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Deductibility Of Pre-Production Interest

Friday, 28 June 2013   (0 Comments)
Posted by: Author: Doria Cucciolillo
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Author: Doria Cucciolillo (The SAIT)


At present uncertainty exists regarding the deductibility of finance charges (for Income Tax purposes) if it relates to the acquisition of an asset that was brought into use in an existing trade of the taxpayer after the interest expenses were incurred. 

It is evident that no deduction will be granted in terms of section 24J(2) for the pre-production portion of the interest expense. Since the asset was not used in the taxpayer’s trade during a certain part of the assessment period, the related expenses were not incurred in the production of income during that time. 

Omission of section 11(bA)

Prior to the deletion of section 11(bA) interest and related finance charges that were incurred before the asset has been brought into use qualified for a deduction in the year of assessment in which the taxpayer started to use the asset in its trade. The legislature considered this section to be redundant and suggested its removal seeing as these expenses already qualify for a deduction in terms of section 11A. 

However, an analysis of the provisions of section 11A (which grants a deduction for pre-trade expenses) seems to contradict the legislature’s theory in this particular instance. It suggests that deduction of pre-production expenses under section 11A is not inevitable, especially not when the taxpayer already carries on a trade. 

Background on section 11A

In order to claim expenses as deductions for Income Tax purposes, it is required that the taxpayer carries on a trade as defined in section 1 of the Income Tax Act. In order to provide a deduction for expenses incurred before the commencement of a trade, section 11A was introduced. Under this section, a taxpayer becomes entitled to a deduction for expenses incurred prior to the commencement of a trade provided that it was incurred in preparation for carrying on that trade. Furthermore, it is required that the pre-trade expense must be mentioned in sections 11(a) to (w), 11B, 11D or 24J in order to qualify for this deduction. Finance charges may therefore fall within the ambit of section 11A since the deduction thereof is regulated by section 24J.  

A deduction is granted for all pre-trade expenses (that complies with the requirements of section 11A) in the year of assessment in which the taxpayer’s trade commence. It is therefore not required to be actually incurred during the year of assessment in which trade commenced and may be carried forward from a former assessment period. It is important to note that the deduction may not result into an assessed loss and may only be set-off against income derived from the specific trade to which it relates. If the pre-trade expenses exceed the income from such a trade, it may be carried forward to a subsequent year of assessment that has sufficient income to utilise the section 11A-deduction.  

Applicability of section 11A to pre-production interest

From the wording of section 11A it appears that this section can only apply to expenses that were incurred before a trade commenced. 

Judgment in the ITC 777-case provided a measure to test whether, or not, a trade has already commenced. It was determined that a trade can only commence if it involves an "active step” that the mere intention to derive income is not sufficient. Therefore, only expenses incurred before the active step takes place, can qualify for a deduction in terms of section 11A. In other words an expense must be incurred in preparation of the commencement of a new or additional trade in order to qualify for a deduction in terms of section 11A. 

The above-mentioned principle can be confirmed through reference to the following court cases: 

In ITC 984 the taxpayer, who was involved in the letting of property, incurred estate agent’s commission in order to secure a tenant for a building it intended to erect. The court regarded this expense to be of a non-capital nature (and therefore deductible for Income Tax purposes) on the grounds that it relates to the derivation of future rental income and not to create an income-producing asset. It is interesting to note that the court did not consider whether, or not, this expense may be regarded as a pre-trade expense since it is obvious that the taxpayer only intended to expand its current letting activities through the erection of a new building which is not regarded as a separate trade. 

In the Reef Estates Ltd v CIR-case the taxpayer, who was also involved in the letting of property, held various properties to be used for purposes of its trade. No income was derived from one of these properties since it was brought into use in a subsequent year of assessment. Before it was brought into use, the taxpayer incurred an expense of £366 in property rates which was disallowed as a deduction for Income Tax purposes. The court ruled in favour of the Commissioner and regarded the expense to be of a capital nature (and therefore not deductible). It stated that the expense was not incurred with the purpose to earn rental income but to hold the property as an asset that will be used to generate income in the future. Furthermore, the court determined that the expense could not be regarded to be incurred in carrying on the existing trade (letting activities of the taxpayer) since the asset was not brought into use in the existing trade during that time.


It is not clear whether or not the intent of the legislature with the deletion of section 11(bA), was to prevent the deduction of pre-production interest where a trade already commenced. Interpretation of current legislation suggests that the latter may be true since no provision is made for the deduction of expenses (for example wear-and-tear, insurance, rates on fixed property and interest) incurred during a period that precedes the date on which an asset is brought into use in an existing trade. Before the deletion of section 11(bA) there was no specific provision under which pre-production costs (excluding interest) qualified for a deduction, except situations where section 11A applied.   

When the provisions of current Income Tax legislation are considered, together with the judgments made in the above-mentioned court cases, it appears that pre-production expenses (incurred before the asset was brought into use) is regarded to be capital in nature if the taxpayer already carries on a trade. It is therefore important to distinguish between assets acquired with the purpose to expand an existing business (costs will be capitalised against the base cost of the asset) and expenses incurred in preparation of carrying on a new or additional trade (where the deduction will be deferred in terms of section 11A until the date that the trade commence).  

Source: South African Revenue Service (SARS). 2009. Interpretation note no 51. Pre-trade expenditure and losses. 



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