On 27 September 2019 the Supreme Court of Appeal (SCA) delivered its judgment in CSARS v Atlas Copco South Africa (Pty) Ltd1. In doing so the court drew heavily on its 2018 judgment in CSARS v Volkswagen SA (Pty) Ltd 2. As was the case in Volkswagen, central to the issues in Atlas Copco were the effects of international accounting standards on the provisions of section 22 of the Income Tax Act, 1962, dealing with the valuation of trading stock.
The taxpayer is a member of the Atlas Copco Group, with its parent company in Sweden. In terms of group policy, its main business is to sell or lease, and subsequently service, machinery and equipment, including spare parts and consumables, imported mainly from Sweden and used in the mining and related industries. Group policy, known as the Finance Controlling and Accounting Manual (FAM), required the taxpayer to write down the value of its trading stock by 50% if it had not sold in the preceding 12 months and by 100% if it had not sold in the preceding 24 months.
The taxpayer duly applied this policy and reflected the resulting values in its tax returns for the 2008 and 2009 years of assessment. SARS took the view that this policy did not comply with the provisions of section 22(1)(a) of the Act, which provides for the carrying value to be reduced to the extent that it had been diminished by reason of "damage, deterioration, change of fashion, decrease in market value or for any other reason satisfactory to the Commissioner". In the first appeal, the tax court had identified what it called the crisp legal dispute between the parties as being "whether the nett realisable value ('NRV') of the Atlas Copco SA's closing stock, calculated in accordance with IAS2, IFRS, South African Statements of Generally Accepted Accounting Practice ('SA GAAP') and the policy, may and should, where it is lower than the cost price of such trading stock, be accepted as representing the value of trading stock held and not disposed of at the end of the relevant years for purposes of section 22(1)(a) of the Income Tax Act". The tax court found that the policy led to a "sensible and business-like result" and was a "just and reasonable basis" for valuing the taxpayer's stock as contemplated in section 22(1)(a). In doing so it had followed the decision of the tax court in Volkswagen, but without the benefit of knowing that the SCA had subsequently reversed this decision.
On appeal by SARS, the SCA noted that section 22(1)(a) is concerned with the value of a taxpayer's trading stock at year end. SARS has the power to allow a deduction in the four circumstances specified in the section: damage, deterioration, change of fashion, decrease in market value or for any other reason satisfactory to the Commissioner. As it had done in Volkwagen, the court observed that this provision is couched in the past tense; in other words, the diminution in value must have already occurred. The exercise was thus one of looking back at what had happened during the past year of assessment.
The taxpayer's case was that the reference to market value in section 22(1)(a) is the same as NRV as employed in the accounting statements. However, the SCA traversed its decision in Volkswagen, summarising the five "important observations" made by Wallis JA:
- whilst annual financial statements prepared in accordance with a group's accounting handbook serve a valuable purpose in providing a true picture of the company's financial affairs, they are not necessarily equally applicable to the determination of the taxpayer's tax liability;
- although there is some scope for overlap, not all the elements of accounting standards relate to the same matters as the section;
- the determination of NRV is based on an assessment of future market conditions. It is forward looking, which has the result that future expenditure is taken into account and becomes deductible a prior year;
- whether NRV reflects a diminution of value of trading stock for purposes of section 22(1)(a) depends, not on its acceptance as part of GAAP, but on its conformity to the requirements for diminution in value as determined on a proper interpretation of the section; and
- the fiscus is concerned with the valuation of trading stock, the question being whether trading stock as a whole had suffered a diminution in value. [This remark had raised some unease in tax circles, suggesting as it did that section 22(1)(a) does not call for an item by item consideration of the value of trading stock].
Accordingly, found the court, the tax court in the present matter had erred as had the tax court erred in Volkswagen.
Atlas Copco, by its own admission in evidence, had not considered whether there had been a diminution by reason of any of the criteria mentioned in section 22(1)(a). It had merely applied the group's policy on aging without regard to any other factor. This purely time-based approach was not entirely consonant with the requirements of section 22(1)(a). It was an arbitrary, fixed and rigid company policy and "did not present the most reliable evidence available at the time in respect of any diminution in value". The taxpayer's auditor testified that they had identified only three product lines that had been sold below cost during the year, and these at between 24% and 26% below cost. As the court commented, this is a far cry from the application of 50% or 100% in terms of the policy. In fact, the auditor conceded that the group policy was "a very aggressive policy".
