About SAFLII
Databases
Search
Terms of Use
RSS Feeds
South Africa: Supreme Court of Appeal
SAFLII
>>
Databases
>>
South Africa: Supreme Court of Appeal
>>
2018
>>
[2018] ZASCA 116
|
|
Commissioner for the South African Revenue Services v Volkswagen South Africa (Pty) Ltd (1028/2017) [2018] ZASCA 116; [2018] 4 All SA 289 (SCA); 2019 (2) SA 362 (SCA); 81 SATC 24 (19 September 2018)
Links to summary
THE
SUPREME COURT OF APPEAL OF SOUTH AFRICA
JUDGMENT
Reportable
Case
no: 1028/2017
In the
matter between:
THE
COMMISSIONER FOR THE SOUTH
AFRICAN
REVENUE
SERVICE
APPELLANT
and
VOLKSWAGEN
SOUTH AFRICA (PTY)
LTD
RESPONDENT
Neutral
citation:
C:SARS v Volkswagen
S A (Pty) Ltd
(1028/2017)
[2018] ZASCA
116
(19 September 2018)
Coram:
NAVSA, SERITI, WALLIS, WILLIS and MATHOPO JJA
Heard
:
6 September 2018
Delivered
:
19 September 2018
Summary:
Income tax – valuation of stock
at year end – s 22(1)(
a
)
of Income Tax Act 58 of 1962 – whether stock to be valued in
accordance with International Accounting Standard 2 (IAS 2
or AC 108)
at net realisable value.
ORDER
On
appeal from:
Tax Court, Port Elizabeth
(Eksteen J and assessors):
1
The
appeal succeeds with costs, such costs to include those consequent
upon the employment of two counsel.
2
The
order of the Tax Court is set aside and replaced by an order
dismissing the appeal and confirming the additional assessments
for
the 2008, 2009 and 2010 years of assessment.
JUDGMENT
Wallis
JA (Navsa, Seriti, Willis and Mathopo JJA concurring)
[1]
Volkswagen of South Africa (Pty) Ltd
(Volkswagen), the respondent in this appeal, is the South African
subsidiary of the well-known
German motor manufacturer, Volkswagen
AG. At the end of each tax year, Volkswagen holds as trading stock a
number of unsold vehicles.
Some of these are manufactured or, in the
case of trucks and buses assembled, at its plant in Uitenhage, while
others are imported,
and a certain number of second hand vehicles are
drawn from its own fleet. In determining its taxable income it is
obliged by s 22(1)(
a
)
of the Income Tax Act 58 of 1962 (the Act) to attach a value to that
trading stock. Ordinarily that value is the cost price of
the stock
calculated in accordance with the provisions of the Act.
[2]
In its returns for 2008, 2009 and 2010 tax
years Volkswagen calculated the value of its trading stock at year
end using its ‘net
realisable value’ (NRV) in accordance
with the provisions of International Accounting Standard 2 (IAS 2)
and the IFRS-Accounting
Handbook for the Volkswagen Group. This
yielded an amount less than the cost price of the trading stock and
it claimed a deduction
from the cost price of the trading stock
represented by the difference between that and NRV.
[3]
The Commissioner for the South African
Revenue Service (SARS or the Commissioner, as the context requires),
the present appellant,
conducted a lengthy audit of Volkswagen’s
tax affairs covering a wide range of issues for the tax years 2008,
2009 and 2010.
At the end of it the Commissioner rejected the
contention that NRV represented the diminished value of the trading
stock at the
end of those years. The differences between cost price
and NRV for the three years in dispute were respectively R72 002 161,
R24 778 855 and R5 294 643. The refusal of an
allowance in these amounts resulted in the issue of revised
assessments levying additional tax for those three years. Volkswagen
appealed against those assessments. The Tax Court (Eksteen
J and
assessors) upheld the appeal and set the revised assessments aside.
The present appeal lies directly to this Court in accordance
with
leave granted by Eksteen J.
The
issue
[4]
In determining its taxable income, a
trading entity is entitled to deduct from its income
[1]
expenses incurred in the production of that income. During the tax
years in question Volkswagen derived income from the sale of
motor
vehicles and was therefore entitled to deduct from that income the
costs incurred in the production and acquisition of those
motor
vehicles. But, from a timing perspective, there was not a perfect
correlation between the income it earned during any given
year and
the costs it incurred in that year in the manufacture and acquisition
of its trading stock. Some of the income flowed
from the sale of
trading stock on hand at the commencement of the tax year. Some of
the costs incurred in manufacturing or acquiring
motor vehicles were
incurred in relation to vehicles that formed part of its trading
stock at the close of the tax year and would
be sold in a future tax
year. In order to reflect its taxable income accurately, the value of
trading stock at the beginning of
the tax year and sold during the
year was included in its cost of sales and the value of its trading
stock at the end of the tax
year was deducted from the cost of sales.
In this way it determined the actual cost of the sales effected
during the tax year and
the sales effected during the year were
matched with the cost of effecting those sales.
