Important judgment for taxpayers regarding the valuation of trading stock


Author:
Jerome Brink.

In C:SARS
v Volkswagen SA (Pty) Ltd
(1028/2017) [2018] ZASCA 116 (19 September 2018)
the Supreme Court of Appeal (SCA) dealt with important principles in the Income
Tax Act, No 58 of 1962 (Act), specifically s22 of the Act dealing with amounts
to be taken into account in respect of trading stock. The judgment will likely
have far-reaching consequences for many taxpayers and this article provides a
brief analysis of the key issues and principles underpinning the judgment.

In C:SARS
v Volkswagen
, the task before the court was to determine whether the Net
Realisable Value (NRV) of Volkswagen South Africa’s (Taxpayer) trading stock,
calculated in accordance with International Accounting Standard 2 (IAS2) of the
International Financial Reporting Standards (IFRS), may and should, where such
NRV is lower than the cost price of such trading stock be accepted as
representing the value of trading stock held and not disposed of at the end of
the respective years of assessment for purposes of s22(1)(a) of the Act.

The Issue

Section
22 of the Act in its simplest form is a timing provision which ensures that the
cost of trading stock in the hands of a taxpayer matches the income earned in
respect of that trading stock sold, or otherwise disposed of.

In this
particular instance, the SCA had to consider s22(1)(a) of the Act which in essence
sets out the general rule pertaining to closing stock held and not disposed of
which must be included in the income of a taxpayer at the end of the year of
assessment. In essence, the closing stock to be included in the income of a
taxpayer is the cost price of the trading stock, less such amount as the
Commissioner may think just and reasonable as representing the amount by which
the value of such trading stock has been diminished by reason of damage,
deterioration, change of fashion, decrease in market value or for any other
reason satisfactory to the Commissioner.

In the
Volkswagen case, the Taxpayer contended that it was entitled to reflect the
value of its trading stock at less than cost as per s22(1)(a) of the Act. The
contention made on behalf of the Taxpayer was that it should be entitled to do
this on the basis of its NRV of its trading stock calculated in accordance with
IAS2, in that its NRV reflected that the value of its trading stock had
diminished.

Importantly,
for purposes which will become more apparent later, the Taxpayer’s trading
stock in casu constituted a number of unsold vehicles including trucks, busses
and passenger vehicles. Furthermore, given that NRV is defined as the estimated
selling price of inventory in the ordinary course of business, less the
estimated costs of completion and the estimated costs necessary to make the
sale, the individual categories of costs taken into account in determining the
NRV of its trading stock were described generally as rework/refurbishment costs;
outbound logistics; marine insurance; sales incentives; distribution fees;
warranty costs, costs relating to the Audi Freeway Plan and the Volkswagen
AutoMotion Plan and roadside assistance costs.

SCA’s interpretation of s22(1)(a) of the Act

The SCA commenced
with its interpretation of the relevant provisions of s22 of the Act and
provided examples of what is contemplated in s22(1)(a) at paragraphs [14] and
[15] as follows:

Four
circumstances namely, damage, deterioration, change of fashion or decrease in
market value, are specified as causing a diminution in the value of trading
stock. All of those can be illustrated quite simply. Goods may be damaged in
transit and as a result can only be sold at less than cost. Their condition may
deteriorate whilst in transit or in storage, as with a cargo of first grade
rice undergoing heating at sea, so that it has to be downgraded to second or
third grade and is only saleable at less than cost. Fashionable clothing tends
to be seasonal and, if not sold before the end of the season, retailers may
need to dispose of unsold surplus stock at discounted prices below cost. A
decrease in the value of trading stock may arise where stock has been acquired
at a particular price and the supplier subsequently reduces the price. For
example, a retailer might acquire mobile phones for R400 from the manufacturer.
If the manufacturer cuts its price to retailers to R300, in order to get rid of
stock before introducing a new model phone, the value of the stock acquired at
R400 has diminished.

The
section contemplates the possibility of there being other reasons for a
diminution of value apart from the four it specifies. For that reason it
empowers the Commissioner to make a just and reasonable allowance to
accommodate a diminution in value of trading stock for any other reason that
may be satisfactory to the Commissioner.

Wallis JA
thereafter held that what is important is that the wording of s22 dictates that
one must ordinarily look back at what happened in the year of assessment under
consideration given that the language is couched in the past tense. The section
is thus not strictly concerned with what may occur in the future, albeit that
there is nevertheless an element of futurity.

