The Supreme Court of Appeal speaks on the apportionment of expenditure

rp_court-image-1-300x16311.jpgIt is trite that the deductibility or otherwise of expenditure incurred by a taxpayer is determined in terms of section 11(a) of the Income Tax Act 58 of 1962, read with section 23. 

Section 11(a) determines what expenditure qualifies for deduction, whilst section 23 prescribes what may not be deducted. Subsections (f) and (g) of section 23 have been described as the negative counterpart to section 11(a). (See Commissioner for Inland Revenue v Nemojim (Pty) Ltd 1983 (4) SA 935 (A) at 946H 947C.)

The general deduction formula

The so-called general deduction formula laid down in section 11(a) of the Act permits the deduction from the taxpayer’s income of – 

‘expenditure and losses actually incurred in the production of income, provided such expenditure and losses are not of a capital nature’, 

whilst section 23(f) and (g) of the Act prohibit a deduction in respect of –

‘(f) any expenses incurred in respect of any amounts received or accrued which do not constitute income as defined in section one;

(g) any moneys, claimed as a deduction from income derived from trade, to the extent to which such moneys were not laid out or expended for the purposes of trade.

It is well settled that – 

‘generally, in order to determine in a particular case whether moneys outlaid by the taxpayer constitute “expenditure incurred in the production of the income”, important, sometimes overriding, factors are the purpose of the expenditure and what the expenditure actually effects’ (per Corbett JA in Commissioner for

Inland Revenue v Standard Bank of SA Ltd 1985 (4) 485 (A) at 498F-G). 

In this regard, the court has to assess the closeness of the connection between the expenditure and the taxpayer’s income-earning operations (Nemojim at 947G-H).

In Joffe & Co Ltd v Commissioner for Inland Revenue 1946 AD 157 at 163, Watermeyer CJ held that:

‘All expenditure, therefore, necessarily attached to the performance of the operations which constitute the carrying on of the income-earning trade, would be deductible and also all expenditure which, though not attached to the trading operations of necessity, is yet bona fide incurred for the purpose of carrying them on, provided such payments are wholly and exclusively made for that purpose and are not expenditure of a capital nature.’

The apportionment of globular expenditure

These well-established principles have proved difficult to apply in circumstances where a globular amount of expenditure incurred by the taxpayer partly qualifies, in terms of these principles, for deduction, and partly does not. In such circumstances, an apportionment is required, but the Act is silent as to the principles that determine the manner of apportionment. Thus, apportionment  is required where expenditure by the taxpayer is partly of a revenue nature and partly of a capital nature, and also where expenditure was incurred partly in order to produce income and partly for purposes other than the production of income. 

These principles have again come to the fore in the judgment of the Supreme Court of Appeal in CSARS v Mobile Telephone Networks Holdings (Pty) Ltd [2014] ZASCA 4 handed down on 7 March 2014, involving an appeal by SARS against a judgment of the High Court and a cross-appeal by the taxpayer.

The deductibility of audit fees incurred by the taxpayer

Amongst the issues was the deductibility or otherwise of audit fees incurred by the taxpayer which was the holding company (referred to in the judgment as “Holding”) of five directly held and a number of indirectly held subsidiaries and joint ventures and was in turn a wholly owned subsidiary of the MTN Group Limited.

SARS did not dispute that the business of the group companies could only have been conducted in corporate form and that the holding company was statutorily obliged to have its financial records audited.

The Supreme Court of Appeal consequently held that –”it has to be accepted, that the audit fee expenditure was a part of Holdings’ general overhead expenses enabling it to carry out all of its activities, irrespective of whether they involved the investment in subsidiaries, the lending of money interest-free to subsidiaries or the lending of money at interest. It follows that the Tax Court’s conclusion that ‘[t]he auditing of financial records is clearly a function which is “necessarily attached” to the performance of [Holdings’] income-earning operations’, cannot be faulted.”

The court went on to say (at para [12]) that where expenditure is laid out for a dual or mixed purpose, the South African courts have, in principle, approved (despite the silence of the Income Tax Act in this regard) an apportionment of that expenditure and that “over time, the courts have applied various formulae to achieve a fair apportionment” – as was done in Secretary for Inland Revenue v Guardian Assurance Holdings (SA) Ltd 1976 (4) SA 522.
The court commented (at para [15])  that “Apportionment is essentially a question of fact depending upon the particular circumstances of each case” and quoted as follows from the judgment of Beadle J in Local Investment Co v Commissioner of Taxes (SR) ) 22 SATC 4.
‘It does not seem possible to me to lay down any general rules as to how the apportionment should be made, other than saying that the apportionment must be fair and reasonable, having regard to all the circumstances of the case. For example, in one case an apportionment based on the proportion which the different types of income bear to the total income might be proper, as was done in the Rand Selections Corporation’s case. In another case, however, such an apportionment might be grossly unfair; for example, in the case where the bulk of the expenditure was clearly devoted exclusively to operations intended to earn income, but which unfortunately in fact earned very little income, with the result that in the particular year of assessment the company earned very little “income”, but from operations which incurred little expense earned relatively large non-taxable amounts. In such a case to apportion the bulk of the expenses to the non-taxable amounts would be unfair. In another case a fair method of apportionment might be to take the proportion which the capital invested in the operations earning the non-taxable amount bears to the total capital invested, as was done in I.T.C. No 832 of 1956.’

The particular difficulty raised by audit fees

There is a particular difficulty in regard to the deductibility of audit fees, first because such expenditure does not in a direct sense produce income and, second, because in this ”a 50/50 apportionment of the audit fees was far too generous to the taxpayer. In all the circumstances I consider that it would be fair and reasonable that only ten per cent of the audit fees claimed by Holdings for each of the tax years in question should be allowed.”

The fee paid by the taxpayer for the implementation of a computer system

The further issue was the deductibility or otherwise of the R878 142 fee paid to KPMG in the present matter for the ”implementation, adjustment, fine tuning and user operation of the [Hyperion computer] system” in respect of which the taxpayer had claimed a 100% deduction (alternatively, a time-based deduction of 94% of the amount).

The question in this regard was whether such expenditure was of a non-deductible capital nature or a deductible revenue nature. 

The Supreme Court of Appeal held (at para [20]) that in view of the absence of any explanation from the taxpayer for its failure to call witnesses with personal knowledge of the workings of the Hyperion system, and the inadequacy of the evidence adduced by the taxpayer generally in this regard, it was well-nigh impossible to determine whether the fee qualified as deductible expenditure.

Consequently, said the court –

“It follows that the Commissioner cannot be faulted for having disallowed that fee in its entirety. In the result the contrary conclusion reached by the full court to that of the Tax Court that the deduction of the KPMG fee must be allowed in full, falls to be set aside.”

The apportionment ordered by the court

In the result, the Supreme Court of Appeal upheld SARS’s appeal against the deductibility of the KPMG fee in respect of the implementation of the Hyperion computer system (with the result that no part of that fee would be deductible) and held that 10% of the audit fees for the relevant years of assessment was deductible (reduced from the 50% allowed by the Tax Court).

This article first appeared