To deduct or not to deduct?
By Jerome Veldsman
Kangra Group (Pty) Ltd v SARS, a decision of the High Court, Cape Town on 27 August 2018, dealt with the “general deduction formula” in income tax, in the context of a breach of contract.
The final step in the determination of “taxable income” is to deduct from “income” all the amounts allowed to be deducted in terms of the Income Tax Act. The most significant deductions are amounts deductible under the general deduction formula (described below).
In 2003, Kangra, effectively controlled by Mr Graham Beck, and AMCI Export Corporation, an American coal trader, entered into a contract for Kangra to deliver a vast quantity of coal over several years to AMCI at a fixed price of USD 27.50/ton.
In about mid-2004, the open market prevailing coal price reached USD 40/ton. On instruction of Beck, Kangra repudiated its contractual obligations, no longer delivered any coal to AMCI, and sold its coal in the open market.
AMCI commenced arbitration proceedings in 2006, and claimed USD15 501 386 from Kangra for contractual damages for the non-delivery of coal. Kangra defended the claim, but settled in 2007, paying ZAR 90 000 000 to AMCI.
In its income tax return for the 2007 tax year, Kangra claimed a deduction of ZAR 90 000 000 under the general deduction formula. SARS disagreed.
The general deduction formula comprises section 11(a), which describes what a taxpayer is entitled to deduct, and section 23(g), which describes what may not be deducted. Simplified, section 11 permits deduction of expenditure and losses actually incurred in the production of the income, provided such expenditure and losses are not of a capital nature:
Note that an accounting point of view is entirely irrelevant to the question whether expenditure or loss is deductible under the general deduction formula. To be deductible, the expenditure or loss must have been incurred for the purpose of earning “income”, and there must be a sufficiently close link between the expenditure incurred and the actual earning of the income.
Accordingly, Kangra had to prove that the payment of contractual damages of ZAR 90 000 000 to AMCI was “actually incurred in the production of” its income earned by selling the relevant coal in the open market.
Kangra had intentionally breached the contract with AMCI, and thus incurred the relevant expenditure.
The Court started with a discussion of cases dealing the question whether negligently incurred expenditure and losses are deductible under the general deduction formula. The fact that expenditure or loss was negligently incurred does not automatically bar the deduction of such expenditure. “Whether or not a loss caused by negligence would be deductible, would depend upon the facts of the particular case and upon such matters as the nature and degree of the negligence and the character of the business.”
The Court held that also with regard to the breach of a contract, whether the expenditure or loss is deductible will depend upon the facts of the particular case:
“It may well be that an incident of trading in coal is the breaching of a contract of sale. For example, there may be a breakdown in the railway system resulting in the load not reaching the port on time and the supplier may have to face a damages claim from the buyer arising out of non-delivery. But that is a wholly different situation to one where the supplier wantonly breaches its obligations in order to secure a more lucrative contract elsewhere.“
The Court held that the law will not tolerate the consequences of an intentionally unlawful act, such as the intentional breach of a contract, as a deduction under the general deduction formula. Accordingly, Kangra lost.
The potential forfeiture of a deduction under the general deduction formula as a result of an unlawful act ought to be factored into the decision-making process. Indeed, if a party to a contract cannot, or refuses to, fulfil its obligations, correspondence ought to be drafted with one eye on potential tax consequences.