General Deduction Formula

Chapter 4
 Allowable deductions are deducted from income when determining the taxable income
 s11 makes provision for the deduction of expenses from a taxpayer’s taxable income
 Before the provisions of s11 can be applied, the Act specifies that the taxpayer must be
carrying on a trade

THE GENERAL DEDUCTION FORMULA s11(a) and s23

• s11(a)-Requirements of the general deduction formula. This section must be read together
with s23
• s11(a) sets out the requirements for what may be deducted (positive test)
• s23 stipulates what may NOT be deducted (negative test)
section 11(a):
for the purpose of determining the taxable income derived by any person from carrying on
any trade, there shall be allowed as deductions from income of such person so
derived...expenditure and losses actually incurred in the production of income, provided
such expenditure and losses are not of capital nature

Components of the general deduction formula

• carrying on a trade
• expenditure and losses
• actually incurred
• in the year of assessment
• in the production of income
• not of capital nature
• laid out or expended for the purpose of trade

ALL COMPONENTS MUST BE PRESENT FOR AN EXPENSE TO BE DEDUCTIBLE

CARRYING ON A TRADE
• s11 provides that:
for the purpose of determining the taxable income derived from any person from carrying
on any trade, there shall be allowed as deductions from the income of such person so
derived.....
• The deductions provided in s11 are restricted to expenditure incurred in carrying on a trade.
• “Trade” as defined in s1 includes:
Every profession, trade, business, employment, calling, occupation or venture, including
the letting of any property and the use of or the grant of permission to use any patent... or
any design...or any trade mark... or any copyright...or any other property which is of a
similar nature
• Definition does NOT include passive investment activities (those producing interest,
dividends, annuities and pensions)
• Speculation in securities or shares might indicate that you are carrying on a trade even
though the scale of investment is not very extensive
• If you are not a moneylender, then interest earned is not ‘carrying on a trade’ therefore no
deduction allowed
• BUT a deduction of interest expense incurred in earning interest income will be
allowed=>limited to interest income (interest expense cannot create a loss)
• The definition of trade includes ‘venture’, held to be a transaction in which a person risks
something with the object of making a profit
• Is a profit motive necessary before a taxpayer can be said to be carrying on a trade?
 the test for deductibility of expenditure is “the real hope to make a profit”. Such hope must
not be based on fanciful expectations but on reasonable possibility –ITC 1292
 the absence of a profit does not necessarily exclude a transaction from being part of a
taxpayer’s trade-CIR v De Beers Holdings (Pty)Ltd
 there is no requirement in our Income Tax Act that the taxpayer concerned should be aiming
at a bet profit in his trading operations-ITC 1274
 A trader may deliberately sell articles at a loss ‘for business purposes’.
• In carrying on a trade there should be profit or an expectation of profit.
• If a transaction is entered into with a purpose of not making a profit or making a loss, it must
be shown to have been connected with the pursuit of the taxpayer’s trade to justify the
conclusion that, despite the lack of profit motive, the money paid out under the transaction
were wholly and exclusively expended for the purpose of trade-CIR v De Beers Holdings

PRE-TRADE EXPENSES
s11A allows expenses incurred before the trade commenced to be deducted when taxpayer
starts
trading

EXPENSES AFTER THE TRADE HAS STOPPED

Activities surrounding the liquidation are not considered to be the carrying on of trade, during a
process of liquidation
The sale of stock during liquidation is not the carrying on of a trade
EXPENDITURE AND LOSSES
• The Act does not define the word ‘loss’ but in Joffe & Co (Pty)Ltd v CIR, the court
held the meaning in the context was “somewhat obscure” and did not appear to
mean anything different from expenditure:
• The word is sometimes used to signify a deprivation suffered by the loser, usually
an involuntary deprivation, whereas expenditure usually means a voluntary
payment of money
• Deductible expenditure is not restricted to expenditure in cash
• The cost to the taxpayer of an asset given in lieu of cash is allowed as a deduction
BUT no value may be placed on the taxpayer’s own labour where the asset was
created by him
• A taxpayer may barter an asset he made for trading stock to be sold in his business
operation. The cost of the trading stock that may be deducted ito of s11(a) will be
limited to the cost of the components incorporated in the asset he has made and
bartered. No deduction may be claimed for his own labour even though the MV of
the asset created may be substantially higher than the cost
• If asset is acquired through a donation or an inheritance, the value of the asset
may be deducted. The value is usually its MV