[5]
In formulating the annual accounts of
trading entities that buy and sell any type of commodity or goods,
accountants always undertake
an exercise of this type. After the
judgment in
Commissioner for Inland
Revenue v Jacobsohn
,
[2]
it became the general practice of the revenue authorities to require
taxpayers to formulate their tax returns on that basis, although
it
was not expressly provided for in the then taxation legislation and
there were arguments that it was inconsistent therewith.
[3]
Statutory provisions were introduced to
deal with the situation in 1956.
[4]
[6]
From a tax perspective, the higher the
value attributed to closing stock at the end of a tax year, the lower
will be the cost of
sales for that year and the greater the taxable
income of the taxpayer. Conversely, the lower the value attributed to
closing stock,
the higher the cost of sales and the lower the taxable
income for that year. If taxpayers had a free hand in determining the
value
of trading stock at year end it would open the way for them to
obtain a timing advantage in regard to the payment of tax, by
adjusting
the value of closing stock downwards. They could by
adjusting these values manipulate their overall liability for tax in
the light
of their anticipations in regard to future rates of tax,
future trading results, the need to incur significant expenses in the
future and the like.
[7]
Sections 22(1)(
a
)
and (
b
) of
the Act are directed at avoiding such manipulation by prescribing the
basis upon which taxpayers are to value trading stock
at the
beginning and end of each year of assessment. The starting point is
that trading stock at year end is to be valued at cost
price. There
are a number of subsidiary rules in regard to the determination of
the cost price. Thus, for example, s 22(3)
provides that the
taxpayer may add to the actual price paid for the goods, the costs
incurred in getting them into their current
condition and location,
and any further costs required to be included in terms of any
generally accepted accounting practice approved
by the Commissioner.
Section 22(5) deals with the problems occasioned by stock being
purchased over time and outlaws the use
of the ‘last in, first
out’ (LIFO) method of valuation, while leaving taxpayers to
choose among other methods, such
as average cost or ‘first in,
first out’ (FIFO).
[5]
[8]
During the tax years under consideration in
this appeal, s 22(1)(a) read as follows:
‘
The amount which shall, in the
determination of the taxable income derived by any person during any
year of assessment from carrying
on any trade (other than farming),
be taken into account in respect of the value of any trading stock
held and not disposed of
by him at the end of such year of
assessment, shall be-
(a)
in the case of trading stock other than trading stock contemplated in
paragraph (
b
),
the cost price to such person of such trading stock, less such amount
as the Commissioner may think just and reasonable as representing
the
amount by which the value of such trading stock … has been
diminished by reason of damage, deterioration, change of
fashion,
decrease in the market value or for any other reasons satisfactory to
the commissioner . . .’
[9]
The dispute in this case is whether the
value of Volkswagen’s trading stock had diminished entitling
the Commissioner to make
a just and reasonable allowance under the
section. In practical terms, an allowance permits the taxpayer to
reflect the value of
its trading stock at less than cost price in its
tax return. Volkswagen contended that it should be entitled to do
this on the
basis of the NRV of its trading stock at each of the
three year ends from 2008 to 2010. It said that NRV reflected that
the value
of the trading stock had diminished.
[10]
The parties formulated their dispute in a
stated case in the following way:
‘
Whether
the NRV of VWSA’s trading stock, calculated in accordance with
IAS 2 and taking account of the individual categories
of costs
referred to … above, may and should, where it is lower than
the cost price of such trading stock as determined
in accordance with
section 22(3) of the Act, be accepted as representing the value of
trading stock held and not disposed of at
the end of the respective
years of assessment for purposes of section 22(1)(a) of the Act.’
The
categories of costs referred to were described generally as
rework/refurbishment costs; outbound logistics; marine insurance;
sales incentives; distribution fees; warranty costs, costs relating
to the Audi Freeway Plan and the Volkswagen AutoMotion Plan
and
roadside assistance costs.
[11]
Eksteen J reached the following conclusion
on this question:
‘
[37] On a careful
consideration of the arguments presented to us I consider that the
NRV as set out in IAS 2 is an appropriate method
by which to
determine the actual value of trading stock in the hands of the
taxpayer at the end of the year of assessment. The
NRV, determined in
this manner must be compared to the cost price, computed in
accordance with section 22(3) in order to determine
whether a
diminution in value has in fact occurred.
…
[44] In all the circumstances,
whereas section 22(1) is silent as to the manner of valuation of
trading stock at the conclusion
of a year of assessment in order to
determine whether a diminution in value has occurred the adoption of
the NRV as a method of
the assessment of value provides a sensible,
businesslike result which accords, in my view, with the purpose of
section 22(1) in
the context of the Act and with the weight of
authority.’
[12]
The effect of the judgment was that where
the valuation of trading stock at NRV at the close of a fiscal year
reflected a value
lower than cost price, the Commissioner was obliged
to make an allowance for the diminution in value of the trading stock
in accordance
with s 22(1)(
a
)
of the Act.
[6]
As will be appreciated, this had potentially far-reaching
consequences for the Commissioner extending beyond the present case.
Under Generally Accepted Accounting Principles in South Africa (GAAP)
trading stock at the end of a year must be valued at NRV.
If the
judgment of the Tax Court was correct then, wherever NRV was less
than the cost price of trading stock, the Commissioner
would be
obliged to permit taxpayers to value trading stock at year end at the
lower of cost price or NRV. The question is whether
that was
consistent with the provisions of s 22(1)(
a
).
