Judgment was recently delivered by Judge Willis in a Tax Court case (Case No. 12262) between the South African Revenue Service ("SARS") and ABC (Pty) Ltd ("ABC"), a wholly owned subsidiary of a JSE listed company ("D Ltd").
The taxpayer, ABC, was a company which focused on mining operations yielding fluorspar, a mineral which is used, inter alia, in the production of hydrofluoric acid, which is in turn used in the manufacture of Chlorofluorocarbons - more commonly referred to as "CFCs" (although similarly complicated, the chemical compound and not the tax concept).
Amongst the issues dealt with by the court was whether expenditure incurred by the taxpayer in terms of marketing fees and management fees, which were paid to its holding company, D Ltd, was excessive. This serves as an indication to taxpayers that SARS is taking cognisance of such transactions.
The terms of the marketing agreement entered into between ABC and D Ltd set out that ABC would pay D Ltd a once-off fee to conduct a study of supply and demand priorities of the product in order to expand the customer base for the product. ABC would also pay a monthly fee to D Ltd and in return, D Ltd would endeavour to increase the customer base of ABC as well as sales of the product, and would be entitled to appoint sub-agents to assist with the marketing of the product.
ABC also appointed D Ltd to manage its financial and other affairs in terms of a management agreement entered into between the parties, and certain expenditure was incurred by ABC in making payments to D Ltd in terms of the management agreement.
The deduction by ABC of the marketing fees incurred was disallowed by SARS on the basis that the fees were excessive. Arguments put forward by SARS in respect of the management fees incurred also included the contention that the management fees paid were inflated and excessive.
Although there is no legislation contained in the Income Tax Act, Act 58 of 1962, as amended ("the Act") which specifically addresses "excessive expenditure", section 11(a) of the Act provides that expenditure is deductible if, inter alia, it is actually incurred in the production of income. Section 23(g) of the Act proceeds to limit the deduction of such expenditure only to the extent that it is laid out or expended for the purposes of trade.
A number of reported cases have held that the Commissioner is entitled to disallow expenditure to the extent that it is considered to be excessive, on the grounds that the expenditure is not actually incurred in the production of the income, as required by section 11(a), nor is laid out or expended for the purposes of trade, as is required by section 23(g), but is inspired by some other motive. In this case, one of such "motives" put forward by SARS was the taking advantage of an accumulated assessed tax loss.
The approach followed by the Tax Court in determining whether the marketing and management expenditure incurred was excessive essentially involved the application of a two step inquiry in respect of each type of expenditure incurred, namely:
- Firstly, an evaluation of the purpose for which the relevant expenditure was incurred by the taxpayer against evidence which illustrated whether such purpose was legitimate and whether the respective objectives were met; and
- Secondly, a comparison of the expenditure incurred by the taxpayer against international and/or industry norms.
In applying the approach set out above, the Tax Court decided that the taxpayer succeeded on appeal in proving that the amounts were indeed deductible.
Interestingly, the court also held that it is not for the Tax Court (or the Commissioner) to say, with the benefit of hindsight, that business expenditure should be disallowed on the basis that it was not strictly "necessary", or that it was not as effective as it could have been. If the purpose of the expenditure was to produce income, in the course of trade, and the expenditure was not of a capital nature, then that is sufficient.
From the principles drawn from in this case, it appears that an attack by SARS on deductions claimed, where the basis of such attack is that the expenditure it is "excessive", may be successfully contested by the taxpayer where the expenditure in question can be effectively measured against its objectives and where such expenditure can be proven to fall in line with comparable norms. A higher degree of assurance may be obtained by taxpayers in obtaining appropriate advice, in particular, with regard to the benchmarking of expenditure against the appropriate criteria by transfer pricing specialists where transactions are concluded between group companies.