Partnership pitfalls

​En commandite partnerships are back in vogue today as an investment vehicle for investors to take advantage of the solar incentives in ss 12B and 12BA of the Income Tax Act 58 of 1962 (Act). However, if not structured properly, they may not produce the desired outcome. In some instances, the law is unclear and in others it can impose an uncommercial burden on an investor.

The use of en commandite partnerships in order to secure tax benefits for investors was very popular in the 1980s when there was a proliferation of schemes covering a variety of asset classes, many of which ended up in lengthy tax disputes in South African courts. They included endowment policies,[1] films,[2] horses used for breeding purposes, aircraft[3] and plantations,[​​4] to name but a few. The promoters of some of the more aggressive schemes claimed that they resulted in a deduction of up to five times the investment. Many film schemes did not even result in films being produced. These schemes resulted in the legislature introducing section 24H into the Act in 1988. Other amendments to the Act have also addressed some of the more aggressive features of past en commandite partnerships such as the attempts to claim interest and other expenses up front.[5​​] Livestock losses were ring-fenced against farming income under para 8 of the First Schedule to the Act.

Nature of partnership

A partnership is a legal relationship arising from an agreement between two or more persons and is formed under South African common law.

An en commandite partnership is a type of partnership in which the business is carried on in the name of one partner only, that is, the general partner (GP). The remaining partners are undisclosed. The undisclosed partners or limited partners (LPs) contribute specified amounts of money and in return share in the profits and losses of the venture with the proviso that their losses are restricted to their specific contributions.

In Joubert v Tarry & Co, de Villiers JP set out the essentialia of a partnership when he stated the following:[6]

'These essentials are fourfold. First, that each of the partners brings something into the partnership, or binds himself to bring something into it, whether it be money, or his labour or skill. The second essential is that the business should be carried on for the joint benefit of both parties. The third is, that the object should be to make profit. Finally, the contract between the parties should be a legitimate contract.'

In ITC 1794, after noting the above essentialia, Davis J stated the following:[7]

'In determining whether a particular contract gives rise to a partnership, regard must be had both to the essentialia of the partnership as evidenced in the agreement and the intention of the parties. The fact that a contract does contain the essentialia of a partnership does not necessarily mean that the legal relationship created by the contract is that of a partnership. Upon a proper construction of the relationship, the true intention of the parties may well be that, notwithstanding the existence of the essentialia of a partnership agreement, a contract other than a partnership has been created. See LAWSA Vol 19 at para 274.'

No limit exists on the number of partners in a partnership for gain under the Companies Act 71 of 2008. Under the now repealed s 30(1) of the Companies Act, 1973, the number of partners in a partnership for gain was limited to 20, save for partnerships in the organised professions that were designated by the minister.

A partnership is not a separate legal entity. In Michalow, NO v Premier Milling Co Ltd the court summed up the common law position as follows:[8]

'At Common Law a partnership is not a legal entity having an existence apart from the individuals constituting it. It cannot have assets and liabilities.'

A partnership cannot have a taxable income because it is not a taxable entity or a taxpayer.[9] It is therefore the individual partners who must account for the income, deductions and capital gains of the partnership in their tax returns.

Section 24H

Section 24H(2) deems LPs to be carrying on the trade of the partnership despite them not being actively involved in the partnership business.[10]

Section 24H(3) limits the amount of any allowance or deduction a limited partner can claim to the sum of

• the partner's contribution;
• any other amount for which the taxpayer is liable or may be held liable to any creditor of the partnership; and
• any income received by or accrued to the taxpayer from such trade or business.

Section 24H(4) then provides that any amount disallowed under s 24H(3) shall be carried forward and be deemed to be an allowance or deduction to which the taxpayer is entitled in the succeeding year of assessment.

Section 24H(3) is a cumulative test and it needs to be applied in each year of assessment.

It poses a particular difficulty in relation to the many solar en commandite partnerships aimed at taking advantage of the s 12BA allowance. The reason is that s12BA grants an allowance of 125% of the cost of the qualifying solar equipment. Thus, an LP investing R100 would be entitled to a R125 allowance. But since the LP's contribution is only R100, the balance of R25 would have to be carried forward to the next year of assessment (disregarding net income). One might try to argue that this is not a sensible or businesslike result[11] but the fact remains that this is the effect of the plain wording of s 24H(3). The legislature was aware of this problem because it deleted the words 'other than section 11bis' which followed the words 'any allowance or deduction …' in the Revenue Laws Amendment Act 74 of 2002. Section 11bis, which was repealed by the same amending act, provided a double deduction for export marketing expenditure. Clearly, it would have been absurd to expect a partner to be liable to creditors for the portion of an allowance which did not involve any outlay of expenditure. But that is precisely the problem that section 12BA poses for an LP. The LP therefore has to agree to be held liable to creditors for an additional amount of 25% of any contribution if any limitation under s 24H(3) is to be avoided, which is not a commercial outcome. The issue was drawn to National Treasury's attention but presumably it was not considered worthy of an amendment because of the temporary nature of the s 12BA allowance.

Section 24H(5)(a) deems the income of the partnership to be received by or accrued to the partners on the date it is received by or accrues to them in common. This rule was inserted to address the outcome of Sacks v CIR[12] which held that partnership profits accrue only when the partners agree to draw up their accounts. The amount that will be received or accrue to each partner must be determined in accordance with the ratio that they agree to share profits or losses.