Section
22(1)(a)
[13]
The starting point in construing the
section is the cost price of the trading stock. The manner in which
that has to be calculated
is dealt with in s 22(3)(
a
).
The parties are agreed that in the circumstances of this case,
Eksteen J correctly held, that the latter section does not affect
the
proper interpretation of s 22(1)(
a
).
The section empowers the Commissioner to allow a deduction from the
cost price, by way of a just and reasonable allowance, in
certain
circumstances where the value of the trading stock has diminished.
[14]
Four circumstances namely, damage,
deterioration, change of fashion or decrease in market value, are
specified as causing a diminution
in the value of trading stock. All
of those can be illustrated quite simply. Goods may be damaged in
transit and as a result can
only be sold at less than cost. Their
condition may deteriorate whilst in transit or in storage, as with a
cargo of first grade
rice undergoing heating at sea, so that it has
to be downgraded to second or third grade and is only saleable at
less than cost.
Fashionable clothing tends to be seasonal and, if not
sold before the end of the season, retailers may need to dispose of
unsold
surplus stock at discounted prices below cost. A decrease in
the value of trading stock may arise where stock has been acquired
at
a particular price and the supplier subsequently reduces the price.
For example, a retailer might acquire mobile phones for
R400 from the
manufacturer. If the manufacturer cuts its price to retailers to
R300, in order to get rid of stock before introducing
a new model
phone, the value of the stock acquired at R400 has diminished.
[15]
The section contemplates the possibility of
there being other reasons for a diminution of value apart from the
four it specifies.
For that reason it empowers the Commissioner to
make a just and reasonable allowance to accommodate a diminution in
value of trading
stock for any other reason that may be satisfactory
to the Commissioner.
[16]
The taxpayer is required to determine the
value of its trading stock at a particular point in time, namely, the
end of the tax year.
As is generally the case in determining the
taxpayer’s taxable income that is an exercise of looking back
at what happened
during the tax year in question. An important aspect
of the language in s 22(1)(
a
)
is that the allowance that the Commissioner may think just and
reasonable is ‘an amount by which the value of the trading
stock has been diminished’. That language is couched in the
past tense. The section is accordingly not concerned with what
may
happen to the trading stock in the future, but with an enquiry as to
whether a diminution in its value has occurred at the
end of the tax
year. All of the instances expressly referred to in the section,
namely damage, deterioration, change of fashion
and decrease in
market value, relate to a diminution of value occurring prior to the
taxpayer rendering its return as a result
of events occurring prior
to that date.
[17]
Counsel for SARS submitted that it
necessarily followed that there could only be a diminution of value
arising from events that
had already occurred before the end of the
tax year. In other words, the events relied on as demonstrating a
diminution in value
of the trading stock must have occurred during
the tax year, even though their impact might only be felt in the
following year.
The goods must already have been damaged or have
deteriorated in condition. In the case of changes of fashion the
change must already
have been apparent by the end of the tax year. In
the case of a decrease in market value, something must have occurred,
such as
the catastrophic decline in the price of wool in
Jacobsohn
’s
case, to enable the taxpayer to say that the value of the trading
stock was now less than its cost price.
[18]
There is merit in this submission, although
it does not entirely remove the element of futurity from the enquiry.
A determination
of the current value of goods that have not yet been
sold, but will be sold in the future, necessarily involves a measure
of prediction
in regard to future events. In my view, the correct
position is that the Commissioner may only grant a just and
reasonable allowance
in respect of a diminution in value of trading
stock under s 22(1)(
a
),
in two circumstances. The first is where some event has occurred in
the tax year in question causing the value of the trading
stock to
diminish. The second is where it is known with reasonable certainty
that an event will occur in the following tax year
that will cause
the value of the trading stock to diminish. An example might be
knowledge that a glut had built up in the market
for a perishable
commodity, where that glut would ensure a marked, certain and
unavoidable decline in the price of that commodity
in the following
year. Both scenarios are consistent with the basic proposition that
the assessment of income tax relates to events
that have already
occurred rather than events that may occur in the future.
[19]
A trading entity that manufactures or
acquires goods for resale does so in the expectation that the price
it pays to acquire those
goods or the costs of manufacture will be
less than the price at which it will be able to sell them in due
course. The cost price
of the goods is therefore not necessarily the
value of those goods in the market place. In acquiring or
manufacturing the goods
in the first place the trader will make
allowance for the need to incur expenditure in relation to them in
order to be able to
sell them at a profit. The expenditure may
include expenses in making the goods marketable, for example,
rectifying minor damage
incurred in transit, packaging the goods,
transporting them to the point of sale and the like. Fees and
commissions may have to
be paid to retailers who will be responsible
for selling them directly to the public. Advertising costs may be
incurred. In the
case of many goods some allowance may have to be
made for post-sale remedying of defects. None of these expenses, nor
any of the
many others that could be envisaged, are relevant to the
cost price of the goods. From a taxation perspective they only become
relevant once they have been incurred in seeking to secure the sale
of the goods. They will then become ‘expenses incurred
in the
production of income’ in terms of s 11(
a
)
of the Act and be taken into account in determining the taxpayer’s
taxable income in the year in which they are incurred.
