On 1 August 2011, the Johannesburg Tax Court (the Court) handed down a significant judgment that is yet to be reported and that specifically addresses, in the words contained in the judgment, "novel and complex" issues relating to the interpretation of the provisions of sections 36(7E) and 36(7F) of the Income Tax Act, 58 of 1962 (the Act).
By way of background, a taxpayer owned three gold mines, where two of the gold mines were in a profitable position and one of the gold mines made a loss during the relevant years. In addition, the taxpayer derived income from non-mining activities. The question was whether the loss of the one mine could be set off against the taxable income derived by the taxpayer from its non-mining activities or whether the loss had to be deducted on a pro rata basis from the income of the profitable mines.
The taxpayer adopted the approach of deducting the loss from the taxable income derived from its non-mining activities as opposed to deducting the loss from the income of the profitable mines. Further, the capital expenditure of the profitable mines was redeemed up to the limit of the taxable income of the profitable mines.
The South African Revenue Services (SARS) adopted the approach that the operating loss of the non-profitable mine should be deducted from the income of the profitable mines on a pro rata basis before redeeming any capital expenditure against the respective taxable income of the mines.
It was argued on behalf of SARS that:
- operating expenses must be deducted from income while capital expenditure relating to a particular mine is to be redeemed against taxable income and that the deduction of capex is ring-fenced in terms of section 36;
- section 11(a) of the Act distinguishes between trades and requires that the operating loss of a trade firstly be deducted from the income derived from that trade, if any;
- the intention of the legislature in enacting sections 36(7E) and 36(7F) was to prevent the corrosion of the non-mining tax base and the taxpayer's approach would be to promote the mischief which the legislature intended to overcome;
- to allow the deduction of expenses from the trade of mining for gold from non-mining activities carried on by the taxpayer would distort and dilute the graduating tax rate applicable to the gold mining trade.
It was argued on behalf of the taxpayer that on a correct interpretation of sections 36(7E) and 36(7F), it is necessary to draw a distinction between a current year loss or operating loss and an assessed loss. An assessed loss, being a loss incurred in a previous year, and carried over from a previous year was ring-fenced in terms of sections 36(7E) and 36(7F).
It is noted that the focus of the judgment related to the application of section 11(a) of the Act as opposed to the interpretation of sections 36(7E) and 36(7F).
Sections 36(7E) and 36(7F)
Unfortunately, the Court did not address the interpretation of the provisions of sections 36(7E) and 36(7F) of the Act as raised in argument before the Court.
The Court only concluded cursorily in relation to the application of sections 36(7E) and 36(7F) that:
"The sequence of deductions of which the current operating loss of a mine is first deducted from mining income, before the deduction of the assessed losses contemplated ss 36(7E) and (7F) and thereafter the capex from the taxable income of the mine to which it relates is consistent with the Legislative intention. By reducing the income of the respective profitable mines through the deduction of the operating loss of one of its mines the amount of capex that may be redeemed against the respective incomes of such profitable mines is also reduced and a measure of preservation of the income from non mining activities is also achieved."
The opportunity for addressing the "novel and complex" issues raised by the case was dismissed in favour of the focus switching to section 11(a) by the Court as opposed to specifically considering the arguments raised by either the taxpayer or SARS. Taxpayers that seek to apply the provisions of sections 36(7E) and 36(7F) of the Act are left in the position where there is no guidance provided by the Courts in circumstances where the provisions of sections 36(7E) and 36(7F) are unclear.
Importantly, in its focus on the interpretation of section 11(a), it is significant that the decision by the Court adopts a contrary approach to the interpretation of section 11(a) of the Act that will likely have far reaching implications.
It was held by the Court that the wording of section 11(a) is clearly unambiguous and that:
"While ss 36(7E) and (7F) ring-fence mining and individual mines, respectively, and in particular in respect of the redemption of capex and the deduction of the balance of the assessed losses from the previous years 11(a) distinguishes between trades and allows certain expenses and losses (current or operating) to be deducted from the income derived from the taxpayer from a particular trade."
The Court drew a distinction between the different trades conducted by a taxpayer in its interpretation of section 11(a). In particular, each trade of a taxpayer must be separated for purposes of claiming any deduction. Effectively, if any taxpayer conducts more than one trade, then the losses incurred in respect of any trade may not be deducted from the income derived by the taxpayer from any other trade.
At paragraph 35 it was held that: "The section does not allow such expenses, or losses, incurred in respect of one trade to be deducted from the income derived by the taxpayer from another trade. In the case of a taxpayer who derived an income from mining and an income from another trade, the taxpayer is not allowed to deduct an operating loss incurred in the mining trade from the income derived from another trade and vice versa. The loss can only be deducted from the income derived from the same trade as the one in which the loss was incurred. The same would apply whether the taxpayer has one or more mines and also derives and income from another trade."
Therefore, applying the decision handed down by the Court, a taxpayer must separate each trade that it conducts for purposes of determining whether any deduction will be allowed under section 11(a). A deduction may only be claimed if the expense or loss of a particular trade relates to the income derived by that particular trade. There is no ability to claim any deduction from one trade against another trade despite the taxpayer conducting both trades.
A strict interpretation of section 11(a) will be applied, leaving the taxpayer in the invidious position where the separate trades of a taxpayer are ring-fenced for purposes of claiming any deduction.
The Court further considered the interpretation of section 20 with specific reference to section 20(1)(b) regulating the set-off of an assessed loss.
The Court agreed with the decision in ITC 1420 that "the assessed loss of the current year of assessment (ie a current year operating loss) incurred by the taxpayer in respect of non-mining activities, would not be deductible from income derived by it from gold mining despite the provision of section 20(1)(b)."The reasoning was that to allow such a position would be to undermine the Legislative intention to tax gold mining companies differentially. In this regard, the Court adopted an approach where the nature of the trade conducted by the taxpayer resulted in differential treatment.
The Court further reasoned at paragraph 33 that:
"But for what was held in ITC 1420, it is apparent that a loss incurred by a taxpayer in respect of one trade may, subject to exceptions, be written off against the income the taxpayer derived from another trade. However, it must be a loss incurred in respect of the trade and not only in respect of a unit or units in respect of that trade."
Thus, the Court circumscribed the application of section 20(1)(b). Specifically, the set-off of a loss from one trade may not occur where the trade comprises a "unit" or "units". In the case before the Court, it was held that the separate mines of the taxpayer constituted such "units" and as such the loss suffered in relation to one "unit" could not be set-off against the profits of the other "units" as the loss was not in respect of the entire gold mining operation.
If a taxpayer passes the hurdle of claiming a deduction of an expense or a loss in relation to a particular trade, the taxpayer will, if there is to be any set-off of any "assessed loss", have to demonstrate that such loss relates to the entire operations of the trade conducted by the taxpayer in question. The Court has thus elevated the importance of there being a single trade not only for purposes of claiming any deduction in terms of section 11(a) but also for purposes of being able to set-off any assessed losses incurred by a taxpayer.
In addition, despite the taxpayer raising the argument that section 36(7G) of the Act should apply to the extent that the Court determined that sections 36(7E) and 36(7F) of the Act were not applicable, the Court chose to dismiss this argument as "hypothetical, or of academic interest" as there was no surplus taxable income after the redemption of capital expenditure in accordance with the provisions of sections 36(7E) and 36(7F). This unreasoned refusal to address such argument leaves the taxpayer without recourse and without any clarity regarding the circumstances when section 36(7G) may be applied by taxpayers.
Natalie Napier, Director, Tax