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To successfully deduct an expense, there must be a link to earning taxable income.

Section 11(a) of the Income Tax Act, the so-called ‘general deduction formula’, seems to have produced more court cases than virtually any other Section of the Act. And each time, the courts tell us the same thing: In order for you to successfully claim an expense as a deduction for income tax purposes, there must have been a clear intention for this expense to have resulted in you earning taxable income from this expense.

Without quoting the actual Section from the Act, the principles of the general deduction formula can be illustrated by the following simple example: You own a shop that sells clothing—but before you can sell any clothing, you need to buy stock so that you have something to sell. When you sell an item of clothing, the amount that you sell it for will represent income in your hands, upon which you would be taxed.

However, when you complete your income tax return, SARS allows you to deduct the cost of the item that you have sold. The net effect is that you are only taxed on the profit, which is the selling price of the item, less the price you paid for it.

What about if you incur expenses that are not directly linked with the earning of your income? For example, if you purchase a property for the purposes of earning rental income, and you finance the purchase of the property by obtaining a loan from a bank, would the interest on the loan be deductible against the rental income?

The answer in this case would be yes and is arrived at by following a simple logic.

Without the property, you cannot earn rental income. Without the loan, you couldn’t buy the property. The bank won’t give you the loan without charging you interest. You can therefore argue that you needed to incur the interest in order to produce the rental income, and therefore the interest should be deductible against the rental income for tax purposes.

This general principle was outlined in a 1936 court case, Port Elizabeth Electric Tramways v Commissioner for Inland Re-venue (1936 CPD 241), in which the judge said that “all expenses attached to the performance of a business operation are deductible whether such expenses are necessary for its performance, or attached to it by chance, or are bona fide incurred for the more efficient performance of such operation, provided they are so clearly connected with it that they may be regarded as part of the cost of performing it”.

So far, so good. But if you decide to purchase shares in a company as a long-term investment, and borrow money to purchase shares, will you be able to deduct the interest against the dividends earned? The answer, in this case, is no.

The reason for this is that Section 11(a) must be read together with Section 23(f). The latter section provides that deductions will not be allowed against amounts received or accrued which do not fall within the definition of ‘income’ as defined in Section 1.

Section 1 of the Act defines ‘income’ as being ‘gross income less exempt income’. While dividends fall within the ambit of ‘gross income’, the fact that they are exempt from tax in terms of Section 10(k)(i) means that they fall outside the definition of ‘income’.

In short, you cannot claim an income tax deduction for expenses incurred in order to earn exempt income.

It is these principles that were the focus of a 2007 High Court case, Sallies Limited v Commissioner: South African Revenue Service (unreported case number A3034/07), in which the taxpayer appealed against a decision of SARS to disallow the write-off of interest against marketing fees earned.

The taxpayer had raised a loan to purchase shares in a US mining company for an amount of R74.75 million. The purchase price was settled partly through the issue of 50 million new shares at 80c each, with the balance of R34.75 million being funded by a loan.

At the same time, the taxpayer entered into a marketing agreement with the company, whereby the taxpayer was to conduct research into the supply and demand of a particular mineral that the company mined. When the taxpayer submitted their return, the interest incurred on the loan was claimed as a deduction against the income from the marketing agreement.

However, SARS had disallowed the deduction on the grounds that the interest had not been incurred in the production of the income from the marketing agreement, but had been incurred for the purposes of purchasing the shares in the company.

In formulating judgement, the judge indicated that when the purchase of the company was being considered, there was nothing in the circular to shareholders indicating that the taxpayer would be entering into a marketing agreement from which fees would be received.

He went on further to state that when the taxpayer borrowed the money, his intention was not to earn management fees from the marketing agreement, but to earn dividend income from the company.

He also added that even if it could somehow be argued that one of the intentions of the taxpayer was to earn management fees when borrowing the money, it was clearly not the dominant intention—this dominant intention was to earn dividend income from the shareholding.

Citing income tax case ITC 873 (23 SATC 89), the judge said that this meant that the deduction of the interest could not be claimed.

Dismissing the appeal with costs, the judge stated that the taxpayer “had failed to prove a clear or close causal connection between the interest incurred, and the income against which it was sought to write it off”.

WRITTEN BY STEVEN JONES

Steven Jones is a registered SARS tax practitioner.

While every reasonable effort is taken to ensure the accuracy and soundness of the contents of this publication, neither the writers of the articles nor the publisher will bear any responsibility for the consequences of any actions based on information or recommendations contained herein. Our material is for informational purposes.

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