WHEN AND HOW LOSS ON A SHARE SALE IS TAX DEDUCTIBLE
The circumstances in which a loss arising from the sale of shares may be claimed as an income tax deduction were clarified in a recent Supreme Court of Appeal (SCA) judgement.
At issue was the refusal by the South African Revenue Service (SARS) to allow the loss as a deduction, partly on a technical interpretation of the trading stock provisions in the Income Tax Act.
The SCA’s decision defined whether or not a deduction for the cost of trading stock may, effectively, be claimed in a later year of assessment if that expenditure was actually incurred in a previous year.
In 1994, Anglovaal Mining, the taxpayer, acquired shares in National Brands. Five years later, during the taxpayer’s 1999 year of assessment, these shares were sold at a loss of R159 702 919. The taxpayer claimed an income tax deduction in its 1999 tax return equal to the loss.
Imagine Anglovaal Mining’s surprise when SARS disallowed the deduction on the basis that the shareholding was capital in nature. The Tax Court also held that even if the shares were revenue in nature, the deduction was not permissible, as the deduction for the cost of the trading stock had to be claimed in the year of assessment that the expenditure was actually incurred.
The Tax Court ruled that as there was no evidence that, technically, the taxpayer had claimed the deduction in its 1994 tax return, it was not entitled to the deduction.
The first issue that the SCA had to rule on was whether the loss was capital or revenue in nature. The taxpayer had a history of trading in shares and accordingly argued that the shares satisfied the definition of “trading stock” in the Act, as the shares had been acquired for the purpose of sale or exchange.
The SCA found that the Tax Court had erred in concluding that the taxpayer had the intention of holding the shares as a capital investment. It judged that the shares were held as trading stock.
The critical SCA-derived lesson for taxpayers lies in the Tax Court’s initial finding that expenditure incurred to acquire trading stock in one year of assessment cannot be claimed for the first time as a deduction in another year of assessment. This finding was overruled by the SCA on appeal.
The Tax Court ruled that the provisions of s11(a) and s22 had to be strictly complied with and that if a taxpayer had not claimed a deduction for the cost of the shares in the year in which they were acquired, it could not rely on s22 to claim a deduction in the year of disposal.
The Tax Court was seemingly concerned that the cost of the shares was not actually claimed as a deduction in the 1994 tax return and then “added back” to taxable income as closing stock in that year. It felt that this process of deduction and add-back was crucial, even though it would have had no practical effect on the taxpayer’s tax position.
The SCA took a more practical, purposive approach in its judgment, which provides clarity on the interpretation of the Act’s s22.
Section 22 provides that, when determining the taxable income of a taxpayer, the value of the trading stock on hand at the beginning and end of the year of assessment must be “taken into account”.
One view is that this means that the value of the closing stock should be added to the taxable income while the value of the purchases and opening stock should be deducted. In other words, the difference between the two amounts must be “taken into account”.
However, in the case of shares, they must be recorded at the end of the year at their cost price, in which case there will not be a difference in the value of the shares as opening and closing stock. Practically, it would serve no purpose to take the value of the shares into account in this way in computing a share trader’s taxable income until the shares are sold.
The SCA found that the taxpayer’s expenditure on shares during the 1994 to 1997 years of assessment had not, technically, been taken into account when computing its income tax liability. As the expenditure incurred on shares in 1994 had no effect on the tax computation (as it was cancelled out by the book value of the shares at the end of the year) until the shares were sold, it had not been necessary to claim the expenditure as a tax deduction in the year in which was incurred.
The SCA judgment suggests that it in these circumstances share traders are not required to go through the process of claiming the cost of shares as a tax deduction in the year that the shares are acquired, then to add such amount back to their income at year end and to go through such a process each year until the shares are sold.
The SCA found that a taxpayer in these circumstances would be entitled to a tax deduction if it merely claimed the loss as a tax deduction in the year in which the shares are sold. As a consequence of this judgment, SARS maybe faced by claims for income tax deductions by taxpayers who purchased shares as long terms investments but subsequently sold the shares at a loss. The decision certainly allows more scope for taxpayers to argue that the loss was revenue in nature since the SCA has ruled that the failure to comply with the trading stock provisions is not decisive.