Lessons from Al Capone Quarter 4 2021

By GRAEME PALMER, Published in Spotlight On Tax Law

It is extraordinary how often the failure to comply with tax obligations derails unlawful or even criminal conduct. The notorious American gangster, Al Capone famously went to prison in 1932 for tax evasion. The law enforcement authorities in the United States realised that mobsters were publicly living extravagant lifestyles yet never filed tax returns. It was easier to secure evidence for tax evasion than their other crimes.

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It was, in fact, the earlier case of United States v. Sullivan, 274 U.S. 259 (1927) that paved the way for the prosecution of Al Capone. In Sullivan, the Supreme Court allowed the prosecution of criminals for income tax evasion notwithstanding the Fifth Amendment right that protects against self-incrimination. Manley Sullivan was a bootlegger whose lawyers argued that filing a tax return on illegal income would amount to self-incrimination, and he was therefore protected by the Fifth Amendment. Justice Oliver Wendell Holmes Jr noted that the Revenue Act,1921 provided that gross income includes, "gains, profits, and income derived from... the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever." Justice Holmes rejected the Fifth Amendment argument pointing out that if a defendant was of the view that information required on his tax return would incriminate him, he could raise that issue on the return but could not simply refuse to file. On the question raised by the defense that illegal expenses would be deducted, Holmes said, "It is urged that, if a return were made, the defendant would be entitled to deduct illegal expenses, such as bribery. This by no means follows, but it will be time enough to consider the question when a taxpayer has the temerity to raise it".

In South Africa, the Supreme Court of Appeal in MP Finance Group CC (in liquidation) v CSARS 2007 (5) SA 521 (SCA) considered whether deposits taken in an illegal and fraudulent pyramid scheme constituted amounts "received" within the meaning of "gross income". It was held by the court that, "An illegal contract is not without all legal consequences; it can, indeed, have fiscal consequences". It follows that money received through theft, fraud or corruption is likely taxable.

The main objective of the South African Revenue Service (SARS) is the efficient and effective collection of tax. To do this, it must ensure the widest possible enforcement of tax laws. It is not within the SARS' mandate to fight crimes such as fraud or corruption; that is the job of the police, Hawks and Special Investigation Unit. But often, the enforcement of tax laws intersects with the unlawful conduct of criminals who have failed to comply with their tax obligations. There are two recent examples in the Gauteng High Court in CSARS v Raphela (unreported) ZAGPPHC 29 March 2021, and CSARS v Hamilton Holdings (Pty) Ltd (unreported) ZAGPPHC 1 March 2021 where, ostensibly, criminal schemes were undone by SARS securing the collection of tax.

In Raphela, SARS launched an application for a preservation order under s163 of the Tax Administration Act 28 of 2011 (TAA) against Mrs Pheladi Raphela (Raphela), PSR Solutions (Pty) Ltd (PSR), and Mrs Thembeka Mdlulwa (Mdlulwa). PSR was awarded a tender to supply 1.5 million face masks at R30 a mask for use by the South African Police Service (SAPS). The tender was for R45 million, and it should have attracted output VAT of R5.8 million.

PSR and Raphela, the company's only director, did not have the funds to acquire the masks to fulfil the tender. Mdlulwa was approached for funding and paid R19.9 million to the supplier of the masks on 14 April 2020. After delivery of the masks, PSR paid Mdlulwa R33.1 million on 21 April 2020, giving her a profit in excess of R13 million in seven days, after the SAPS had paid 125% more than the actual cost of the masks. PSR did not account for the output VAT on the supply of the masks in its returns, SARS estimating an amount due on VAT, penalties, and interest to be at least R14.5 million.

By the end of July 2020, PSR had only R110,377 left in its bank account, the funds having been expended on payments to Raphela, luxury German vehicles, and property. There was, however, R24 million remaining in Mdlulwa's South African bank account. Mdlulwa was permanently residing with her family in Spain, and her residence in South Africa had not been maintained or occupied for several years.

