A long battle about apportioning audit fees for tax purposes culminated on 7 March 2014 in defeat for the taxpayer in CSARS v Mobile Telephone Networks Holdings (Pty) Ltd (966/12) [2014] ZASCA 4. The Supreme Court of Appeal overturned the decision of the High Court, which had overturned that of the tax court. The effect of the judgment is that, although audit fees are deductible in principle, a formula-based apportionment of audit fees is not permitted.
The general principle in issue is how to treat expenses, audit fees in this case, that relate to both taxable income such as interest and to exempt income such as dividends. Expenditure incurred in respect of exempt income is not deductible, for obvious reasons. The question arose as to the appropriate method by which to apportion these expenses.
The facts
The taxpayer was the holding company of a number of subsidiaries in the group and earned by far the majority of its income from dividends from these companies. It also made interest-free loans to its subsidiaries, and interest-bearing loans to other group companies. It thus had two sources of income: dividends from its subsidiaries and interest from loans to members of the group. The taxpayer had no employees, but used the resources of the group instead.
SARS apportioned the audit fees based on the relationship between the taxable portion of the revenue, the interest, and the exempt portion, the dividends. The result was that most of the audit fees were not deductible. In the years in question, 2001 to 2004, the disallowed percentage of the fee varied between 94% and 98%. The taxpayer appealed to the tax court, contending that the entire audit fee was deductible, basing its argument on the respective numbers of entries in the records. The tax court rejected both parties’ arguments and held that a 50/50 apportionment was appropriate.
Both parties appealed to the High Court; the taxpayer persisting with its view that a full deduction was justified, alternatively that 94% of the fee was deductible based on an alleged time basis. The court accepted the alternative submission, thus finding against SARS, and SARS duly appealed to the SCA.
The principles
The SCA considered the well-settled principle that, in deciding whether expenditure has been incurred in the production of income, as required by the Income Tax Act, 1962, “important, sometimes overriding factors are the purpose of the expenditure and what the expenditure actually effects”. The court has to assess the closeness of the connection between the expenditure and the income earning operations. Accordingly, the audit fees were a part of the general overhead expenditure enabling it to carry out all its activities. Thus the audit of financial records is “necessarily attached” to the performance of the income-earning operations.
Application of the principles
The question was the extent to which those income-earning operations generated taxable revenue. The court acknowledged the principle of apportionment where expenditure meets the “necessarily incurred” test but relates to both taxable and exempt income. The problem is to establish an acceptable basis of apportionment. Previously the courts have applied formulae, as in CIR v Nemojim (Pty) Ltd [1983] 45 SATC 291 AD and CIR v Rand Selections Corporation Ltd [1956] 20 SATC 390 AD, or a basis that the court deemed to be fair in the circumstances, as in Tuck v CIR [1988] 50 SATC 98 AD. In the present case, the court recoiled from basing the apportionment on a formula which might not reflect the actual situation, or on the respective number of entries, or even on a narrow comparison of the sources of revenue. It was not possible to lay down general rules as to how to apply apportionment. The court acknowledged that “an auditor has to undertake a wide range of general tasks which do not relate to specific income items”.
The MTN audit function involved far more than the time spent on the book entries, which may well have made up a relatively small component of the overall audit time. For example, the group consolidation would necessarily have taken considerable time. It was clear that the interest-earning operations made up a modest part of the operations, and the apportionment would have to reflect this reality. SARS’s approach was too narrow, and that of the taxpayer was too generous. In all the circumstances, the court considered it fair and reasonable to allow 10% of the audit fees.
Where does this leave taxpayers in relation to audit fees and similar expenses? In their favour is the fact that the court has confirmed that audit fees are “necessarily attached” to operations. At least once in the recent past, SARS has argued, unsuccessfully, that audit fees should be disallowed altogether. In SARS’s favour is the finding that audit fees are subject to apportionment. And both parties are on notice that consideration of the specific circumstances and not formulaic approaches is necessary in apportioning expenditure.
The case also dealt with a capital/revenue argument in relation to the costs associated with the installation of a software system, but that is a topic for another article.
