Tax Treatment of Non-Trade Expenses and Forfeiture of Assessed Losses
Tax Treatment of Non-Trade Expenses and Forfeiture of Assessed Losses
By Johann Benade, Associate Director and James Language, Senior Consultant
Richard Nixon, the 37th President of the United States, once said: ‘Make sure you pay your taxes- otherwise, you can get into a lot of trouble.’
The claiming of expenses and the carry forward of assessed losses by companies that are not carrying on a trade, remain areas of high risk and contain many pitfalls for the unwary.
The term "trade" is broadly defined in the Income Tax Act to include, among other things, any profession, business, trade or occupation. However, whether a company is considered to be carrying on a trade is often a contentious issue.
Companies may inadvertently fall outside this definition due to inactivity or reduced business operations, leading to the disqualification of expense claims and assessed losses.
Companies must ensure that expenses claimed in terms of section 11(a) read with section 23(g) of the Income Tax Act are incurred in the production of income, are laid out for purposes of trade and are not capital in nature. If a company is not actively trading, expenses might not meet the criterion of being laid out for purposes of trade or may not be in the production of any income, leading to disallowance by SARS.
Over the years this issue has led to numerous disputes between taxpayers and SARS and on occasion has ended up in the courts, for example in the recent case of Unitrans Holdings Ltd v CSARS, A3094/2022 [2023] ZAGPJHC. In this case, Unitrans declared in its 2011 tax return that it had earned R34 million in interest income from its subsidiaries. It further claimed an amount of R68 million in interest paid by it to its shareholder.
SARS disallowed the interest claimed in terms of section 24J(2) of the Income Tax Act because, in its view, the expenditure incurred was not in the conduct of any trade, nor was it incurred in the production of income. Section 24J(2) has similarly worded ‘production of income’ and ‘trade’ requirements as section 11(a). On the facts, the taxpayer lost in the Tax Court and its appeal to the Johannesburg High Court also failed.
Companies with seasonal or irregular business activities may struggle to demonstrate continuous trade. SARS may disallow expense claims and the set-off of assessed losses carried forward from previous years of assessment if it deems that the company was not trading during certain periods.
Proper documentation and evidence of business activities are crucial. Companies failing to maintain comprehensive records may find it difficult to substantiate their trading status and related expense claims.
The complexity of tax laws and regulations, and the frequent amendment thereof, mean that companies without sufficient tax expertise may make errors in their filings. This can lead to disputes with SARS and potential penalties.
SARS Practice Note 31 states that although a person other than a money-lender who earns interest on capital or surplus funds invested does not carry on a trade and that any expenditure incurred in the production of such interest should not be allowed as a deduction, it is nevertheless SARS’s practice to allow expenditure incurred in the production of the interest to the extent that it does not exceed such interest income.
Section 20(1) of the Act requires a company to carry on a trade during the current year of assessment in order to be able to set off a balance of assessed loss carried forward from the previous year of assessment against the company’s income in the current year.
An assessed loss is a tax loss that occurs when a company's allowable deductions exceed its income. This loss can generally be carried forward to future tax years to offset future taxable income, thereby reducing future tax liabilities.
The ability to carry forward assessed losses is important for companies, especially in volatile or cyclical industries, as it provides a cushion against future taxable profits.
If a company has earned no income from carrying on a trade in the current year of assessment, SARS’s interpretation is that it must be clear that a trade has been carried on in the current year of assessment for the set-off of the assessed loss brought forward to be permitted.
Another consideration to note is that in terms of an amendment to section 20(1)(a) of the Act, which applies to all companies with financial year-ends ending on or after 31 March 2023, the set-off of the balance of assessed losses carried forward is restricted to the higher of R 1 million or 80% of the company’s taxable income arising in the current year. This amendment severely affects many companies with accumulated assessed losses and creates yet another tax risk area for such companies.
In another recent case, which is unlikely to be contested in the courts, a company accumulated significant losses and eventually stopped trading during the 2019 year of assessment. However, it continued to incur winding-up administrative expenses during the 2020 and 2021 years of assessment. These expenses were claimed in the relevant returns and were initially allowed as deductions, thereby increasing the assessed loss by the amounts claimed.
Having performed an audit of the company, SARS stated that in its view, the company had stopped trading in the 2019 year of assessment and that it should not have claimed any deductions in respect of the administrative expenses incurred during the 2020 and 2021 years of assessment. SARS also stated that since the company had stopped trading, the accumulated assessed loss as at the end of the 2019 year of assessment would be forfeited.
In this case, the company accepted SARS’ findings and agreed to additional assessments being issued to it in respect of the 2020 and 2021 years of assessment, disallowing the expenses claimed.
SARS also imposed a 25% understatement penalty in respect of the expenses erroneously claimed. In view of the relatively insignificant amounts involved, the company did not object to the penalties imposed.
When the additional assessments were received, it was noted that the disputed expenses were correctly disallowed for the 2020 and 2021 years of assessment but that the assessed loss from the 2019 year of assessment still reflected on both the additional assessments for the 2020 and 2021 years of assessment. This is regarded as unintentional as SARS had clearly stated in its letter of findings that the 2019 assessed loss would be forfeited.
