By Doria Cucciolillo, Senior Consultant and Associate Professor David Warneke, Tax Partner
In the process of carrying on a business and creating value, taxpayers incur a variety of expenditure and inadvertently often incur losses. From an income tax perspective, careful consideration must be given to the nature of such amounts and the purpose for which they have been incurred, to determine whether a deduction is claimable in the determination of taxable income. Complexities often arise in practice as amounts that qualify for recognition as an expense in terms of the financial reporting framework applied in calculating the profit or loss from an accounting perspective do not necessarily qualify for an income tax deduction in terms of the Income Tax Act 58 of 1962 (‘the Act’). The opposite situation is often also true in that an amount may qualify for an income tax deduction, whereas it is capitalised for accounting purposes.
The deductibility of expenditure and losses is primarily governed by the “general deduction formula”, which consists of section 11(a) read with section 23(g) of the Act. Section 11(a) represents the so-called “positive test” which sets out the requirements for an amount to qualify for an income tax deduction. In terms of section 11(a), a person must, in determining the taxable income derived during the year of assessment from carrying on a trade, deduct expenditure and losses actually incurred in the production of income, provided that such expenditure and losses are not of a capital nature. An amount that qualifies for a deduction under section 11(a) must, however, also pass the “negative test” contained in section 23(g), which prohibits a deduction for amounts to the extent that such amounts were not laid out for purposes of trade. An amount that does not qualify for a deduction in terms of the general deduction formula, for example due to the amount being capital in nature, may still qualify for a special deduction or allowance in terms of other provisions of the Act.
The Act does not enumerate the types of expenditure that are of a capital nature, nor does it contain any definition of the term “capital nature”. There is also no all-encompassing test that applies in distinguishing between expenditure of a capital nature and expenditure of a non-capital (i.e. revenue) nature. The enquiry is often challenging and depends on the specific facts and circumstances surrounding the incurral of the expenditure and consideration of the relevant principles established by case law. The focus of this article is to highlight certain types of expenditure which sometimes cause confusion in practice.
A common example of expenditure of a capital nature is the cost of acquiring plant and machinery that forms part of the capital structure of a business. It is important to bear in mind that all expenditure relating to the acquisition of such an asset, such as the cost of delivery and direct installation costs, would normally be capital in nature and form part of the cost of such an asset on which a capital allowance may be claimable. Expenditure incurred in moving business assets to a new premises and in altering the new business premises is also considered to be capital in nature and not deductible under the general deduction formula, unless it relates to the cost of moving the taxpayer’s trading stock. A specific capital allowance in terms of section 11(e) or 12C may, however, be available in respect of moving costs. The relocation of a business premises may also result in expenditure incurred in the transfer of a business licence, which would also be considered capital in nature. For example, a liquor trader may incur fees to transfer its liquor licence from one premises to another. Such fees would not be deductible.
In the context of capital assets, it is also important to distinguish between expenditure incurred in respect of the repair of an asset, which may qualify for a specific deduction under section 11(d) of the Act and expenditure incurred in respect of the renewal or improvement of an asset, which is generally not deductible. Section 11(d) permits a deduction for expenditure actually incurred in respect of the repair of immovable property occupied for purposes of trade or any machinery, implements, utensils, and other articles used by the taxpayer for purposes of trade. To qualify as a repair, there must be damage or deterioration of a subsidiary part of the original asset and the repair should merely restore the asset to its original condition, with the use of different materials being permitted. If the whole or substantially the whole of the asset is reconstructed, it would constitute a “renewal” of an asset and the expenditure would not be deductible. Similarly, the creation of a new or enhanced asset with an improved income-earning capacity would constitute an improvement for which the expenditure is not deductible.
Where there is an alienation, loss or destruction of a fixed asset, it would result in a capital loss and no deduction is claimable unless it involves a qualifying tax-depreciable asset and all the requirements to claim a scrapping allowance under section 11(o) of the Act are met. In this context, events that may result in a capital loss include the alienation of an asset through the transfer of ownership thereof, the loss of an asset due to theft and the destruction of an asset resulting in the item being extinguished or damaged beyond repair. The provisions of section 11(o) should be considered in these circumstances to determine if a deduction is claimable.
If a taxpayer incurs expenditure for travel, whether in South Africa or abroad, such expenditure is considered of a capital nature if the purpose of the underlying travel is to create or improve an income-producing asset of the taxpayer or to acquire a capital asset. This would, for example, be the case when travel is undertaken to acquire a fixed asset to be used by the taxpayer in its business, to acquire a new agency that constitutes a capital asset for such a business or to establish a new branch or business in another location. The cost of travel undertaken to protect the capital assets or income-earning capacity of a business, would also be disallowed as it is capital in nature.
Taxpayers often enter into agreements to acquire shares in a company that are held as a long-term investment to generate returns, form joint ventures with other persons or take part in corporate reorganisation or restructuring transactions. Expenditure incurred by a taxpayer in respect of these type of transactions, such as professional and legal fees, is considered capital in nature as it is incurred to establish, improve or add to the income-earning structure of the business. From the perspective of a company issuing shares, no deduction is claimable in respect of the costs incurred in raising share capital on the basis that such expenditure is closely related to the company’s capital structure and it is therefore capital in nature. Examples of such costs include underwriting commissions, legal fees and other professional fees. Expenditure related to the incorporation of a company and expenditure incurred to alter the memorandum of incorporation of a company are also closely related to the capital structure of the company and are not deductible. Where a taxpayer incurs a loss on the disposal of a business or shares, such a loss would be capital in nature unless the taxpayer is a trader or dealer in shares or business ventures.
Even if an amount qualifies as a deduction in terms of the provisions of section 11(a), among others, the taxpayer may be required to spread the deduction in terms of section 23H. Subject to certain exceptions, this would be required in respect of goods or services, all of which will not be supplied or rendered during the year of assessment in which the expenditure is incurred and, in respect of any other benefit, where the period to which the expenditure relates extends beyond the year of assessment in which the expenditure is incurred.
Inappropriately claiming a deduction for expenditure that is of a capital nature may lead to the imposition of severe understatement and underestimation penalties. The taxpayer may also be exposed to interest on the late payment of normal tax resulting from the understatement. Taxpayers should therefore contact a tax advisor for assistance with any uncertainties.