A technical report analyzing the term “actually incurred” in South African Income Tax laws.
Income Tax Laws An analysis of the term actually incurred in section 11(a) of income tax act no. 58 of 1962 (as amended) CONTENTS Page 1. SYNOPSIS. 4 2. ACTUALLY INCURRED IN THE CONTEXT OF SECTION 11(A) . 8 3. WHY IS ACTUALLY INCURRED A CRITICAL PROVISION. 12 3.1 What does it mean to be actually incurred. 12 3.2 What happens if there is an unconditional obligation to pay an amount that cannot be quantified at the end of the year of assessment. 32 3.3 Must be actually incurred in the year of assessment. 42 3.4 No requirement to be necessarily incurred. 44 3.5 When is an amount in dispute actually incurred . 46 4. THE IMPACT ON INCURRAL, OF CERTAIN SELECTED RECENT LEGISLATION. 51 4.1 Provisions relating to leave pay – Section 23E. 53 4.2 The accrual and incurral of interest – Section 24J. 64 5. OPPORTUNITIES AND PROBLEMS 5.1 Mismatching of income and expenditure. 68 5.2 The Second Year Problem. 79 6. CONCLUSION 85 7. BIBLIOGRAPHY 88 1.SYNOPSIS Generally Accepted Accounting Practice includes statement AC000: Framework for the preparation and presentation of financial statements. This sets out broad and definitive rules governing the recognition of liabilities and income and expenditure in financial statements. Specifically the following paragraphs need to be considered: Recognition of liabilities: 91. A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably… Recognition of expenses: 94. Expenses are recognised in the income statement when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. This means in effect that recognition of expenses occurs simultaneously with the recognition of an increase or a decrease in assets …. 95. Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the and the earning of specific items of income. This process, commonly referred to as the matching of costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transaction or other events; …. The fisc takes little notice of these rules when it comes to the recognition of expenditure for the purposes of taxation. It is the part of these rules that govern the general deduction provision that this report will examine. Section 11(a) of the South African Income Tax Act No. 58 of 1962 (as amended) reads as follows: 11. General deductions allowed in the determination of taxable income.- For the purpose of determining the taxable income derived by any person from the carrying on of any trade within the Republic, there shall be allowed as deductions from the income of such person so derived- (a) expenditure and losses actually incurred in the Republic in the production of the income, provided such expenditure and losses are not of a capital nature. The section defines the conditions that must be met for expenditure and losses to be allowed as deductions from income. The expenditure or losses must have been: Actu ally incu rred in the year of asse ssme nt In the Republic of South Africa. In the production of the income. Such expenditure or losses must not be of a capital nature. The section has to be read together with s23(g) 23. Deductions not allowed in the determination of taxable income.- No deductions shall be made in respect of any moneys, claimed as a deduction from trade, to the extent to which such monies were not laid out or expended for the purposes of trade.’ This report will focus on the meaning of the term “actually incurred” (as a critical part of the recognition process) and not on the other requirements. It will explore the difference between the accounting requirements for expenditure and liabilities to be recognised, and the requirements for recognition for Income Tax purposes. It will try to better understand the meaning and implications of this phrase, with a view to be able to better manage and control its impact on the recognition of expenditure and losses. It will also explore some of the grey areas that can and have caused the taxpayer and the fisc considerable problems in the past. In concluding, some of the recent legislative changes will de discussed and considered. 2. ACTUALLY INCURRED IN THE CONTEXT OF SECTION 11(a). Section 11(a) of the South African Income Tax Act No. 58 of 1962(as amended), reads as follows: 11. General deductions allowed in determination of taxable income.- For the purpose of determining the taxable income derived by any person from the carrying on of any trade within the Republic, there shall be allowed as deductions from the income of such person so derived- (a) expenditure and losses actually incurred in the Republic in the production of the income, provided that such expenditure and losses are not of a capital nature. Section 11(a) is broadly referred to as the general deduction provision. It is intended to cover the requirements for expenditure and losses to be deductible in the determination of taxable income. Whilst the section is comprehensive as it stands, there is a further critical requirement that the expenditure and losses have been incurred during the year of assessment. This is not expressly stated in the section, but it is considered to be implicit that expenditure is only deductible for tax purposes, in the year in which it is incurred. Significant important case law exists to support this contention. Thus, should expenditure, usually deductible under s11(a), not be claimed as a deduction in the year in which it is incurred, it may not be claimed in any other year, unless the Act provides otherwise. The recognition or deductibility of expenditure, provided all the other requirements are met, is triggered by incurral. This report will focus on three main issues surrounding incurral: a. Was expenditure actually incurred? To establish this, one needs to understand and define exactly what constitutes actual incurral. b. When did incurral take place? This will lead to understanding exactly when the action or actions which triggered incurral, took place. The timing of incurral will determine the year of assessment in which the expenditure or loss may be deductible in the determination of taxable income. In the Caltex