How to save on tax
24 June 2009

In order to claim a deduction of expenditure in terms of the general deduction formula contained in section 11(a) read with section 23(g) of the Income Tax Act No. 58 of 1962, it is a requirement that the expenditure be incurred for the purposes of the taxpayer's "trade". This "trade" requirement is also contained in several of the sections providing specific deductions, such as section 24J(2) which provides a deduction in respect of interest expenditure.

In the context of property developers, depending on the factual scenario, interest expenditure incurred prior to the development of the property may not be deductible in terms of the general deduction formula, as it may not comply with the "trade" requirement. For example, the court has held in Income Tax Case No. 697 (1950), 17 SATC 93, that interest expenditure relating to a period in which an old building was demolished and a new building erected was not deductible as it was not laid out for the purposes of trade. In this regard the court held as follows:

"It seems to me that until the asset becomes an asset capable of producing income any expenditure upon it is of a preliminary nature and is not deductible, because the rates and interest were not laid out exclusively or at all, in point of fact, for the purposes of trade. If a taxpayer has no asset with which he can trade then he cannot be trading..."

The Act, however, makes specific provision for the deduction of certain pre-production expenditure in the year of assessment during which the trade commences in terms of section 11(bA), section 11(bB) and section 11A.

Section 11(bA) is applicable in respect of pre-production interest expenditure incurred in relation to certain specified assets, including amongst others "any machinery, plant, building or any improvements to a building...". It has been held by the court in Income Tax Case No. 1619, 59 SATC 309, that the reference to "buildings" in section 11(bA) does not include land. Property developers may accordingly rely on section 11(bA) to obtain a deduction of interest expenditure incurred prior to the commencement of trade in respect of the acquisition of buildings. However, no such deduction will be allowed in respect of the interest expenditure incurred to acquire land. Where a property developer acquires property with the intention to demolish the existing buildings, the cost of the buildings is likely to be negligible and the purchase price, and the interest costs in respect of the funding thereof, will relate mostly to the cost of the land.

Section 11(bB) is available in respect of interest expenditure incurred for purposes of acquiring "machinery, plant, aircraft, implement, utensil, article or livestock" and does not provide relief to property developers.

Section 11A provides for a deduction of expenditure incurred prior to the commencement of trade, in the year of assessment in which the trade commences (subject to certain limitations). In order for section 11A to find application, it must be shown that the pre-production interest expenditure would have been allowed as a deduction in terms of section 11 (other than section 11(x)), section 11B or section 11D, had the expenditure been incurred after the taxpayer commenced carrying on the relevant trade.

Currently, interest is deductible in terms of section 24J(2) if it is incurred after the commencement of trade. On a literal interpretation, section 11A will, accordingly, not find application in respect of pre-production interest, as the interest would not have been deductible in terms of section 11.

However, section 11A was inserted into the Act by the Revenue Laws Amendment Act No. 45 of 2003 with effect from 1 January 2004. At that time, section 24J was merely a timing section and did not operate as a charging section which provided for the deduction of interest. Interest was deducted in terms of section 11(a) and section 24J was applied to determine the amount of interest which may be deducted in each year of assessment.

Section 24J was amended by the Revenue Laws Amendment Act No. 32 of 2004 with effect from 1 January 2005, so that section 24J thereafter operated as the charging section and a deduction of interest is to be claimed in terms of section 24J(2) (and not section 11(a)).

Accordingly, at the time when section 11A was introduced, and when it became effective, interest was deductible in terms of section 11(a). Interest expenditure on the cost of acquiring land would accordingly have been deductible in terms of section 11(a) had the taxpayer's trade commenced at the time when the interest was incurred, and section 11A would have applied. This would allow the taxpayer to claim a deduction of pre-production interest incurred in respect of the cost of acquiring land, in the year of assessment when the taxpayer's trade commenced.

When section 24J was amended to operate as a charging section, it had the consequential effect that section 11A no longer applied to pre-production interest in respect of land. There is no indication in the Explanatory Memorandum to the Revenue Laws Amendment Act, 2004 in terms of which section 24J was amended that such a consequence was intended. After a discussion with National Treasury, it appears that this was indeed an oversight and unintended and that the legislation will be amended to rectify the situation. As at the date of writing this article, the draft Revenue Laws Amendment Bill, 2009 has not yet been released and it remains to be seen whether the relevant amendments have been incorporated.

Should section 11A be amended accordingly, property developers will be entitled to claim a deduction of interest expenditure incurred in respect of the acquisition cost of land prior to the commencement of trade, in the year of assessment when trade commences. It should be noted that a deduction in terms of section 11A will be "ring-fenced" and may not be applied against the income derived from any other trade. If the interest expenditure exceeds the income derived from the relevant trade, it may be carried forward and set-off against the income derived from that trade in the following year of assessment.

It also remains to be seen whether the expected amendment will apply retrospectively as the interest expenditure in relation to projects which began trading prior to the amendments may not otherwise be deductible.

Andrea Coetzee and Taryn Solomon, www.moneywebtax.co.za