PRINCIPLES OF TAXATION

(TAX2601)

CONTENT DOCUMENT
LEARNING UNIT 5

Trading deductions and trading stock

CONTENTS
5.1 Background
5.2 General deduction formula
5.3 Specific deductions
5.4 Prohibited deductions
5.5 Prepaid expenses
5.6 Trading stock
5.7 Conclusion and integrated question
ANNEXURE: Prescribed case law relevant to this learning unit

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INTRODUCTION ___________________________________________________________

In learning unit 4, we discussed the first two components of the framework, namely gross income (the
general definition and specific inclusions) and exempt income, to show you how to calculate income for a
taxpayer for a year of assessment.

In this learning unit, you will build on the knowledge that you have acquired thus far and learn about the
next component in the framework, namely deductions. In particular, we will look at general deductions
and specific deductions, as well as deductions that are specifically not allowed and that are known as
prohibited deductions. At the end of the learning unit, we will also cover trading stock.

Definition
Gross income
Specific
inclusions
Income Less:
Exempt
income
Less:
General
deductions

Specific This learning

Deductions deductions unit

Prohibited
Gives: deductions

Taxable income Capital

before capital gains allowances

Plus:

Capital gain

Gives:

Taxable income

Figure 5.1: Taxable income framework

STUDY PROGRAMME ________________________________________

Refer to the suggested study programme in the “How to study TAX2601” document.

You should spend a minimum of 24 hours on this learning unit.

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LEARNING OUTCOMES ___________________________________________________

After you have completed this learning unit, you should be able to

• state the requirements of the general deduction formula (together with applicable case law) and
apply the formula in a practical situation in the form of a discussion, like a case study
• calculate and apply the specific deductions to a taxable income calculation
• apply the prohibited deductions to a taxable income calculation
• apply the trading stock provisions to a taxable income calculation

PRESCRIBED STUDY MATERIAL FOR THIS LEARNING UNIT _____________________

Chapter 4 in the prescribed textbook.

 SECTIONS OF THE PRESCRIBED TEXTBOOK WHICH YOU MAY IGNORE

4.3.2 – VAT (section 23C of the Income Tax Act)

4.4.1 – Private and domestic expenditure (section 23(a) and (b) of the Income Tax Act)
4.4.8 – Expenditure relating to employment (section 23(m) of the Income Tax Act)

CONTENTS

5.1 Background

Textbook: section 4.1 Introduction

When running a business, a taxpayer incurs certain expenses that he/she would ultimately like to claim as
a deduction when calculating his/her taxable income and, consequently, pay less tax. However, before an
expense may be claimed as a deduction, it must qualify as an allowable deduction in terms of the Income
Tax Act. Such allowable deductions are deducted from “income” in the framework. The result of this
calculation is taxable income (assuming there are no capital gains to be included, which will be dealt with
in learning unit 7).

Read section 4.1. Introduction

Deductions for income tax purposes and accounting expenses will differ in some
instances because deductions are provided for in the Income Tax Act and
expenses are provided for by the International Financial Reporting Standards
(IFRS). This means that taxable income will not be the same as the accounting
net profit for any year.

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The Act makes provision for the general deduction formula in terms of which most operating expenses,
incurred by the taxpayer during the operation of an entity, may qualify as allowable deductions.
5.2 General deduction formula

Textbook: section 4.2.1 Introduction

Study section 4.2.1.

Deductions are allowed in terms of

• the general deduction formula – section 11(a) read with section 23(g)
• specific deductions – section 11 (mainly)

Work through the example in this section in the prescribed textbook.

List the requirements of the general deduction formula in terms of section 11(a) read with
section 23(g) of the Income Tax Act itself. It is very important to memorise this.

5.2.1 Case law

No prescribed text

Before we deal with each component of the general deduction formula, it is important to understand the
relevance of case law (court cases). Not all criteria for the general deduction formula are easy to interpret
in different situations and, as a consequence of decided tax cases, many important legal principles have
been established. Legal precedent must be followed to help us apply some of the principles of the general
deduction formula to situations where interpretation is not straightforward.

You do not need to study the facts of each court case in detail, however, you do need to take note of which
principle (requirement of the general deduction formula) was dealt with. More important is that you should
be able to link each court case to the correct requirement in the general deduction formula when you are
answering a discussion question or online quiz questions. For purposes of this module you may refer to a
court case by only making use of the name of the court case. We do provide you with the full reference(s)
of the court cases, but you do not have to use the full reference in your written assessments. On third year
level you will study case law in more detail. We provide you with a list of the prescribed case law for this
learning unit at the end of this learning unit. When answering a question that needs reference to case law,
you must only use the prescribed case law and not any other court cases.