Oil case Botha J.A. made the point that income tax is assessed on an annual basis , this lends support to the contention that expenditure incurred in a particular year of assessment is only deductible in that same year. The determination of the year in which the expenditure or loss is actually incurred, brings more problems to be resolved. c. There is the problem of expenditure in respect of which the obligation to pay is, or during the year, becomes, unconditional, but which cannot be quantified until after the termination of the year of assessment. This again leads to a plethora of problems to resolve. The second year problem being but only one. All the issues give rise to thorny problems. There are many more issues. The courts and the legislature have battled. Some of the problems encountered have been raised by the two most recent Commissions of Inquiry such that legislation has recently been introduced to resolve them in the future. This will also be discussed and considered. The primary objective of this report is to try to help to better understand this fundamentally critical area of the tax law. Planning to avoid future problems is easier then dealing with a problem after it has arisen, because history cannot be changed except in exceptional circumstances To be able to plan so that the occurrence of incurral can be planned rather then simply to be in the lap of the Gods. This is infinitely better then defending past actions. It is both cheaper and the outcome much more certain. 3. WHY IS “ACTUALLY INCURRED” SUCH A CRITICAL PROVISION: 3.1 What does it mean to be actually incurred . In interpreting a fiscal statute, It is important to distinguish between the presumptions of statutory interpretation and the rules or canons of construction. The presumptions have obligatory force, being legal rules derived from the common law. They are intrinsic to the principle of legality because they qualify parliament s legislative enactments and exist side by side with the provisions of all statutes. The rules or canons of construction, on the other hand, have no status as legal rules and are merely conceptual models applied(or not applied as the case may be) by judges grappling with the meaning of particular legislative provisions. The traditional approach to the interpretation of statutes, often referred to as the Cardinal rule, holds that the literal meaning of the wording of a provision must be ascertained by the use of ordinary grammatical rules. If the meaning of the words is clear, then this meaning represents the intention of Parliament, the object of statutory interpretation always being to stamp a particular meaning with the Legislature s impramatur by means of the fiction of parliamentary intent. Considerations of equity, hardship, or social policy are irrelevant once the intention of Parliament is unambiguously established. . In Partington v Attorney General, Lord Cairns stated that if a person sought to be taxed comes within the letter of the law, he must be taxed, however great the hardship may appear to the judicial mind to be. In other words, if there may be an equitable construction, certainly such a construction is not admissible in a taxing statute. In Cape Brandy Syndicate vs IRC Rowlatt J.  said: In a taxing Act one has to look merely at what is clearly said. There is no room for any intendment. There is no equity about a tax. There is no presumption as to tax. Nothing is to be read in, nothing is to be implied. One can only look fairly at the language used. Given some of the rules of interpretation above, it must be apparent that great care must be taken when trying to establish the meaning of fiscal statutes. The end result does not have to be equitable or reasonable. It is therefore critically important to understand the law so that the taxpayer is able at the outset to properly plan his affairs so as to achieve tax efficiency, while at all times keeping within the law. In IRC v Duke of Westminster Lord Tomlin said at 19 TLR 472, Every man is entitled, if he can, to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be . To have been actually incurred , means that an unconditional legal liability to pay now or at some other time has arisen. Payment does not have to have been effected for incurral to have occurred. Once the events that constitute incurral have taken place, the expenditure or loss has been actually incurred , and the expense or loss will be recognised in the determination of taxable income, given the assumption that all other requirements have been met. Thus incurral can be seen to be that which triggers recognition. GAAP lays down very clearly that: Recognition of liabilities A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. Thus, probability can precipitate recognition in the financial statements. This is then brought to account by raising provisions to cater for anticipated probable expenditure. The Act very clearly in Section 11(a), requires actual incurral, and as if that were not enough, Section 23(e)spells out the negative test loud and clear: 23. Deductions not allowed in the determination of taxable income.- No deductions shall in any case be made in respect of any of the following matters, namely- (e) income carried to any reserve fund or capitalised in any way. The Tax Act requires that unconditional legal liability exists before an expense has been incurred. Probability however likely, does not meet the bill. An expense or loss which is contingent upon the happening of an uncertain future event is not actually incurred. The liability therefor is not absolute and unconditional. The Members Handbook of the Institute of Chartered Accountants also spells out that: The amount of a contingent loss should be provided for by a charge in the income statement if: it is probable that future events will confirm that, after taking into account any related probable recovery, the value of an asset has been impaired or a liability has been incurred at the balance sheet date, and a reasonable estimate of the amount of the resulting loss can be made. Again, here is the contrast between a contingent liability