The points for consideration by the Supreme Court of Appeal ("SCA") in Telkom SOC Limited v C:SARS on 25 March 2020 were two-fold. First, did Telkom realise a deductible foreign exchange loss upon the disposal of certain USD-denominated loans in terms of section 23I of the Income Tax Act, 1962 ("ITA")? Secondly, was Telkom entitled to a full deduction for cash bonuses it had paid to a third-party for connecting subscribers to Telkom Mobile or was the deduction limited in terms of section 23H of the ITA?
Section 24I – foreign exchange loss
The facts relevant to this issue were simply this: Telkom made a number of shareholder loans to an indirect subsidiary in Nigeria, Multi-Links. By October 2011, a total amount of USD531-million was outstanding on the loan account. With dwindling prospects of ever recovering the amounts or resuscitating the business of Multi-Links, Telkom decided to sell the total loan claims to HIP Oils for a mere USD100. Both the Tax Court and the SCA referred to Telkom's investment as being "disastrous".
Telkom argued that it had realised a foreign exchange loss when it sold the loans to HIP Oils for USD100. Telkom was thus, or so it contended, entitled to a corresponding foreign exchange deduction upon realisation of those loans as envisaged in section 24I(10). SARS, on the other hand, argued that notwithstanding that Telkom had realised a significant loss from a business perspective, there was in fact an exchange gain that fell to be taxed in terms of section 24I. Section 24I of the ITA essentially prescribes the income tax treatment of foreign exchange gains and losses on exchange items.
At the centre of the dispute between Telkom and SARS was their divergent interpretations (and applications) of the term "ruling exchange rate", or more specifically the proviso to that definition (as it is defined in section 24I(1)). The effect of Telkom's application meant that a "disposal rate" of ZAR0 00002:USD1 (being USD100 divided by USD531-million) would be used on disposal of the loans to calculate the foreign exchange gain or loss. Conversely, SARS argued that the exchange gain or loss should simply have been determined with reference to the spot rate on the date when the loans were disposed of (i.e. ZAR7.99: USD1). This was so, SARS contended, because the USD100 consideration was not determined by applying a "rate other than [the] spot rate...", as required by the proviso. Based on SARS' interpretation, there would be a taxable foreign exchange gain in Telkom's hands of ZAR267-million. To this end, Telkom argued that SARS' position did not take into account the "commercial reality of the transaction" and that it was not sensible or businesslike.
Could Telkom really be liable to pay tax in circumstances where a disastrous investment that had left it at least ZAR3.9-billion out of pocket?
The Tax Court rejected Telkom's arguments. It held that "exchange rate" meant the rate which reflects the value of the particular currency in question. It was further held that the purpose of section 24I was to facilitate the conversion of foreign currency into ZAR, as opposed to serving as a section 11(a), general deduction for a loss.
On appeal to the SCA, the court upheld the Tax Court's findings in this regard. It added that the word "rate" in section 24I, read in its proper context, referred to an exchange rate as that term is traditionally understood. According to the SCA it was evident that the USD100 consideration for the loan was based on perceived value of the loan and that currency exchange ratios played no role in the determination of the price. Telkom could therefore not rely on the proviso to the definition of "ruling exchange rate" which would have allowed it to use the "disposal rate", calculated as ZAR0,00002:USD1. The spot rate had to be used.
The provisions of the eighth schedule to the ITA, read with section 25D, should also be kept in mind. A loan with a "base cost" of UDS531-million that is disposed of for "proceeds" equal to USD100, would (as a general proposition) create a significant capital loss in the hands of the creditor if the loan was held on capital account. These provisions would patently take cognisance of the "commercial reality" of a poor investment.
In light of the significant deterioration of the ZAR, and indeed the global economy, there are undoubtedly a number of taxpayers who will find themselves in precarious positions not too dissimilar from Telkom vis-à-vis its Multi-Links investment. The recently introduced section 24I(4) may potentially come to the aid of these companies. Effective after 1 January 2019, this section provides that where a realisation of a debt resulted in a loss that was due to a decline in the market value of such debt, a taxpayer may deduct any foreign exchange gains included in its income in the current year, or in any previous years of assessment. The same position applies to debts that are irrecoverable on realisation. These provisions might have allowed Telkom, for instance, to deduct the forex gain of ZAR267-million that was otherwise held to be taxable.
The judgment also contains a number of important principles relating to the interpretation of statutes. Among these was confirmation that the contra fiscum rule may still find application, but only after a purposive approach has been followed which yields two plausible interpretations.
Section 23H – cash incentive bonus
The second issue for consideration was SARS' decision to allow only a portion of a cash incentive bonus to be deducted against Telkom's taxable income.
In terms of the incentive, Telkom paid certain cash bonuses to a third-party company, Velociti, once it procured subscriptions from customers to Telkom's network. The particular bonus would then depend on the tariff plan and certain other milestones attained.
SARS disallowed a substantial portion of the bonuses paid in terms of section 23H(1)(b)(ii) of the ITA. It did so because it argued that those amounts, which would otherwise be deductible in terms of section 11(a), read with section 23(g) of the ITA, were barred from being deducted in full because they were expended in respect of a "benefit", and the benefit to which the expenditure related extended beyond the year of assessment during which they were incurred (i.e. the 2012 tax year).
As a general proposition, section 23H(1) of the ITA contains a so-called matching principle. The effect of the principle is that where expenditure is actually incurred by a taxpayer for goods that are yet to be supplied, services that are yet to be rendered, or benefits that are yet to be enjoyed, the taxpayer must spread the deduction for expenditure incurred over the tax years during which the goods are supplied, the services are rendered, or the benefits are enjoyed.
The point for deliberation was thus when the benefit was enjoyed by Telkom. Was it once the new contracts had been entered into with the new customers, all being before the end of the 2012 tax year, as held by the Tax Court, or was it over the course of the new contract periods? SARS argued that it was the latter and that the deduction had to be apportioned over the 24 month-period of the new subscriptions.
The SCA, dismissing the Tax Court's findings, upheld SARS' argument and found that Telkom did not enjoy any benefit immediately upon the conclusion of a new contract, but only when the connections turned into income by way of subscription fees over the course of the contract period.
It is noticeable that neither the Tax Court nor the SCA considered whether the payments were made in respect of services. It could be argued the Velociti was indeed rendering a service to Telkom and that the expenditure was paid in respect of those services. Under this construction, the services would arguably have been rendered in full by the end of the 2012 year of assessment, rendering section 23H inapplicable. This would of course require a detailed analysis of the contracts and whether these constitute a service. It is perhaps on this basis that the Tax Court and SCA did not take the enquiry further.
Taxpayers should thus carefully consider whether their expenditure relates to a "benefit" or a "service". In addition, taxpayers should also take account of the section 23H(2) of the ITA. This section provides that if the apportionment of the expenditure as required by section 23H(1) does not "reasonably represent a fair apportionment", such expenditure must be made in a manner that is fair and reasonable. Any such apportionment must of course be carefully considered.
Telkom has indicated to its shareholders that it intends to petition an appeal to the Constitutional Court.
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