Foreign exchange and local change: The Supreme Court of Appeal considers section 24I of the Income Tax Act and the effect of COVID-19 on time periods in the Tax Administration Act

In the Tax Court, the issue pertaining to the application of section 24I of the Income Tax Act 58 of 1962 (ITA) was decided in favour of the Commissioner for the South African Revenue Service (SARS), whereas the findings pursuant to the dispute regarding section 23H of the ITA favoured Telkom SA SOC Limited (Telkom). As a consequence, Telkom brought an appeal against the findings of the Tax Court regarding the section 24I findings and SARS brought a cross-appeal against the findings in terms of section 23H of the ITA.

The Appeal

Facts

During the period 2007 to 2009, a subsidiary of Telkom acquired 100% of the issued share capital of a telecommunications company that was resident in Nigeria (Nigerian Company). In order for the Nigerian Company to become financially viable, Telkom advanced numerous shareholder loans amounting to USD877,022,900.86 to it. By 2011, USD346,000,000.00 of the loans had been converted into preference share equity while the remainder of the loans in the amount of USD531,022,900.86 were outstanding on the loan account. During Telkom’s 2012 year of assessment, the equity interests of Telkom and its subsidiary in the Nigerian Company were sold to a third party. Telkom’s rights in respect of its loans to the Nigerian Company were also sold to the third party for USD100.

In the 2012 year of assessment tax return, Telkom claimed a deduction in the amount of R3,961,295,256 as a foreign exchange loss in terms of section 24I of the ITA. SARS disallowed the said deduction and issued an additional assessment in terms of which SARS assessed Telkom for tax in the amount of R425,188,643 as a foreign exchange gain.

Judgment

In coming to its findings, the SCA stated that the resolution of this dispute was to be found in the interpretation of the provisions of section 24I of the ITA. This section provides for the tax treatment of gains or losses incurred by taxpayers on foreign exchange transactions and requires that any such gain or loss must be included in or deducted from the income of a taxpayer to the extent that the provisions apply thereto.

Section 24I contains many definitions to which regard must be had in applying the section. For the present matter, the crucial definition was that of “ruling exchange rate” (RER). The pertinent aspects of the definition of “ruling exchange rate” are set out in section 24I(1) as follows:

‘”ruling exchange rate” means, in relation to an exchange item, where such exchange item is –

(a)   a loan or advance or debt in a foreign currency on –

(i)     transaction date, the spot rate on such date;

(ii)    the date it is translated, the spot rate on such date; or

(iii)   the date it is realised, the spot rate on such date:

Provided that where the rate prescribed in respect of a loan or advance or debt in terms of this definition is the spot rate on the transaction date or the spot rate on the date on which such loan or advance or debt is realised, and any consideration paid or payable or received or receivable in respect of the acquisition or disposal of such loan or advance or debt was determined by applying a rate other than such spot rate on transaction date or date realised, such spot rate shall be deemed to be the acquisition rate or disposal rate, as the case may be.”

At issue between the parties was the determination of the RER on the realisation date of the loan, which rate would ultimately dictate the extent of the gain or loss that was to be included in, or deducted from, Telkom’s income.

It was Telkom’s submission that the proviso to the definition of RER applied to the facts and that a rate other than the spot rate at the date on which the loan was realised stood to be used to determine the foreign exchange gain or loss. It was argued that the USD100 received by Telkom as consideration for the disposal of the loan was clearly not determined by applying the spot rate at the time to the transaction, as a consequence of which it was apparent that “a rate other than […] the spot rate” had been utilised.

Telkom contended that the pertinent question to be answered was whether the consideration of USD100 was determined by applying a “rate”. It was submitted that “rate” should be taken to mean “the price paid or charged for a thing or class of things”, with the result being that the consideration of USD100, having been agreed upon by the parties to the transaction, fell within the meaning of “rate”. The basis of this argument was that the context of the word “rate” indicated that the word did not refer to an exchange rate between currencies, but rather to an agreement as to value or worth. Ultimately, Telkom concluded that the consideration of USD100 was determined using a rate other than the spot rate, and that the proviso to the definition of RER had to be applied to the transaction.