Now we will deal with each component of the general deduction formula separately.

5.2.2 Trade

Textbook: section 4.2.2 Trade

Study section 4.2.2.

An important tax case that dealt with the trade requirement was Burgess v CIR 55 SATC 185.

The principle: To be able to claim an amount under section 11(a), it is necessary for a taxpayer to be
carrying on a trade. The fact that there is no continuity or that there is a lack of profit motive or risk does
not necessarily mean that trading is not taking place.

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5.2.3 Tax versus accounting

Textbook: section 4.2.3 Tax versus accounting

Read section 4.2.3.

5.2.4 Expenditure and loss

Textbook: section 4.2.4 Expenditure and losses

Study section 4.2.4.

For this requirement, it is important to remember that the expenditure may be in a form other
than cash, for example, payment can be made by issuing shares, land or assets.

5.2.5 Actually incurred

Textbook: section 4.2.5 Actually incurred

Study section 4.2.5.

An important tax case that dealt with the “actually incurred” requirement was Edgars Stores LTD v CIR
(1988 AD).

The principle: Before an expense can be deducted in terms of section 11(a), it must be unconditional, that
is, the expense must not be contingent – the event must have taken place.

It is important that you understand the meaning of contingent. This term refers to an event that may or may
not occur; there is therefore uncertainty about the transaction. It is dependent on a possible future event.

The following is a simple example to illustrate the above:

You may decide, for instance on 27 March 2024, that an expense will become payable only if it rains on
3 April 2024. If it does rain on 3 April 2024, you will have incurred the expense on 3 April 2024. If it does
not rain on 3 April 2024, the event does not take place and therefore the expense is not incurred.

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Note that it is not necessary for the expense to be actually paid for it to be incurred.
As long as the liability has been incurred (i.e. there is a legal liability to pay the
amount owed), a deduction may be claimed.

5.2.6 During the year of assessment

Textbook: section 4.2.6 During the year of assessment

Study section 4.2.6.

For tax purposes, according to this requirement, the expenditure is claimed in the year in which
it is incurred. Remember, the year of assessment is the same as the financial year.

5.2.7 In the production of income

Textbook: section 4.2.7 In the production of income

Study section 4.2.7.

An important tax case that dealt with the requirement of “in the production of income” is Port Elizabeth
Electric Tramway Company LTD v CIR 8 SATC 13.

The principle: The test called the “inevitable concomitant” or “closely connected” test firstly requires that
the purpose (task performed) of the expenditure should be established. Next, it should be determined
whether the task was necessary and whether an expected or foreseeable risk was attached to that task.
Thus, it should be asked whether the expense is so closely connected with the income earned that it may
be regarded as part of the cost of performing it.

It may happen that an expense is incurred to earn income and exempt income. In
such a case, the expense must be apportioned and only the portion relating to the
income is deductible.

Work through the following example:

One of Dunlop (Pty) Ltd’s workers lost a finger while operating a machine in its factory.
Dunlop (Pty) Ltd is a manufacturing company and manufactures all its products in this
factory. In January 2024, the court granted the worker compensation amounting to
R10 000. Dunlop (Pty) Ltd only paid the compensation in April 2024, after its year-end on
31 March 2024. Is the R10 000 compensation deductible? Cover the solution and see if
you can argue whether the expense of R10 000 is deductible or not.

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Solution

In addition to satisfying the other requirements of the general deduction formula, an

expense must be incurred in the production of income. Is the compensation paid closely
connected with Dunlop’s income-earning operations? The risk of injury to its employees
operating machines in the factory is closely connected with the production of Dunlop’s
income. Therefore, it could be said that the expense was an inevitable concomitant of
Dunlop’s type of business.

Was the expense actually incurred at year-end, since it was paid in April 2024 only?
Although the expense was paid in the following year of assessment, the company’s liability
had been fixed by the court and it was, therefore, unconditional as of January 2024. It was
therefore actually incurred and deductible in the 2024 year of assessment.

5.2.8 Not of a capital nature

Textbook: section 4.2.8 Not of a capital nature

Study section 4.2.8.

