Miner or manufacturer? The plot thickens
10 October 2014
Posted by: Author: PwC South Africa
Author: PwC South Africa
A recent decision in the Johannesburg Tax Court (Case No 13410 – judgment delivered on 4 August 2014) has served to add to the confusion that surrounds the question of whether a person is carrying on mining activities or manufacturing activities.
In this matter, the taxpayer (a company) carried on mining operations on property which it did not own. It extracted mineral ore from the earth and transported this to its concentrator plant on the property. At the concentrator plant, the ore was smelted, which separated the mineral content from the rock, after which the minerals were recovered by means of a flotation process.
The contract for the sale of mineral concentrates provided that payment for concentrate delivered would only be determined some four months after delivery, due to various factors related to market prices and rates of exchange. The contract provided further that the moisture content of the concentrate should not exceed a specified level, and if it exceeded such level, the taxpayer would be liable for the costs of drying the concentrate.
In its returns of income for the 2007, 2008 and 2009 years of assessment, the taxpayer excluded the value of sales of product made in the last four months of the year of assessment from the current year’s income. In terms of section 24M of the Income Tax Act (the Act), where a person disposes of an asset during a year of assessment and the amount of the consideration cannot be fully quantified in that year of assessment, so much of the amount as cannot be quantified is deemed not to have accrued to that person in that year of assessment.
The taxpayer’s filing position in respect of its income was accepted by the South African Revenue Service (SARS). However, SARS disallowed a portion of the operating expenditure incurred by the taxpayer in the relevant year of assessment, in terms of section 23F(2) of the Act. This section provides that a deduction for expenditure incurred during a year of assessment in the acquisition of trading stock is to be disregarded to the extent that it exceeds the proceeds for the sale of such trading stock that has accrued to the taxpayer.
The taxpayer objected to the assessments disallowing the expenditure, and, its objection having been disallowed, appealed the matter to the Tax Court.
The taxpayer raised two principal arguments against the disallowance of expenditure. First, it argued that the mineral-bearing ore mined by it did not constitute trading stock. Second, it contended that there was no acquisition of the mineral-bearing ore. For these reasons, the provisions of section 23F(2) of the Act do not apply.
SARS, on the other hand, contended that the mineral-bearing ore was trading stock and that it had been acquired by the taxpayer. It argued that the purpose of section 23F(2) was to achieve a matching of taxable income and deduction, such that, where the accrual of income is deferred, the deduction of expenditure related to that deferred income should also be deferred and allowed as a deduction in the year in which the income accrues.
The judgment of Victor J is difficult to follow and to reconcile to other decided judgments. That said, the judgment seeks to deal with the two principal issues.
The trading stock argument
The taxpayer’s argument was based on the fact that section 15A of the Act was not in force in the relevant years of assessment. This section provides that mineral-bearing ore constitutes trading stock. It therefore argued that the mineral-bearing ore was not trading stock. Further, it was argued, the ore was not acquired for purposes of manufacture, sale or exchange, and, as such, did not fall within the scope of the definition of ‘trading stock’ in the Act. The concentrate was trading stock, and therefore the costs of acquisition of the trading stock must be limited to the costs attendant upon acquiring the concentrate from the ore.
This elegant argument severed the continuum of the mining activity into two separate processes, namely the mining of the ore and the extraction of the concentrate. By dividing the process into discrete elements, the impression is created that no trading stock arises in the first element, because what is severed from the earth is not yet trading stock, and only the second element gives rise to trading stock. Victor J appears to have accepted this argument.
That Victor J was persuaded by this argument is not altogether surprising, given that there are judgments of the Supreme Court of Appeal which have seriously blurred the law in relation to trading stock, in particular insofar as the distinction (if any) between mining and manufacturing is concerned. Victor J concluded that the ore could not be trading stock by reason that it was not stockpiled at any time, relying on the decision in CIR v Foskor Ltd 72 SATC 174 (SCA), whichheld that mineral ore stockpiles were trading stock which must be taken into account for purposes of section 22 of the Act, as authority for this conclusion. Further, she found that the decision in Richards BayIron and Titanium (Pty) Ltd & Another v CIR 1996 (1) SA 311(A) dealt with mineral stockpiles in the context of manufacturing rather than mining.
These two decisions in the Supreme Court of Appeal have been severely criticised for ignoring the difference between mining and manufacturing, and it is unfortunate that our courts of lesser jurisdiction are compelled to apply and reconcile the decisions.
Victor J concluded that only the concentrate met the requirements for the application of section 23F(2) of the Act, because it was trading stock, whereas the mineral-bearing ore was not trading stock.
