Deductibility of fines, penalties, etc

September 2010

On 26 February 2010 SARS issued Interpretation Note No.54: regarding the prohibition, in terms of section 23(o) of the Income Tax Act No. 58 of 1962 (the Act), of the deductibility of expenditure in respect of corrupt activities, fines and penalties.


Section 23(o) reads as follows ?


“No deductions shall in any case be made in respect of any expenditure incurred

  1. where the payment of that expenditure or the agreement or offer to make that payment constitutes an activity contemplated in Chapter 2 of the Prevention and Combating of Corrupt Activities Act, 2004 (Act No.12 of 2004); or

  2. which constitutes a fine charged or penalty imposed as a result of an unlawful activity carried out in the Republic or in any other country if that activity would be unlawful had it been carried out in the Republic.”


The Interpretation Note begins by saying that corruption hampers democratic processes, good governance, sustainable development and fair business practices, and that many countries, including South Africa, prohibit the tax-deductibility of bribes.


The Interpretation Note goes on to say that section 23(o) was enacted in 2005 and took effect from 1 January 2006, and that, before the enactment of this sub-section, the Act did not specifically address the non-deductibility of expenses incurred in respect of illegal activities.


The Interpretation Note says that some commentators had argued that bribes, fines and penalties were deductible if they satisfied the criteria for deductibility laid down in the general deduction formula (that is to say, section 11(a) read with section 23) of the Act, in other words, if the expenditure was incurred for the purpose of producing income.


Thus, for example, prior to the enactment of section 23(o), it was arguable that a taxpayer who carried on a road haulage business ought to be able to deduct fines paid for overloading his trucks, on the grounds that his purpose in overloading them was to earn income. Section 23(o) now rules out any deduction being granted for expenditure falling within its scope.


The Interpretation Note observes that the common law crime of bribery committed by state officials was abolished by the enactment of the Corruption Act of 1992 which created a new offence called “corruption” which subsumed both the common law crime and the offences created by previous legislation.


This situation is now covered by the Prevention and Combating of Corrupt Activities Act of 2004.


Examples of corrupt activities which may fall under the last-mentioned Act, and where any payment for such activities may accordingly not be tax-deductible include ?

  • pharmaceutical corporations rewarding doctors with gifts for prescribing their drugs to patients;

  • business people providing gifts to potential clients to secure contracts for themselves;

  • sports referees being paid to fix the outcome of a match;

  • money paid by record companies to radio and television stations to secure air time for the music they are promoting; and

  • public officials being bribed to secure a particular result, for example, a state prosecutor being bribed to arrange a plea bargain.


Enforceability and proof

The strength of the case for prohibiting tax-deductions for bribes and other corrupt payments is undeniable.


However, there are problems of proof, particularly where a dubious fee is paid to a middle-man to secure a particular result.


For example, a fee may be paid to a “lobbyist” to persuade a politician to do something or refrain from doing something, where there may or may not be a tacit understanding that part of the fee will be used to pay a bribe.


The proposition, expressed in the Interpretation Note, that an example of a corrupt activity is that of “businesspeople providing gifts to potential clients to secure contracts for themselves” is fraught with difficulty.


What of a businessperson who takes a potential client out to lunch? Or who invites a potential client to his luxury private viewing box to watch a cricket match?


It surely cannot be suggested that such conduct, of itself, falls within the scope of chapter 2 of the Prevention and Combating of Corrupt Activities Act of 2004.


Interpretation note addresses only one side of the problem

The real weakness of the Interpretation Note, however, is that it fails to acknowledge the obverse issue, namely, whether illegal income is or should be subject to income tax.


To put the issue in sharp focus, take the hypothetical case of a businessperson paying a corrupt bribe to a government official to induce the latter to grant a favour. Is the receipt subject to income tax in the official?s hands?


It would be the height of cynicism and double standards for a tax system to deny a tax-deduction for a corrupt payment, yet take a slice of that payment by taxing the recipient. Yet, it would seem that this may indeed be the way our law stands at present.


The Supreme Court of Appeal decision in MP Finance Group

In the 2007 decision of the Supreme Court of Appeal in MP Finance Group CC (in liquidation) v C:SARS, the court held that the proceeds derived from carrying on an illegal pyramid scheme had been “received” for income tax purposes as from the date when the individuals in question (the fraudsters) know that the scheme is insolvent and fraudulent and that it would be impossible to pay the investors what they had been promised. From that date, said the court, the amounts contributed by investors formed part of the fraudster?s gross income.


The decision does not articulate the principle that amounts derived from illegal activities have the character of “income” but such a finding, it is submitted, appears from the court?s conclusion that, as from the aforesaid crucial juncture, the entities in question “made their money by swindling the public. That was their income.”


There are two disconcerting aspects to the judgment. The first is the complete silence of the court on the moral and ethical dimension of the case, and the question whether SARS (as an organ of state) makes itself complicit in fraud by taxing the proceeds of fraudulent activities and, if so, whether this is inconsistent with the constitutional values that underpin South Africa?s legal order.


The answer to this multi-faceted question is far from self-evident, but it is suggested that it is unfortunate that the Supreme Court of Appeal chose to remain silent on an issue of such importance.


The second, and related issue, is that the effect of the judgment in MP Finance was that SARS, by virtue of its statutory preferential claim to the residue of the proceeds of the now-insolvent pyramid scheme, had first claim to the depleted proceeds of the scheme.


In other words, the payment of income tax to SARS depleted the meagre funds available for reimbursement to the innocent and cheated investors. Given the public concern about the prevalence of crime and corruption in South Africa, it is unfortunate that the Supreme Court of Appeal confined its decision to the particular facts of the case, and did not give the country the benefit of its view on the larger question of the taxability of the proceeds of crime. It is believed that SARS takes the view that the proceeds derived from (for example) illicit sales of liquor and from drug-dealing are taxable. There is nothing in the Supreme Court of Appeal?s judgment in MP Finance to suggest that the court would regard this practice as not sanctioned by the tax laws.


Would SARS take the same view ? and would the courts view with approval ? taxing the proceeds of (say) car hijacking, robbery or hit squad activity?


In the 1963 decision of the English Court of Appeal case of Griffiths (Inspector of Taxes) v JP Harrison (Watford) Ltd Lord Denning squarely confronted the issue of whether criminals are entitled to be taxed on the basis that they are “carrying on a trade” in the following words:


“Take a gang of burglars. Are they engaged in trade or an adventure in the nature of trade? They have an organisation. They spend money on equipment. They acquire goods by their efforts. They sell the goods. They make a profit. What detail is lacking in their adventure? You may say it lacks legality, but it has been held that legality is not an essential characteristic of a trade. You cannot point to any detail that it lacks. But still it is not a trade, nor an adventure in the nature of trade. And how does it help to ask the question: If it is not a trade, what is it? It is burglary and that is all there is to say about it.”


It is implicit in Lord Denning?s view that the consequences of crime should be dealt with by the criminal law (which may, inter alia, decree that the proceeds of crime are to be forfeited to the State) and that the fiscus should not allow itself to be tainted by taxing the proceeds of crime.


Our courts have yet to confront this issue, and it is a pity that SARS?s Interpretation Note on the deductibility of corrupt payments does not, at least, acknowledge the issue and put it squarely on the table for debate.




IT Act:S 11(a)

IT Act:S 23 and s 23(o)

IT Act: Interpretation Note No 54

Corruption Act No. 94 of 1992

Prevention and Combating of Corrupt Activities Act No. 12 of 2004