For the purposes of determining a party's taxable income derived from carrying on a trade, Section 11(c) of the Income Tax Act (58/1962) provides for the deduction of legal expenses which arise during or by reason of a taxpayer's ordinary trading operations. More specifically, any legal expenses incurred by a taxpayer for "any claim, dispute or action at law arising in the course of or by reason of the ordinary operations undertaken by the [taxpayer] in the carrying on of [its] trade" are deductible.
For a taxpayer to deduct legal expenses (eg, legal practitioner fees, expenses incurred in procuring evidence or expert advice, court expenses, witness expenses, taxing expenses, expenses of sheriffs or messengers of the court and other litigation expenses of a similar nature), they:
- must relate to a claim, dispute or action at law;
- must have arisen during or by reason of the taxpayer's ordinary operations undertaken in the course of its trade; and
- must not be of a capital nature.
Must relate to claim, dispute or action at law The Income Tax Act fails to define the phrase "claim, dispute or action at law". However, the meaning of this phrase was considered in a case in which the taxpayer incurred expenditure on securing legal representation before a commission of enquiry appointed under Section 417 of the Companies Act (61/1973).(1) The South African Revenue Service commissioner argued that the word 'dispute' referred to a defined and readily identifiable dispute between the parties. Although the court did not find it necessary to decide the issue as commissions appointed under Section 417 are appointed by a court, it expressed the view that the word 'dispute' covers "any disagreement as a result of which parties require legal assistance".
Must arise in course or by reason of taxpayer's ordinary operations For purposes of Section 11(c) of the Income Tax Act, it is not a requirement that legal expenses be incurred in the production of income. Arguably, all that is required is for legal expenditure to have arisen during or by reason of the taxpayer's ordinary trading operations.
The term 'trade' is given a wide meaning in Section 1 of the Income Tax Act and includes:
"Every profession, trade, business, employment, calling, occupation or venture, including the letting of any property and the use of or the grant of permission to use any patent as defined in the Patents Act, or any design as defined in the Designs Act, or any trade mark as defined in the Trade Marks Act, or any copyright as defined in the Copyright Act, or any other property which is of a similar nature."
The courts have interpreted the phrase "arising in the course of or by reason of ordinary operations undertaken by him in the carrying on of his trade" to mean that the deductibility of legal expenses under Section 11(c) does not depend on the purpose of the expenditure, but rather the causal connection of the relevant events to the taxpayer's trade.
For example, in Income Tax Court (ITC) Case 1837(2) the taxpayer, a premier of a province, had made remarks at a press conference that resulted in him being successfully sued and ordered to pay damages for defamation. It was held that the claim for damages had arisen in the course and scope of his employment as premier and was sufficiently closely related to his ordinary trading operations to establish the requisite causal connection between such expenditure and those trading operations. As such, the legal expenses incurred in defending the claim were deductible under Section 11(c) of the Income Tax Act.
Must not be of capital nature The question of whether expenditure is of a capital nature depends on the facts of each case. For example, what may be capital expenditure in the case of one taxpayer may be revenue expenditure in the case of another. A useful test, which has been applied and endorsed in a number of South African judgments,(3) is to ascertain whether the expenditure was incurred to create, acquire or improve an income-producing asset, in which case it will be of a capital nature. As with most capital or revenue matters, there is seldom tax certainty and a view must be formed based on a myriad of tax cases with contrasting principles and decisions. Some of these cases are summarised below.
In ITC Case 1241,(4) a scrap metal merchant erected a crushing machine on hired land zoned by the local municipality for general residential purposes. The municipality then gave notice calling for the removal of the machine, which the company ignored. The municipality consequently instituted proceedings in the Supreme Court for an order directing the company to remove the machine. In an attempt to gain time and continue the profitable use of the machine for as long as possible, the company decided to use all legitimate means of resisting the granting of an order for the machine's removal. Simultaneously, the company attempted to find a suitable alternative site for the machine.
The court – having regard to the fact that the purpose and effect of the expenditure was to delay the granting of an order compelling the machine's removal for as long as possible – held (at 306) that:
"The legal expenses incurred did not create or enhance any asset, they did not bring about any advantage for the enduring benefit of trade, and they were more closely related to the appellant's income-earning operations than to its income-earning structure. [T]he appellant took a calculated risk, and the expenditure was in truth no more than part of the cost incidental to the performance of the income-producing operations."
The court accordingly concluded that the legal expenses incurred were not of a capital nature and were deductible under Section 11(c) of the Income Tax Act.
In ITC Case 1677(5) a party (D) applied for an interdict against the taxpayer, a publishing company, on the basis that the taxpayer had published two textbooks which constituted an infringement of D's copyright. The court had to decide whether legal expenses incurred by the taxpayer were of a capital nature.
The court rejected the taxpayer's argument that the expenditure did not give rise to any asset or advantage of an enduring nature on the basis of the decision in Secretary for Inland Revenue v Cadac Engineering Works (Pty) Ltd.(6) Cadac had manufactured cookers under a licence from the patent holder and asked it to institute legal proceedings against another firm, Homegas, which had started marketing cookers in competition with Cadac. Cadac undertook to indemnify the patent holders for its legal expenses. The court held that the legal expenses were of a capital nature as they were directed at preserving and perhaps expanding the field in which the taxpayer's business operated. This was further the case as the expenditure had been incurred by Cadac to eliminate the competition of Homegas. It was therefore not deductible.
Based on the reasoning in Cadac, the court in ITC Case 1677 held that the taxpayer's litigation was instituted to preserve an asset and protect the taxpayer's market. The legal expenses were therefore capital in nature and not deductible.
In light of the above, to the extent that the requirements of Section 11(c) are met, legal expenses should be deductible. However, it is important for taxpayers to bear in mind that such deduction is limited where the expenses:
- are not of a capital nature;
- are not incurred in respect of any claim made against the taxpayer for the payment of damages or compensation if by reason of the nature of the claim or the circumstances any payment which is or might be made in satisfaction or settlement of the claim does not or would not qualify for deduction under Section 11(a) of the Income Tax Act;
- are not incurred in respect of any claim made by the taxpayer for the payment to it of any amount which does not or would not constitute income of the taxpayer; and
- are not incurred in respect of any dispute or action at law relating to any such claim as referred to in the previous two bullet points. In other words, where legal expenses are incurred with regard to a claim, it must be made for the taxpayer to:
- pay damages or compensation deductible under Section 11(a) of the Income Tax Act; or
- derive an amount that will be included in its income.
For further information on this topic please contact Gigi Nyanin at Cliffe Dekker Hofmeyr by telephone (+27 115 621 000) or email ([email protected]). The Cliffe Dekker Hofmeyr website can be accessed at www.cliffedekkerhofmeyr.com.
Endnotes
(1) ITC Case 1419 (1986) 49 SATC 45.
(3) See, for example, New State Areas Ltd v Commissioner for Inland Revenue (1946 AD 610) and Commissioner for Inland Revenue v George Forest Timber Co Ltd (1924 AD 516).
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