THE CONSTITUTIONALITY OF TAXING ILLEGAL INCOME IN SOUTH AFRICA

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CHAPTER 2: THE CONSTITUTIONALITY OF TAXING ILLEGAL INCOME IN SOUTH AFRICA

Introduction

The Republic of South Africa (RSA) is a constitutional democracy. This means that the Constitution is the supreme law of the land and all other laws must be consistent with it to be valid.30 The Constitutional Court will declare any statute, including a fiscal statute, invalid if such statute is found to be inconsistent with the Constitution.31
Chapter 2 of the Constitution contains the Bill of Rights, which is the cornerstone of democracy in RSA.32 Section 35 falls under Chapter 2 and deals with the rights of arrested, detained and accused persons. Section 35(3) guarantees every accused person a right to a fair trial, which, in terms of sub-section (3) (j) of that section, includes the right not to be compelled to give self-incriminating evidence.33 Furthermore, evidence obtained in a manner that violates any right in the Bill of Rights must be excluded if the admission of that evidence would render the trial unfair or otherwise be detrimental to the administration of justice.34
Current revenue laws in RSA require taxpayers to make full disclosures to SARS regarding taxable income. A taxpayer who fails to make full disclosure may be charged with the offence of tax evasion. Tax evasion has been defined as an illegal non-disclosure of income, the rendering of false returns, and the claiming of unwarranted deductions.35 It ‘connotes the use of illegal and dishonest means to escape tax’.36 Full disclosure will therefore in this sense have to include honest disclosure of the manner in which the income is derived, to avoid rendering false returns. However, in some instances the income is derived from unlawful activities, or is otherwise tainted with illegality. In such instances the disclosure of the manner in which the income is derived would expose the taxpayer to a possible prosecution for a non-tax criminal offence such as drug trafficking, prostitution or even robbery.
The discussion in this Chapter firstly shows, as portrayed in legal literature and case law, that the principle of taxability of income derived from unlawful activities is well established in South African law. Thereafter the focus shifts to how the current laws fail to sufficiently protect taxpayers (who acquire income unlawfully or whose declared income is otherwise tainted with illegality) from use of their tax disclosures as self-incriminating evidence. To this end provisions of various fiscal statutes compelling disclosure are discussed, as well as statutory provisions that purport to preserve secrecy of such disclosures. Decided cases that demonstrate how the courts have had to pronounce on the admissibility of tax disclosures in criminal prosecutions are also discussed. It is argued that the use of tax disclosures in criminal prosecutions against the taxpayer violates the constitutional right to a fair trial because it amounts to self-incriminating evidence. It is suggested in conclusion that some concrete safeguards need to be adopted from other jurisdictions that have had to deal with the same problem.