Section 24H(5)(b) then provides that partners will be entitled to a deduction or allowance based on their share of the income referred to in s 24H(5)(a). This requirement can lead to some conflicting results in the context of capital allowances. Typically, the LPs contribute the capital to purchase the equipment while the GP makes a nominal contribution but takes a bigger slice of the partnership profits. For example, assume 10 LPs each contribute R100 000 and the GP contributes R1 000. However, the GP takes 20% of the profits while the LPs each take 8%. How is the s 12BA allowance to be shared? If it were shared in accordance with the fractional interest of each LP in the solar equipment, each LP would be entitled to a R125 000 allowance with the GP's share being R1 250. But if we apply s 24H(5)(b), the GP's share would be 20% × R1 251 250 = R250 250. Yet, s 12BA(2) states that the deduction is 125% 'of the cost incurred by the taxpayer'. How then can the GP claim R250 250 when incurring a cost of only R1 000? The result of s 24H(5)(b) would be to divert a large portion of the allowance away from the LPs who incurred the expenditure to the GP who is not entitled to claim it.

Clearly, s 24H(5)(b) is in conflict with s 12BA. When two provisions of a statute are in conflict, the rules of interpretation require the maxim generalia specialibus non derogant (general provisions do not derogate from specific ones) to be applied to resolve the conflict. In ITC 79 the court stated:[13]

'When, therefore, there were special provisions in a statute and also general ones and the latter conflicted with the former, the special provisions were read as exceptions from the general ones.'

In this instance, s 12BA is the more specific provision and so should take precedence. If this approach is followed, each LP would be entitled to an allowance of R125 000, while the GP would be entitled to R1 250. It is possible that the sort of allowance the draftsperson had in mind in s 24H(5)(b) was something related to income such as an allowance for bad debts (s 11(i)), doubtful debts (s 11(j)), debtors allowance (s 24) or the allowance for future expenditure (s 24C).

Closure of partnership

Before acquiring any solar equipment, all the LPs should be in place. If additional partners are admitted after the equipment has been acquired, the pre-existing LPs will have to dispose of a fractional interest in the partnership assets in exchange for a share in the contribution made by the incoming LP, thus triggering a recoupment of the s 12BA allowance under s 8(4)(a) and (nA).[14] The fractional interest acquired by the incoming LP will be second-hand, thus disqualifying that LP from claiming the s 12BA allowance. Instead, the incoming LP will have to be satisfied with a 100% deduction under s 12B.

What would happen in the event that one of the existing partners dies or wishes to dispose of their partnership interest? If a buyer can be found, the exiting LP will suffer a recoupment and the buyer will be entitled to the s 12B allowance on the second-hand equipment. However, at least this will not have any impact on the rest of the LPs. Sometimes the GP will agree to take up the LP's share to give the LPs the peace of mind that they will have a buyer for their interest.

New or second-hand

With the 2025 year of assessment and the s 12BA window fast running out, the question arises whether the equipment could be installed on a client's premises while the investors are found. The equipment can then be sold to the LPs as a turnkey project. Caution needs to be exercised here lest the equipment is no longer regarded as new and unused. It would be best not to bring the equipment into use besides some preliminary testing before selling it to the LPs.

Retaining ownership

One of the requirements of ss 12B and 12BA is that the claimant has to be the owner or if not, an acquirer under an instalment credit agreement. When equipment is permanently affixed to a client's premises, the maxim superficies solo cedit (whatever is attached to the land forms part of it) means that in the absence of a contractual arrangement to the contrary, the client becomes the owner of the equipment.[15] It is therefore essential in any agreement with the client to stipulate that the equipment remains the property of the partnership and will be removed at the end of the contract period.

Beware letting

Agreements with clients are nearly always structured as power purchase agreements rather than leases for good reason. Charging the client for the electricity produced is not the same as charging a rental for the equipment. While s 12BA allows a lessor to claim the allowance by permitting the equipment to be 'used by that taxpayer or the lessee of that taxpayer, in the generation of electricity', s 12B by contrast, requires the equipment to be 'used by that taxpayer in the generation of electricity'. Thus, on the face of it, a lessor would not qualify for the allowance under s 12B(1)(h) and would need to default to s 11(e). On 30 July 2024 SARS released a draft Guide on the allowances and deductions relating to assets used in the generation of electricity. Its comments in para 2.3 on whether a lessor can claim the s 12B(1)(h) allowance seem ambiguous and require clarification. Regardless of whether a lessor claims an allowance under s 11(e), 12B or 12BA, the allowances will be ring-fenced against the lease rentals under s 23A. For any investor in an en commandite partnership, that would mean that they cannot set off the allowance against other taxable income, making the investment far less attractive.

Commercial risk​

Finally, while it is nice to have a large tax deduction, one should not let the tax tail wag the commercial dog. Around 1991 while I was at SARS, two promoters of a plantation scheme asked me if I would give them a ruling that their partnership agreement would not result in any limitation under s 24H(3). On reading the relevant clause, it was clear that the partners' exposure was unlimited. I told them I was happy to give them the ruling but I personally would not touch such an arrangement with a bargepole. Subsequently, the scheme turned out to be a financial disaster because of farm mismanagement and problems with the trees. Both professionals faced sequestration.

One would like to think that solar projects are less risky than a plantation but they are not without risk. Many solar projects rely on gearing to boost the tax deduction but this also increases the risk because the debt has to be repaid with interest. Understanding the risks associated with the investment is essential. Choosing a promoter with a proven track record and the necessary expertise would be a good starting point for a successful solar venture.