[20]
The cost price of acquiring or
manufacturing goods may bear little relationship to the market value
of those goods or the price
at which the trader proposes to sell
them. Yet section 22(1)(
a
)
provides that in the ordinary course it is to be the statutory basis
for fiscal purposes of establishing the value of trading
stock at
year end. It is only when the ‘value of such trading stock has
been diminished’ that an allowance may be made.
What is meant
by this expression?
[21]
To read the section as referring to a
reduction in the market value of the trading stock, would lead to
allowances being claimable
for damage, deterioration, change of
fashion or decrease in market value even though the trader still
fairly anticipated making
a profit from the sale of the goods.
Returning to an example mentioned earlier, if goods are damaged in
transit they may nonetheless
be profitably sold as ‘slightly
shop soiled’ or ‘slightly damaged’. It would be an
absurd reading of the
section to permit an allowance in those
circumstances and counsel were rightly agreed that only reductions in
value below the cost
price of the trading stock would justify an
exercise of the Commissioner’s discretion.
[22]
The only way to make sense of the
expression ‘value of such trading stock’ in this context
is to accept, as the arguments
by counsel effectively did, that it
refers to an artificial concept of value represented initially by the
cost price of the goods.
That is the baseline against which any
diminution in the value of the goods must be measured. In turn, it
raises the question of
when damage, deterioration, change of fashion,
decrease in market value or any other reason may be taken to reduce
the value of
the goods as reflected in their cost price.
[23]
Some guidance can I think be found in the
situation in
Jacobsohn
,
where a dramatic decline in the future price of wool meant that the
wool stocks held by the taxpayer – a trader in wool
–
were irretrievably devalued.
[7]
One infers from the judgment that there was no prospect of any
revival of the price. Someone wishing to purchase wool in that market
would, for the immediate and foreseeable future, have been able to
procure it at a price lower than the price paid by Jacobsohn
to
acquire his stocks. In those circumstances the value of the stocks of
wool held by him, when measured against cost price, had
been
diminished. As a trader he needed to dispose of his stocks, but any
endeavour to sell his stocks of wool at prices higher
than cost price
would certainly be doomed to failure. The effect was that in
practical terms he suffered the decline in value of
his trading stock
in the year prior to that in which the stock would be sold.
[24]
The same approach can be applied to the
other specified instances leading to a diminution in value of trading
stock. A seller of
swimwear with a large stock of men’s
swimming trunks or briefs in fashionable brands, may find it
impossible to sell them
above cost price, when the trend in male
beachwear shifts towards the ‘baggies’ favoured by
surfers. This is not a
fanciful example. In the last twenty years the
dramatic rise and decline in popularity of Blackberry pagers and
Nokia phones may
conceivably have caused retailers to be left with
stock purchased at prices far above those at which the manufacturers
were then
trying to dispose of the same stock.
[25]
Damage and deterioration are directed at
the same situation. They only provide grounds for an allowance to be
made under s 22(1)(
a
)
if the nature of the damage or deterioration is so severe when
measured against the cost price that it can be said in common
parlance ‘ the goods are no longer worth that’.
[26]
I conclude that on a proper interpretation
of s 22(1)(
a
)
the cost price of the goods, and not the actual or anticipated market
value on their sale, is the benchmark against which any
claimed
diminution in value is to be measured. A claim for an allowance must
be based on events that are known at the end of the
tax year for
which the allowance is claimed or events that it is known will occur
in the following year. There will only be scope
for an allowance
where the events in question have led to the cost price of the goods
ceasing to be a proper measure of their value.
In substance, the
allowance enables the taxpayer to say that, because of the diminution
in value of its trading stock, it has suffered
a loss in the current
year in the determination of its taxable income and it should be
permitted to set off that loss immediately
instead of waiting for it
to materialise when the goods are sold in a later year.
[8]
[27]
Volkswagen contended that there had been a
reduction in the value of its trading stock ‘for another
reason’. It did
not say that there had been a decrease in
market value of its cars. Instead it contended that valuing trading
stock at year end,
in accordance with NRV and IAS 2, properly
reflected a diminution in value of that trading stock and accordingly
justified
the reduction in value for which it contended. Whether that
was so depends upon a consideration of IAS 2, the concept of NRV
and its application to the facts of this case. That must then be
measured against the provisions of s 22(1)(
a
)
in accordance with the interpretation set out above.
IAS
2 and NRV
[28]
The International Financial Report
Standards (IFRS) are internationally accepted standards issued by the
International Accounting
Standards Board (IASB). International
Accounting Standard 2 (IAS 2) was originally issued in 1993 with
revisions being issued in
2003 and 2006. The version with which we
are concerned was updated on 2 January 2008. The Accounting
Practices Board reissued
it in South Africa as AC 108 without
alteration and it forms part of the statement of Generally Accepted
Accounting Practice (GAAP).
[29]
IASB was formed in 2001 as the successor
organisation to the International Accounting Standards Committee,
which had been setting
International Account Standards since 1973.
The fundamental objective of IASB, according to its constitution is:
‘
to develop, in the public
interest, a single set of high-quality, understandable and
enforceable global accounting standards that
require high-quality,
transparent and comparable information in financial statements and
other financial reporting to help participants
in the world’s
capital markets and other users make economic decisions.’
