for the appellant to have earned income from those Nostro accounts. The reality was that it was not going to earn any income unless it moved the deposits to a call account.
Counsel for the appellant submitted that section 98 of the Income Tax Act did not apply to the facts of this matter.
In Zimbabwe, SMITH J set out the four requirements that must co-exist in order to entitle the Commissioner to invoke section 98 of the Income Tax Act in A v Commissioner of Taxes 1985 (2) ZLR 223 (HC)…,. The four requisites are:
(a) The presence of a transaction, operation or scheme;
(b) Intended to avoid or postpone or reduce liability for any tax;
(c) Through means or ways not normally employed or which create rights or obligations which would not be ordinarily be created by parties dealing at arm's length;
(d) The Commissioner forms the opinion that the avoidance or postponement or reduction of such liability was the sole or one of the main purposes of the transaction, operation or scheme.
I deal with each of these requisites in turn.
(a) The appellant lawfully opened the Nostro accounts in question. The amounts in the accounts were deposited by clients in the normal course of business and not by the appellant.
The respondent suggested that the holding of funds in excess of the transactional needs for the clients was to the extent of the excess a scheme because this went unabated for three consecutive tax years.
I recognise, as SMITH J, and before him, McDonald JP…, in Commissioner of Taxes v F 1976 (1) RLR 106 (AD)…, did; that the words transaction, operation or scheme are all embracing and would apply to any activity carried out by a taxpayer.
In the circumstances of this case, I would find that holding excess idle funds in the Nostro accounts for three consecutive tax years constituted a scheme.
(b) The second element for determination is whether the scheme had the effect of avoiding or postponing or reducing tax liability.
The appellant stated that it could only earn income by moving the funds from the Nostro accounts to call accounts. It established, beyond a shadow of doubt, and the point was accepted by the respondent in the letter disallowing the objection, that Nostro accounts, whether held with related parties or not, do not earn interest. It was also accepted by counsel for the respondent, in argument, that the rates of interest offered on offshore call accounts was negligible. The appellant did not move the funds from the Nostro accounts onshore for two reasons;
(i) The first, proffered by the Chief Finance Officer of the appellant and amplified by his deputy in evidence, was that in 2009 and 2010, before the introduction of the RTGS platform in Zimbabwe, all funds were transacted through Nostro accounts.
In my view, that constituted the normal and usual method of operation for local Banks - including the Central Bank.
(ii) The second was that the prudential risk management policies of the appellant dictated that the money be kept in the Nostro accounts rather than be invested onshore.
The Bank had a low risk appetite and preferred to safeguard depositors' funds rather than invest the funds in a fragile and uncertain market. It does not appear to me that the scheme was entered into to avoid earning income. It was carried out to preserve the funds.
(c) The third element was not fulfilled.
It was the normal method of operation for any Bank with a Nostro account. It was not suggested by the respondent that the Nostro accounts with unrelated parties were operated differently from the ones in issue. The treatment and balances were the same for both related and unrelated parties. The Deputy Chief Finance Officer established that this was a common worldwide practice amongst all banks holding Nostro accounts. No rights or obligations not normally associated with this type of account were created for the related parties.
(d) The opinion of the Commissioner that the scheme was designed solely or mainly to avoid tax liability was incorrect.
It was common cause that the deposit of the funds in the Nostro accounts did not create a tax liability for the appellant. The decision by the appellant to hold the funds in the Nostro accounts, rather than investing them, could not, and did not, create any tax liability for the appellant. In the absence of such a tax liability, the Commissioner could not properly come to the opinion that holding the funds in the Nostro accounts was designed either solely or mainly to avoid, postpone, or reduce a tax liability that did not exist.
In deeming notional interest on the basis that the holding of huge amounts of idle funds in Nostro accounts did not make commercial sense for a Bank that derived most of its income from interest earnings, the respondent lost sight of the fundamental principle behind our income tax legislation. It is designed to tax income that has been created. The income must have accrued to or been received by the taxpayer. It is not designed to tax income which is not in and has not come into existence.
That the respondent was aware of this fundamental principle is demonstrated by the contradictory averments that characterise paragraph 13 of its pleadings.
It first suggested that the appellant committed tax evasion before imputing interest income that in reality was not earned. The bottom line was that either way income had to exist before it became liable to taxation. The income must either have accrued to or been received or deemed to have accrued or been received by the taxpayer in order to trigger tax liability.
In any event, it seems to me that, stripped of all the technical points, Commissioner for Inland Revenue v IHB and AH King 1947 (2) SA 196 (A)…,.; (1947) 14 SATC 184 (A)…, amongst other things, established that there is no obligation on any taxpayer to earn income.
The examples suggested by counsel for the appellant and conceded by counsel for the respondent demonstrate the point.
A registered legal practitioner in private practice who chooses to do pro bono work cannot be taxed on the notional income he could have earned. Nor would he be taxed on the income differential if he elects to take a less paying job in the public service. Indeed, neither would a Bank be assessed to tax on the highest interest rate offered in its or any other jurisdiction against any lower rate it would have accepted.
It is clear to me that where the activities of a taxpayer do not or fail to create income; it is beyond the remit of the Commissioner to wear the mantle of an investment adviser to the taxpayer and suggest to the taxpayer avenues for more income creation. I would add, as an apt reminder to the respondent, the words of BEADLE CJ in Commissioner of Taxes v Rendle 1965 (1) SA 59 (RAD)…, that:
“It is not for the Commissioner to direct how a taxpayer should run its business.”
It further seems to me that the Commissioner has no mandate to usurp the role of the onshore regulatory authority in respect of Nostro accounts. It was up to the appellant to deal with the deposits as it pleased subject, of course, to the requirements of both onshore and offshore regulatory authorities.
SILKE, in Income Tax in South Africa…, is to the same effect. The learned authors suggest that:
“If, by this interpretation, Internal Revenue considers that it is entitled to impute rights or obligations to a transaction that do not exist in the actual bargain between the parties, for example, to assume a reasonable rate of interest when none was actually stipulated, it is considered that it misinterprets s 103(1). On the basis of this principle, it is considered that the Commissioner is not entitled to apply s 103(1) in order to subject to tax a lender of an interest-free loan on an amount that he could have earned by way of interest had he charged it; a professional man who renders services to another person free of charge; or a trader who sells trading stock at a price below its current market price. In all these circumstances there is no amount 'received or accrued' on which an assessment may be framed. The existence of such an amount, it is submitted, is an essential requisite for the application of s 103(1).”
I am satisfied that the respondent wrongly invoked section 98 to the Income Tax Act to bring to account notional interest to the gross income of the appellant in the three tax years in issue.
