South Africa: Apportionment Of Dual Purpose Expenditure: Round II

Last Updated: 29 November 2011
Article by Mmangaliso Nzimande

Dividends, other than certain foreign dividends, received by or accrued to or in favour of any person, do not constitute 'income' as defined in section 1 of the Income Tax Act, Act 58 of 1962 ("the Act"), being exempt from normal tax under section 10(1)(k)(i) of the Act.  In terms of section 11(a), any expenditure which has not been incurred for the purpose of producing income will not be allowed as a deduction.  Where expenditure has been incurred partly to earn income and partly to earn dividends, that is, with a dual purpose, Corbett J A in the case of Commissioner for inland Revenue v Nemojim, 1983 (4) SA 935 (A) held that in such circumstances the courts may apportion the expenditure between the two purposes and in making such an apportionment the court has to consider what would be fair and reasonable in the circumstances of the case.

In ITC 1842 (2010), 72 SATC 118 the Tax Court had to consider whether and to what extent audit fees incurred by a company which derived its revenue from dividends and from interest, were incurred in the production of 'income' as defined in the Act, or in respect of dividends, or for both purposes.

The company was a wholly owned subsidiary of a public listed company.  The collective business of the group is the operation of mobile communications networks, the provision of related services and the performance of related functions.  The company was an investor in shares and lender of funds, primarily in the context of a debenture scheme arrangement which exists in relation to companies within the group and their staff members.

The company submitted income tax returns for the 2001 to 2004 years of assessment. The percentage of total revenue derived from dividends and from interest for the relevant tax years averaged the following:

  •  Dividends:  95%
  •  Interest:  5%

The company claimed deductions of certain expenses for the relevant tax years including audit fees.  The audit fees incurred by the company related to revenue in the form of dividends and revenue from interest.  The Commissioner: South African Revenue Service ("the Commissioner") apportioned the audit fees in accordance with the ratio between dividends received and interest earned, and disallowed the portion allocated to dividends received.  In the result, the bulk of the expenditure for audit fees was disallowed.

Although the dividends constituted the bulk of the company's revenue for each of the tax years, the auditors of the company estimated that only about 6% of the audit was devoted to auditing the revenue from dividends.  The company also demonstrated that, on an analysis of the number of postings to the various accounts and journal entries for each of the relevant tax years, only about 6% of its transactions related to dividends; the balance of the entries related to the earning of interest.

In determining whether the audit fees were incurred in the production of 'income' (as defined) or in respect of dividends, or for both purposes, the court held that the criteria for determining if expenditure was incurred in the production of income is, in its view, whether the expenditure was connected to the taxpayer's income earning operations, rather than if the expenditure actually produced income as was stated by Watermeyer J in Joffe & Co Ltd v Commissioner for Inland Revenue, 1946 AD 157.

The court stated that the auditing of financial records is clearly a function which is "necessarily attached" to the performance of the company's income-earning operations.  The absence of any revenue directly attributable to the audit does not entail that moneys laid out for the audit have been expended for purposes of earning income.  Apart from the statutory obligation to undertake an audit, audited financial statements are also necessary to comply with the requirements of the Johannesburg Stock Exchange, to give comfort to creditors and to access further funding as and when it may be required by the company for its business.

The court held that expenditure may be incurred with a dual purpose, namely, for producing 'income' (as defined) and for producing revenue which is not 'income' (for example, exempt dividends).  In such circumstances the court may apportion the expenditure between the two.  This approach finds support in the judgment of Corbett J A in the case of Commissioner for Inland Revenue v Nemojim, 1983 (4) SA 935 (A).

After determining that the audit fees were incurred with a dual purpose, the Tax Court discussed various cases in which various formulae were applied to achieve a fair apportionment and stated at paragraph 21 that in all these cases, the apportionment had an arithmetic basis, either through the use of a formula, or by allocating specific components of expenditure to deductible and non-deductible categories. Circumstances may occur, however, where it is not possible to devise a fair and reasonable formula, and it may also not be possible to break down the expenditure into deductible and non-deductible components. In a case where the apportionment of expenditure between revenue and capital was at issue, Corbett CJ, in Tuck v Commissioner for Inland Revenue, 1988 (3) SA 819 (A), weighed the comparative importance of each element of the expenditure against the other and held that it is not possible to infer that the one element is more important than the other and, considering all the circumstances, considered that a 50/50 apportionment would be fair and reasonable.

The company led evidence that only 6% of the time spent by the auditors on its audit was in respect of revenue from dividends and that only 6% of the entries in the company's cash book and ledgers related to dividends.  However, the court found that, in contrast, much work was done in respect of the company's interest income and that it was significant that the company's dividend receipts over the four tax years constituted, on average, about 95% of its total revenue.

After weighing up the relative importance of a company's annual audit for its interest income as against its dividend income, the court held that the audit function is, in light of the much larger amounts of money involved in the company's dividend producing operations than in its interest producing operations, and bearing in mind the purpose of auditing, of greater importance for its dividend producing operations than for its interest producing operations.  The court was of the view that neither the ratio applied by the company nor the ratio applied by the Commissioner constituted a fair basis of apportioning the audit fees.

The Tax Court held that because neither the company nor the Commissioner suggested an acceptable basis of apportionment, it was free to devise a basis which would, in its view, be fair. The Tax Court held that a 50/50 apportionment of the audit fees would be just and equitable. It recognized not only the greater importance of the audit for the dividend earning operations, but also the time spent by the auditors on the interest-earning operations. In the result, the company was entitled to claim 50% of the audit fees as a deduction from "income" in respect of each of the four years of assessment.

The appellant  ("MTN Holdings") appealed against the Tax Court's decision and the matter was heard by the full bench of the South Gauteng High Court, Johannesburg in a recent unreported case of Mobile Telephone Networks Holdings (Pty) Limited v The Commissioner for the South African Revenue Service (Case No: A5033/10).

The court stated that, in its view, the acceptance that it was common cause that MTN Holdings was a trading entity constituted an essential element in determining the issues.  In addition, the court was also of the view that the undisputed contention of MTN Holdings that on average only 6% of the entries in its books of account such as the cash book, and ledger related to dividends was an important consideration.

The Tax Court held that upon a proper application of the law pertaining to the apportionment of expenses, the facts are clear. Only 6% of time was spent on the dividend section of the audit. The court was also of the view that the appellant's evidence could not be rejected and that the facts as proven, that is, the amount of work done must remain the yard stick or benchmark and not the value of the dividend income.

The court held that the expenditure was incurred to directly facilitate the carrying on of the appellant's trade not only in a legally compliant manner, but to generate income and that "the appellant does not have to show a direct link or connection but a closeness of connection between the expenditure and the income." (at paragraph 17). The court stated that there are instances where expenditure does not casually produce the income, but is still deductible in terms of section 11(a) of the Act.

The unchallenged evidence led on behalf of MTN Holdings, that is,  that only 6% of the auditor's time was spent on the dividends, with the balance in relation to interest which was MTN Holding's income-producing activity, left the court with no option but to rule in favor of the appellant and order an apportionment of 94% being deductible.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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