Making Commercial Sense of Section 24C
29 May 2013
Posted by: Author: Bernard du Plessis and Ansu Kretzmann
Source: Bernard du Plessis and Ansu Kretzmann
The Commissioner for the South African Revenue Service ("the Commissioner”) recently published a Draft Interpretation Note on the allowance of future expenditure on contracts in terms of section 24C of the Income Tax Act 58 of 1962 ("the Act”). Section 24C provides an allowance for expenditure that will be incurred in a future year of assessment under a contract, when income under that contract is received or accrued in advance. The provision is aimed at providing tax relief to ensure that amounts received in advance, and that will be required to fund future expenditure on the same contract, will not be eroded by tax becoming payable on the prepaid income.
Although originally intended for the construction industry, section 24C is now widely applied to prepayments received on contracts in various contexts. One such application is in product warranties, for example motor vehicle warranties. Whereas a warranty provides consumers with "cover” against defective workmanship or material, a maintenance contract is designed to maintain or repair components (including lubricants) which are necessitated due to wear and tear. As regards the warranty, product manufacturers would, normally predict future expenditure based on highly accurate, actuarial calculations of expenditure future expenditure that is likely to be incurred in respect of a range of products sold.
To date SARS has applied a ruling practice (which was in accordance with some case law) that allowed a deduction for expenditure that had a high degree of probability and inevitability, as deductions that will be incurred. In the Draft Interpretation Note, however, the Commissioner has now taken a completely opposite and narrow interpretation of what he regards as "a high degree of probability and inevitability”.
The Draft Interpretation Note provides that the words "will be incurred” indicate that the Commissioner must be satisfied that there is a high degree of probability and inevitability that the expenditure will be incurred. A taxpayer must therefore be able to demonstrate that, although the expenditure is contingent at the end of the year of assessment, there is a high degree of certaintythat the expense will in fact be incurred in a future year. This interpretation is based on the views expressed by the Tax Court in ITC 1601 (1995) 58 SATC 172 that: "Counsel for the Commissioner, in my view, correctly contended that the Commissioner will not be satisfied that future expenditure will be incurred where there is only a contingent liability. There must be a clear measure of certainty as to whether the expenditure in contention is quantified or quantifiable.”
The Draft Interpretation Note expressly states that in circumstances where the performance is not contractually obligatory, but onlypotentially contractually obligatory due to an act other than just the taxpayer’s customer taking action, the degree of certainty required is "unlikely to be met”.
This narrow interpretation of the application of section 24C is set to have adverse implications on the pricing for all product warranties, as the amounts received in respect of the warranty (normally upfront as part of the purchase consideration of the product) will in future be fully taxed, potentially leaving the grantor of the warranty under funded for its expected future expenditure in fulfilling the warranty. Although there are different ways in which to mitigate the commercial impact of this interpretation, it may result in an adverse impact on the price of the products under warranty.
What is encouraging though is that SARS seems to understand the impact that such a dramatic shift in interpretation could have on the market. For example, not all manufacturers would have understood the impact of the draft interpretation note, or alternatively as the interpretation note is still only in draft, may choose to proceed as they have in the past. This could lead to a substantial disadvantage for industry players choosing to apply the new interpretation of policy, resulting in reduced ability to retain or attack market share in highly competitive commercial environments. In order to potentially assist, SARS did indicate that they may be amenable to consider, based on a UK principle, to phase in the revised interpretation in order to level the playing fields for all affected.