Income Tax Deductions v Value-Added Tax Deductions
11 December 2013
Posted by: Author: Robert Gad and Jadyne Devnarain
Author: Robert Gad and Jadyne Devnarain (ENS)
Broadly speaking, in their ordinary business operations, certain entities are entitled to claim certain deductions for income tax and value-added tax ("VAT”) purposes. In this article we discuss the tests used by South African courts and in practice, for income tax and VAT purposes, in order to determine whether a taxpayer will be entitled to such deductions. Consideration will be given specifically to the deduction of legal expenses incurred by a taxpayer in terms of section 11(c) of the Income Tax Act No. 58 of 1962 ("Income Tax Act”) and the deduction of input tax in respect thereof in terms of section 1 read with section 7 of the Value-Added Tax Act No. 89 of 1991 (the "VAT Act”).
An income tax perspective
Section 11(c) of the Income Tax Act provides, most relevantly, for a deduction from income of -
"any legal expenses … actually incurred by the taxpayer during the year of assessment in respect of any claim, dispute or action at law arising in the course of or by reason of the ordinary operations undertaken by him in the carrying on of his trade…” (Our underlining).
The phrase "arising in the course of or by reason of ordinary operations undertaken by him in the carrying on of his trade” has been considered by our courts and has been interpreted to mean that the deductibility of expenditure in terms of section 11(c) of the Income Tax Act does not depend on the purpose of the expenditure, but rather the causal connection of the relevant events with the taxpayer’s trade. Accordingly, it would be sufficient if the causal connection between the ordinary trading operations of the taxpayer and a claim, action or dispute is sufficiently close that it can be regarded as having arisen in the course of or by reason of the trading operations. For example, in the case of ITC 1710 (1999) 63 SATC 403, an employee of the taxpayer who was the owner of a farm producing grapes, had while working in the vineyards, negligently set a neighbour’s farm alight causing severe damage thereto. The High Court, in an action for damages brought against the taxpayer, had found that the employee in question had acted within the course and scope of his employment and the taxpayer was accordingly liable for the damages caused by the employee as a result of the fire. The taxpayer, in order to defend the legal action, had incurred legal costs and the issue to be decided by the court was whether such costs were deductible in terms of section 11(c) of the Income Tax Act. It was found that the costs in issue were connected by chance with work performed by the employee on the farm, as part of the taxpayer’s business and that there was a sufficient causal connection with the taxpayer’s farming operations. Accordingly, it was held that the legal costs incurred by the taxpayer were deductible in terms of section 11(c) of the Income Tax Act.
In light of the above, it appears that the test for determining whether expenditure will be deductible in terms of section 11(c) of the Income Tax Act would be to consider the causal connection with the taxpayer’s trade. The purpose for which the expenditure is incurred or the purpose of the events giving rise to the costs is not the deciding factor.
A VAT perspective
Section 7(1)(a) of the VAT Act provides, inter alia, that:
"there shall be levied and paid for the benefit of the National Revenue Fund a tax, to be known as value-added tax-
(a) on the supply by any vendor of goods or services supplied by him on or after the commencement date in the course or furtherance of any enterprise carried on by him…” (Our underlining).
Essentially a VAT vendor is entitled to an input tax deduction on the acquisition of goods or services exclusively for making taxable supplies in the course or furtherance of his enterprise. In order for a taxpayer to claim an input tax deduction in terms of section 1 of the VAT Act, the taxpayer must be a registered VAT vendor, be carrying on an enterprise and must have paid VAT on goods or services which the vendor acquired wholly for the purpose of consumption, use or supply in the course or furtherance of any enterprise carried on by him, as envisaged in section 7(1)(a) of the VAT Act.
In the fairly recent case of the Commissioner for the South African Revenue Service v De Beers Consolidated Mines Limited (2012) ZASCA 103, an aspect that the Supreme Court of Appeal ("SCA”) had to consider was whether the VAT charged to the vendor on fees for certain local advisory services qualified for deduction as input tax. De Beers Consolidated Mines Limited ("DBCM”) engaged the services of a range of South African advisors and service providers, including attorneys ("local suppliers”), to assist in finalizing a proposed transaction. DBCM treated the amounts expended to obtain such services as deductible input tax in its VAT returns. The Commissioner disallowed the input tax claim, against which DBCM lodged an objection. The objection was disallowed by the Commissioner and DBCM lodged an appeal to the Tax Court held in Cape Town which also found, inter alia, that the VAT paid by DBCM in respect of certain local services was not deductible as input tax. The test was whether the services acquired by DBCM were acquired for the purpose of consumption, use or supply of goods or services in the course or furtherance of the enterprise. The SCA had to, inter alia, clarify the meaning of and nature of the word "enterprise” since the purpose of acquiring the services and whether they were consumed or utilized in making taxable supplies could only be determined in relation to a particular enterprise. This involved a factual enquiry as to what constituted DBCM’s enterprise. The SCA, in adopting a restrictive approach, found that DBCM’s enterprise, for the purposes of the VAT Act, consisted of mining, marketing and selling diamonds. It was found that the services provided by such local suppliers were provided for multiple purposes, but ultimately not for the purpose of making taxable supplies by an enterprise which mines, markets and sells diamonds.
In light of the above, it would seem that there are two distinct tests, from an income tax and VAT point of view, in determining whether a taxpayer can claim a deduction. From an income tax perspective, the test is whether these is a causal connection between the relevant events (giving rise to legal expenditure) and the taxpayer’s trade whereas from a VAT point of view, the test is whether the expenditure incurred in procuring legal services were acquired for the purpose of consumption, use or supply of goods or services in the course or furtherance of the taxpayer’s enterprise. Another (perhaps over simplified way) summary of the position is that for income tax purposes, deductions in respect of overhead and general business expenditure not aimed directly at the taxpayer’s income earning activity will be allowed whilst for VAT purposes, our courts tend to require VAT expenditure to be incurred by the taxpayer, significantly more directly in connection with the earning of (vatable) income.
This article first appeared on ensafrica.com.