Court splits taxing issue of audit fees down the middle

Tim Desmond, Director - Tax and Commercial Departments, Garlicke & Bousfield Inc

The Gauteng South Tax Court recently considered the deductibility of audit fees for an intermediary holding company. The taxpayer was a subsidiary of a listed company and itself had a number of direct and indirect subsidiaries. It also lent funds within its group of companies. The case related to the taxpayer’s 2001 to 2004 years of assessment.

The deductibility of the taxpayer’s audit fees depended on the application of the Income Tax Act’s so-called “general deduction formula”. This has been the subject of a great deal of litigation, but each case is very much dependent upon its own facts.

The specific issue in this case, was whether the audit fees were incurred in the production of the taxpayer’s income. The term “income” is defined in the Income Tax Act. It does not include amounts that are exempt from income tax. The taxpayer earned two types of income – dividends and interest. The dividends were exempt from income tax and so did not constitute income (as defined). The interest did constitute income.

The audit fees in this case, could then be said to have been incurred with a dual purpose. They were incurred in the production of both exempt dividends and taxable interest. In such situations, our courts have sought to apportion the expenditure between the two purposes. There have been cases where formulas have been employed to effect such an apportionment. There have also been cases where the court has taken a more subjective approach.

In this case, both SARS and the taxpayer proposed methods of apportionment. SARS’ proposal was on the basis of the relative amounts of the dividends and interests. That would result in only 1 to 11% of the audit fees being deductible in each of the four years of assessment. The taxpayer’s proposal was based on the amount of time that the auditors spent on dealing with the dividend and interest income respectively. That would result in 94% of the audit fees being deductible.

The court rejected both proposals and made its own apportionment. The court’s apportionment was on a 50:50 basis. It was not based on any formula. It was described by the court as a fair basis that recognised aspects of each of the parties’ submissions. It appears from the judgement that, if either party had put up a better substantiated basis of apportionment, the result could have been different. The court, faced with two proposals that it regarded as simplistic and unacceptable, resorted to a fairly arbitrary “middle ground”.