It is suggested that the SARS system of carrying forward assessed losses in situations where a company has stopped trading should be revisited, as the current systems appears to be unable to deal with the forfeiture of an assessed loss, either at the request of the taxpayer or by way of decision made by SARS following an audit of the taxpayer’s affairs.
There are instances where taxpayers may prefer to forfeit their assessed losses, perhaps for strategic reasons or to simplify their tax affairs. However, the current system does not provide a clear mechanism for this. Taxpayers may face prolonged uncertainty if SARS does not have a streamlined process to handle such requests efficiently.
SARS should introduce clear procedures and guidelines for companies wishing to voluntarily forfeit their assessed losses. This should include a straightforward application process and criteria for approval.
SARS should also develop more transparent audit protocols that clearly define the conditions under which SARS may disallow the carry-forward of assessed losses. This could include detailed criteria and examples to ensure fairness and consistency.
SARS should improve the communication process between itself and taxpayers regarding the status of assessed losses, particularly following an audit. SARS should ensure that taxpayers are informed in a timely manner and have access to a fair and efficient appeals process.
SARS should preferably update the Tax Administration Act to reflect these changes, ensuring that both SARS officials and taxpayers are aware of their rights and responsibilities regarding assessed losses. It should engage with stakeholders, including tax professionals, business associations and legal experts to gather input on the proposed changes and ensure that they address the practical challenges faced by companies.
If a change in the applicable legislation is not considered necessary, SARS should at least amend its E-filing system to allow for a company to indicate that it has stopped carrying on a trade and that it confirms that any assessed loss as at the end of the previous year is forfeited.
By revisiting the policy and implementing these revisions, SARS can create a more efficient and fair system for handling assessed losses, particularly in cases where companies have ceased trading. This would not only benefit taxpayers by providing greater clarity and predictability but also enhance SARS’s ability to enforce tax laws effectively.
Regular consultation with tax advisors can help companies navigate the complexities of tax laws. They can provide guidance on the company’s trading status and ensure expenses are claimed only in appropriate circumstances.
Companies should periodically review their tax positions, especially if there are changes in business activities. This proactive approach can help identify and address potential issues before they escalate.
In conclusion, the complexities involved in claiming expenses and carrying forward assessed losses when a company is not actively trading pose significant risks. By understanding the challenges, maintaining thorough documentation, seeking professional advice and ensuring continuous business activity, companies can mitigate these risks and navigate the tax landscape more effectively. Revisiting and possibly revising the current regulations to provide clearer guidelines and more flexibility could also help reduce these risks and provide a fairer system for businesses.
The sage advice of Richard Nixon remains valid!
Richard Nixon, the 37th President of the United States, once said: ‘Make sure you pay your taxes- otherwise, you can get into a lot of trouble.’
The claiming of expenses and the carry forward of assessed losses by companies that are not carrying on a trade, remain areas of high risk and contain many pitfalls for the unwary.
The term "trade" is broadly defined in the Income Tax Act to include, among other things, any profession, business, trade or occupation. However, whether a company is considered to be carrying on a trade is often a contentious issue.
Companies may inadvertently fall outside this definition due to inactivity or reduced business operations, leading to the disqualification of expense claims and assessed losses.
Companies must ensure that expenses claimed in terms of section 11(a) read with section 23(g) of the Income Tax Act are incurred in the production of income, are laid out for purposes of trade and are not capital in nature. If a company is not actively trading, expenses might not meet the criterion of being laid out for purposes of trade or may not be in the production of any income, leading to disallowance by SARS.
Over the years this issue has led to numerous disputes between taxpayers and SARS and on occasion has ended up in the courts, for example in the recent case of Unitrans Holdings Ltd v CSARS, A3094/2022 [2023] ZAGPJHC. In this case, Unitrans declared in its 2011 tax return that it had earned R34 million in interest income from its subsidiaries. It further claimed an amount of R68 million in interest paid by it to its shareholder.
SARS disallowed the interest claimed in terms of section 24J(2) of the Income Tax Act because, in its view, the expenditure incurred was not in the conduct of any trade, nor was it incurred in the production of income. Section 24J(2) has similarly worded ‘production of income’ and ‘trade’ requirements as section 11(a). On the facts, the taxpayer lost in the Tax Court and its appeal to the Johannesburg High Court also failed.
Companies with seasonal or irregular business activities may struggle to demonstrate continuous trade. SARS may disallow expense claims and the set-off of assessed losses carried forward from previous years of assessment if it deems that the company was not trading during certain periods.
Proper documentation and evidence of business activities are crucial. Companies failing to maintain comprehensive records may find it difficult to substantiate their trading status and related expense claims.
The complexity of tax laws and regulations, and the frequent amendment thereof, mean that companies without sufficient tax expertise may make errors in their filings. This can lead to disputes with SARS and potential penalties.
SARS Practice Note 31 states that although a person other than a money-lender who earns interest on capital or surplus funds invested does not carry on a trade and that any expenditure incurred in the production of such interest should not be allowed as a deduction, it is nevertheless SARS’s practice to allow expenditure incurred in the production of the interest to the extent that it does not exceed such interest income.