Its
predecessor had a similar aim and objective.
[30]
This objective was expanded upon in a
Conceptual Framework document prepared by the IFRS Foundation, which
is the body under which
the IASB operates. That document states the
second objective in the following terms:
‘
The objective of general
purpose financial reporting is to provide financial information about
the reporting entity that is useful
to existing and potential
investors, members and other creditors in making decisions about
providing resources to the entity. Those
decisions involve buying,
selling or holding equity and debt instruments, and providing or
settling loans and other forms of credit.’
The
framework document expands upon this. In objective 10 it is said
that:
‘
Other parties, such as
regulators and members of the public other than investors, lenders
and other creditors, may also find general
purpose financial reports
useful. However, those reports are not primarily directed to these
other groups.’
[31]
Annual financial statements prepared in
accordance with IFRS, as embodied in GAAP in South Africa, serve a
valuable purpose in providing
a fair picture to investors,
shareholders and creditors of companies about their financial
affairs. In doing so, it is important
that the picture is fair, both
in regard to the past trading activities of the company and also as
to its future prospects. It
may be more important for those reading
the accounts to know that prospects for the year ahead are gloomy,
than that the company
made substantial profits in the year past. That
is why annual financial statements contain many forward looking
statements and
why IAS 1 on the Presentation of Financial Accounts
requires management to make a specific assessment of the entity’s
ability
to continue as a going concern. The auditor must assess the
appropriateness of management’s use of the going concern basis
of accounting and identify any material uncertainty that may cast
significant doubt on the entity’s ability to continue as
a
going concern.
[32]
Valid though these principles may be for
the purposes to which they are directed, they are not necessarily
equally applicable to
the determination of a taxpayer’s
liability to income tax in accordance with the provisions of the Act.
That is to be determined
from year to year and the Act’s
provisions do not necessarily accord with current accounting
principles. Whether the concept
of NRV reflects a diminution of value
of trading stock for the purposes of s 22(1)(
a
)
depends therefore, not on its acceptance as part of GAAP, but on its
conformity to the requirements for such a diminution in value
as
determined on a proper interpretation of that section.
[33]
IAS 2 is the prescribed accounting
treatment for inventories. These are defined to include all assets
held for sale in the
ordinary course of business. Net realisable
value (NRV) is defined as the estimated selling price of inventory in
the ordinary
course of business, less the estimated costs of
completion and the estimated costs necessary to make the sale. It
refers to:
‘…
the net amount that
the entity expects to realise from the sale of the inventory in the
ordinary course of business. Fair value
reflects the amount for which
the same inventory could be exchanged between knowledgeable and
willing buyers and sellers in the
marketplace. The former is an
entity-specific value; the latter is not. Net realisable value for
inventories may not equal fair
value less costs to sell.’
[34]
In terms of clause 9 of IAS 2,
inventories shall be measured at the lower of cost or NRV. Detailed
provisions are set out in
clauses 10 to 18 for the determination of
the cost of inventories. These include all costs of purchase,
conversion, and other costs
of bringing the inventories to their
present location and condition. They do not include storage costs,
administrative overheads
that do not contribute to bringing the
inventories to their present location and condition, or selling
costs.
[35]
Clause 28 of IAS 2 deals with NRV and
explains its purpose. It says that
‘
The cost of inventories may
not be recoverable if those inventories are damaged, if they have
become wholly or partially obsolete,
or if their selling prices have
declined. The cost of inventories may also not be recoverable if the
estimated costs of completion
or the estimated costs to be incurred
to make the sale have increased. The practice of writing inventories
down to net realisable
value is consistent with the view that assets
should not be carried in excess of amounts expected to be realised
from their sale
or use.
’
It
is unclear whether the final sentence of this clause is applicable
only when the value of inventories has fallen as a result
of
extraneous factors such as damage, obsolescence, a fall in sale
prices or an increase in costs, or whether it is more general.
In
other words, does it require inventories to be written down when
there has been no extraneous event, but simply because the
entity has
made an assessment that contrary to their initial, perhaps optimistic
view, they will be unable to dispose of the inventory
at a price
above cost price?
[36]
The determination of NRV is firmly based on
the entity’s assessment of future market conditions. Clause 30
says that estimates
of NRV are based on the most reliable evidence
available at the time the estimates are made of the amount the
inventories will
realise. Significantly, these estimates take into
consideration matters such as fluctuations in price or cost relating
to events
occurring after the end of the period for which the
accounts are being prepared ‘to the extent that such events
confirm conditions
existing at the end of the period’. This
does not mean that those conditions were anticipated or foreseen at
the end of the
relevant period. It means that if subsequent events
make it clear that at the end of the period the inventory was worth
less than
cost it should be written down to NRV.
Volkswagen’s
determination of NRV
[37]
Volkswagen classified the items forming
part of its NRV calculations as ‘Distribution and Selling
Costs’. The distribution
costs were its rework/refurbishment
costs, outbound logistics, marine insurance and distribution fees.