This line of reasoning, it is submitted, is questionable. A mining operation is undertaken to win a mineral from the soil or a constituent thereof. The mineral that is finally available for sale is the only item of trading stock that is acquired and disposed of. The process by which it is acquired is a continuum that commences when the ore is severed from the earth and ends when the mineral is recovered in saleable form. All costs attendant upon winning the ore and extracting the mineral are arguably costs in respect of the acquisition of the trading stock. To simply ignore part of the continuous process by an artificial division into separate stages leads to a conclusion that is questionable.
The acquisition argument
Victor J was urged by the taxpayer to find that the taxpayer had actually acquired the minerals at the point that the mineral-bearing ore was severed from the earth. All other costs incurred in respect of the various mining processes leading to recovery of the concentrate in saleable form, it was urged, were incurred after the acquisition, and therefore did not fall within the scope of section 23F(2) of the Act. This argument was rejected.
However, Victor J took the view that, since the mineral-bearing ore was not trading stock, the costs attendant on its acquisition fell outside the scope of section 23F(2). She was therefore concerned only with the expenditure incurred in respect of the acquisition of the concentrate. In this regard she ruled further that any costs incurred in reducing the moisture content to meet the requirements for sale were incurred after the acquisition of the concentrate and were not incurred in respect of the acquisition of the concentrate.
There is apparent conflict in the reasoning behind the decision, in the sense that it was stated at paragraph :
In my view there are similarities between the Foskor and Appellant’s case. Some form of transforming low value raw materials occurred, resulting in high value finished goods. The only difference is that the Appellant was involved in the entire process, from mining, to manufacturing and trading. The purpose of the taxpayer in both cases is similar, and hence their treatment should actually be the same as the raw material was acquired. The difference will be in the taxation formula applied in manufacturing versus mining. (Emphasis added)
However, the final statement of the decision at paragraph  reads:
This begs the question: If the Court has stated that the Appellant was involved in the entire process, from mining to manufacturing to trading, how could the Court later conclude that the second phase was not a manufacturing process?
The second phase process of producing concentrate remains a mining process and not a manufacturing process. Accordingly the taxation formula to be applied to the second phase shall be that of mining.
The quantum issue
The judgment dealt also with the amount that was required to be disregarded. In this respect, there is also evidence of a lack of clarity.
Section 23F(2) of the Act states:
Where a taxpayer has during any year of assessment disposed of any trading stock in the ordinary course of his or her trade for any consideration the full amount of which will not accrue to him or her during that year of assessment and any expenditure incurred in respect of the acquisition of that trading stock was allowed as a deduction under the provisions of section 11(a) during that year or any previous year of assessment, any amount which would otherwise be deducted must, to the extent that it exceeds any amount received or accrued from the disposal of that trading stock be disregarded during that year of assessment.
The elements are:
- Trading stock must have been disposed of and the income not yet accrued; and
- Expenditure must have been incurred in respect of the acquisition of that trading stock, which is deductible in terms of section 11(a) of the Act.
If these elements are present, the amounts incurred in respect of the expenditure incurred under section 11(a) which would have been deductible but for the application of section 23F(2) shall be disregarded. This, it is submitted, is the interpretation to be applied to the word ‘otherwise’ in this context.
The judgment deals with arguments advanced but does not appear to conclude on the proper application of section 23F(2) of the Act.
On a proper interpretation, it is submitted, the costs incurred in the acquisition of the trading stock need to be identified by reference to the manner in which a deduction is claimed in respect of such costs. To the extent that the costs rank for deduction in terms of section 11(a) of the Act (whether in the current or a prior year of assessment), they should be taken into account for purposes of section 23F(2) of the Act. However, any amounts allowed as a deduction that fall outside the provisions of section 11(a) (e.g. mining capital expenditure and prospecting expenditure) cannot be disregarded.
This argument appears not to have been advanced or considered in the course of the judgment (we stress, however, that we do not have access to the case record and make this supposition on the basis that it was not addressed expressly in the judgment). However, it points to the exclusion of infrastructural overheads, such as depreciation, that may have been absorbed as part of the cost of trading stock.
One is left with the inescapable impression that this matter will proceed on appeal to the Supreme Court of Appeal. The amount of tax involved is significant, and the principles deserve clarification.
In the event that the matter does proceed on appeal it is to be hoped that the Supreme Court of Appeal will examine its earlier decisions on trading stock in the context of the mining industry critically. It is imperative that we understand what is mining and what is manufacturing, as the formula applicable to the taxation of each of these activities is different.
In addition, a clear explanation of the application of section 23F(2) of the Act would be most welcome.
This article first appeared on pwc.co.za.