Another ruling on income tax allowances for future expenditure

The provision has been the subject of two recent Supreme Court of Appeal (SCA) cases.

The first was CSARS v Big G Restaurants (Pty) Ltd (157/18) [2018] ZASCA 179 (3 December 2018) which was discussed in our Tax & Exchange Control Alert of 7 December 2018. In that case the taxpayer was a franchisee. It concluded franchise contracts which entitled it to operate restaurants. Under the contracts the taxpayer was obliged to upgrade the restaurants from time to time. The taxpayer claimed an allowance under section 24C for future expenditure to be incurred by it under the upgrading obligation.

The SCA ruled in favour of the Commissioner. The court held that two requirements must be met for the provision to apply. First, there must be income received or accrued in terms of a contract. Second, that income must be used to finance future expenditure which a taxpayer will incur in performing its obligations under that same contract. The SCA found that the taxpayer did not receive income from the franchise contracts; instead, it earned income from contracts with patrons for the sale of food.

The court rejected the taxpayer’s argument that the franchise contract and the contracts with patrons were inextricably linked. It held that, even though a contract (such as a franchise contract) is useful or even necessary to enable a taxpayer to earn income, it does not mean that its income is earned “in terms of” that contract.

The facts in the more recent case of CSARS v Clicks Retailers (Pty) Ltd (58/2019) [2019] ZASCA 187 (3 December 2019) were the following. The taxpayer, a retailer, ran a loyalty programme. Under that programme, the retailer issued cards to participants in the programme (members). The relationship between the retailer and the members was governed by the terms and conditions pertaining to the cards (Card Contract). Members earned points when they initially bought goods (First Purchase) from the retailer and presented their cards. If members earned enough points, they received vouchers which they could use as payment for future purchases (Second Purchase).

The retailer claimed an allowance under section 24C for expenditure it would incur to honour vouchers which participants would redeem in a subsequent tax year.

The taxpayer argued as follows. The Card Contract in itself created no claim for rewards. It was the First Purchase contract that brought the member’s claim into existence and determined the content of the retailer’s obligation to issue rewards. So, on each occasion that the retailer issued rewards, there was a “direct and immediate connection” between the retailer’s obligation to do so and the First Purchase contract.

On the basis of the Big G judgment, Judge Dlodlo dismissed the notion that section 24C applies where there are different contracts but they are “inextricably linked”. He held that the contract that created the right to income for the retailer was the First Purchase contract. However, the contract that obliged the retailer to honour the vouchers (and thereby to incur expenditure when a customer concluded the First Purchase contract with the retailer), was neither that contract, nor the Second Purchase contract – it was the Card Contract. Consequently, the expenditure incurred by the retailer in honouring the vouchers did not arise in terms of the same contract, i.e. the First Purchase and Second Purchase contracts, but in terms of the separate and distinct Card Contract.

In a separate but concurring judgment, Judge Wallis agreed with those principles. Wallis JA went on to state the following in relation to the purpose of section 24C (at pages 11 and 12 of his judgment):

“[24]…Most businesses recognise that they will be required in the ordinary course of their operations to incur future expenditure. An obvious example would be the need to make provision for the replacement of machinery and equipment in order to keep their operations up to date…The finance for such activities would have to be found from the ordinary stream of income of the business, or from borrowings. To permit an allowance for such future expenditure would result in future expenses being taken into account before they were incurred and afford taxpayers a means to manipulate the timing of tax payments. That was not the purpose of section 24C...

[26] The reason section 24C was introduced was not to afford a means whereby the taxpayer could take account of expenses foreseen but not yet incurred, but to alleviate the tax burden that would otherwise rest on builders and other taxpayers engaged in manufacturing businesses, where it is the practice to obtain a deposit or other payment in advance of work being undertaken…A problem arises where the deposit is paid in one year and the expenses in performing the contract are incurred in the following year. Absent s 24C the contractor would be obliged to declare and pay tax on the whole of the amount received in the first year and be left to set off against other income the expenses incurred in fulfilling the contract in the second year. In effect money paid to finance the performance of the contract would need to be diverted to the payment of tax, leaving the contractor to finance the performance of the contract from other resources. Permitting the taxpayer to deduct an allowance in respect of the cost of financing the performance of the contract in the second year restores the balance between income and expenditure.”

As an aside, the judge also said something interesting about the concept of expenditure. The expenditure of the retailer in this case was the cost of the stock which it acquired in the ordinary course of its business. It did not acquire stock specifically for purposes of the loyalty programme. Essentially, the court held that the retailer had no outlay; it was simply selling the stock at a discount to members much as it would do on stock clearance or “Black Friday” sales to ordinary customers.

The takeaways from the judgment are the following:

First, it neatly summarises the requirements that will need to be met if a taxpayer wishes to claim an allowance under section 24C:

1. A contract must be concluded under which revenue is received by the taxpayer.
2. The taxpayer must undertake obligations under that contract to be performed in the following tax year.
3. The performance of those obligations must oblige the taxpayer to incur expenditure in future.
4. The revenue received from the contract must be used to finance the performance of the taxpayer’s obligations under the contract.

Second, all taxpayers should ensure that they obtain advice before entering into contracts to establish whether or not the terms of the contracts will enable them to qualify for the section 24C allowance.

Third, retailers (and other enterprises) should take extra care when they design and implement loyalty programmes to ensure that they are tax effective. (In fact, the same applies to other retail programmes such as the supply of gift cards – see, for example, A Company v The Commissioner for the South African Revenue Service (IT 24510) [ZATC] 1 (17 April 2019) discussed in our Tax & Exchange Control Alert of 26 April 2019.)