On 1 June 2016, the Supreme Court of Appeal (SCA) handed down judgment in Avenant v The Commissioner for the South African Revenue Service (367/2015)  ZASCA 90 (1 June 2016), where it had to interpret s26(1) and certain paragraphs of the First Schedule. This case forms the subject matter of this article.
Avenant, the taxpayer, carried on “pastoral, agricultural or other farming operations” in terms of s26(1) of the Act and filed tax returns which showed that a portion of his overall taxable income was derived from his farming operations. The farming income consisted of payments that the taxpayer received from a co-operative (Co-op), of which he was a member, for grapes that he delivered to the Co-op for the purpose of being made into wine. On delivery, the taxpayer’s grapes were pressed into a pulp and mixed with the pulp from pressing grapes of the same cultivar and class, such as Sauvignon Blanc and Chenin Blanc, delivered by other farmers, who were also members of the Co-op. These common pools of individual cultivars and classes of grapes were managed by the Co-op.
As at midnight on 28 February 2009, (the end of taxpayer’s 2009 year of assessment) all of the taxpayer’s harvested grapes had been delivered to the Co-op and pressed into pulp to begin the process of wine making. The Co-op thereafter bottled or packaged the wine, marketed and sold it. The members of the Co-op did not sell their produce, or transfer ownership to the Co-op meaning it did not become the owner of the produce.
The SCA had to decide the following four questions:
Whether the income received by the taxpayer, which is generated by the sale of wine, constitutes income derived from “carrying on pastoral, agricultural or other farming operations” in terms of s26(1) of the Act?
The court held that the transformation of grapes into wine does not result in the income earned from the sale of wine, being removed from the ambit of income derived from the taxpayer’s agricultural operation. The income earned from the sale of wine is therefore also taxable in terms of the First Schedule.
Whether the pressing of the grapes delivered by the taxpayer to the Co-op results in the pulp no longer constituting ‘produce’ as contemplated in paragraph 2 of the First Schedule?
The taxpayer argued that after the grapes were pressed they no longer existed at midnight on 28 February 2009 and once the resultant pulp was mixed with the pulp from other farmers’ grapes, the mixture was a work-in-progress in a process of manufacture, namely the manufacture of wine by the Co-op and therefore not the taxpayer’s produce at all. The taxpayer further argued that the process whereby the mixed pulp was treated with chemicals to aid the fermentation process constituted a process of manufacture which substantially changed the character of the materials out of which the wine was made, meaning it no longer constituted ‘produce’ of the farming operation. The court rejected this argument and agreed with SARS that the pulp was essentially ‘wine in process’, which fell within the concept of the ‘produce’ of a wine grape farmer as envisaged by the First Schedule. The principle laid down by the court was that:
The extent to which the identity of a natural product may be transformed by some form of treatment until it no longer exists as produce, must depend upon the product as well as the nature and extent of the processing, or treatment, to which it is subjected. Each case must be decided upon its own facts.
The extent to which the raw product loses its identity by confusion and survives only as an inseparable portion of a factory product due to the manufacturing process, is an important consideration to take into account to answer this question, but did not apply in this instance.
The court further held that a contextual and purposive interpretation of the word ‘produce’ had to be adopted. Produce, as in the case of ‘trading stock’ dealt with in s22 of the Act, includes work-in-progress, and therefore the pulp produced by pressing the grapes falls within the definition of ‘produce’. The SCA held that the principle underlying the inclusion of closing stock in the income tax calculation, being the balancing of the person’s tax calculation for that tax year and which also underlies paragraph 2 of the First Schedule, had to be applied by taking into account the existence of the pulp in that tax year.
Whether the pressing into a pulp of the taxpayer’s grapes and its subsequent mixing with the pulp of other members of the Co-op, results in what was delivered by the taxpayer no longer being “produce held and not disposed of by him”, in terms of paragraph 2 of the First Schedule?
The court stated that just as trading stock is ‘held and not disposed of’ if the taxpayer has ownership in it, the same principle applied to ‘produce’. Here, the taxpayer retained ownership even though the grapes were delivered to the Co-op, meaning they were still ‘held’ in terms of paragraph 2 of the First Schedule. The SCA held that the taxpayer retained joint ownership, in an undivided share, of the pooled pulp and at a later stage the pooled wine, pro rata to his contribution of grapes to the pool.
As the taxpayer retained ownership of the pulp, the Co-op could never have held it for the purpose of sale by itself. The pulp remained the taxpayer’s “own produce derived from his or her farming operations” in terms of paragraph 2 and he therefore had to have accounted for his produce. If this were not the case, farmers could mix their produce together before the year end to avoid having to account for closing stock. Such an interpretation gives effect to the purpose of the legislation, is in accordance with its language, and achieves sensible and business-like results.
Did the pulp have a value at midnight on the last day of the 2009 year of assessment?
The court had to consider paragraph 9 of the First Schedule, which merely states that the value to be placed on the ‘produce’, as referred to in paragraph 2, must be ‘fair and reasonable’. SARS is not compelled to apply a market value, but may adopt another method provided it is fair and reasonable. The taxpayer argued that the pulp had a negative value as the production costs incurred by the Co-op prior to any grapes being delivered to it, exceeded the pulp’s intrinsic value. SARS argued that the value of the pulp was greater than zero, when valued with reference to either the distilling wine price or the pulp’s production cost.
The court held that the pulp was not valueless when one considered that the wine to be produced is intended to be sold at a profit and that in each year the taxpayer had received positive returns from the pool. The distilling wine price was an ascertainable value, reflected in wine statistics and publications and was a calculated by using a specific formula. The court found that this method of calculation is practical, workable and realises a positive value for the stock and therefore places a fair and reasonable value on the stock. Regarding the production costs method, the court found that the taxpayer’s costs in relation to his wine farming activities were objectively ascertainable based on the evidence before it and this was therefore also an acceptable method of calculation.
The court dismissed the appeal with costs and upheld the decision of the Tax Court to refer the matter back to SARS for re-assessment. SARS is entitled to re-assess the taxpayer to tax in accordance with the principles set out in this judgment.
Although the facts of the case relate to the wine farming industry, the SCA’s judgment has implications for the broader farming community as well. In essence, where a person conducts operations that fall within the scope of s26(1) of the Act, any produce from these operations that such person has not disposed of at the end of their year of assessment and over which they retain ownership, will have to be included in their income tax calculation for that year of assessment. Furthermore, if the goods produced in terms of the s26(1) operations went through a manufacturing process before being sold as the final product, they will still constitute ‘produce’. For the natural product to no longer constitute ‘produce’, it will have to lose its identity. Whether such loss of identity has occurred will depend upon the product as well as the nature and extent of the processing, or treatment, to which it is subjected.
Based on this principle, a farmer of seeds or nuts who has delivered seeds or nuts to a co-operative where they might go through a cleaning process before being packaged and sold to the public, will most likely have to include any seeds or nuts not yet sold at the end of a year of assessment. On the other hand, a farmer producing grain used in the production of bread or producing mealies to be used in the production of mealie meal, might not have to include the processed, but unsold bread or mealie meal as ‘produce’ at the end of the year of assessment, if it is found that the grain or mealie meal, has lost its identity due to the extent of the manufacturing process to which it has been subjected.
Written by Louis Botha and Heinrich Louw