General principles for tax deductions

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When can you deduct an expense?  Section 11(a) contains the general principles.

One of the most-asked tax questions goes along the lines of “can I deduct xxx against my income?” There are two ways to answer this type of question.

One is to create a never-ending list of every type of deduction one could contemplate, together with its exceptions, circumstances under which such expense cannot be deducted, and so forth. The other is to explain the general principles that apply to claiming a particular expense as a deduction.

However, before one even gets down to the criteria for deductibility, there is an overriding principle: the taxpayer must be carrying on a ‘trade’ from which it is intended that income will be derived.

The term ‘trade’ (as defined in Section 1 of the Income Tax Act) encompasses “every profession, trade, business, employment, calling, occupation or venture, including the letting of property and the use of … any patent, any design, or any trademark …”.

Once the trade requirement has been met, the specific criteria for deduction then apply. These criteria, which are contained in Section 11(a) of the Income Tax Act, are that a deduction is permitted in respect of:

expenditure or losses,
actually incurred,
during the year of assessment,
in the production of the income, and
not of a capital nature.

Expenditure or losses
Both expenses and losses qualify for deduction, and on the face of it there is little distinction between the two. However, there are some subtle differences.

An expense arises from a conscious decision to pay out an amount in the course of someone’s trade. An example would be a bakery that has to purchase flour with which to bake bread.
A loss, on the other hand, is an unexpected, involuntary event that has negative financial consequences. A supermarket that has a power failure would sustain losses when all of its perishable foods go bad as a result of no power being supplied to its freezers and refrigerators.

Actually incurred
To satisfy this requirement, the expense needs to be unconditional. Paying a particular expense in cash will undoubtedly do so; however, an unconditional liability to pay an expense at a future date will also suffice.

An example would be when a motor vehicle repair workshop has purchased several vehicle parts on credit. Provided that there is an unconditional obligation to pay for such parts, the expense is said to have been “actually incurred” even though physical payment only takes place at a later date.

It is however not necessary for the taxpayer to prove that the expense was necessarily incurred. It is not the role of SARS to determine whether the expense was prudent or otherwise.

While it may not, for example, be necessary for a security gate manufacturer to put two coats of paint on their products instead of one, the fact is that it would have incurred expenses relating to the extra coat of paint and would therefore be entitled to claim the deduction.

During the year of assessment
Over the years the courts have held that any expense that is incurred by a taxpayer must be claimed in the tax year during which it is incurred.

While it makes sense to do so, there are circumstances where such expenses are not claimed timeously. The late submission of employee expense claims is often cause for such expenditure being recorded in a later year, as is an invoice for services rendered during a previous period.

However, given that SARS allows around 8 months after the end of the tax year for individuals to submit their returns, and 12-24 months in the case of corporate taxpayers, it is not unreasonable to expect such expenditure to be claimed in the tax year in which it is incurred.

In the production of the income
This is probably the most onerous requirement since it is not just any expenditure that qualifies for deduction, but only that expenditure which has been incurred for the purpose of producing income.

However, adding to the complication is that there is often not a direct connection between the incurring of expenses and the production of a particular stream of income. For that matter, there are very little (if any) expenses that directly produce income. Even goods purchased for resale do not produce any income unless they are actually sold.

What, then, about indirect expenses such as factory rentals, salaries and wages, utilities such as electricity and water, and the like?

Fortunately, it has become established practice that in order to qualify for deduction, an expense need not directly produce income. As long as such expense has been incurred for the purpose or with the intention of deriving income, such expense will usually qualify for deduction.

This means that salaries and wages, for example, will qualify for deduction provided that the activities of the employees engaged will ultimately result in some or other income being produced.

But what about so-called ‘indirect’ expenditure that does not bear a direct relationship to the income-generating activities of the business? Items that come to mind include bank charges, audit and accounting fees, printing and stationery, and salaries paid to administrative staff.

While these expenses do not directly produce income, they form part of the income-earning structure, and it has become accepted practice to allow such expenses as a deduction.

When such an expense comes before the courts to decide, they normally look at the underlying facts, asking the following two questions:

Is there an act that can be identified as having been performed for the purpose of producing income; and
Is the expense that the taxpayer seeks to deduct sufficiently closely linked to the performance of such act?

Looking briefly at the Port Elizabeth Electric Tramway Co v CIR (1936 CPD) court case, the act identified was that of carrying passengers on trams for reward, for which the employment of drivers is a critical component.

Once the act was thus identified as being in the production of income, all that was left for the court to decide was whether the payment of compensation to relatives of a deceased employee was closely connected enough to that act.

In this case, the court held that there was such a connection, and ordered that the expense be allowed as a deduction.

Not of a capital nature
The final requirement that needs to be satisfied is that the expense must not be of a capital nature, and there are probably more court cases attempting to solve the capital / revenue conundrum than any other.  It is therefore clear that each individual case must be judged on its own merits.

There are however a few general principles that will guide taxpayers in determining whether an expense is capital or revenue:

Is the expense part of an income-making activity, or does it form part of the income-generating structure?

An example would be that of a motor car. For a taxpayer that deals in the buying and selling of cars for profit, such as a motor dealer, expenses incurred in buying cars for resale would be of a revenue nature and thus deductible.

However, if a pharmaceutical company purchases the same car, to be used by its sales representative, such car would be part of their income-earning structure, and the expense would therefore be of a capital nature and thus not deductible.

Does the expense give rise to an enduring benefit?

An example of expenditure giving rise to such a benefit would be the cost of moving and erecting a machine, connecting it to the power supply, and preparing it for first use. For accounting purposes, such expenditure would be capitalised together with the cost of the asset, and the tax treatment follows the same practice.

Is the expense bringing about an improvement to one’s income-earning structure, or merely restoring it to its former condition?

This is the old ‘repair vs. improvement’ argument, which can be answered as follows:

If the expense directly and significantly enhances the market value of the asset, it is of a capital nature.
If it is merely restoring the asset to its former state and any enhancement to its market value is incidental, the expense will be of a revenue nature and allowable for deduction.

As can be seen, the question of whether an expense is of a capital or revenue nature is a rather grey area, and for this reason, SARS usually asks for additional information where there may be an element of doubt—particularly when it comes to repairs and maintenance, where many a taxpayer has tried to write off an improvement, thereby claiming it for tax purposes.

While every reasonable effort is taken to ensure the accuracy and soundness of the contents of this publication, neither the writers of the articles nor the publisher will bear any responsibility for the consequences of any actions based on information or recommendations contained herein. Our material is for informational purposes.

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