Section 22(1)(a) of the Act in essence provides that 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’ 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.
Practice Note 36 further 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 acceptable to the Commissioner to the extent that a taxpayer can provide reasonable justification for such method.
The judgment in C:SARS v Atlas Copco provides and summarises some of the critical views of the SCA on the matter including summarising five critical aspects of the views expressed by Leach J in the Volkswagen case. Ponnan JA (with reference to various authorities) commented as follows at paragraph :
Section 22(1)(a) is concerned with the value of the trading stock of a taxpayer as trading stock at year end. It empowers SARS to allow a deduction from the cost price, by way of a just and reasonable allowance, in the four circumstances specified namely, damage, deterioration, change of fashion or decrease in market value or for any other reason satisfactory to the SARS. The rationale for the existence of these provisions ‘is neither far to seek nor difficult to comprehend’. The section is couched in the past tense. It is concerned with an enquiry as to whether a diminution in value has already occurred. In other words, the cost price must already have diminished. The circumstances expressly mentioned in the section relate to a diminution of value as a result of events occurring prior to the rendition by the taxpayer of its tax return. The exercise is thus one of looking back at what happened during the tax year in question.
Taxpayer’s method of writing down trading stock in casu
In C:SARS v Atlas Copco, the taxpayer was a member of the Atlas Copco Group (Group), with its parent company in Sweden. The main business of the taxpayer was to sell or lease – and thereafter service – machinery and equipment (including spare parts and consumables) that were imported mainly from Sweden, for use in the mining and related industries in South Africa. The taxpayer’s parent company had conceived a policy known as the Finance Controlling and Accounting Manual (FAM) or The Way We Do Things (WAY), which was implemented and applied by all companies within the Group. In terms of the policy, the taxpayer was to write down the value of its closing stock by 50%, if such closing stock had not sold in the preceding 12 months, and by 100% if it had not sold in 24 months.
The taxpayer applied the policy by writing down its closing stock (separated into six categories) by the fixed percentages reflected in the policy. In its 2008 and 2009 tax returns it included the amounts it claimed the value of its trading stock had diminished by during those years of assessment. SARS, however, took the view that the write down of stock by the taxpayer did not comply with the provisions of section 22(1)(a) of the Act and assessed the taxpayer accordingly. The Tax Court initially upheld the appeal by the taxpayer against the additional assessments. In upholding the appeal, the Tax Court held that the net realisable value (NRV) of the taxpayer’s closing stock for 2008 and 2009, calculated in accordance with International Accounting Standard 2 (IAS2), International Financial Reporting Standards (IFRS), SA Generally Accepted Accounting Practices (GAAP) and the policy (which policy was in line with IAS2 and IFRS), may and should, where it is lower than the cost price of such trading stock, be accepted as representing the value of trading stock held and not disposed of at the end of the relevant years for purposes of section 22(1)(a) of the Act.
The Commissioner for SARS appealed against the tax court judgment and the matter was heard in the SCA after the SCA had already handed down the judgment in respect of a similar set of issues in C:SARS v Volkswagen.
Decision of the SCA in C:SARS v Atlas Copco
Prior to handing down the judgment, Ponnan JA initially applied the five principles laid down by Leach J in C:SARS v Volkswagen to the six different categories of trading stock held by the taxpayer and commented generally on the taxpayer’s contentions as follows [at para 12]:
It is difficult to discern the basis on which the taxpayer contended for a diminution of the value of its trading stock. That is because its version migrated from an initial reliance on a deemed obsolescence to reliance on a group policy in accordance with IAS2. The taxpayer did not suggest that there has been a diminution by reason of ‘damage, deterioration, change of fashion [or] decrease in the market value’. It appears to be simply contending that because the items in question had remained on its shelves for a particular length of time, it was entitled to write down those items by fixed percentages by applying IAS2 to determine a new NRV and create provision for obsolescence.
In concluding that the judgment of the Tax Court stood to be set aside, Ponnan JA held as follows at para :
It is apparent when the evidence relating to all six categories [of trading stock] is considered, that the taxpayer’s approach essentially boiled down to this: because it held thousands of items of stock at year end, it was not feasible for it to individually value each item. For that reason, it applied its policy with reference to item descriptions. This evidence was accepted by the Tax Court in support of the proposition that the legislature could not have intended that a trader assess each individual item of closing stock in circumstances where they hold thousands of items of trading stock. But this was misplaced. SARS never contended that the taxpayer had to assess each individual item of stock. On the contrary, as SARS accepted, the practice of sampling in these situations is a well-recognised method of dealing with the challenges of high volume trading stock. But, that is not what the taxpayer did in this instance.
The taxpayer in this case raised similar arguments to the taxpayer in C:SARS v Volkswagen and it is interesting to note that the matter proceeded to the SCA notwithstanding that the matter was heard after the SCA handed down the judgment in C:SARS v Volkswagen. The SCA in C:SARS v Atlas Copco confirmed its findings as per the Volkswagen case and while the court’s findings do not require taxpayers to value each and every item individually, there needs to be a method to writing down its stock and a taxpayer should be able to substantiate this method sufficiently. This is in accordance with the guidance provided in Practice Note 36 and the general practical methods accepted by SARS in the past.
In respect of the initial proposed amendments to section 22 (which deviated from the above principles), the Minister of Finance tabled the revised draft Taxation Laws Amendment Bill, 2019 in Parliament on 30 October 2019. The proposed clause 24 reads as follows:
(1) Section 22 of the Income Tax Act, 1962, is hereby amended by the addition in subsection (1) to paragraph (a) of the following proviso:
‘‘:Provided that for the purposes of this subsection—
(i) the amount of trading stock must be taken into account in determining taxable income by including such amount in gross income; and
(ii) in determining any diminution in the value of trading stock, no account must be taken of the fact that the value of some items of trading stock held and not disposed of by the taxpayer may exceed their cost price; and’’.
(2) Subsection (1) comes into operation on 1 January 2020 and applies in respect of years of assessment commencing on or after that date.
The new revised proposed amendment is different to the initial proposed amendment and it will be interesting to consult the revised explanatory memorandum to be issued in due course in order to gauge the rationale for the new proposal.