Paying income tax on no income

01 November 2007 Robert W Vivian, University of the Witwatersrand

Professor Robert Vivian takes a closer look at the recent extraordinary case of SARS v Brummeria 2007 SCA, in which the Supreme Court of Appeals ruled that income tax should be paid on no income.

Income tax in theory is levied only on income actually received or accrued - this has always been the case (until now that is). The fundamental principle of taxation was laid down by Adam Smith in 1776, and is codified in law in terms of s1 of the Income Tax Act, which defines gross income in terms of Smith's canon, the relevant portion of which reads, '... the total amount, in cash or otherwise, received by or accrued to ...(the taxpayer] during such year of assessment...'

Tax on interest free loans?

The facts of the Brummeria case are laughably simple, once you strip the verbiage out. Future residents paid sums of capital to the developers of a retirement village to build units for them. These future residents would then acquire the right to live in the complex until they died, paying only the levy to cover the running costs. The question then is, does the developer pay tax on the interest free loans?

Firstly, we need to determine what is the 'income' that SARS thinks the developer earns. The future residents lend capital to the developer, interest free. Had they charged interest, the developer would have paid interest to the future residents. Therefore the interest charges are an expense, not income, seen from the developer's point of view. The developer could not invest this money to earn interest since the developer was obliged to build units with the money.

Had the developer invested the money and earned interest, the developer would have had to pay the future interest. This interest cost would have to be passed on to the resident. The developer's income would thus be the difference earned on the margin.

Alice in Wonderland

To tax possible schemes and not actual transactions is to plunge tax into the Wonderful World of Alice in Wonderland.

What SARS thought to be the income was (para 5) 'an amount equal to the value of the rights of the companies (developer) to use the funds advanced to them as interest-free loans' and (para 11), 'the commissioner's case is that it was the right to retain and use the loan capital, interest free, for the relevant periods, which constituted the right which had an ascertainable money value and which accrued to the companies.' Had the future residents charged interest, this would have been an expense in the hands of the developers. This expense is now treated as income - that is a first in confusion. Not surprisingly the tax court, which heard the case, dismissed the claim.


The appeal court's point of departure (para 11) was to consider, "whether the rights to use the loans interest free, constituted 'amounts' which 'accrued to' the companies." The question is not and never has been does an amount accrue but does income accrue. If there is no income, there can be no tax. If it is not income which is taxed, then as David Ricardo pointed out, it is tax on capital - and that would require a specific Act of parliament.

Interpretation and precedent

In my previous article Taxing Parents I referred to a problem which has arisen in the courts, when progressing from one case to another. This problem can be illustrated by the so-called game of telegraph a teacher once taught me. He caused us to line up and went to the first student and whispered in his ear, 'Dear Sir, can I have a glass of water.' By the time the message came to me it was,'Dear Sir, can I take out your daughter.' I will leave it to the reader's imagination as to what came out at the end of the line.

Well, this is pretty much what is happening with modern case 'law'. As matters progress from one case to another, the 'law' takes on new meanings and in the end, it bears no resemblance to the initial actual law; income tax on income. It is not suprising that Roman law systems with codified laws do not recognise the doctrine of precedent. It has now been suggested that anyone should pay income tax other than out of income received or accrued.

Our courts now seem to have difficulty in interpreting the concept of income accrued and it may be necessary to petition parliament to change the system of taxation to cash received, to make it very clear that only income received is subject to income tax.

And the individual taxpayer is the loser

If one seriously believes the Brummeria case, then possibly every retirement complex now faces insolvency. What is the future arrangement for old age homes to be? Take the following example. The future resident now lends the developer R1 million at 10%, receiving an income of R100 000 per annum. The developer builds the unit and charges the future resident R100 000 per annum as rental to recover the interest charge. The developer now pays no tax at all on this amount. He reflects an income of R100 000 and an expense of R100 000. The resident however is in a different position. He reflects an income of R100 000 (paid by himself) and incurs and expense of R100 000 which SARS disallows as being a private expense. So he now has an income of R100 000 on which to pay tax. SARS gets the money it would have got had the taxpayer left the money in the bank.

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