Taxation of Income Derived from Illegal Activities

Background

The contentious issue of taxability of illegal income or income derived from unlawful activities stems from the belief of some, notably Alphonse Gabriel “Al” Capone (Al Capone), the Italian-American gangster who led a Prohibition-era crime syndicate.37 Al Capone argued that governments should not benefit from the proceeds of crime as States prohibit their citizens from engaging in criminal activity.38
However, the unanimous opinion of tax authorities and other influential writers (as specified below) appears to be that proceeds of crime and of other unlawful activities should be subject to taxation in the same manner as income derived from lawful enterprises. Even Michael Pampallis,39 who appears to question the morality of taxing earnings derived illegally from prostitution, agrees that such earnings qualify as ‘gross income’ for the purposes of the definition of this term in section 1 of the Income Tax Act.40 Pampallis argues that if income from prostitution is good enough for the fiscus to tax, then the prostitute should also be allowed to go about her business of prostitution unhindered by the law. This seems to be an argument more for legalising prostitution than against taxation of earnings from prostitution.
Olivier,41 discussing ITC 1789,42 points out that according to case law there is a requirement for an amount to form part of gross income of a taxpayer, namely that such amount has to be received by that taxpayer on his behalf and for his own benefit. The learned author contends, however, that the subjective intention of the recipient (of the amount in question) is not decisive. She opines that ‘to hold otherwise would mean, for example, that money received by a person who trades on a Sunday in contravention of municipal by-laws would be deemed to have never been received’.43
Goldswain,44 while steering clear of the merits of the argument of Al Capone (mentioned above), does make the point that if that argument held sway in South Africa, it would mean that criminals are living in their own little tax haven in this country.
Donaldson,45 writing about the cricket ‘match fixing’ scandal involving Hansie Cronje, agrees. Cronje was the former RSA national cricket team captain who was involved in fraudulent conspiracies with international bookmakers to irregularly influence cricket match results. Donaldson suggests in a rather tongue in cheek tone that the former captain should be allowed to continue with his dodgy dealings provided he declares his ill-gotten income for tax purposes. ‘A man should be allowed to do what he has to do to put food on the table – as long as he pays his taxes too,’ he opines, suggesting the introduction of an ‘Ill-Gotten Gains’ tax.46 Pugsley,47 writing on the same topic a year later, also agrees with Donaldson. The latter author sees in the scandal ‘a golden opportunity to plump up the State’s coffers’ by assessing Hansie for tax on the income derived from ‘match fixing’.48
Classen,49 submits that the phrase ‘accrued… in favour of a person’ as it appears in the Income Tax Act definition of ‘gross income’, could be relied on to levy tax on illegally produced income. The learned author points out,50 that the reason income derived illegally would usually not be taxed is not because it is not taxable, but because the revenue authorities are not aware of its existence since it is excluded from tax returns in most cases. It is only after the perpetrators of such illegal activities have been caught out that the decision has to be made on whether to levy tax on their income.51
What follows is a discussion of the position of the RSA courts regarding the taxation of income derived from illegal activities. The aim is to demonstrate that taxpayers in RSA have no choice but to declare their taxable income, regardless of the legality of the means by which they derive that income.

Case law

As has been stated above, the Income Tax Act does not specifically provide for taxation of proceeds of illegal activities. This has resulted in our courts having to enquire, in each case, whether such proceeds are covered by the definition of ‘gross income’ in section 1 of the Act,52 before arriving at a decision as to their taxability. The cases that have dealt with this matter are, however, limited in number.
In CIR v Delagoa Bay Cigarette Co Ltd, 53 the first decided case on the issue, the taxpayer was a company that sold packets of cigarettes. The price was inflated considerably on a batch of these packets. Each packet in the batch contained a numbered coupon that put the buyer in line to win a monthly prize. The issue was whether two-thirds of the inflated price, allocated by the taxpayer for the distribution of prizes, would be included in its gross income, since the amount had been received in contravention of an Act regulating lotteries. It was held that the transaction between the taxpayer and the purchasers of the cigarettes was essentially a sale and that when the company distributed prizes, these were not refunds of the purchase price. This was because some purchasers received no prizes, while those who did, received more than they had paid for the cigarettes. There was therefore a receipt that was taxable, and its taxability was not affected by its illegality.
In COT v G,54 a 1981 Zimbabwe High Court decision, the court had to decide whether a government agent, who had misappropriated funds meant for secret operations, had ‘received’ those funds for the purposes of income tax. The court seemed to assume that it is possible to tax proceeds of illegal activity, but held that the term ‘received’ should be given its ordinary meaning and that no logical reading would take it to mean a unilateral taking such as theft.55 The court went on to rely on the decision in Geldenhuys v CIR,56 in holding that it was clear that ‘received by’ must mean received by the taxpayer on his own behalf and for his own benefit. The court held that in deciding whether the taxpayer has received an amount on his own behalf and for his own benefit, it was not only his (the taxpayer’s) intention that was important, but also the intention of the giver. In this case it was clear that the government had never intended for the thief to keep the funds in question and to do with them as he liked, so the thief could not be said to have received the funds at all.
In ITC 1624,57 a 1997 decision, the taxpayer rendered services to a customer, which included the payment to Portnet of wharfage fees, to be recovered from the customer. In a particular year of assessment, the taxpayer fraudulently rendered accounts, ostensibly in respect of wharfage fees, to the customer and in this way received amounts which it was not legally entitled to. The taxpayer then sought to rely on COT v G (supra) to argue that it had not received anything for the purposes of gross income, since the amounts had not been received by it ‘on its own behalf and for its own benefit’. The court held that none of the cases relied upon by the taxpayer (including COT v G) were authority for the proposition that where a trader receives payment of money in the course of carrying on its trade which it obtains by making a fraudulent or negligent misrepresentation to a customer, it does not intend to receive it as part of its business and in the course of its business. The court then held that the amount in question had to be included in the taxpayer’s income for income tax purposes. COT v G was thus distinguished. ITC 1624 was discussed in full by Michael Stein,58 who saw inconsistencies in the approaches adopted by the courts in this case and in COT v G. Stein expressed the view that ‘we may very well not yet have heard the last word from our courts on this fascinating subject’.59
Indeed the Supreme Court of Appeal, in MP Finance,60 provided some certainty on the subject.61 The facts in that case were briefly that the taxpayer had operated an illegal and fraudulent investment enterprise commonly known as a pyramid or Ponzi scheme.62 The objective of the scheme was to part investors from their money by promising irresistible but unsustainable returns on various forms of ostensible investments. The scheme paid returns for a while to some of the investors out of new investors’ deposits before finally collapsing, owing many millions. Substantial amounts of the deposits were appropriated by the taxpayer. The perpetrators of the scheme were aware at the time they took the deposits that it was insolvent, that it was fraudulent, and that it would be impossible to pay all the investors what they had been promised.
The taxpayer contended that because the scheme was liable in law immediately to refund the deposits, there was no basis on which it could be said that the deposits were ‘received’ within the meaning of the Income Tax Act and they were consequently not subject to tax. The court drew a difference between the relationship between the investor and the scheme operator on the one hand, and that between the scheme operator and the fiscus on the other. It was held that an illegal contract is not without all legal consequences and that it can have fiscal consequences. The enquiry, as between the scheme operator and the fiscus was whether the amounts paid to the scheme operator in the years of assessment in issue came within the literal meaning of the Income Tax Act. The court held that they did: The amounts paid to the scheme operators were accepted with the intention of retaining them for their own use and benefit and, notwithstanding that in law they were immediately repayable, they constituted receipts within the meaning of the Income Tax Act and were duly taxable. This decision effectively overruled COT v G (above) by doing away with the ‘intention of the giver’ consideration.
This case, therefore, finally decided that proceeds of unlawful activities are taxable provided that the taxpayer had an intention to appropriate the proceeds on his own behalf and for his own benefit.
Moreover, the penalties prescribed for failing to disclose income in tax returns apply equally to failure to disclose illegally derived income.63