Example 4.1
ACTUALLY INCURRED
• Expenditure deductible is both amounts paid AND amounts for which the taxpayer still owes
• Expenditure actually incurred does NOT mean amounts that are due and payable
• A liability payable after the year of assessment is still deductible
• If payment is conditional on the happening of an event, whether suspensive or resolutive, the
expense is only actually incurred once the condition has been met
• Until the condition has been met, it remains a contingent liability that is not tax deductible-
Nasionale Pers BPK v CIR
• Before an expense can be deducted, it must be unconditional. The expense must not be
contingent: the event must have taken place-Edgars Stores Ltd v CIR
• If an outcome of a legal dispute is unresolved by end of the y/a, any possible compensation
payable is only incurred when the dispute is settled
• If a dispute goes to court, only when the final court renders its decision that the expenditure
is actually incurred-CIR v Golden Dumps (Pty)Ltd
• but expenses “actually incurred” cannot mean ‘actually paid’. So long as the liability to pay
them actually has been incurred they may be deductible”-Port Elizabeth Electric Tramway
Company v CIR
• Transferring a contingent liability to a purchaser; the cost is not incurred and therefore not
deductible-Ackermans Ltd v SARS
• Before it may be said that expenditure has actually been incurred, there must be a clear legal
liability to pay at that particular time-ITC 1094
• Distinguish between expenditure that is subject to a contingency and expenditure that
cannot be quantified but estimated on the last day of the y/a and quantified in the next year
• Expenditure is incurred when the event giving rise to the liability occurs
• Fact that the expenditure cannot be quantified does not disqualify it as a deduction
• Asset acquired at an unquantifiable amount, s24M states that the unquantifiable portion of
the amount will be deemed to be incurred in y/a in which amount can be quantified
• Which date is used for an unconditional legal liability? Contract relating to the transaction
may determine that date
• Payments made in advance present a problem. s23H places a limitation on the amount
deductible on prepaid expenses
• “actually incurred” does not mean “necessarily incurred” so if expense complies with all the
requirements of the general deduction formula, it cannot be disallowed because it was not
“necessarily” incurred.

Example 4.2

YEAR OF ASSESSMENT
• Courts held that the expenditure incurred can ONLY be deductible in y/a in which it was
incurred
• If expenses are not deducted in y/a in which incurred, it can never be claimed-COT v
Company
• Except: s23H provides that a deduction of a prepaid expense must be spread over the period
to which the expense relates
IN THE PRODUCTION OF INCOME
• Capital amounts are excluded from the definition of gross income therefore expenditure
incurred in the production of exempt income or capital income are NOT allowed as a
deduction
• Court decisions on whether an expense was incurred in the production of income
 The test (called the “inevitable concomitant” or “closely connected” test) required that the
purpose of the expenditure be established. Next, determine if the task was necessary and
whether an expected or foreseeable risk is attached to the task.
 Ask if expense is so closely connected with the income earned that it may be regarded as part
of the cost of performing it-Port Elizabeth Electric Tramway Company Ltd v CIR
 Compensation paid is disallowed as a deduction if the negligent action is not a necessary
concomitant of the trading operations-Joffe & Co (Pty) Ltd v CIR
 Not required that claimable expenditure must have produced income in the same year that it
is incurred-Sub-Nigel Ltd v CIR
 Expenditure will be regarded as part of the cost of performing the income-earning operations
if “it would be proper, natural or reasonable to regard the expenses as part of the cost of
performing the operation”-CIR v Hickson
• Purpose of the expenditure is an important consideration
• If purpose is to earn a return which does not fall within the definition of “income” or to
preserve capital, expenditure is NOT deductible-CIR v African Greyhound Racing
Association (Pty) Ltd
• It is also possible that expenditure is incurred for more than one purpose, the deduction is
apportioned
 Example 4.3

• Fines and bribes

S23(o) prohibits the deduction of fines, bribes, unlawful kickbacks or penalties due to
unlawful activities

