Section 22(1)(a) of the Act sets out the general rule pertaining to closing stock held and not disposed of which must be included in the income of a taxpayer at the end of the year of assessment. In essence, the closing stock to be included in the income of a taxpayer is the cost price of the trading stock, less such amount as the Commissioner of SARS (Commissioner) may think just and reasonable as representing the amount by which the value of such trading stock has been diminished by reason of damage, deterioration, change of fashion, decrease in market value or for any other reason satisfactory to the Commissioner.
Given the wide discretion afforded to SARS in this respect, SARS’s Practice Note No. 36 issued on 13 January 1995 (Practice Note 36) provides some guidance on the subject. Practice Note 36 quotes with approval an extract from ITC 1489 53 SATC 99, wherein it was held, amongst others:
- That if a method of reducing the cost of stock by a percentage is adopted (because, for example, it is impractical to value individual items of stock), the percentage reduction should not only be supported by trading history and, where appropriate, post-balance sheet experience, but the Commissioner should be told how that percentage is arrived at.
- That the Commissioner has to exercise a discretion with regard to the amount by which the value of trading stock has been diminished and cannot exercise that discretion if he is not told on what basis the accounts submitted to him have been prepared; hence the Act, by implication, requires such a disclosure.
Practice Note 36 concludes that where stock is written off on a fixed, variable or any other basis (not representing the actual value by which it has been diminished) that may be acceptable to the Commissioner to the extent that a taxpayer can provide reasonable justification for such method.
The critical issue is that Practice Note 36 and the previous case law on the matter accepts that it may be impractical to value individual items of stock and thus a taxpayer may utilise an alternative method so long as suitable justification for utilising that method can be provided. In particular, while one may for example be able to value stock on an item-by-item basis where one only has ten items of such stock that will ultimately be sold (eg aeroplanes), the matter is altogether different where the items of stock run into the thousands. For instance, the third category in the definition of “trading stock” includes consumable stores, and spare parts acquired by a taxpayer to be used or consumed in the course of the taxpayer’s trade. This includes such specific items as nuts and bolts which would likely be very difficult to value on an item-by-item basis.
Proposed changes to diminution in value of closing stock
Notwithstanding the guidance on the matter and previous case law, the 2019 Draft TLAB now proposes that any diminution in the value of trading stock must be determined on an item-by-item basis. Section 22 of the 2019 Draft TLAB states that s22 of the Act is to be amended by the addition to ss(1) of the following proviso:
“: Provided that for the purposes of this subsection:
(a) the amount of trading stock must be taken into account in determining taxable income by including such amount in gross income; and
(b) any diminution in the value of trading stock must be determined on an item-by-item basis.” [Our emphasis]
Reasons for the change
Curiously, the draft Explanatory Memorandum on the 2019 Draft TLAB (Memorandum) does not appear to clarify nor explain the rationale for the proposed change and is altogether silent on the proposal, despite various issues that arise. First, such an amendment will have far-reaching implications and ramifications for taxpayers given the various impracticalities already discussed above. This is notwithstanding the fact that previous case law has accepted that the diminution of trading stock on an item-by-item basis can be impractical. Second, it represents a substantial shift in policy given the guidance in Practice Note 36. Lastly, there is no explanation as to what is meant by “item-by-item” and whether this includes categories of items or rather each and every item down to the last nut and bolt.
Furthermore, s22(1)(a) of the Act already has a pending amendment wherein the entire s22(1)(a) is to be substituted by s37(1)(a) of the Taxation Laws Amendment Act, 25 of 2015 with effect from a date yet to be determined. This amendment will remove the discretion afforded to the Commissioner in the provision and provide for a mechanism wherein the Commissioner will instead publish, by way of public notice, the additional reasons giving rise to the diminution in value of trading stock. This amendment is in accordance with the policy decision to remove the various discretions afforded to the Commissioner in the various tax Acts while moving to more objective tests and provisions. It is thus interesting that the proposal in the 2019 Draft TLAB has arisen prior to the promulgation of the new proposed substitution of s22(1)(a) of the Act.
The proposed amendments are still in draft form and it is anticipated that there will be various submissions made to National Treasury and SARS on this proposed amendment as well as extensive discussions during the relevant public engagement on the 2019 Draft TLAB. It will be interesting to monitor developments in the coming months given the wide ramifications this will have for many taxpayers.