As the court stated, this evidence indicated that the taxpayer's approach to the valuation of its trading stock was flawed and ordinarily this would have been dispositive of the appeal. However, it was necessary to deal with each of the six categories that made up the taxpayer's trading stock.
Slow moving and overstock categories. The taxpayer asserted that it operated in the mining sector and had to meet orders at relatively short notice. For this reason it had surplus stocks of various items from time to time. The FAM policy was applied to these items, not because they had deteriorated, but because they had been on hand for longer than the group's 12-month or 24-month policy. There was no indication of any diminution in these items; it was "at best an unmotivated guesstimate" as to whether there would in future be demand for them.
Goods in transit. These were goods that for whatever reason had to be returned to the Swedish parent company. On the evidence of the taxpayer's witness, the taxpayer relied on an unsubstantiated estimate of the value of these stocks.
Demonstration items. Although the taxpayer's witness conceded that these ought to have been recorded in a fixed asset register, they were kept as part of inventory and valued for tax purposes at 50% of cost, save for items that could not be located; these were reduced by 100%. The evidence suggests a less than satisfactory treatment of these items.
Dynapac stock. This consisted of road construction heavy equipment and spare parts. This had been acquired in October 2008, a mere two and a half months before the financial year end. Under the "enormous pressure" of year end preparations, the taxpayer had simply followed Dynapac's valuation policy and written assets off by 100%. There was no evidence that the diminution conditions of section 22(1)(a) had been considered, let alone applied.
Standard cost items. These comprised items acquired from the parent company, only to be notified by the latter later during the tax year of a price increase or decrease. The taxpayer was unable to tender any satisfactory evidence as to the value of the stock at year end.
It was apparent to the court that the taxpayer's approach in respect of all the stock categories was that, because it held thousands of items of stock at year end, it was not feasible to value each item individually. The tax court had accepted this explanation in support of the proposition that the legislature could not have intended that a trader should assess every item of closing stock in these circumstances. The SCA found that this acceptance was misplaced. SARS had never contended that the taxpayer had to assess each item individually. SARS had accepted that the practice of sampling is a well-recognised method of dealing with high volume trading stock. However, this was not what the taxpayer had done in the present matter.
For all the reasons given, the decision of the tax court could not stand. The appeal was upheld with costs, including two counsel.
The taxpayer had also appealed against SARS' imposition of interest under section 86quat of the Act for underestimating provisional tax based on the taxpayer's estimate of taxable income. The court found no warrant for remitting this interest.
The SCA has now twice within a year confirmed that the application of accounting standards to valuing trading stock, without reference to the four circumstances in section 22(1)(a) of the Act, is not acceptable for tax purposes. Unfortunately, however, the court did not clarify the aspect of the Volkswagen judgment that has caused the unease in tax circles, and which appears in (e) above. In fact, all the court did was to refer without comment to the statement of Wallis JA at : "However, I can see no reason for the Commissioner to accept that Volkswagen's trading stock had diminished in value on the basis of a calculation where Volkswagen took advantage of the 'swings', where the NRV was lower than cost price, but disregarded the 'roundabouts', where the reverse was true. For tax purposes the question was whether Volkswagen's trading stock as a whole had suffered a diminution in value" With the utmost respect, if by 'roundabouts' the learned judge was referring to increases in the NRV of some items of trading stock, these are irrelevant for purposes of section 22(1)(a). The section is clear: if the value of an item of trading stock has fallen below its cost price, in consequence of one or more of the circumstances contemplated in section 22(1)(a), its carrying value for tax purposes is the lower figure. If the NRV of the item has increased above cost, its carrying value is the cost price.
However, the court in Atlas Copco accepted SARS' statement that sampling is a well-recognised, and by implication acceptable, method of dealing with high volume trading stock. The wider implication is that blanket valuation methods are not acceptable, if trading stock is not high-volume, an item by item, or at least by groups of stock of similar nature and value, approach is required.
1 (834/2018)  ZASCA 124
2 (1028/2017  ZASCA 116
29 October 2019
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