• Theft
Losses due from theft or embezzlement are losses attached to the business operations by chance
and will be deductible provided they are closely connected to the operation that they may be
regarded as part of the cost of performing it.
In relation to “employee theft”, the court held in COT v Rendle that the expenditure:
was sufficiently closely connected with the firm’s business operations as to be regarded as part of
the cost of performing those operations.
ITC 1221 confirmed that theft losses by a managing director, a director or a manager in the position
of a proprietor will not be deductible
In ITC 1242 it was held that:
As a prerequisite to deductibility the taxpayer must establish that the risk of the loss which he
seeks to deduct from his income is inseparable from, or a necessary ingredient of, the carrying on
of the particular business

Example 4.4
• Social responsibility expenses
Amounts are deductible

• Recurrent expenses
Amounts deductible are audit and accounting fees, printing costs of annual reports, the cost
of publishing annual financial statements, annual fees for quotations on the JSE Ltd and fees
of transfer secretaries.
PN 37 provides for the deduction of fees paid to accountants, bookkeepers and tax
consultants for the completion of income tax returns for taxpayers whose remuneration
includes income such as commission or for taxpayers who earn income in the form of
interest, as well as administration fees charged by institutions administering the affairs of
pensioners.

• Ex gratia payments
TP making voluntary payments related to his trade still qualifies for a deduction
NOT OF CAPITAL GAIN
As in the case of capital receipts, the Act does not define or explain what constitutes capital
expenditure, and it was said in Sub-Nigel Ltd vs CIR that it is:
impossible to give a definition of what is expenditure of a non-capital nature which will act
as a touchstone in deciding all possible cases.
The Principle used: “operations vs structure” test: expenditure is to be regarded as part
of the cost of performing income-earning operations or as part of the cost of establishing or
improving or adding to the income-earning structure.
Other tests that were developed can be summarised as follows:
• The true nature of the transaction. The true nature is a matter of fact and the purpose
of the expenditure is an important factor; if it is incurred for the purpose of acquiring a
capital asset for the business, it is a capital expenditure, even if it is paid in annual
instalments.
• Closeness of the connection to the income-earning operations
• An asset or advantage for enduring benefit. Acquisition of goodwill (an enduring
benefit) is a capital expense, while a continuing advertising campaign is of revenue nature
• Fixed or floating capital. The test to establish whether there are any enduring benefits or
permanent assets created by the expenditure .The relation of the expenditure to the fixed
capital (fixed asset) or the floating capital (trading stock) will determine whether the
expenditure is of a capital nature or revenue nature
• “Once and for all” expenditure/ Recurrence test
Generally, capital expenditure is spent “once and for all” and revenue expenditure is
recurrent of nature
• Nature of the business carried on
• Halfway house between capital and revenue. There is no halfway house between
capital and revenue
• Summary. The purchase of capital (fixed) assets (buildings, plant and machinery)
constitutes capital expenditure, while the purchase of trading stock constitutes non-capital
expenditure.
The cost of improving or adding to capital assets is a capital expense and the cost of repairs to
the property is of a revenue nature.

Example 4.5

LAID OUT OR EXPENDED FOR THE PURPOSES OF TRADE-s23(g)

