Future expenditure on contracts – the basics
25 April 2013
Posted by: Author: Doria Cucciolillo
Source: Doria Cucciolillo
When a taxpayer is contractually liable to perform certain duties, it may happen that he or she receives an advance payment that relates to such work. This payment will be subject to normal income tax on the earlier of receipt or accrual. Normally the advance payment (or a part thereof) will be used to finance future expenditure that needs to be incurred in order to fulfill the contractual liabilities. This expenditure can only qualify for a deduction during the year of assessment in which it is actually incurred. Therefore, the receipt of an advanced payment may result into inconsistencies since the income subject to tax is not matched with deductible expenditure. In other words, the tax implications arising from this contract may give rise to a vast increase in taxable income in one year, while deductible expenditure may significantly reduce taxable income during future years of assessment.
A situation like the above may also impose cash flow problems for the taxpayer involved. Fortunately, section 24C was introduced in an attempt to allocate the income tax liabilities (that arise from these transactions) in a more consistent manner. In essence, this section provides temporary tax relief in the instance where a person receives an advanced payment in terms of a contract, provided that such payment will be used to finance future expenditure.
It is evident from the last mentioned requirement that section 24C can only apply if the advanced payment will be used to finance future expenditure. The concept "future expenditure” refers to expenses (from the wording of the Act it is clear that losses will not qualify) that will be incurred after the end of the year of assessment during which the advanced payment was received or had accrued to the taxpayer. Furthermore these expenses must be eligible for an income tax deduction when it is incurred or it must relate to the acquisition of an asset that will qualify for an allowance in terms of the Act. There must be a high degree of certainty that these expenses will be necessary and unavoidable when contractual obligations are carried out.
It is important to ensure that the Commissioner is satisfied that the amount will indeed represent future expenditure, before it is included in the calculation of the section 24C-allowance.
The implications of section 24C
If a taxpayer’s taxable income includes an advance payment (arising from a contract), an allowance will be granted if all the necessary requirements of section 24C are satisfied. The purpose of this allowance is to provide temporary, instead of additional, tax relief. Although it will reduce taxable income in one year, it must be reversed in the following year of assessment. In the long run, the net effect of this allowance will be nil and the normal tax liability arising from this contract will not be reduced, but rather postponed.
The process can be explained as follows: When an advance payment is included in taxable income, an allowance is used to reduce taxable income to the extent that this advance payment will be used to finance future expenses. In the following year of assessment, this allowance must be added back. The allowance may not exceed the amount that is received or accrues to the taxpayer during the year of assessment as a result of the contract. In this instance it is important to remember that any reversal of a previous year’s allowance is deemed to be income that accrued to the taxpayer in the current year. The allowance is also applied during each year of assessment in which income is received or accrues from this contract until it reaches the amount of zero.
The calculation of the allowance is as follows: First it must be determined to what extend the total expenses of this contract relates to the total contract price. This ratio is multiplied by the total advance payments that was received by or had accrued to the taxpayer up and until the end of the year of assessment. This will indicate to what extend the advanced payments will be used to finance future expenditure. All expenses that were actually incurred during the current or previous year of assessment must be deducted from this calculation. Since these amounts have already qualified for a deduction in terms of section 11(a), it must be excluded from the allowance to avoid a situation where a taxpayer’s taxable income is reduced twice with the same amount during a single year of assessment. Taking into account the purpose of this allowance, it makes sense that expenses that were actually incurred may not form part of this allowance since the taxpayer was already granted with relief for these expenses through a tax deduction.
When a capital asset is acquired, the section 24C-allowance will simply equal the future costs that will be incurred to acquire such asset. This allowance will be limited to the payment received in advance. In this instance, there is no need to apply the above mentioned formula if the future cost of the asset will be fully covered by the payment received in advance.
Section 24C is especially beneficial for taxpayers in the construction industry (although its use is not restricted to this sector). Building contractors, for example, normally requires the payment of a deposit before the work commence since the materials needed to complete this work is quite expensive. If the receipt of such payment is accompanied by enormous tax liabilities, it will have a significant impact on the taxpayer’s cash flow and its ability to finalise the contractual obligations. This clearly stresses the importance of section 24C and the necessity of the temporary relief provided by this section.
List of References
South African Revenue Service (SARS). Draft interpretation note: Allowance for future expenditure on contracts.
Stiglingh M, Koekemoer A, van Schalkwyk L, Wilcocks JS & de Swardt RD. 2012. SILKE: South African Income Tax 2013. Durban: LexisNexis Butterworths – (Page 194).