18 October 2018 South African Appeal Court addresses tax treatment of stock obsolescence provisions and net realizable value adjustments From an income tax perspective,1 the closing value of trading stock (other than financial instruments) is accounted for at cost 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 market value, or any other reason satisfactory to the Commissioner." In practice, the South African Revenue Services (the SARS) has been known to disallow the deduction of stock obsolescence provisions where the taxpayer is unable to prove that trading stock has "diminished by reason of damage, deterioration, change of fashion, decrease in the market value or for any other reason satisfactory to the Commissioner." The view taken by the SARS is well summarized in the recent judgment (the Case) handed down by the Supreme Court of Appeal.2
The Case therefore provides some clarity on the tax treatment of the stock obsolescence provisions, in that it confirms the principle that, provided the taxpayer is able to prove that an event has either already occurred in the tax year or will (with a reasonable degree of certainty) occur in the following tax year that will cause the value of the trading stock to diminish, that stock obsolescence provision should be allowed as a tax deduction. There is a caveat to this view, in that the diminution in the value of trading stock must be assessed against the cost price of the trading stock and not its market value. In other words, one will only get an income tax adjustment5 if an event causes the value of stock to drop below cost (and not market value). The Court also goes on to consider the concept of net realizable value (NRV), as contemplated in International Accounting Standard 2 (IAS 2), in terms of its application to section 22(1) and the facts of the case. In this regard, it notes the following:
In terms of IAS 2, inventory is measured from an accounting perspective at the lower of cost and NRV. NRV is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to make the sale. Any write-down to NRV is recognized as an expense in the period in which the write-down occurs. Based on the facts in the Case, it was noted that the taxpayer had calculated the value of its trading stock at year end applying NRV. This yielded an amount less than the cost price of the trading stock and the taxpayer had therefore claimed a deduction in terms of section 22(1) (a). It was further noted that the taxpayer, in calculating NRV, took various costs into account that would only be incurred in the future, both in relation to the sale and distribution of the trading stock. In discussing the correlation between the manner in which trading stock is accounted for from an accounting perspective (in accordance with IAS 2) and from a tax perspective (in accordance with section 22(1) (a)), the Court states the following:
Consequently, on the basis that in calculating NRV the taxpayer had mostly taken into account costs that would be incurred in the future, it was held that the Tax Court had erred in its conclusion that NRV is an appropriate method by which to determine the value of trading stock at the end of a year of assessment for income tax purposes. The appeal by the Commissioner was therefore upheld and the deduction in respect of the closing value of trading stock (based on NRV) was disallowed. One additional observation arising from the judgment, is the view that the SARS is concerned with the value of trading stock as a whole, and that writing down the value of part of the trading stock ignores the fact that the NRV of the remaining stock is higher than cost. In this regard, the Court concludes that, for tax purposes, the question is whether trading stock as a whole has suffered a diminution in value. While this approach is not actually applied in the Case (because the basis for diminution is not accepted in the first instance), it is a matter for serious concern as this "holistic" assessment of NRV would not appear to align with that adopted for accounting purposes, which assesses NRV at an individual level and reduces the cost of items where NRV is below cost but disregards instances where NRV exceeds cost. This view certainly requires further analysis in terms of understanding its alignment with the application of section 22(1) (a) and also its practical implication for taxpayers. The Case clearly illustrates the need for taxpayers to pay close attention to NRV stock adjustments and to critically assess whether these align with the provisions of section 22(1) (a). In particular, where an NRV adjustment is determined with reference to future events and expenses, these would not support a deduction in terms of section 22(1) (a) and should be added back for tax purposes. Document ID: 2018-2070 |
