Which factors affect the value of trading stock on hand?

On 19 September 2018 in CSARS v Volkswagen SA (Pty) Ltd (1028/2017) [2018] ZASCA 116 the Supreme Court of Appeal reversed the decision of the tax court and found in favour of SARS in a matter dealing with the valuation of trading stock on hand at the end of a financial year.  Central to the dispute was the interpretation and application of International Accounting Standard 2 (IAS 2) and the IFRS-Accounting Handbook to the several categories of trading stock held by Volkswagen SA (Pty) Ltd (VWSA).  The court found in effect that accounting standards do not supersede income tax legislation and principles.

For the 2008, 2009 and 2010 years of assessment, VWSA had closing stock consisting of unsold vehicles.  Some of these were manufactured or, in the case of trucks and buses, assembled at its Uitenhage plant, while others were imported, and there were some second hand vehicles drawn from its own fleet.  In terms of section 22(1)(a) of the Income Tax Act, 1962 (Act), VWSA was required to determine the value of this stock for tax purposes.  It did this by determining the net realisable value (NRV) in accordance with IAS-2 and the IFRS Handbook, which yielded an amount less than the cost price of the trading stock.  VWSA it claimed a deduction from the cost price of the trading stock represented by the difference between that and NRV.

SARS conducted a lengthy audit of VWSA’s tax affairs for the years in question, at the end of which SARS rejected VWSA’s calculation of the value of closing stock.  This resulted in the issue of additional assessments reflecting substantial increases in the value of the stock, with corresponding increases in the taxable income.  It was against these additional assessments that VWSA had objected and successfully appealed in the tax court.

The SCA pointed out that the direct relationship between the value placed upon trading stock on hand and taxable income on the other enabled taxpayers to manipulate their taxable income upwards or downwards as it suited them.  For this reason section 22(1)(a) provided that a taxpayer who claimed that the NRV of an item of stock was less than its cost price would have to satisfy SARS that this claim was acceptable.  The criteria for so deciding were set out in the section, these being: damage, deterioration, change of fashion, decrease in the market value or for any other reasons satisfactory to SARS.

Section 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.  The generally accepted accounting practice contended for by VWSA, namely IAS-2 read with the IFRS Handbook, was to take into account certain categories of costs, 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.  Did these expenses add to the costs of the trading stock?

Eksteen J, presiding in the tax court, had decided that the NRV determined in terms of IAS-2 was an appropriate method by which to determine the value of trading stock for purposes of section 22(1)(a).  He stated: ”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.”

In the SCA, Wallis JA identified and then discussed the four circumstances that could lead to a diminution in the value of trading stock below cost price before proceeding to discuss each in turn:

Damage, deterioration, change of fashion or decrease in market value.  To these must be added other circumstances satisfactory to the Commissioner.  The court drew attention to what it described as an important aspect of the language used, namely that it was couched in the past tense: “an amount by which the value of the trading stock has been diminished”.  All the events that may have contributed to the diminution must have happened in the past.  This did not exclude entirely the element of futurity.  “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”.

However, expenses in making the goods marketable, such as rectifying minor damage incurred in transit, packaging costs, transportation expenses to the point of sale, fees and commissions to retailers, advertising costs and some allowance for post-sale remedying of defects were not relevant to the cost price of the goods.

Counsel on both sides agreed that the baseline for determining whether any diminution in value had occurred was the cost.  The question was whether some event or agency reduced the value to below cost.  An example was a catastrophic fall in the price of wool, as in CIR Jacobsohn 1923 CPD 221, where the taxpayer would never have been able to recoup his cost, let alone realise a profit, on sales of his stocks of wool after the price had plunged after he had acquired his stocks.  The court offered similar examples, such as a purveyor of swimming trunks or briefs (scants?) when “baggies” became the attire of choice.  Or the dramatic rise and decline in the popularity of Blackberry and Nokia phones, which may have resulted in retailers being left with stocks that consumers had rejected as they moved on to smartphones.