The selling costs were sales
incentives, warranty costs, costs
relating to the Audi Freeway Plan and the Volkswagen AutoMotion Plan
and roadside assistance
costs. Distribution costs were costs that
were anticipated to be incurred between Volkswagen’s
headquarters in Uitenhage
and the various dealerships through which
its vehicles would be sold. Selling costs were costs that would be
incurred once the
vehicles were sold.
[38]
The first of these items,
‘rework/refurbishment costs’, were costs anticipated to
be incurred in remedying damage to
vehicles forming part of the
trading stock so as to put them in a condition for resale. There is
no indication whether these costs
related to vehicles already damaged
at the end of each fiscal year, or whether they were an allowance in
expectation that such
minor damage would be suffered before the
vehicles could be sent to the dealerships. As this item related only
to fully built up
imports for all three years and to the assembly of
trucks and buses in one year, it is likely that at least part of it
related
to the costs of remedying damage suffered by such vehicles
while in transit to South Africa. Such damage would have occurred
prior
to the end of the year in which the vehicles were imported.
[39]
Outbound logistics represented the costs of
transporting vehicles from Volkswagen’s distribution yard to
dealerships. It related
to the actual cost of transporting the
vehicle to the dealer and not an unanticipated increase in such
costs. In relation to year
end trading stock it was a cost that would
be incurred when the vehicle was sent to the distributor in the
following year.
[40]
Distribution fees would also be incurred in
the following year. These were fees paid by the taxpayer to its
holding company Volkswagen
AG under a ‘Distribution and
Assistance Agreement’ that does not form part of the record.
These fees were a transfer
payment between a subsidiary and its
parent company for the sale and distribution rights in relation to
Volkswagen and Audi vehicles
in South Africa and payment for an
unspecified range of support services provided by Volkswagen AG. It
is unclear whether they
were specific to each vehicle forming part of
the trading stock or simply an apportionment of a global fee
calculated annually
in accordance with the provisions of the
Distribution and Assistance Agreement.
[41]
All of the other items related to costs to
be incurred once the vehicles to which they related were sold. All
were estimates of
costs ‘anticipated to be incurred’. As
they would only be incurred once the vehicles were sold it could
reasonably
be anticipated that they would usually be incurred in the
following year, but that would not necessarily be the case. In the
case
of warranty costs and the Audi Freeway Plan and Volkswagen
AutoMtion Plan, whether they would be incurred in the following year
or, a year or more later, would depend upon when the vehicle would be
sold and when the costs under the warranty or the two plans
would
arise. The same is true of roadside assistance costs.
Discussion
[42]
It is appropriate to reiterate that the
question posed to the Tax Court, and answered affirmatively, was:
‘
Whether the NRV of VWSA’s
trading stock, calculated in accordance with IAS 2 and taking account
of the individual categories
of costs referred to … above, may
and should, where it is lower than the cost price of such trading
stock as determined
in accordance with section 22(3) of the Act, be
accepted as representing the value of trading stock held and not
disposed of at
the end of the respective years of assessment for
purposes of section 22(1)(a) of the Act.’
Was
the Tax Court’s conclusion justified in the light of the
construction placed upon s 22(1)(
a
)
earlier in this judgment? Expressed differently, does NRV represent
the diminished value of trading stock in terms of that section?
[43]
There is obvious scope for an overlap
between the provisions of s 22(1)(
a
)
and those of IAS 2. The former refers to a diminution of value of
trading stock caused by damage, deterioration, change of fashion,
or
decrease in market value. Clause 28 of IAS 2, quoted above in
para 35, records that the cost of inventories may not be
recoverable
if they have been damaged or have become obsolete in whole or part.
To that extent the two correspond. But the other
elements to which
IAS 2 refers do not relate to the same matters as s 22(1)(
a
).
They are concerned with future matters such as changes in likely
selling prices, or increases in the estimated costs of completion
or
the estimated costs of making sales. A wage settlement at an
unexpectedly high level, or an increase in transport costs generated
by a fuel price rise or a decline in the value of the currency, would
increase the costs of making sales in due course and have
to be taken
into account in determining NRV.
[44]
With the sole potential exception of some
vehicles forming part of Volkswagen’s stock in trade having
suffered damage requiring
refurbishment during the relevant year, all
of the items used by Volkswagen in its calculation of NRV were
concerned with costs
that would be incurred in the future in the sale
and distribution of vehicles. Even the extent of any damage requiring
refurbishment
was anticipated to be minor. The schedule attached to
the stated case showed that a modest R525 per vehicle was allowed
under this
head. There could be no question therefore of the value of
trading stock being diminished below cost price as a result of damage
to the vehicles constituting such stock. This was a provision to
cover minor scratches and dents. No claim for refurbishment was
made
in respect of used vehicles, which is a further indication that this
was a minor item.
[45]
The calculation of NRV was based on a
standardised ‘Wholesale Selling Price’ for each vehicle.
Similarly the amounts
deducted from that figure were standard amounts
in respect of each vehicle model. An NRV adjustment was made when the
NRV was less
than the cost of each item of stock. The overall
deduction in respect of the NRV of vehicles was made in respect of
those vehicles
only. There is no suggestion of an adjustment in the
opposite direction, where the NRV was higher than the cost price.