and one which, had been encountered, run into or fallen upon. In the Australian case, FCT vs James Flood (Pty) Ltd, the taxpayer sought to deduct in the year of income in question, amounts in respect of annual leave which were due for payment to employees only in the following fiscal year. In terms of the applicable industrial agreement these amounts were only payable to employees at a future date , and under a variety of circumstances an employee who did not serve his full period might not become entitled to anything. The company sought to deduct a proportion , equivalent to the period of service in the year of assessment, of the amount which would become payable if the employee in the course of the next year, completed the required 12 months service. The court accepted that a liability can be incurred although it may not be due and payable. In respect of the leave payment due to employees in the following fiscal orchard held that there was no debitum in praesenti solvendum in futuro (a debt or obligation complete when contracted, but of which performance cannot be required until some future period), because their period of service had not yet qualified them for annual leave. To qualify for deduction, the liability must have been incurred in the sense that it had been encountered, run into or fallen upon . The taxpayer must have completely subjected himself to the expenditure although it need not be an immediate obligation enforceable at law and it need not be indefeasible. The appeal by the Commissioner was allowed. In Caltex Oil (SA) Ltd vs SIR ,the appellant company obtained supplies of crude oil and other products from Caltex (UK) Ltd and Caltex Services Ltd, both located overseas. Invoices would be rendered to the appellant in British Sterling, immediately the goods were shipped. Upon receipt of the invoices, the appellant would convert the purchase price into SA Rands at the rate of exchange ruling on the date of shipment. Entries were made in the appellant s books at this time. The value so recorded was never altered despite fluctuations in the Rand currency between the date of purchase and the end of the appellant s financial year on 25 December of each year. On 19 November 1967, the rate of exchange between the Rand and the pound sterling changed from R2 =1 , to R1.7207 = 1. As a result of this, the amounts owing to the overseas companies reduced. The debt due to Caltex Services Ltd reduced by R14,031, and the debt due to Caltex (UK)Ltd reduced by R1,336,271. The debt to Caltex Services was settled before the end of the financial year. The other debt remained outstanding. The respondent added back the sum of the two amounts in the determination of the appellants liability for tax for 1967. The sole issue that was put before the Appeal Court, was whether thee two sums, which the appellant. by reason of the devaluation of sterling, was not required to pay, could be said to be part of the expenditure actually incurred. Botha J.A. summed the unanimous judgement up as follows: The appellant actually discharged its liability to Caltex Services Ltd after the devaluation and before the end of the 1967 tax year by expending R14,031 less than the amount of R98,217 entered in its books of account. It seems quite impossible to say that merely because the higher amount of R98,217 was entered in appellant s books of account as the equivalent, as at the date of the relevant transactions, of 48,925 sterling, the expenditure actually incurred in connection with the Caltex Services Ltd transactions, was anything more than the amount actually expended by the appellant. He went on further: the amount of expenditure actually incurred for the purpose of s11(a) can only be the amount required in rands to discharge that liability in the tax year in which it was incurred. With regard to the second larger liability which was still outstanding at the end of 1967; It was at the end of the 1967 tax year that the amount of the expenditure actually incurred during the year had to be determined and brought into account The appellant never incurred a liability to pay an amount of R9,353,920 to Caltex UK Ltd, but was an amount expressed in sterling which, for the purposes of the Income Tax Act, had to be reflected in the equivalent thereof in rands converted at the date at which the expenditure actually incurred is required to be quantified and brought into account for the purposes of s11(a) of the Act, or at the date of the discharge of that liability within that fiscal year. To sum it up simply, with regard to the debt paid during the year, the amount actually incurred was the amount paid in settlement thereof. In respect of the liability unsettled at the year end, only the amount calculated as being payable at the end of the year, was the amount actually incurred. The balance of the amount claimed was dependant upon an uncertain future event, and had not been actually incurred. In Nasionale Pers vs KBI the appellant undertook to pay its employees a 13th cheque after the completion of a full year of service, or pro rata thereof for shorter service. The bonuses were paid on 30 September of each year. It was a condition of the payment thereof that the company was entitled to recover bonuses from employees not still in the employ of the company on the 31 October following. The financial year of the company ended on 31 March of each earth company sought to claim a pro rata portion of the bonuses (6/12) as a deduction in the year ending March previously. The appeal was based on two contentions: I. The issue of bonuses was a commercial reality – they would have to be paid; the majority of the workforce would qualify. ii. The taxpayer s liability to pay a bonus for each month of service existed subject only to a resolutive condition in the event of him/her leaving the employ of the taxpayer before 31 October. Thus the expenditure had been actually incurred. Hoexter J.A. , held that: The obligations to employees were individual and not collective. Thus the liability to the employees as a group was no more than the liability would be to each individual