In the end, there can be only one contract – the SCA considers section 24C of the Income Tax Act

Author: Louis Botha.

On 3 December 2018, the Supreme Court of Appeal (SCA) handed down judgment in CSARS v Big G Restaurants (Pty) Ltd (157/18) [2018] ZASCA 179 (3 December 2018), concerning s24C of the Income Tax Act, No 58 of 1962 (Act).

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In terms of s24C of the Act, a taxpayer can, under certain
circumstances, claim an allowance in respect of future expenditure
incurred against income received by or accruing to a taxpayer, which
income will be utilised wholly or partly to finance the future
expenditure. The matter was initially heard by the Tax Court, which
found in favour of Big G Restaurants (Pty) Ltd (Taxpayer). SARS appealed
the Tax Court judgment to the SCA. We discussed the Tax Court judgment
in our Tax & Exchange Control Alert of 2 March 2018.

Facts

The matter came before the Tax Court as a special case in terms of
Rule 42 of the Tax Court’s Rules read with Rule 33 of the Uniform Rules
of Court. The agreed facts of the case were the following:

  • The Taxpayer is a franchisee that operates restaurants in terms of
    various written franchise agreements with the franchisor, Spur Group
    (Pty) Ltd (Spur).
  • The terms of the franchise agreements are virtually identical.
  • A copy of one of those agreements was annexed to the special case
    (Franchise Agreement) and was considered to reflect the terms of all the
    agreements.
  • In terms of the Franchise Agreement, the Taxpayer undertook that for
    the duration of the agreement, the main object and sole business
    carried on by it would be the operation of Spur Steak Ranch Restaurants
    and restaurants specialising in pizza and pasta, under the style of
    Panarottis.
  • In terms of the Franchise Agreement, the Taxpayer had to pay Spur a
    monthly service fee and the Taxpayer was required to upgrade and/or
    refurbish its restaurants at reasonable intervals, as determined by
    Spur.
  • In respect of its 2011 to 2014 years of assessment, the Taxpayer
    claimed certain amounts in terms of s24C of the Act in relation to
    future expenditure to be incurred, due to the obligation to upgrade and
    refurbish restaurants under the Franchise Agreement.

Questions of law and Tax Court decision

The Tax Court had to answer two questions:

  • Firstly, whether income received by the Taxpayer from operating the
    franchise businesses, were amounts received or accrued in terms of the
    Franchise Agreement as envisaged in s24C of the Act;
  • Secondly, whether the expenditure required to refurbish or upgrade
    restaurants was incurred ‘in the performance of the taxpayer’s
    obligations under such contract’, as contemplated in s24C.

The Tax Court found that the Taxpayer’s income was income earned for
purposes of s24C under the same contract as that under which the
Taxpayer’s future expenditure would be incurred. Consequently, it
ordered that the additional assessments raised by SARS for the 2011 to
2014 years of assessment be set aside. The main issue in the appeal was
whether the income received by the Taxpayer from operating its franchise
business, included any amount received or accrued in terms of the
Franchise Agreement, as envisaged in s24C of the Act.

Judgment

In terms of s24C(2) of the Act, future expenditure under a contract will be deductible, where “…income
of any taxpayer in any year of assessment includes or consists of an
amount received by or accrued to him in terms of any contract and the
Commissioner is satisfied that such amount will be utilised in whole or
in part to finance future expenditure which will be incurred by the
taxpayer in the performance of his obligations under such contract…”

SARS argued that on any interpretation of s24C, the Taxpayer did not
earn income from the Franchise Agreement and as such, could not claim
the allowance under s24C. This is because the Taxpayer received income
in terms of the ad hoc contracts concluded with patrons when meals were sold to them.

