23 January 2020 by and Tax & Exchange Control Alert

Is a debt a loan for tax purposes?

It is trite that a loss or expenditure resulting from an advance of funds is deductible under section 11(a) of the Income Tax Act 58 of 1962 (Act), provided it meets the requirements under the section. One of the requirements of section 11(a), is that the loss or expenditure in question, must not be of a capital nature.

In answering the question whether the loss or expenditure incurred is of a capital nature, one must distinguish between fixed capital, which is deployed in order to equip the income earning structure of the business and floating capital, where the capital employed in a business is constantly changing form, from goods to money and vice versa as part of the taxpayer’s income-earning operations.

In the ordinary course, a loss resulting from funds advanced as fixed capital, will constitute a loss of a capital nature. Therefore, in the event that the funds become irrecoverable, the loss would not be deductible under section 11(a) of the Act.

However, in Solaglass Finance Co (Pty) Ltd v Commissioner for Inland Revenue 1991 (2) SA 257 (A), it was held that where a taxpayer can show that it has been carrying on the business of banking or money-lending, a loss incurred by the taxpayer as a result of an irrecoverable loan will be deductible, provided it also meets the other requirements of section 11(a). In respect of the requirement in section 11(a) that the loss suffered must not be capital in nature, it was held in Solaglass Finance that if the funds constitute floating or circulating capital, that is, stock in trade, the loss suffered as a result of the loan will be revenue and not capital in nature.

Where a taxpayer is owed a debt and the debt becomes irrecoverable, the taxpayer would suffer a loss that would only be deductible in terms of section 11(a) of the Act, if all the requirements of the section are met, including the requirement that the debt must not be capital in nature. The question regarding the deductibility of a debt that had become irrecoverable, arose in the judgment handed down by the Tax Court, Cape Town in Taxpayer v Commissioner for the South African Revenue Service [2019] ZATC 3 (15 November 2019). In this matter, the question was whether funds advanced in the context of a consignment sale agreement between two subsidiaries of a holding company constituted fixed capital and were as such not deductible under section 11(a).

Background

The taxpayer (Taxpayer) and D Exporters (Pty) Ltd (D) were subsidiaries of XYZ Holdings (Pty) Ltd and both conducted the business of purchasing fruit locally and selling it to the export market. In 2014, one of the Taxpayer’s major suppliers of fruit, E (Pty) Ltd (E) was in financial difficulty. The Taxpayer acquired E’s business pertaining to F fruit with the aim of ensuring the continued supply of F fruit. The major asset purchased was the F fruit and the purchase price for the F fruit made up the bulk of the purchase price paid for the E business.

Because of the prevailing circumstances, the Taxpayer had to finance the purchase price for the E business, by agreeing to sell the F fruit to D, which would issue pro forma invoices to V Exchange. In turn, V Exchange provided finance to the Taxpayer to acquire the E business, based on the purchase commitment made by D. The terms of the consignment sale were that the sale price was not fixed upfront, but the Taxpayer would receive whatever D was able to sell the fruit for after the deduction of D’s costs. From an accounting perspective, the price of the fruit sold to D was included in the Taxpayer’s trading revenue for 2014 and the cost of the fruit acquired from E was included in its cost of sales line.

D lacked the infrastructure to enable it to market the fruit. Therefore, the Taxpayer and D also agreed that the Taxpayer would provide the necessary resources and incur the expenditure for items such as shipping and logistics and charge D an equivalent amount for doing so. This was necessary because in order for the Taxpayer to receive anything from the sale of fruit to D, D had to sell the fruit in the export market.

In the Tax Court the evidence of the Taxpayer was that the trading operation involving the fruit from E was not as successful as had been hoped and that D was indebted to the Taxpayer in the amount of R18,273,271.26. At the end of the 2014-year D had no resources to settle its indebtedness and the amount was written off. This gave rise to a loss in the hands of the Taxpayer.

D accounted for the written off debt as additional income and declared this amount as part of its taxable income. SARS agreed that this was the proper tax treatment of the amount in D’s books. The Taxpayer however, accounted for the written off amount as a loan between itself and D. When the Taxpayer claimed this loss as a deduction, SARS took the view that the loss in the hands of the Taxpayer was of a capital rather than a revenue nature because the net debt of D to the Taxpayer was accounted for by the Taxpayer as a loan.

Judgment

In determining whether the amount written off by the Taxpayer was capital or revenue in nature, the Tax Court reasoned that the fact that an amount written off was advanced as a loan, is not itself determinative of whether it is capital or revenue in nature. This is because the accounting treatment applied by the Taxpayer is not determinative of either the legal or correct tax position. The question is always one of substance rather than form, considering the facts of the case.

The Tax Court explained that what is important are the circumstances giving rise to the indebtedness. To this end the Tax Court highlighted that one must analyse the nature of the capital to which the expenditure or loss relates. It further highlighted the distinction between fixed capital, on the one hand, which is deployed to equip the business on a non-recurring basis and is capital in nature, and floating capital, on the other, which frequently changes form from money to goods and vice versa and is regarded as revenue.

According to the Tax Court, the fact that the account in the books of the Taxpayer ought not to have been called a loan account, but rather a trading or control account was of little significance since this was not itself determinative of the nature of the expenditure or loss. It was evident to the Tax Court that the Taxpayer could have made a trading profit on the fruit but did not, with the result that it suffered a trading loss after writing off D’s debts. The loss was not as a result of an investment concerned with supporting an extraneous business of D. Instead, it was an indebtedness that arose from the Taxpayer’s trading activities with D.

On this basis the Tax Court concluded that the amount owing to the Taxpayer, was related to the sale of E fruit to D on consignment, taking account of payments made in part-settlement of D’s indebtedness on that account. It did not amount to a deployment of the Taxpayer’s fixed capital in order to equip its income-earning structure. This, according to the Tax Court, was a clear example of the deployment of floating capital as it was not intended to remain outstanding, but intended to be converted back into cash in the ordinary conduct of the Taxpayer’s trade.

Observations

In this judgment the Tax Court highlighted that the difference in the tax treatment of a loss or expenditure resulting from an advance of funds is dependent on whether the loss or expenditure is of a capital or revenue nature. This determination is made by having regard to the circumstances in which the loss or expenditure is incurred.

Importantly, whether a taxpayer accounts for the funds advanced as a loan or a debt is not determinative, but one must look at the nature of the funds advanced. What is of consequence is whether the expenditure or loss is a result of funds advanced as fixed capital in order to equip the taxpayer’s income-earning structure, thereby being capital in nature or as floating capital forming part of the taxpayer’s trading activities, thereby being revenue in nature.

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