employee. The future uncertain event (whether the employee would be in the appellants employ on 31 October) which would give rise to the obligation to pay a holiday bonus, was an event which fell outside the tax year of the applicant. In simple words, the conclusion drawn, was that at the end of March, there was no unconditional obligation to pay a bonus to any employee. Whilst it was probable that the company would be required to pay bonuses of the quantum calculated, to the majority of the workforce, there was no unconditional liability to pay any single employee a bonus ,in existence at the end of the financial year in question. Thus the expenditure could not have been actually incurred in the year in question. The appellant in ITC 1531, had received R360,000, on 1 August 1983, being the proceeds of a loan raised in Germany. The loan was repayable in Deutschemarks (DM)in the future. Between 1 August 1983 and 31 December 1983, the Rand had declined against the DM. The effect of the devaluation was that the indebtedness to the lender, expressed in SA Rands as at 31 December 1983, was R370,509.16. During 1984 a further loan was raised in Germany. The proceeds in SA Rands was R200,000. The further loan was also repayable in DM. On the last day of the 1984 year of assessment, the indebtedness of the appellant, based on the rate of exchange rate prevailing amounted to, R730,382.65. In effect, the adverse movement in the exchange rates, the appellant s liability had been increased in the 1984 year by R159,873.49. No further loans were made. On the last day of assessment for 1985, the amount, owed by the appellant, according to the exchange rates then prevailing, amounted to R1,195,199.33. A further fall in the value of the Rand against the DM during the 1985 year had increased the liability of the appellant by R464,816.68. The appellant claimed the R464,816.68 as a deduction from income in the 1985 year. The appellant contended that he was entitled as a matter of principle, to claim a deduction in respect of an unrealised loss resulting from a variation in the rates of exchange during the year of assessment in issue. No part of the loan was paid or discharged during the 1985 year. The Commissioner contended that the words actually incurred in s11(a) do not mean that the expenditure must be due and payable at the end of the year in question. There must be a clear liability to pay existing at the end of the year in question, even though the payment thereof may only fall due in later years. For such a liability to be incurred, it must not be subject to a contingency, ie an uncertain future event. It was contended that the foreign exchange losses, were notional losses and were conditional upon the rate of exchange prevailing at the time of payment. In the judgement handed down it was held that: When a taxpayer owes an amount expressed in a foreign currency, the amount is owed unconditionally and uncontingently. There is with certainty, an amount of expenditure incurred. Fluctuations in the rate of exchange can only effect the amount or quantification of the certain liability. It is only the quantification that is contingent. The liability itself is absolute. The unrealised foreign exchange loss incurred by the appellant was deductible from its income under s11(a). The appeal was allowed. The case was taken on appeal. The issue before the court depended on whether the unrealised foreign exchange loss constituted an expenditure or loss actually incurred in the Republic in the production of income as envisaged by s 11(a). Corbett CJ pointed out that the real question was whether by reason of currency fluctuations the taxpayer had actually incurred in the Republic in the production of the income, during the year of assessment concerned any outgoing or liability in respect of its foreign loan that could be classed as either an expenditure or a loss in the production of the income. It was held that the loss would only be deductible in the year in which the loan was repaid, because only then would such a loss have been actually incurred. The conversion of the loan proceeds into local currency was merely part of the practical mechanics of giving effect to the loan. The decision in the Caltex case was distinguished as being different because it was in respect of the acquisition of stock in trade which had to be quantified at the end of the year of assessment. The appeal was allowed. In ITC 1444 a manufacturer of products entered into agreements with overseas suppliers of raw materials to supply fixed amounts of raw materials at fixed or determinable prices at future dates. This was done to protect the manufacturer against price fluctuations and to guarantee the availability of supply. Payment for the goods was to be cash against documents . The taxpayer deducted from its 1983 year of assessment amounts in respect of contracts concluded for the purchase of future supplies of materials. In the judgement handed down, McCreath J. held that: The question to be determined in the instant case is therefore whether it can be said that by concluding the contracts to which I have referred the taxpayer, during the year of assessment ending 31 December 1983, incurred an absolute and unqualified legal liability in respect of the expenditure arising out of the said contracts or whether such expenditure was conditional upon the happening of some future event. the taxpayer was only required to pay the purchase price of the production materials forming the subject matter of the said contracts, against receipt of the bills of lading and invoices relating to the production materials to be supplied in terms thereof the taxpayer was not required to effect payment until the bills of lading and invoices in respect of each quantity of the production materials had in fact been received by the taxpayer s agent abroad. it is clear from the evidence of Mr A that no unconditional legal obligation rested upon the taxpayer to effect payment prior to the receipt of the said documents. In essence the judgement took the view that the only time that an unconditional obligation arose, was at t