Section 24C of the Income Tax Act 1961 has been part of the Act since 1980 and has been a source of periodic disputes between taxpayers and SARS. Although it was originally intended for the construction industry, taxpayers have sought, with varying success, to bring their transactions within its provisions while SARS is alert to interpret it as narrowly as it deems fit. SARS has long recognised that the section can and does apply to a wide range of activities, and has stated as much in Interpretation Note 78. This was the basis of IT 14240, heard in the Cape tax court as B v CSARS on 28 August 2017. In its judgment, delivered on 3 November 2017, the court found in favour of the taxpayer, a franchisee of a “chain” restaurant, thus enabling it to use section 24C to provide out of current turnover an amount for future expenditure on obligatory periodic refurbishments.
The dispute between the parties involved both section 24C and section 11(d), the latter presumably relating to the familiar repairs v improvements debate in relation to the nature of the refurbishments. By agreement between the parties, the current case dealt only with the section 24C aspect.
Section 24C is commendably brief. Its requirements are that:
- an amount forming part of a taxpayer’s income must accrue to the taxpayer
- during a year of assessment
- in terms of any contract
- and the amount will be used in whole or in part to finance future expenditure
- to be incurred by the taxpayer in the performance of the taxpayer’s obligations under that contract. (Emphasis added)
Where these five conditions are present, the taxpayer is entitled to an allowance in respect of the future expenditure relating to the amount.
The taxpayer operated a number of restaurants in a franchise chain under various franchise agreements between it and the franchisor. The agreements were identical in all material respects. The provisions central to the present matter were:
- that the taxpayer actively operate the business, which implied the provision of meals to customers
- that failure to do so was a material breach
- a number of clauses dictating to the taxpayer the branded products it must use, how its restaurant must be constructed in accordance with the franchisor’s requirements, how its staff was to be trained, supervised and even replaced at the franchisor’s election, the prices that it could charge, the monthly franchise fee payable, that it must maintain the restaurant in such manner as determined by the franchisor, upgrade and/or refurbish it, play only pre-recorded music approved by the franchisor, only offer food and beverage items approved by the franchisor, operate during business hours specified by the franchisor, and contribute to the franchisor’s marketing fund in the manner specified
- and a host of other provisions from which it was clear that the franchisor exercised complete control over the operations of the taxpayer.
As Counsel for the taxpayer put it, it was no exaggeration to say that the franchisor exercised almost absolute control over the taxpayer via the franchise agreement.
Perhaps the most crucial provision in the matter was Clause L1.4, which provided that the franchisee agreed “…to upgrade and/or refurbish the Restaurant at reasonable intervals determined by the Franchisor to reflect changes in the image, design, format or operation of…[the franchisor’s restaurant chain]…from time to time and required of new…franchisees subject to approval by the franchisor of detailed plans and specifications for all construction, repair or refixturing in connection with such upgrading or remodelling…’”.
The court considered Interpretation Note 78, which states in relation to the obligation requirement in section 24C that there must be a “high degree of probability and inevitability that the expenditure will be incurred by the taxpayer.”
SARS argued that it is an absolute prerequisite that there be a single contract from which both income accrues or is received and an obligation is created to incur future expenditure. There could be no quibble with this submission. SARS then contended that there were in fact two contracts: the contract for the franchise, which included the obligation for future expenditure, and which created the right of the taxpayer to establish and operate the restaurants under the franchise licence and trademark of the franchisor in exchange for payments of franchise fees; and the day-to-day sales of meals to customers, who in turn paid for them and to which the franchisor was not a party. It was largely out of the proceeds of the second contract, together with possible bank finance, that the franchisee carried out the obligatory improvements. Consequently, according to SARS, the costs of the improvement obligation did not emanate from the franchise contract. There were thus two separate contracts, legally independent and separate from each other; no income was received by or accrued to the taxpayer in terms of the franchise agreement; no future expenditure was incurred in terms of the sales transactions to customers; and therefore section 24C did not apply. Perhaps clutching at straws, Counsel for SARS argued that, although the obligation was absolute, it was nonetheless dependent on the franchisor’s approval and thus conditional.
Counsel for the taxpayer argued that, while it was so that the taxpayer received income from its customers due to sales of meals, the fact of the matter was that it could not provide those meals, and thereby earn its income, without the franchise agreement. The franchise agreement was the fons et origo of the taxpayer’s income, and here lay the clear, direct causal link.
After traversing a number of cases dealing with section 24C, and others addressing the meanings of key words and phrases, and applying the by now familiar rules of interpretation set out in Natal Joint Municipal Pension Fund v Edumeni Municipality [2012] (4) SA 593 SCA, the learned judge found herself persuaded that, given the language used in the franchise agreement; the context and apparent purpose to which section 24C was directed; Interpretation Note 78; and the authorities to which she had referred on key words and phrases, the franchise agreement and the sales of meals to customers were inextricably linked and not legally independent and separate. The fact that the taxpayer was obliged under the franchise agreement to operate the restaurant and provide meals to customers, and failure to do so would have been a material breach, evidently weighed with the court.
Judgment thus went to the taxpayer.
As to costs, the taxpayer applied for an order against SARS, on the grounds that it was unreasonable for SARS to suggest that the allowances claimed did not qualify under section 24C. However, the court did not consider that SARS had been unreasonable in adopting the approach that it did. Each case in matters such as the present one was very fact specific and, from the decisions of the tax court to which the court had been referred, it seemed clear that there was generally no easy answer to this type of debate. As a result, there was no order as to costs.
While franchisees of “chain” restaurants will applaud this decision and set about applying it to their situations, much would depend on the provisions of each franchise agreement. As the court correctly observed, each situation is fact specific and there is no room for a one size fits all approach to the application of section 24C.