The SCA, in agreeing with the findings of the Tax Court and the submissions made by SARS, found that Telkom’s arguments stood to be rejected for the following reasons:

1. Section 24I deals with losses or gains caused by foreign exchange fluctuations and is not applicable to a ‘business’ loss of the kind incurred by Telkom.
2. When the proviso to the definition of RER is interpreted in the context of the section as a whole, the use of the word ‘rate’ means an exchange rate which reflects the value of a particular currency. It is a currency exchange rate, and not a discount rate, that is contemplated by the proviso.
3. In order to satisfy the requirement in the proviso that the consideration must be ‘determined’ by ‘applying’ the rate, the consideration would have had to be the result of a process of calculation which utilised the ‘rate’ as a factor to produce that result. The only type of rate that would have been able to perform this function was one which compared two items against one another, such as a currency exchange rate. It was apparent that the consideration for the loan of USD100 was agreed by reference only to the perceived value of the loan and that currency exchange ratios played no role in the determination of the price.

The SCA agreed that section 24I is not intended to deal with the tax consequences of commercial losses and that its operation is limited to gains and losses arising out of currency fluctuations. In the result, the SCA dismissed Telkom’s appeal with costs.

The Cross-Appeal

Facts

In the 2012 year of assessment, Telkom made a “cash incentive bonus” payment to Velociti (Pty) Ltd (Velociti) in the amount of R178,788,421 in respect of the connection of initial subscriber contracts relating to special tariff plans. These connections were made by Velociti on behalf of Telkom and the amount paid by Telkom as the cash incentive bonus was claimed as a deduction. However, SARS only allowed a portion thereof as a deduction and added back the remainder in terms of section 23H(1)(b)(ii) of the ITA.

Judgment

Section 23H of the ITA limits the deductions claimable in a year of assessment in respect of certain expenditure that has been incurred in advance, and makes provision for the said expenditure to be claimed over a period to be determined in accordance with the provisions of the section.

At issue in the cross-appeal was whether SARS was entitled to apply section 23H to limit the deduction in the 2012 year of assessment, with the result that the balance paid was spread out over a number of years. The SCA embarked on an inquiry into the benefits derived by Telkom from the expenditure incurred, specifically when and how the benefit was enjoyed by Telkom, and agreed that the period to which the expenditure relates must be the period during which the benefit was enjoyed.

It was submitted on behalf of SARS that Telkom did not incur the cash incentive bonus expenditure merely to establish the new connections with customers, but rather that the benefit was derived by Telkom by means of the subscription fees paid by the customers over the fixed term period of the contract. In this manner, Telkom only derives a benefit from the expenditure incurred when the connection turns into fee income, and this only happens over the period of the contract when subscription fees are paid by customers.

It was contended by Telkom that the cash incentive bonus was paid to Velociti in respect of the connections that had to have been made prior to 30 September 2011 and that the benefit therefore did not extend past the 2012 year of assessment, resulting in section 23H not being applicable. Furthermore, it was contended that the fact that Telkom paid a separate commission to Velociti for the benefit that it derived from the subscription fees over the period of the contracts was indicative that the cash incentive bonus was paid solely in respect of the connections that had been made and did therefore not relate to the fees paid by customers over the contract periods.

The SCA concurred with the submissions of SARS that the true benefit derived by Telkom was the monthly subscriber payments over the anticipated 24-month period and that the term of the contracts therefore represented the periods in respect of which the benefit was derived by Telkom. It was held that:

“Although the conclusion of the contract benefitted Telkom, the enjoyment of that benefit was spread out over the period of the contract, so that the period to which the expenditure related could not be limited to the first year.”

Lastly, in response to the submission by Telkom that it paid a separate ongoing commission to Velociti over the subscription period and that this commission, and not the connection bonus, was the quid pro quo for the subscription fees, the SCA stated that the pertinent question was whether Telkom derived a benefit from the connections over the contract period. The SCA answered this question in the affirmative and held that the fact that another payment was made by Telkom did not render this fact irrelevant. In the result, the SCA upheld the cross-appeal and found that section 23H was to be applied to the cash incentive bonus paid by Telkom.