This accords
with IAS 2, clause 29 of which requires that NRV must be
determined item by item, unless that is impractical. In that way any
shortfall
likely to arise when the stock item is sold is identified
and accounted for immediately, but no account is taken of surpluses
that
are likely to be realised on other stock items when they are
sold. That prevents the trader from claiming profits in respect of
sales that have not as yet taken place.
[46]
While understandable from an accounting
point of view, from a taxation perspective there are problems with
this approach. The fiscus
is concerned with the value of trading
stock as a whole. Writing down the value of part of the stock to NRV
ignores the fact that
the NRV of the remaining stock is higher than
cost price. The overall position with a company that is a going
concern will probably
be that the NRV of the trading stock, taken as
a whole, will be greater than cost price. In a solvent and profitable
trading company
it would be surprising if it were not. Companies do
not usually acquire, or manufacture, trading stock that they think
will realise
less than it cost. To pursue that course for any length
of time would lead to insolvency. Using NRV is a legitimate approach
from
an accounting perspective. 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.
[47]
For the purposes of the stated case the
Commissioner accepted the correctness of Volkswagen’s figures
pertaining to its evaluation
of NRV. That concession related to the
accuracy from an accounting perspective of the calculation of NRV. I
do not question that,
but if the same approach were transposed to the
field of Volkswagen’s tax liability, it would leave the
Commissioner with
little scope for assessing the legitimacy of a
calculation relating in its entirety to the future trading
circumstances of the
taxpayer. For example, how would he query the
assessment of the wholesale selling price when that was a price set
by the taxpayer,
or possibly in this instance, its holding company?
How would he challenge its assessment of the average costs per
vehicle of rework/refurbishment
or sales incentives? Where the
majority of items in a calculation are to be determined by the
taxpayer itself, unlike expenses
actually incurred, the spectre of
manipulation for tax purposes arises. I am not saying that it
occurred in the present case, but
that possibility is relevant to
whether NRV should be accepted as appropriate for adoption in
assessing claims for an allowance
under s 22(1)(
a
).
[48]
Some of the deductions in this case appear
to have had a disproportionate effect on the calculation of NRV. The
illustrative schedule
annexed to the stated case referred to eleven
Audi vehicles of varying descriptions. In respect of each one an
amount of R29 906
was deducted from the wholesale selling price
in respect of the Audi Freeway Plan. In all but one instance, that
item alone had
the effect of reducing the NRV to a figure below the
cost price of the vehicle. In the one exception, the addition of the
standard
amount allowed in respect of a sales incentive was
sufficient to bring the NRV below cost price. Both of these were
standard costs
to be incurred when selling the vehicle. IAS 2 states
that selling costs are not taken into account in determining the cost
of
inventories. It seems strange therefore that they must be brought
into the reckoning when determining NRV for the purpose of departing
from cost price as a measure of the value of inventory at year end.
Presumably the reason is that shareholders and investors should
not
be under a misapprehension as to the future prospects of profitable
sales. That is significantly different from an assessment
of the
profitability of the business in the year that has ended, which is
the issue for the purposes of taxation.
[49]
Volkswagen’s own description of what
it was seeking to do in invoking IAS 2 is interesting. This was
set out in its notice
of objection to the revised assessments. The
relevant paragraphs of that notice read as follows:
‘
3.7.3 Volkswagen valued the
relevant trading stock
for
financial accounting purposes
in
conformity with IAS 2 at the lower of cost or net realisable
value. It adopted the same value for the purposes of s 22(1)
of
the Income Tax Act.
3.7.4 The determination of net
realisable value requires an examination not only of the gross amount
that will be realised on disposal
but also of the costs that will be
incurred to make the sale. The rationale is that the trading stock
must be valued in the context
of the business in which it is held and
stated at
the value
at which it would be sold in an arm’s length disposal of the
business
. This
value is derived by establishing the net amount that would flow to
the business as a consequence of the sale of the trading
stock in the
normal course. The sale value of the item is reduce by the costs that
will be incurred in order to effect the sale.
That represents the
value that will accrue to the business on realisation of the trading
stock.’ (Emphasis added.)
[50]
The underlying assumption was that what was
desirable and necessary from a financial accounting perspective was
equally applicable
to the entirely different question whether the
value of the trading stock at the close of the tax year had been
diminished by events
occurring during that year. The assessment was
of the value of the stock if there were an arm’s length
disposal of the business.
But s 22(1)(
a
)
is concerned with the value of the trading stock as trading stock at
year end. It is unclear why, from a financial accounting
point of
view, one would value stock as if the business was being disposed of,
especially when dealing with a subsidiary of the
largest motor
vehicle manufacturer in the world, thereby rendering the possibility
of such a disposal unlikely, but it is plainly
irrelevant to the
valuation of trading stock for tax purposes.
[51]
IAS 2 makes the point that NRV is different
from fair value. The latter is the amount for which an asset could be
exchanged or a
liability settled between knowledgeable and willing
parties in an arm’s length transaction in the market. The
passage quoted
from Volkswagen’s notice of objection appears to
confuse the two. Fair value reflects the current value of the goods
in the
market. NRV reflects the amount it is thought they will
realise in the market at some future date. Fair value seems more
closely
related to an assessment of the value of trading stock at a
specific point in time.