The negative part of the formula, and must be read together with s11(a) to determine whether
an amount may be deducted from the income.
Section 23(g) reads as follows, prohibiting the deduction of:
Any moneys, claimed as a deduction from income derived from trade, to the extent to which
such moneys were not laid out or expended for the purposes of trade
If a portion of the amount is not for purposes of trade then that portion may not be deducted
for tax purposes.
PROHIBITED DEDUCTIONS-s23
The following are prohibited even though they sometimes comply with s11(a):
• the cost incurred in maintaining the taxpayer, his family or his establishment-paragraph a
• domestic and private expenses including the rent of or cost of repairs of or expenses in
connection with any premises not occupied for the purpose of trade or any dwelling-house or
domestic premises except for that part which is occupied for the purpose of trade-paragraph
b
 A part of any domestic property will be deemed not to have been occupied for the purpose of
the taxpayer’s trade unless it is specifically equipped and is regularly and exclusively
used for such purposes
 No deduction will be granted if the taxpayer’s trade relates to employment, unless the
taxpayer’s income is derived mainly from commission or other variable payments based on
his work performance and his duties must be mainly performed (more than 50%) outside an
office provided to him by his employer
• any loss or expense, the deduction of which would be allowable to the extent to which it is
recoverable under any contract of insurance, guarantee, security or indemnity-paragraph c
• any tax, duty, levy, interest or penalty imposed under the Act-paragraph d
• income carried over to any reserve fund or capitalised in any way-paragraph e
• expenses incurred from exempt income-paragraph f
• the “negative test” of the general deduction formula which is read together with section 11(a)
to determine whether an expense may be deducted from income-paragraph g
• interest which might have been made on any capital employed in trade (notional interest)-
paragraph h
• any expenditure, loss or allowance to the extent of which it is claimed as a deduction from
any retirement fund lump-sum benefit or retirement fund lump-sum withdrawal benefit-
paragraph i
• any expense incurred by a labour broker or a personal service provider
The only deductions that a labour broker or personal service provider may deduct are:
 any amounts paid or payable to any employees of the labour broker or personal service
provider for services rendered by the employees, which will be taken into account when
calculating the taxable income of the employees
 legal expenses, bad debts, contributions to funds on behalf of employees, any amount paid to
an employee on which he/she is taxed and any refund of expenses paid by persons; and
 operating expenses for business premises, including repairs, finance charges, fuel,
maintenance and insurance of assets if such premises and assets are used wholly and
exclusively for purposes of trade-paragraph k
• any expense incurred iro the payment made for any restraint of trade-paragraph l
• any expense, loss, allowance which relates to any employment of or any office held by any
person which derives any remuneration. According to paragraph m, only the following
expenses for salaried persons can be deducted:
 contributions to pension funds or RAF; or
 legal expenses, wear and tear allowance, and any amount paid back to an employee on which
he/she is taxed, and any restraint of trade payments paid back to the employer
 premiums paid by that person or by an employer ito an insurance contract to the extent that
it covers loss of income, provided that the amounts payable will constitute income; and
 rent, repairs or expenses in connection with any dwelling-house or domestic premises.
Expenses must qualify ito s11(a) or s11(d) (repairs) to the extent that the deduction is not
prohibited under paragraph (b) (private and domestic expenses)-paragraph m
• no deduction or an allowance may be made for any asset to the extent that a government
grant was given which is exempt from tax and the grant was given for purposes of acquiring
that asset-paragraph n
• no deduction of fines, bribes, unlawful kickbacks or penalties due to unlawful activities-
paragraph o
• no deduction is allowed for the value for any insurance policy ceded to an employee, director,
their family or a retirement fund of which they are members-paragraph p
• no deduction for expenditure incurred in the production of income in the form of foreign
dividends-paragraph q

Example 4.6
SPECIFIC TRANSACTIONS
A few type of expenditure that do NOT qualify for specific deduction are:
• Advertising
Advertising expenditure by an existing business = non-capital expenditure, BUT if there was
an extensive advertising campaign that may create an asset of a permanent nature or an
enduring benefit it will be of capital nature
• Damages and compensation
Hardly incurred in the production of income and will be allowed IF the connection between
the business carried on and the cause of the liability is very close, an inevitable concomitant
• Donations
Donations are gratuitous payments not made in the production of income but rather as an
appropriation of income that has already been earned
• Education/Training
Expenditure incurred in obtaining a qualification or in improving a qualification is of capital
nature and not deductible. Expenditure incurred in maintaining a level of knowledge or
expertise is of a non-capital nature and is therefore deductible
• Entertainment
An agent or representative may deduct all entertainment expenditure incurred in the
production of income (if he earns more than 50% of remuneration as commission from sales)
BUT any other employees may not
• Goodwill
Capital in nature unless the taxpayer buys and sells businesses for a profit, as goodwill gives
rise to an enduring benefit
• Insurance
Deduction is granted for all insurance premiums incurred in the course of a taxpayer’s
trade
• Interest
Interest incurred on loans used for business purposes is deductible. Interest on a loan
used to buy assets which produce exempt income, interest on a loan to pay dividends or
interest on a loan to used to pay taxes, is not deductible
• Salaries and wages
Expenditure on salaries and wages is incurred in the production of income and is
deductible.
Bonuses are incurred to reward employees for past services but also to provide
incentives for future services.
• Theft and losses
Not deductible unless they may be regarded as an inevitable concomitant of the trade
carried on
• Vacant or unproductive property
Not deductible because the expenditure is not in the production of income
• Wasting assets
Assets such as mines, quarries and forests are exhausted in the course of their use.
Expenditure incurred in the acquisition of these assets is of capital nature

Example 4.7
Example 4.8