Comment

The findings of the SCA pertaining to the interpretation of the provisions of section 24I are significant in light of the current economic climate in which South African taxpayers find themselves. The recent downgrade of South Africa’s sovereign credit rating to “junk” status by rating agency Moody’s Investors Service, the increasingly negative impact of the COVID-19 pandemic on South Africa’s economy, and the overall weakening of the rand, have had negative repercussions for South African entities.

To the extent that the Rand continues to weaken, South African entities may face substantial losses, including those arising from foreign exchange items. 

At present, the findings of the SCA in the Telkom matter are binding. However, Telkom has announced that it intends appealing the adverse findings of the SCA to the Constitutional Court, the outcome of which may influence the application of section 24I and section 23H in similar circumstances.

While the timelines in which Telkom must lodge its appeal to the Constitutional Court are determined by the rules applicable to that court, taxpayers who are involved in audits or dispute resolution proceedings with SARS should take note of the effect that the lockdown (pursuant to the COVID-19 pandemic) will have on certain time periods prescribed in the Tax Administration Act 28 of 2011 (TAA).

On 1 April 2020, the Draft Disaster Management Tax Relief Administration Bill, 2020 (Bill) was published for public comment. The Bill contains a proposal regarding the extension of certain time periods prescribed in the TAA and provides that the period of the national lockdown be regarded as dies non for those specified time periods listed in the Bill.

Dies non is a day (or days) that has no legal effect and which will not be counted for purposes of the calculation of the time periods listed in the Bill. As such, the days of the lockdown period will be excluded from any calculation regarding the time period during which either SARS or a taxpayer is required to adhere to those obligations that are listed in the Bill.

The sections (prescribing the time periods to which dies non will apply) that are listed in the Bill are stated below. Dies non will apply:

1. in respect of a notice under section 47 of the TAA if the notice requires a taxpayer to attend an interview on a date within the national lockdown period;
2. in respect of a notice under section 48(1) of the TAA if the date of the field audit in the notice is on a date within the national lockdown period;
3. for a notice to appear at an inquiry under section 53 of the TAA if the date of appearance is on a date within the national lockdown period;
4. under section 60(3) in respect of a warrant of search and seizure issued under section 60 of the TAA;
5. in respect of a ruling under Chapter 7 of the TAA;
6. under section 99(1) of the TAA (dealing with the issuance of assessments and prescription);
7. in relation to section 100 of the TAA (dealing with the finality of assessments); and
8. in respect of dispute resolution under Chapter 9 of the TAA, including the dispute resolution rules under section 103 (dealing with objections and appeals).

The Explanatory Memorandum to the Bill explains that the purpose of this proposal is to “provide individuals and businesses impacted by COVID-19 with additional time to comply with selected tax obligations or due dates that are affected by or fall within the lockdown period”. It should, however, be noted that these extended time periods do not apply to the filing of tax returns or the payment obligations of taxpayers.

A similar proposal has been made in the Bill regarding specified time periods prescribed in the Customs and Excise Act, 91 of 1964.

The following example illustrates how a taxpayer may be affected by these proposals in the Bill, should they come into effect, without further amendment: A taxpayer is issued with an additional income tax assessment on 27 February 2020 and the taxpayer intends lodging an objection in respect thereof. In terms of Rule 7 of the Tax Court Rules promulgated in terms of section 103 of the TAA, the taxpayer has 30 days in which to lodge the objection. In the absence of the national lockdown, the taxpayer would have had to lodge the objection by 9 April 2020. However, due to the resultant exclusion of the days falling within the lockdown period, the taxpayer will only have to lodge the objection by 4 May 2020.

The public is invited to submit written comments on the proposed legislation to the National Treasury’s tax policy depository at 2020AnnexCProp@treasury.gov.za and Adele Collins at acollins@sars.gov.za by close of business on 15 April 2020.