And it was here that tax law diverged from accounting standards.  The court accepted that the International Financial Report Standards issued by the International Accounting Standards Board served a valuable purpose in providing a fair picture to investors, shareholders and creditors of companies about their financial affairs.  In doing so, it was important that the picture was fair, in regard to both the past trading activities of the company and to its future prospects.  In fact, it might be more important to know that prospects for the year ahead were gloomy, than that the company had made substantial profits in the year past.  This was why annual financial statements contained many forward looking statements and why IAS-1 on the Presentation of Financial Accounts required management to assess the company’s ability to continue as a going concern.  The auditor was required to assess the appropriateness of management’s use of the going concern basis of accounting and to identify any material uncertainty that may cast significant doubt on the company’s ability to continue as a going concern.

IAS-2 required that financial statements reflect 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.  This was not what section 22(1) postulated.  As a result, the items in dispute, because they had not actually been incurred by the end of the year, did not fall to be taken into account to reduce the closing stock value of the trading stock.

VWSA had classified the items forming part of its NRV calculations as “distribution and selling costs”, consisting of rework and refurbishment costs, outbound logistics, marine insurance, distribution fees, sales incentives, warranty costs, costs relating to the Audi Freeway Plan and the Volkswagen AutoMotion Plan and roadside assistance costs.  It was apparent, in the view of the court, that nearly all these costs would have been incurred in the pursuit of or following sales.  The sole potential exception was damage to vehicles in stock having suffered damage during the year, which was a very minor contributor to the calculations, being a mere R525 per vehicle.  This basis of calculating the NRV of stock on hand accorded with IAS-2; the question was whether it accorded with income tax principles as contemplated in section 22(1).

The court found that the use of NRV was inconsistent with two basic principles underpinning the Income Tax Act.  The first was that taxable income is levied from year to year on the basis of events during each year.  Trading prospects for the ensuing year are not SARS’ concern.  This could be expressed by saying that tax is backward looking.  By contrast, NRV is forward looking.  The second inconsistency was that using NRV meant that expenses incurred in a future year in the production of income accruing in that year became deductible in a prior year.  The tax court had erred in failing to recognise that section 22(1) 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”.  Whether using NRV was a sensible and businesslike manner of valuing trading stock was neither here nor there.  The question was whether the result of using NRV accurately reflected the diminution in value of trading stock contemplated in section 22(1).  The court found that only the very minor item of R525 per vehicle for refurbishment necessitated by damage could possibly qualify as diminution in value.

Accordingly, the appeal succeeded and the additional assessments for 2008, 2009 and 2010 were confirmed.

I conclude with one slightly disquieting remark of the court.  It seemed to suggest that trading stock need not be valued on a line by line basis.  With respect, this cannot be correct.

Subject to this reservation, this decision is, with respect, correct in terms of established income tax principles. Our courts have long held that accounting treatment is, at best, some indication of the taxpayer’s intention, but it is not determinative of the nature of a transaction.  Seventy years ago, in Sub-Nigel Ltd v CIR [1948] 15 SATC 381 AD, the Appellate Division, as it then was, made this point.  The same court reiterated this principle 17 years later in SIR v Eaton Hall (Pty) Ltd [1975] 37 SATC 343 AD.  Since then, and by coincidence, given the fact that the VWSA matter was about trading stock, at least two further judgments have made the same point in dealing with trading stock issues:  Richards Bay Iron & Titanium (Pty) Ltd & another v CIR [1995] 58 SATC 55 AD, a case who main claim to a place in the pantheon of celebrated tax cases is its analysis of the definition of “trading stock”; and CSARS v AA the Motorist Publications (Pty) Ltd [2001] 63 SATC 325 CPD.

Attempts to apply the provisions of IFRS in tax matters are understandable, given the inevitable complexity of the calculations required to arrive at values consistent with IFRS and perhaps understandable reluctance to do them all again for tax purposes.  Moreover, IFRS itself appears in the Income Tax Act, two examples being section 24J and 24JB.  One could comment on whether it is appropriate for the decisions of an unelected group of accounting specialists located far from South Africa to have any place in our income tax legislation; but that is a debate for another day.