The Taxpayer conceded that it would not earn any income if it did not
provide meals to patrons, but contended that it was obliged do so in
terms of the Franchise Agreement, which was its source of income and
stated how it had to operate its restaurants. Relying on the judgment in
Oosthuizen & Another v Standard Credit Corporation Ltd
1993 (3) SA 891 (A), the Taxpayer argued that the phrase “in terms of”
in s24C(2) of the Act should be given a wide meaning, namely that the
Taxpayer’s income was earned “pursuant to” or “in accordance with” the
Franchise Agreement.

Relying on the judgment in Slims (Pty) Ltd & Another v Morris NO
1988 (1) SA 715 (A), the SCA held that the phrase “in terms of”, has an
ordinary (narrow) or wide meaning. In that case, the majority judgment
held that the meaning of a word depends on the subject matter and
context in which it appears. Elaborating on this issue, it explained
that the word “kragtens” (the Afrikaans equivalent of “in terms of”) is
clearly capable of having different meanings. In the narrow sense, it
can be used to denote a direct and immediate connection between the two
concepts linked by it and in a wide sense, it may indicate no more than a
loose and indirect relationship between the two concepts. In its wide
meaning, the word is not confined to the designation of “a direct or
exclusive connection between the two matters which it serves to link to
each other”.

In Slims, the majority judgment held that in the context of
s37(5) of the Insolvency Act, No 24 of 1936, the wide meaning of “in
terms of” should be preferred. In Oosthuizen, where the words
were interpreted in the context of a lease agreement, it was held in the
majority judgment that the wide meaning should apply.

The SCA then had to consider whether the wide meaning or ordinary
meaning of “in terms of” applies in the context of s24C(2) of the Act.
In the SCA’s view, there is a direct and immediate connection between
the requirements of s24C and that the Taxpayer must earn income from the
same contract in terms of which obligations are incurred, to claim the
allowance. The fact that the income and obligations must originate from
the same contract, points to the conclusion that the allowance in s24C
was intended to apply to cases where income earned in terms of a
contract is received before expenditure will be incurred to perform
obligations under the same contract.

In the SCA’s view the narrow meaning of “in terms of”, is supported
by the context and the background to the provision, which constitutes an
exception to s23(e) of the Act. Section 23(e) states that no deduction
shall be made in respect of income carried to any reserve fund or
capitalised in any way. In terms of the Explanatory Memorandum to the
Income Tax Act 104 of 1980 (Memorandum), which introduced s24C, the
purpose of s24C was to address situations where a contract, typically a
construction contract, provides for an advance payment to enable the
recipient to finance the performance of its obligations under the
contract (eg to purchase materials). The scenario in the Memorandum
contemplates that the same contract creates the right to income and the
obligation that has to be performed.

In applying the narrow meaning of “in terms of” to the current facts,
the SCA held that the Taxpayer does not receive income under the
Franchise Agreement. Instead, the Taxpayer earns income from contracts
with patrons. The Taxpayer’s income is derived from payments received
from patrons as a direct result of food sold to them.

The SCA rejected the Taxpayer’s argument that the Franchise Agreement
and the contract(s) with patrons were inextricably linked, and that
both contracts required the Taxpayer to service meals to its patrons to
earn income, out of which franchise fees were payable to the franchisor.
Its reason for rejecting the argument was that even though a contract
is useful or even necessary to enable a taxpayer to earn income, it does
not mean that its income is earned “in terms of” such contract. The
court also noted that in ITC 1667 (1999) 61 SATC 439 (C), a similar argument to the one made by the Taxpayer was rejected.

The SCA upheld the appeal with costs.

Comment

The practical importance of this judgment is that in order for a
taxpayer to claim the allowance in terms of s24C, it must ensure that it
earns income and incurs obligations under the same contract.

Therefore, where taxpayers anticipate a situation arising whereby
they will earn income under a contract prior to incurring obligations or
expenses, they must structure their affairs and agree with the
counterparty that the obligations must be incurred under the same
contract in terms of which income is earned. To ensure that they achieve
the desired outcome and can legitimately claim the s24C allowance,
taxpayers should always obtain proper legal advice before entering into
the transaction.