Groups of companies often pay expenses on behalf of other group entities, or incur costs centrally and recharge them. The Tax Court recently considered whether a company could deduct the operating costs of an associated mining company that it paid under a contractual obligation. In this article, I consider how the court applied the requirements of section 11(a) of the Income Tax Act 58 of 1962 (the ITA) to this arrangement, and where I believe the reasoning may arguably open to question.

The arrangement

The taxpayer was a wholly owned subsidiary of a group listed on the New York Stock Exchange. The group also held 74% of Clarisse Mining, and a BEE shareholder held the remaining 26%. Clarisse Mining supplied chrome to the taxpayer under an offtake agreement. The taxpayer concluded the agreement to secure a reliable chrome supply. It also constructed a plant on Clarisse Mining’s premises, because Clarisse Mining could not fund the plant itself.

The offtake agreement provided that the taxpayer would cover Clarisse Mining’s operating costs if the mine went into care and maintenance. This happened in the 2018 to 2020 years of assessment. The taxpayer had no right to recover these costs from Clarisse Mining, and it continued to trade through an alternative supply arrangement. The dispute also concerned production costs that the taxpayer had paid before the care and maintenance period and could not recover, which it claimed as a bad debt. This article deals with the care and maintenance costs, which SARS disallowed and the Tax Court agreed were not deductible.

Actually incurred

A taxpayer actually incurs expenditure when it is liable to make a payment and the liability is its own. The service providers issued their invoices to Clarisse Mining, and their contracts were with Clarisse Mining rather than the taxpayer. The taxpayer argued that the offtake agreement obliged it to pay these amounts. The court distinguished between paying another person’s expenses and incurring expenditure for purposes of section 11(a), and found against the taxpayer on this requirement.

In my view the court did not necessarily deal with the two separate obligations that may have existed here. Clarisse Mining owed the first obligation to the suppliers. The taxpayer, however, claimed the deduction for a different obligation, namely the one it assumed towards Clarisse Mining under the offtake agreement. The judgment does not address that second obligation, and I am therefore not convinced by the court’s conclusion on what the taxpayer actually incurred. Regardless, the practical relevance is that the agreements must make clear which obligation the taxpayer incurs, and the taxpayer must be clear which obligation it claims the deduction for.

Production of income

The expenditure must be connected to the operations from which the taxpayer earns income, and the closeness of that connection matters. The taxpayer received no chrome while Clarisse Mining was in care and maintenance. It argued that it paid the costs to secure its future supply of chrome. The court held that a payment to protect something, or to secure a longer term future benefit, is capital in nature. It concluded that this expenditure was capital, and that conclusion is understandable. Had the expenditure not been capital, section 23H of the ITA may arguably have been the next hurdle, because the taxpayer paid for a benefit it would receive only in the future.

One should assess this requirement from the perspective of the person who incurs the expenditure. From Clarisse Mining’s perspective, the payments were for safety related services. From the taxpayer’s perspective, they secured future supply. Only the taxpayer’s perspective is relevant to its own deduction.

The trade requirement

The taxpayer must incur the expenditure in carrying on its own trade. The court held that the taxpayer’s trade did not include paying another company’s operating costs, even under a contractual obligation. The taxpayer’s answer was again that it assumed the obligation to secure its future chrome supply, which related to its own trade.

The court’s reasoning on this requirement is less clear. It appears to distinguish between the taxpayer’s current trading activities and its future trading activities. I am not aware of authority for reading the trade requirement in that way. That an expense relates only to future trading activities is arguably an indication of a capital expense, rather than a failure of the trade requirement. Where expenditure also benefits other group entities, the question is whether the taxpayer incurs it for its own trade, for another entity’s trade, or for both.

Care and maintenance costs and dualism

The court added that care and maintenance expenditure does not qualify for a section 11(a) deduction when the mine itself incurs it. SARS treats it as unredeemed capital expenditure under section 36 of the ITA. The court regarded the taxpayer’s claim as an attempt to recharacterise this expenditure and described it as an impermissible avoidance arrangement. SARS also submitted that the ITA does not permit a dualism in which one taxpayer claims the expenditure of another.

It is perhaps questionable whether there is anything untoward in a non-mining company paying amounts based on a supplier’s care and maintenance costs to secure its future supply. The agreements are not available, however, and this view remains tentative. The risk of the dualism argument is, however, real. A clear recharge agreement that records what is recharged, and on what basis, distinguishes between paying someone else’s expense and incurring one’s own. The basis may be the cost incurred plus a mark-up or another measure, provided the agreement records it.

Take-home message

Arrangements where one group company pays, recharges or recovers the expenses of another require careful attention to who actually incurs the expenditure. The contractual arrangements determine this, and without them the taxpayer relies on an invoice in another company’s name. The production of income and trade requirements must be assessed from the payer’s perspective and tested against the payer’s own activities and trade. Group expense arrangements are not always messy, but this judgment shows that they can be. Where a group relies on recharge or cost-sharing arrangements of this kind, one should carefully review the agreements and the section 11(a) position before claiming the deduction.