The deductibility of a taxpayer’s losses incurred as a result of an ‘inherent risk’ of his trade
03 November 2015
Posted by: Author: PwC South Africa
Author: PwC South Africa
Where an accident or other mishap results in a taxpayer’s incurring an involuntary loss, a question can arise as to whether that loss is deductible for income tax purposes in terms of the general deduction formula laid down in section 11(a) of the Income Tax Act 58 of 1962 as having been incurred in the production of income.
In Port Elizabeth Electric Tramway Co v CIR 1936 CPD 241,Watermeyer J expressed the underlying principle by saying that –
‘all expenses attached to the performance of a business operation bona fide performed for the purpose of earning income are deductible whether such expenses are necessary for its performance or attached to it by chance or are bona fide incurred for the more efficient performance of such operation provided they are so closely connected with it that they may be regarded as part of the cost of performing it.’ (Emphasis added.)
Particular risks are inherent in certain trades
In Joffe & Co v CIR 1946 AD 157, the taxpayer company carried on business as engineers in reinforced concrete. A concrete structure erected by the company collapsed and killed a workman employed by the building contractor. In an action brought by the deceased’s dependants, the court held that the taxpayer company had been negligent in its construction of the collapsed structure and it was ordered to pay damages and costs. The taxpayer sought to deduct these damages and costs for income tax purposes.
In holding that the taxpayer’s damages were not deductible, Watermeyer J said that –
‘There is nothing . . . to suggest that such negligence, and the consequent liability which negligence entailed, were necessary concomitants of the trading operations of a reinforced concrete engineer . . . ’ (Emphasis added.)
This dictum seems to be the origin of the principle that, where the taxpayer incurs a liability for damages, those damages are tax-deductible only if that risk was inherent in the taxpayer’s trade.
Thus, in COT v Rendle 1965 (1) SA 59 (SRAD), 26 SATC 326, the Appellate Division of the High Court of Rhodesia held that the deductibility of fortuitous expenditure depends on whether the chance or risk of its being incurred is sufficiently closely connected with the taxpayer’s business operations, and that the taxpayer must show that the risk of the mishap which gives rise to the expenditure was inseparable from or a necessary incident of the carrying on of the particular business.
It is, however, no easy matter to determine what risks are inherent in particular trades.
Is theft or misappropriation an inherent risk of trading?
In Lockie Bros Ltd v CIR 1922 TPD 42, 32 SATC 150 at 151 it was held, in essence, that theft by subordinate employees of the firm was an inherent risk of the business but theft by the managing director was not.
Perhaps morals have declined, or perhaps the freer flow of information in the modern era has resulted in revelations of dishonesty in high circles that would previously have been kept under wraps.
In any event, the recent decision of the High Court of Zimbabwe in Z Co (Pvt) Ltd v Zimbabwe Revenue Authority (2015) 77 SATC 83 signals a sobering judicial acknowledgement of the new morality or lack of morality in state institutions.
In this case, it was held, on the basis of the principles laid down in Rendle, that where the taxpayer, a registered tobacco merchant, had deposited funds with the Reserve Bank of Zimbabwe to be used by the taxpayer for the purchase of tobacco in terms of exchange control regulations, and where some US$2.2 million of those funds had gone missing, having been ‘lost’ while in the hands of the Reserve Bank, such a loss was a risk inherent in the taxpayer’s business.
In other words, the risk of the misappropriation of a taxpayer’s funds held by a state agency is an inherent risk of the taxpayer’s trade.
Or, to put it in the more cautious language of the judgment, that loss was ‘fortuitous expenditure and not an outlay of a capital nature, incurred in the ordinary course of the business operations of [the taxpayer]’ and was therefore deductible in terms of the Zimbabwean Income Tax Act.
This article first appeared on pwc.co.za.