Section 20(1) of the Act requires a company to carry on a trade during the current year of assessment in order to be able to set off a balance of assessed loss carried forward from the previous year of assessment against the company’s income in the current year.
An assessed loss is a tax loss that occurs when a company's allowable deductions exceed its income. This loss can generally be carried forward to future tax years to offset future taxable income, thereby reducing future tax liabilities.
The ability to carry forward assessed losses is important for companies, especially in volatile or cyclical industries, as it provides a cushion against future taxable profits.
If a company has earned no income from carrying on a trade in the current year of assessment, SARS’s interpretation is that it must be clear that a trade has been carried on in the current year of assessment for the set-off of the assessed loss brought forward to be permitted.
Another consideration to note is that in terms of an amendment to section 20(1)(a) of the Act, which applies to all companies with financial year-ends ending on or after 31 March 2023, the set-off of the balance of assessed losses carried forward is restricted to the higher of R 1 million or 80% of the company’s taxable income arising in the current year. This amendment severely affects many companies with accumulated assessed losses and creates yet another tax risk area for such companies.
In another recent case, which is unlikely to be contested in the courts, a company accumulated significant losses and eventually stopped trading during the 2019 year of assessment. However, it continued to incur winding-up administrative expenses during the 2020 and 2021 years of assessment. These expenses were claimed in the relevant returns and were initially allowed as deductions, thereby increasing the assessed loss by the amounts claimed.
Having performed an audit of the company, SARS stated that in its view, the company had stopped trading in the 2019 year of assessment and that it should not have claimed any deductions in respect of the administrative expenses incurred during the 2020 and 2021 years of assessment. SARS also stated that since the company had stopped trading, the accumulated assessed loss as at the end of the 2019 year of assessment would be forfeited.
In this case, the company accepted SARS’ findings and agreed to additional assessments being issued to it in respect of the 2020 and 2021 years of assessment, disallowing the expenses claimed.
SARS also imposed a 25% understatement penalty in respect of the expenses erroneously claimed. In view of the relatively insignificant amounts involved, the company did not object to the penalties imposed.
When the additional assessments were received, it was noted that the disputed expenses were correctly disallowed for the 2020 and 2021 years of assessment but that the assessed loss from the 2019 year of assessment still reflected on both the additional assessments for the 2020 and 2021 years of assessment. This is regarded as unintentional as SARS had clearly stated in its letter of findings that the 2019 assessed loss would be forfeited.
It is suggested that the SARS system of carrying forward assessed losses in situations where a company has stopped trading should be revisited, as the current systems appears to be unable to deal with the forfeiture of an assessed loss, either at the request of the taxpayer or by way of decision made by SARS following an audit of the taxpayer’s affairs.
There are instances where taxpayers may prefer to forfeit their assessed losses, perhaps for strategic reasons or to simplify their tax affairs. However, the current system does not provide a clear mechanism for this. Taxpayers may face prolonged uncertainty if SARS does not have a streamlined process to handle such requests efficiently.
SARS should introduce clear procedures and guidelines for companies wishing to voluntarily forfeit their assessed losses. This should include a straightforward application process and criteria for approval.
SARS should also develop more transparent audit protocols that clearly define the conditions under which SARS may disallow the carry-forward of assessed losses. This could include detailed criteria and examples to ensure fairness and consistency.
SARS should improve the communication process between itself and taxpayers regarding the status of assessed losses, particularly following an audit. SARS should ensure that taxpayers are informed in a timely manner and have access to a fair and efficient appeals process.
SARS should preferably update the Tax Administration Act to reflect these changes, ensuring that both SARS officials and taxpayers are aware of their rights and responsibilities regarding assessed losses. It should engage with stakeholders, including tax professionals, business associations and legal experts to gather input on the proposed changes and ensure that they address the practical challenges faced by companies.
If a change in the applicable legislation is not considered necessary, SARS should at least amend its E-filing system to allow for a company to indicate that it has stopped carrying on a trade and that it confirms that any assessed loss as at the end of the previous year is forfeited.
By revisiting the policy and implementing these revisions, SARS can create a more efficient and fair system for handling assessed losses, particularly in cases where companies have ceased trading. This would not only benefit taxpayers by providing greater clarity and predictability but also enhance SARS’s ability to enforce tax laws effectively.
Regular consultation with tax advisors can help companies navigate the complexities of tax laws. They can provide guidance on the company’s trading status and ensure expenses are claimed only in appropriate circumstances.
Companies should periodically review their tax positions, especially if there are changes in business activities. This proactive approach can help identify and address potential issues before they escalate.
In conclusion, the complexities involved in claiming expenses and carrying forward assessed losses when a company is not actively trading pose significant risks. By understanding the challenges, maintaining thorough documentation, seeking professional advice and ensuring continuous business activity, companies can mitigate these risks and navigate the tax landscape more effectively. Revisiting and possibly revising the current regulations to provide clearer guidelines and more flexibility could also help reduce these risks and provide a fairer system for businesses.
The sage advice of Richard Nixon remains valid!