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09 November 2018
The South African courts have held, on a number of occasions, that taxpayers are entitled to deduct damages or compensation paid to third parties. However, this principle does not apply in all cases.
The case of Kangra Group (Pty) Ltd v Commissioner for SARS (A20/18) was recently heard by the full bench of the Western Cape division of the High Court.
The salient facts were relatively simple: the taxpayer, Kangra Group (Pty) Ltd, was a coal mining company linked to the well-known entrepreneur and philanthropist, Graham Beck. It supplied coal to AMCI under a set of agreements. The price of the coal was fixed under the contract at about $25 per ton. During the term of the contract, the price of coal in the international market increased considerably to about $40 per ton.
The taxpayer unilaterally decided to stop supplying coal to AMCI at the fixed price and to start supplying coal to third parties at the higher price. AMCI instituted arbitration proceedings against the taxpayer and the parties eventually settled. The taxpayer conceded AMCI's claim and agreed that it would pay AMCI an amount of R90 million. During the relevant period, Kangra Group's coal business was spun off from the Kangra Group to another entity, namely Kangra Coal (Pty) Ltd to facilitate a black economic empowerment transaction with a chosen partner.
One of the key facts before the court was that Beck concluded the settlement agreement on behalf of the Kangra Group and the representative from AMCI relating to the Kangra Group's (and/or Kangra Coal's) obligations of supplying coal to AMCI. On that basis, the taxpayer sought to deduct the settlement amount for income tax purposes in terms of the general deduction provision in Section 11(a) of the Income Tax Act (58/1962).
The provision reads as follows:
11. General deductions allowed in determination of taxable income
For the purpose of determining the taxable income derived by any person from carrying on any trade, there shall be allowed as deductions from the income of such person so derived:
(a) expenditure and losses actually incurred in the production of the income, provided such expenditure and losses are not of a capital nature…
Historically, taxpayers have inevitably succeeded and failed in claiming expenses akin to damages and compensation pursuant to three issues, including:
1.whether the expenses were incurred for the purposes of conducting the taxpayer's trade;
2.if so, whether such expenses were incurred in the production of income; and
3.thirdly, whether such expenses incurred were of a revenue or capital nature (if the answers to the above two queries were in the affirmative).
In Kangra Group, Judge Gamble focused on, amongst others, the second enquiry which was neatly summarised in one of the leading cases on whether expenses are incurred in the production of income, namely Port Elizabeth Electric Tramway Co Limited v CIR 8 (SATC 13), in which Acting Judge President Watermeyer (as he then was) dealt with the issue as follows:
income is produced by the performance of a series of acts and attendant upon them are expenses. Such expenses are deductible expenses provided they are so closely linked to such acts as to be regarded as part of the cost of performing them.
A little reflection will show that two questions arise:
In Kangra Group, Gamble thus set out the crux of the matter at paragraph 27:
In the result it was incumbent on the taxpayer to establish before the Tax Court that the conclusion of the settlement agreement with AMCI was linked "distinctly and directly" with the actual earning of income by the Group before it could qualify as a deduction. To put it differently, it may be asked whether the taxpayer proved that such income as was produced by repudiating the supply agreements with AMCI, was received by the Group (or accrued to it) as a consequence of such repudiation.
The court at paragraph 47 surmised that the settlement agreement was the price that was paid for the opportunity to earn additional income from selling coal at $40 rather than $25 per ton, that amounted to a return of more than 60% over what would have been received had the coal been sold to AMCI. Gamble held that the question that had to thus be determined by the court was twofold:
The court found that the payment did not constitute expenditure for purposes of the general deduction formula and in doing so, applied, among other things, the relevant principles enunciated in the leading cases on damages and compensation, including PE Tramway as well as Joffe & Co (Pty) Ltd v CIR 13 (SATC 354) where it was established that damages had to be a necessary concomitant of the taxpayer's trade. The court in Kangra Group v SARS held as follows:
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.
Notwithstanding the court's conclusion at paragraph 55 that the taxpayer's payment of R90 million in settlement of the claim in arbitration did not constitute 'expenditure' as contemplated under Section 11(a), Gamble nevertheless (out of caution), considered and held that in any event such expenditure was not incurred in the production of income. Paragraph 58 of the judgment summarises Gambles conclusion concisely as follows:
It is evident, furthermore, that any income associated with the alleged expenditure actually accrued to the benefit of Kangra Coal. That was the entity which reflected a substantial increase in turnover for the fiscal years in question and that entity has already rendered its tax returns and claimed all related expenditure for those years. Mr. Beck's decision to claim the deduction, not on behalf of Kangra Coal but the Group, seems rather to have been influenced by a number of other developments.
The further developments referred to by Gamble were threefold, including that Beck no longer had control of Kangra Coal at the time the relevant deduction was claimed, that the terms of the sale of the coal business agreement provided that Kangra Group was only liable for contingent liabilities which existed at the time of the sale and all other liabilities had been transferred to Kangra Coal and that Beck's decision to vest the claim in the Kangra Group (as opposed to Kangra Coal) was therefore a strategic one at the end of the day.
On that basis Gamble dismissed the appeal of the taxpayer given that it had not discharged the onus of establishing that it was entitled to claim the general deduction contended for. It is interesting to speculate whether the court may have reached a different conclusion to the extent that the deduction was claimed in Kangra Coal itself as opposed to Kangra Group. There may have been an argument for the taxpayer in that instance given the closer connection between the expenditure and the income earned. However, one may well have also encountered further difficulty proving that the expenditure was of a revenue nature given that the settlement agreement arguably enabled the taxpayer to increase its income earning capacity by selling coal at a higher price to other third-party customers.
It is clear that before a taxpayer calculatedly breaches an agreement, it should carefully consider the incidence of tax.
For further information on this topic please contact Ben Strauss at Cliffe Dekker Hofmeyr's Cape Town office by telephone (+27 21 481 6300) or email (firstname.lastname@example.org). Alternatively, please contact Jerome Brink at Cliffe Dekker Hofmeyr's Johannesburg office by telephone (+27 115 621 000) or email (email@example.com). The Cliffe Dekker Hofmeyr website can be accessed at www.cliffedekkerhofmeyr.com.
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