Deductions – Apportionment of holding company expenses

court hoodMobile Telephone Networks Holdings (Pty) Ltd (the taxpayer) v Commissioner for the South African Revenue Service [2011]73 SATC 315, the taxpayer was the holding company of five directly held subsidiaries and a number of indirectly held subsidiaries and joint ventures, within a group of companies. The collective business of the operating companies within the group was the operation of mobile telecommunication networks.

By virtue of the taxpayer’s shareholding in its subsidiaries, the taxpayer earned exempt dividend income. In addition thereto, the taxpayer lent money to group companies and accordingly earned interest income.

The taxpayer did not conduct any activities other than investment holding (equities) and money-lending. However, the exempt dividend income received on shares far outweighed the interest income and made up between 89% and 99% of the taxpayer’s total income in respect of the relevant years of assessment.

To comply with its statutory obligations, the taxpayer employed auditors to audit its financial statements for the 2001 to 2004 years of assessment respectively. In addition thereto, the taxpayer paid an amount to KPMG as a ‘training fee’ in respect of a computerised accounting system.

The taxpayer sought to deduct the expenditure incurred in respect of the auditing and training fees for the 2001 to 2004 years of assessment. However, the South African Revenue Service (SARS) only allowed between 2% and 6% of the audit fees to be deducted based on the ratio of the taxpayer’s interest income to its exempt dividend income. SARS further disallowed the training fees on the basis that it was capital in nature.

The taxpayer objected but SARS disallowed the objection. The taxpayer then appealed to the Tax Court.

Decision of the Tax Court
The Tax Court held that:

  • the incurral of the audit fees was necessarily attached to the income earning operations of the taxpayer because without the audit the taxpayer could not comply with the Johannesburg Stock Exchange’s (JSE) requirements and so give confidence to creditors and access loans;
  • the audit fees were laid out for a dual purpose, being the earning of interest income and the earning of exempt dividend income, both being equally important to the taxpayer’s business;
  • a 50% apportionment would be appropriate; and
  • the training fees paid to KPMG were capital in nature and should not be deductible.

The taxpayer subsequently appealed to a full bench of the High Court. The taxpayer’s argument had always been that 100% of the audit fees should qualify for deduction. However, in the alternative, the taxpayer argued that 94% should be deductible on the basis that 94% of the time spent by the auditors related to the interest income and not the exempt dividend income.

SARS also cross-appealed the Tax Court’s findings in respect of the 50% apportionment of the audit fees.

Decision of full bench
The full bench of the High Court held that:

  • the expenditure is deductible as it properly relates to and is closely connected to the operation and the income earning activities of the taxpayer;
  • a fair measure for apportionment is the amount of time spent by the auditors in respect of the interest income as against the exempt dividend income;
  • a deduction of 94% of the auditing fees should be allowed; and
  • the training fees should be allowed in full as a deduction as it was a necessary concomitant of the taxpayer’s income-earning operations (it related to the earning of interest income as opposed to exempt dividend income).

Consequently, SARS appealed to the Supreme Court of Appeal (SCA) against the decision of the full bench of the High Court.

Decision of the Supreme Court of Appeal
The SCA gave judgment on 7 March 2014. The SCA set out the law relating to the deductibility of expenditure as follows:

In terms of the general deduction formula contained in section 11(a) of the Act, expenditure incurred by a taxpayer is tax deductible if it is:

  • Actually incurred in the production of income; and
  • Is laid out for the purposes of the taxpayer’s trade.

However, it will not be deductible if it is:

  • Capital in nature (section 11(a) of the Act);
  • Incurred in respect of amounts not constituting income as defined (section 23(f) of the Act); and
  • Not laid out or expended for the purposes of trade (section 23(g) of the Act).

To determine whether expenditure is incurred in the production of income, factors to consider are:

  • The purpose of the expenditure; and
  • What the expenditure actually effects (CIR v Standard Bank of SA Ltd, [1985] 47 SATC 179.).