Every business need sources of capital because capital provides the money for the assets a business
needs to carry on its operations. Common examples of business assets include the following:

• The working cash balance a business needs for its day-to-day activities
• Products held in inventory (trading stock) for sale
• Long-life operating assets (buildings, machines, computers, office equipment, etc)

Expenditure incurred (e.g. raw materials) to purchase or manufacture inventory for sale is regarded as part
of the business income-earning operations, whereas the expenditure incurred to purchase buildings and
machines is of a capital nature, as buildings and machines are part of the income-earning structure of a
business. The latter capital expenditure would not be deductible for tax purposes in terms of the general
deduction formula. However, some allowances may be claimed on certain capital expenditure
(covered in learning unit 6).

Sometimes, a business will incur expenditure that will not be so straightforward to determine whether it is
of a capital nature or not. Then certain tests may be applied to help determine the capital or revenue nature
of expenditure.

These tests are the following:

• The true nature of the transaction
• The closeness of the connection to the income-earning operations versus the income-earning
structure
• Creating an asset or advantage that provides an enduring benefit
• Once and for all expenditure
• The nature of the business that is carried on

An important tax case that dealt with the requirement of “not of a capital nature” is New State Areas Ltd v
CIR 14 SATC 155.

The principle: Expenditure must be regarded as part of the cost of performing income-earning operations
or as part of the cost of establishing, improving or adding to the income-earning structure: the so-called
operations-versus-structure test. The other tests that can be used to help decide the matter were the “fixed-

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versus-floating-capital” test, the test to establish whether there was any enduring benefit or a permanent
asset created by the expenditure, and even the recurrence test.

Floating capital expenditure takes place when expenditure frequently changes its
form from money to goods with the purpose of making a profit. This represents a
deductible expense; one example is the purchase of stock.

Fixed capital expenditure represents capital expenditure that may qualify for
capital allowances, for example machinery, although the cost of such machinery
will not be deductible in terms of the general deduction formula.

Work through the following example:

Constructo (Pty) Ltd entered into a contract to purchase a piece of vacant land adjoining its
factory to use as parking for its clients. The cost of the land amounted to R230 000, which
was paid in cash.

Is the R230 000 deductible in terms of the general deduction formula?

Solution
The R230 000 incurred to purchase the vacant land is an expense of a capital nature. This
land forms part of the income-earning structure and it is not connected to the income-
earning operations. This expense was incurred as part of the fixed capital of the business
rather than as part of its floating capital. Therefore, the expense is not deductible.

Note that the tests to determine whether an amount is of a capital nature or not
from a “gross income” point of view will differ from those used to determine
whether expenditure is of a capital or revenue nature from a general deduction
point of view.

Compile a list of the tests used to determine whether or not amounts are of a capital nature
from a gross income point of view and from a general deduction point of view.

The solution to this activity can be found at the end of this learning unit. First try to
do it yourself.

You can watch Video 1 uploaded in the LU 5 tab on the module page. This video
was recorded by the lecturers and it covers Question 4 Part B of TL201 (also
uploaded in the LU 5 tab on the module page) relating to the general deduction
formula. Note that this video is not a replacement for your study material, but
merely an additional resource. You must still study all the learning material in detail.

5.3 Specific deductions

Textbook: section 4.3 Specific deductions

If a particular expense does not meet the requirements of the general deduction formula,
perhaps because it is considered to be of a capital nature or it was not incurred in the
production of income, the taxpayer can look whether there is a specific provision in the Act
that may allow the deduction of the specific expense in question.

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For this module, the specific deductions will be dealt with as follows:

• section 23B – double deductions

• section 11 of the Act, in alphabetical order (some have been excluded from this
module)
• section 18A donations to public benefit organisations

5.3.1 Double deductions

Textbook: section 4.3.1 Double deductions – section 23B

Study section 4.3.1.

5.3.2 VAT

No prescribed text

Since value-added tax (VAT) is not part of this module, you do not need to know the VAT consequences
for expenses. You may assume that all figures you will deal with are exclusive of VAT and, therefore, no
adjustments need to be made.

5.3.3 Legal expenses

Textbook: section 4.3.3 Legal expenses

Study section 4.3.3.

Work through the example in this section in the prescribed textbook.

Were you able to work out how we arrived at the R1 000 here?