Declaration 
Dedication 
Acknowledgements 
List of Abbreviations 
Table of contents 
CHAPTER 1: INTRODUCTION AND GENERAL STATEMENT OF THE PROBLEM
1.1 Introduction
1.2 Problem Statement
1.3 Rationale
1.4 Methodology
1.5 Scope
1.6 General remarks
CHAPTER 2: THE CONSTITUTIONALITY OF TAXING ILLEGAL INCOME IN SOUTH AFRICA
2.1 Introduction
2.2 Taxation of Income Derived from Illegal Activities
2.3 Self-incrimination: A brief background
2.4 Self-incrimination: Legislation
2.5 Self-incrimination: Preservation of secrecy
CHAPTER 3: THE CONSTITUTIONALITY OF TAXING ILLEGAL INCOME IN THE UNITED STATES OF AMERICA (USA)
3.1 Introduction
3.2 Taxation of Income Derived from Illegal Activities
3.3 Self-incrimination: Legislation
3.4 Self-incrimination: Case law
3.5 General remarks
CHAPTER 4: THE CONSTITUTIONALITY OF TAXING ILLEGAL INCOME IN THE UNITED KINGDOM (UK)
4.1 Introduction
4.2 Taxation of Income Derived from Illegal Activities
4.3 Self-incrimination: Legislation
4.4 Self-incrimination: Case law
4.5 General remarks
CHAPTER 5: SUMMARY OF THE COMPARATIVE STUDY
5.1 Introduction
5.2 The Republic of South Africa (RSA)
5.3 The United States of America (USA)
5.4 The United Kingdom (UK)
CHAPTER 6: CONCLUSION AND RECOMMENDATIONS FOR CHANGE IN SOUTH AFRICA
6.1 Conclusion
6.2 Recommendations for change in South Africa
BILIOGRAPHY
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