The
correct position, as Wallis JA put it, was that the Commissioner can only grant
a just and reasonable allowance in respect of diminution in value of trading
stock under s22(1)(a) in two circumstances, namely:

  • where
    some event has occurred in the tax year in question causing the value of
    the trading stock to diminish; and
  • where
    it is known with reasonable certainty that an event will occur in the
    following tax year that will cause the value of the trading stock to
    diminish. An example given by Wallis JA in this regard was one of simple
    supply and demand microeconomics, namely where there may be knowledge on
    the part of the taxpayer that an excess supply had built up in the market
    for a perishable commodity, where that oversupply would ensure a marked,
    certain and unavoidable decline in the price of that commodity in the
    following year.

Another
important aspect of Wallis JA’s judgment was that the cost price of the goods,
and not the actual or anticipated market value on disposal, should be the
benchmark against which any diminution in value should be allowed. Wallis JA
went on to conclude that what is required is the presence of known events
during the year in question (or events that will occur with reasonable
certainty in the following year) which have led to the cost price of the goods
ceasing to be the proper measure of their value.

Having
established the views of the court regarding the interpretation and application
of s22(1)(a) of the Act in general terms, Wallis JA then proceeded to consider
the Taxpayer’s arguments and submissions against this background, with specific
reference to the Taxpayer utilising NRV as calculated in accordance with IAS2
to value its trading stock at year end.

Discussion of issues and judgment

Having
considered and discussed the relevant aspects of NRV as calculated in accordance
with IAS2 and with specific reference to the Taxpayer’s submissions, Wallis JA
held at paragraph [43] as follows:

There is
obvious scope for an overlap between the provisions of s22(1)(a) and those of
IAS 2. The former refers to a diminution of value of trading stock caused by
damage, deterioration, change of fashion, or decrease in market value. Clause
28 of IAS 2, quoted above in para [35], records that the cost of inventories
may not be recoverable if they have been damaged or have become obsolete in
whole or part. To that extent the two correspond. But the other elements to
which IAS 2 refers do not relate to the same matters as s22(1)(a). They are
concerned with future matters such as changes in likely selling prices, or
increases in the estimated costs of completion or the estimated costs of making
sales.

Wallis JA
proceeded to raise several practical difficulties in accepting the Taxpayer’s
method, including that writing down the value of part of the stock to NRV
ignores the fact that NRV of the remaining stock is higher than cost price and
that it would leave the Commissioner with little scope for assessing the
legitimacy of a calculation relating in its entirety to the future trading
circumstances of a taxpayer.

In
addition to the practical difficulties discussed, Wallis JA, in upholding the
appeal and finding in favour of the Commissioner, held that the utilisation of
NRV within this context was inconsistent with two basic principles of the Act.
First, that NRV was patently forward looking whereas the concept of taxation is
backward looking and therefore incompatible. Secondly, that by using NRV within
this context, expenses incurred in a future year of assessment in respect of income
earned in that succeeding year become deductible prematurely in a
prior year (ie timing mismatch).

Observations

There is
no doubt that the judgment will have a far-reaching and profound impact in
respect of how Taxpayers and SARS consider, interpret and apply the provisions
of s22(1)(a) of the Act. The key question, however, is the extent to which the
judgment can be applied in matters of this nature. It should be appreciated
that the SCA was presented with a specific set of facts which may ultimately
result in the judgment having, to some extent, limited application.

For
instance, “trading stock” as defined in s1 of the Act contemplates three
separate categories of trading stock. In the Volkswagen case, the SCA was
tasked with broadly considering the first two categories of trading stock
namely anything that is produced, manufactured, or acquired for the purposes of
sale or exchange or anything, the proceeds on disposal of which, form part of
the gross income of the taxpayer. In broad and simple terms, therefore, stock
which is ultimately acquired or produced in order to ultimately sell or
otherwise dispose of.

The SCA,
however, was not tasked with considering the application of s22(1)(a) of the
Act within the context of the altogether different third category of trading
stock, namely consumable stores, and spare parts acquired by a taxpayer to be
used or consumed in the course of the taxpayer’s trade. This category of
trading stock is not within the realm of the usual trading stock contemplated
and is used in a taxpayer’s production process as opposed to for resale
purposes and one may thus argue that the Volkswagen case should be applied with
a measure of caution to the calculation of the diminution in value of this
category of trading stock, given its distinct features.

A further
important aspect to note from the judgment is the general discussion of
accounting principles and their application to South African tax law concepts.
Since time immemorial, there has been robust discussion regarding the use and
application of accounting principles within tax law. While Wallis JA was clear
that one must apply accounting principles with caution to interpretational
difficulties within tax law, upon careful reading of the judgment one may
nevertheless argue that Wallis JA stopped short of completely discarding the
value and benefit of accounting principles in ascertaining the reasonability of
tax positions taken by taxpayers in specific circumstances.

The
application, interpretation and effects of this judgment will certainly be
interesting to observe in the coming years.

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