The order sought against Mdlulwa was not based on her tax liability, but that of PSR. Mdlulwa opposed SARS' application for a preservation order, stating that she was not the mastermind of the tender transaction. She further contended that SARS should freeze the account of the taxpayer, not her account. The court held that the restricted interpretation which Mdlulwa placed on s163 was not supported by the wording of the section. Section 163 contemplates granting an order against a taxpayer or other person, clearly being someone other than the taxpayer. Its aim is to prevent the dissipation of assets, particularly where the taxpayer appears to be unable to meet its estimated tax liability. Section 163 did not require collusion or an intention of dissipation on the part of the other person (i.e. Mdlulwa) – all SARS must show is a material risk to the assets which, in the absence of a preservation order, will no longer be available. The court concluded that preserving the funds which emanated from the taxpayer and were now in the hands of Mdlulwa as an "other person" were sufficient grounds for a preservation order.

In Hamilton Holdings (Pty) Ltd, SARS sought a preservation order against six respondents which the court concluded were the alter ego of Hamilton Ndlovu (Ndlovu). Ndlovu's businesses were engaged exclusively in the sale of various goods to the state. Contracts were awarded to Ndlovu's entities to supply goods to the National Health Laboratory Service (NHLS) to combat the COVID crisis.

Ndlovu came to notoriety and the attention of SARS when he bragged on social media about five luxury vehicles he purchased, collectively valued at R10.5 million. When SARS investigated Ndlovu's tax affairs, they found that he had not filed a return since 2016. The respondents' tax and VAT returns were outstanding for several years, particularly those linked to the NHLS contract. Some of the respondents had declared themselves dormant when they were clearly trading. Collectively, the respondents were paid about R49.6 million from the NHLS contracts alone, without paying any money to produce or acquire the goods that were sold to the NHLS. SARS estimated collective VAT and tax liabilities of the respondents in excess of R60 million.

The respondents argued that the SARS' case was aimed at showing a "possible" tax liability, and what was required by s163 was a "probable" liability. The court held that these labels were semantics; what mattered was whether the collection of tax would be imperiled, having regard to the facts and circumstances. The very premise of s163 is that the true tax liability is unknown and remains to be determined. SARS officials can only make estimates, and these, Sutherland ADJP held, should be generous rather than conservative because the purpose is to ensure that all due tax is collected. A dispute of fact about the estimate was therefore futile. If there is hardship due to the seizure of assets, s163(7) makes provision for relief.

The critical question, Sutherland ADJP said, was whether reasonable grounds existed to believe there was a real risk of assets being dissipated, which would frustrate the collection of tax. Here, the court found there were several salient factors that included: the delinquency in rendering tax returns, the diversions of huge sums among various businesses, the spendthrift nature of Ndlovu in acquiring five luxury cars, the storage of a huge sum in an investment vehicle with international links, and the payment of R20 million to a trust to purchase a property. These factors, in the Court's opinion, made a preservation order reasonable and appropriate.

Section 163 is just one weapon in an extensive SARS tax collection arsenal. SARS has broad powers to gather information, hold an inquiry, audit, or investigate a taxpayer. It can conduct a search and seizure, request security from a taxpayer, enforce judgments, institute liquidation proceedings, and request third parties to pay SARS to satisfy a taxpayer's tax debt. In addition, there are a myriad criminal offences in Chapter 17 of the TAA, for tax evasion and non-compliance with tax Acts.

As certain as the sun will rise tomorrow, those involved in unlawful conduct will continue to fall foul of their tax obligations. It doesn't seem to occur to even the shrewdest criminals that their unlawful conduct does not absolve them of their tax obligations. Sometimes the tax collection machinery can be quicker, easier, and more effective in dispensing justice than the options available to other law enforcement agencies. After boasting that "they can't collect legal taxes from illegal money", Al Capone was sentenced to 11 years in prison for failing to file tax returns. There are lessons to be learnt from Al Capone for taxpayers and law enforcement agencies alike.

Palmer is a Partner with Garlicke & Bousfield.