[52]
Apart from these practical difficulties,
the use of NRV is inconsistent with two basic principles that
underpin the Act. The first
is that taxable income is determined and
taxation levied from year to year on the basis of events during each
tax year. The Commissioner
is not concerned, save where allowances
such as depreciation or provisions for bad debts are concerned, with
the taxpayer’s
trading prospects in later years. This principle
is sometimes expressed by saying that taxation is backward looking.
By contrast
NRV is explicitly forward looking. It is concerned with
the amount that the trader is likely to receive when the goods are
realised
and for that reason it takes account of the expenses that
will be incurred in making the sale.
[53]
The second inconsistency with principle is
that using NRV has the effect that expenses incurred in a future tax
year in the production
of income accruing to or received by the
taxpayer in that future tax year, become deductible in a prior year.
That is inconsistent
with the basic deduction provision in s 11(
a
)
of the Act, that what may be deducted in any tax year in the
determination of taxable income is ‘expenditure and losses
actually incurred in the production of the income’. Allowing
Volkswagen to deduct in a current year expenses that will be
incurred
in the following year in earning income flies in the face of that
provision.
[54]
With respect, I think that the learned
judge in the Tax Court erred in failing to recognise that s 22(1)(
a
)
is not concerned with contrasting cost price with a value determined
by ‘an appropriate method by which to determine the
actual
value of trading stock in the hands of the taxpayer at the end of the
year of assessment’. In looking for a sensible
and businesslike
manner of valuation of trading stock at year end he answered a
question other than the one posed by the facts
and formulated by the
parties in the stated case. That question was whether NRV should be
used to determine the value of trading
stock at year end for the
purposes of claiming an allowance against cost price under
s 22(1)(
a
).
Whether it was a sensible and businesslike manner of valuing trading
stock from an accounting perspective was neither here nor
there. The
concern was whether it accurately reflected the diminution in value
of trading stock contemplated in the section.
Result
[55]
A concern that arose in the course of
argument was whether any part of the items taken into account by
Volkswagen in the calculation
of NRV could legitimately have founded
a contention that to some degree, albeit not to the extent reflected
in the NRV, events
had occurred that justified the Commissioner in
making an allowance in favour of the taxpayer under s 22(1)(
a
).
On careful consideration of the items making up the NRV calculation
it appears that the only possibility in that regard would
have been
damage to vehicles justifying the rework/refurbishment claim.
However, that was a minor item that on its own would not
have had the
effect of diminishing the value of the trading stock to the extent
required to warrant the Commissioner making an
allowance in favour of
the taxpayer.
[56]
In the circumstances the appeal
succeeds and the following order is made:
1 The appeal succeeds with costs, such costs to include those
consequent upon the employment of two counsel.
2
The
order of the Tax Court is set aside and replaced by an order
dismissing the appeal and confirming the additional assessments
for
the 2008, 2009 and 2010 years of assessment.
_________________________
M J D WALLIS
JUDGE OF APPEAL
Appearances
For
appellant: R G Buchanan SC (with him R J Tsele)
Instructed
by: Ledwaba Mazwai Attorneys, Pretoria
Kramer
Weihmann Joubert, Bloemfontein.
For
respondent: M N Janisch SC (with him C M Rogers)
Instructed
by: Chris Baker & Associates, Port Elizabeth
Symington
De Kok, Bloemfontein.
[1]
Income is the amount remaining after deducting
from its gross income all amounts that are exempt from tax.
Commissioner for Inland Revenue v
Nemojim (Pty) Ltd
1983 (4) SA 935
(A)
at 946G-H. The three expressions ‘gross income’,
‘income’ and ‘taxable income’ are defined
in
s 1 of the Act.
[2]
Commissioner for Inland Revenue v Jacobsohn
1923 CPD 221
(
Jacobsohn
).
See the explanation by Marais JA in
Richards
Bay Iron & Titanium (Pty) Ltd and Another v Commissioner for
Inland Revenue
[1995] ZASCA 81
;
1996 (1) SA 311
(AD) at
316F-317C.
[3]
See (1955) 4
The
Taxpayer
21.
[4]
Commissioner for Inland Revenue v Nemojim
(Pty) Ltd
, supra, at 956G-957C.
[5]
The use of LIFO serves to arrive at the lowest
possible value for trading stock at year end. If used over a period
of years it
consistently lowers the profits earned each year.
According to BC 12 in the Board Commentary to IAS 2 the use of LIFO
in financial
reporting is usually tax-driven, because it results in
a cost of goods sold expense item that reduces profits.
[6]
A similar conclusion was reached in
ITC
13626
para 53. That too involved a
taxpayer that was a South African subsidiary of an international
group of companies, where the calculation
of NRV was undertaken in
terms of IAS 2 and the Group’s accounting and auditing
database entitled ‘The Way We Do
Things’.
[7]
See fn 3 above. It is unnecessary to consider
whether the judgment conflated end of tax year value and future
market value, as
might be suggested by a passage at 229-230, as the
matter is now dealt with legislatively.
[8]
The term ‘loss’ is used here in its
generic sense and not in the technical meaning it bears in s 11(
a
)
of the Act.