The closeness of the connection between the expenditure and the income earning operations must thus be assessed (CIR v Nemojim [1983] 45 SATC 241).
Also, all expenditure necessarily attached to the income earning operations, as well as all expenditure not necessarily so attached, but which is bona fide incurred for the purpose of the income earning operations, can in principle qualify for deduction (Joffe & Co Ltd v Commissioner for Inland Revenue [1946] 13 SATC 354).

However, where expenditure is incurred for a dual purpose, and cannot be directly attributed to a specific income item, the expenditure must be apportioned on some basis (SIR v Guardian Assurance Holdings (SA) Ltd [1976] 38 SATC 111; CIR v Nemojim, [1983] 45 SATC 241).

The courts usually apply an arithmetic formula or basis, but where this is not possible or leads to inequitable results, an apportionment must be made that is “fair and reasonable, having regard to all the circumstances of the case”. General rules catering for each and every set of circumstances cannot necessarily be laid down (Local Investment Co v Commissioner of Taxes [1958] 22 SATC 4).

In this regard the SCA confirmed that apportionment “is essentially a question of fact depending upon the circumstances of each taxpayer”.

Based on the above exposition of the applicable law, and having regard to the facts of the case, the SCA firstly accepted that the incurral of the audit fees was necessarily attached to the performance of the taxpayer’s income-earning operations, and could not be wholly disregarded on that basis.

Secondly, the SCA implicitly accepted that the audit fees were incurred for a dual purpose, and that an appropriate apportionment had to be made.

In this regard the SCA rejected the apportionment method based on the time spent by the auditors on auditing the Taxpayer, which the High Court had previously approved.

The reasons advanced by the SCA are that:

  • An audit is directed at signing off an audit opinion;
  • An auditor performs a range of general tasks that cannot necessarily be attributed to a specific income item; and
  • It is meaningless to assert that a certain amount of time was spent on one item without knowing how much time was devoted to the other items, in order to make a comparison.

In addition, the SCA noted that any apportionment must be weighted in favour of disallowing any deduction because:

  • The greater part of the loans made by the taxpayer was interest-free;
  • The interest-earning activities on the one hand were small in relation to the dividend earning activities and the making of interest free loans on the other hand;
  • The taxpayer’s value lay in its principal business as a holding company of ‘extremely valuable subsidiaries’;
  • The time spent by the auditors on the interest entries (mainly in respect of a share incentive scheme) was small compared to the overall audit time;
  • The audit involved an audit of the taxpayer’s affairs as a whole; and
  • The taxpayer’s predominant operations were in respect of the earning of dividends and not interest.

The SCA agreed that the application of an arithmetic formula is not necessarily appropriate in this case, but held that a 50% apportionment is overly generous.
The SCA accordingly held that only 10% of the audit fees qualify for deduction.

In respect of the training fees paid to KPMG relating to the computerised accounting system, the SCA held that they are not deductible.

Essentially, the SCA found that the taxpayer had not produced any reliable evidence explaining what the ‘training fees’ were for. The witnesses of the taxpayer had very little personal knowledge of the fees. Accordingly, the taxpayer could not discharge the onus of having to prove that the expenditure or any portion thereof, qualified for deduction.

The legal principles set out by the SCA in this case in respect of the deductibility of expenditure adhered to by the principles previously adopted by the court.

However, it is respectfully submitted that the reasons advanced for allowing a 10% deduction are unclear and unconvincing.

It appears that there is no objective basis stemming from the evidence or otherwise for arriving at an apportionment of 10%. It seems to be an arbitrary number that subjectively, according to the court, is a fair percentage. This is really no different from the Tax Court’s finding that 50% was a fair percentage.

Further, the judgment is not clear as to whether a time-based or effort-based apportionment method may never be applied, or whether such a method was only inappropriate in this specific case.

Accordingly, and with respect, it is submitted that the judgment does not as such constitute a very useful precedent for purposes of tax law.

Because the SCA did not take a very rigid or objective approach in determining an apportionment percentage, it is expected that similar cases where apportionment is at issue will come before the SCA in future.

Unfortunately, it is expected that SARS will use the outcome of this judgment to aggressively resist deductions for overhead costs claimed by holding companies that mainly receive exempt dividend income.