In recent times, taxpayers holding thousands of items of stock have had difficulties in convincing the Commissioner of the South African Revenue Service of the value of their obsolete closing stock at year end. For the most part, the Commissioner has been denying taxpayers the right to take into account any diminution in the value of their closing stock. Some relief is in sight now that the Tax Court has spoken, for the second time.
The important, currently unreported judgment (ITC 13626) was handed down in May 2018 and it clarifies the method of determining the value of closing stock, which had diminished for various reasons such as damage, change in fashion and decrease in market value, as referred to in section 22(1)(a) of the Income Tax Act (ITA), 1962.
This judgment is significant for taxpayers who hold large quantities of closing stock and who cannot, for practical reasons, individually assess each item of closing stock to determine the extent of the diminution in value at year end.
Section 22 of the ITA deals with trading stock and requires a taxpayer to include in its taxable income, the “value” of its closing stock at year end. The value of closing stock is defined in paragraph (a) of section 22(1) as the cost price of the trading stock less an 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 reason and which the Commissioner deems just and reasonable”.
The problem is that the Commissioner has recently denied taxpayers any diminution in the value of their obsolete closing stock, often for no good reason. The Tax Court judgment sheds light on many practical questions:
- What is expected of a taxpayer in proving the value of its closing stock and what evidence must it provide to convince SARS of the value of its closing stock?
- What should a taxpayer who holds thousands of items of closing stock do to convince the Commissioner of the diminution in value?
- If a taxpayer values its closing stock at the lesser of cost and realisable value in a particular tax year, does it have to prove to the Commissioner that the relevant stock was ultimately disposed of for that realisable value? How would a taxpayer who holds thousands of items of obsolete closing stock go about proving this?
Tax Court’s view
The Court held that if the Commissioner does not recognise that a diminution in value has occurred, the Tax Court can, on appeal, exercise its own decision in substitution for the Commissioner’s decision. The Tax Court further held that in this case–
- The net realisable value (NRV) if calculated in terms of IAS 2 (an International Accounting Standard) the International Financial Reporting Standards (IFRS) and SA GAAP, is an appropriate method for determining the actual value of closing stock at the end of the year of assessment. IAS 2 requires closing stock to be measured at the lower of cost and NRV.
- The legislature could not have intended that a trader assess each individual item of closing stock.
- IAS 2 requires estimates of NRV to be made, based on the most reliable evidence at the time. The value of closing stock is not a definitely ascertainable amount; it is an estimated amount.
- In this case, the taxpayer was subject to external and internal audits, and it applied IAS 2 and an internal group policy (which also complied with IAS 2. The reasonableness of the diminution amount was subject to audits.
- There is nothing in section 22(1)(a) which could be interpreted as requiring a trader to prove that – an item of obsolete closing stock can no longer be used; the item of closing stock was ultimately disposed of for the realisable value.
The Tax Court also rejected SARS’ argument that a diminution amount must represent the actual value by which stock has diminished in value. The Court held that when a diminution amount is calculated, the closing stock is still “held and not disposed of” and that no actual event would have occurred at that stage. An actual event only occurs when stock is sold or scrapped, and by that time, it no longer forms part of closing stock.
Further, the Tax Court rejected SARS’ argument that “only events that exist at year end … be taken into account in calculating the value of closing stock. The Court held that SARS’ argument was contrary to SA GAAP/IFRS and the authorities which require post-balance sheet experience to be taken into account in determining NRV where appropriate. Events that occurred in the period between the close of the accounting period and the date on which the directors approved the financial statements would be “post-balance sheet experience” as referred to in Tax Code 1489.
The Tax Court accepted that where slow-moving stock had not been sold for 12 to 24 months, this was a clear indication that the value of the closing stock had probably diminished.
Time for SARS to speak up
This case should be good news to taxpayers who hold thousands of items of stock and received revised assessments in respect of the value of their closing stock. Provided the taxpayer can show that they applied IAS 2 and SA GAAP/IFRS, they should be successful in proving that their section 22(1)(a) adjustment to the value of their closing stock was just and reasonable.
The Commissioner should reconsider how he exercises his discretion as his refusal often amounts to the exercise of no discretion at all. The cost of litigating against SARS is high - taxpayers would be justified in expecting SARS to now confirm its willingness to accept the two Tax Court judgments and that it is acceptable for taxpayers to apply accounting standards when calculating values of obsolete closing stock for purposes of section 22(1)(a).
Although decisions of the Tax Court are not binding on other taxpayers, in the interest of good tax administration, it is time for SARS to be pragmatic and make a public statement about this issue.
For further information please contact Melody Makeka, Communications Coordinator, Bowmans, +27 21 480 7898, Mobile +27 74 101 9082, Email melody.makeka@bowmanslaw.com