For the total legal fees of R6 000 incurred, total compensation of R60 000 was received.
R10 000 received relating to lost revenue over the total R60 000 represents “one-sixth”
(R10 000/R60 000 = 1/6 or 0.167. Therefore, only one-sixth (1/6) of the legal fees incurred
may be claimed under section 11(c) (R60 000 x 1/6 = R10 000 or R60 000 x 0.167 =
R10 000), as the other portion is of a capital nature.

You should be able to determine whether or not the legal costs in a question are deductible.
As a rule of thumb, if the expense or transaction that the legal fees relate to will be
deductible in terms of the general deduction formula, then the legal fees will be deductible,
and the other way around.

5.3.4 Restraint-of-trade payments

Textbook: section 4.3.4 Restraint of trade payments

Study section 4.3.4 and work through the example.

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Remember, it is not the lesser of the number of years of restraint or three years, but the lesser
amount incurred after dividing this amount by the number of years of restraint or by three. In the example,
this is the reason that Mrs Y’s restraint-of-trade deduction is over three years, as R3 million divided by
3 years is R1 million, which is less than the R3 million divided by 2,5 years, which is R1,2 million.

You must show both amounts in your calculation, together with the wording “the lesser of” and then deduct
the lesser amount to receive all the marks. Refer to self-assessment question 5.1 in this tutorial letter for
an example.

5.3.5 Registration and acquisition of patents, copyrights, designs and trademarks

Textbook: sections 4.3.5 Registration of patents, copyrights, designs and trademarks and 4.3.6
Acquisition of patents, copyrights and designs

Study section 4.3.5.

Expenses relating to intellectual property, for example patents, copyrights, designs and trademarks, are
of a capital nature and therefore they will not qualify as a deduction under section 11(a), but they may be
claimed under section 11(gB) and 11(gC).

Section 11(gB) basically deals with the expenses relating to obtaining the grants (registration) of patents,
registration of copyrights, designs and trademarks, and the extension or renewal of registered trademarks,
patents, copyrights and designs.

The actual acquisition of patents, copyrights and designs is dealt with in section 11(gC).

Now, study section 4.3.6.

Try to complete the following diagram:

Acquisition of patents, copyrights and designs

Expenditure < R5 000 – the Expenditure > R5 000 – the

allowance will be: allowance will be:

A? B?
C?

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Note that the allowance of 5% or 10% is deducted every year (not only in the
first year) until the full acquisition cost is claimed.

The acquisition of a trademark does not qualify for a deduction in terms of

section 11(gC); only the renewal of the registration period of a trademark
will be allowed as a deduction in terms of section 11(gB).

If taxpayers incur expenditure in the creation or development of intellectual property, they can seek to
claim a deduction under section 11D (research and development).

5.3.6 Research and development expenditure

Textbook: section 4.3.7 Research and development expenditure

Study section 4.3.7.

Take note that you must distinguish between operating research expenses of a revenue nature (on which
you can claim a 150% deduction) and capital assets used for research (on which you can claim a
50%/30%/20% allowance on the cost).

All the requirements of section 11D(2) must be met in order to claim a 150% deduction. If the approval
from the Minister is not received or the expense is incurred before the application for approval was
submitted, then only 100% of the cost for expenses of a revenue nature may be deductible.

5.3.7 Bad debts and doubtful debts

Textbook: sections 4.3.8 Bad debts and 4.3.9 Doubtful debts

Study sections 4.3.8 and 4.3.9.

Work though the example on bad debts.

Do not confuse these two sections – one is about a deduction for the actual debts that
have gone bad (i.e. not recoverable) and the other is about a deduction of the provision
made by the taxpayer for debts that are doubtful.

Remember

• A bad debt deduction may only be claimed as long as the debt gave rise to income
as defined (i.e. gross income less exempt income), which will be taxed since it is part
of taxable income. For example, the accounting journal entry was Cr Sales (income
statement), Dr Debtor (balance sheet).
• The allowance that can be claimed in respect of doubtful debts are determined by
whether the company applies International Financial Reporting Standards
(IFRS) 9 or not. You can assume that none of the companies in your assessments
apply IFRS 9.

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• The 40% and 25% doubtful debts allowance calculation is applied only to the list of
doubtful debts, not to the full debtor’s balance (read the information given in a
question carefully).
• If a doubtful debts allowance is claimed in one year, it must be added back to income
in the following year.

5.3.8 Contributions made by an employer to retirement funds

Textbook: section 4.3.10 Contributions by an employer to pension, provident and benefit funds

Study section 4.3.10.

All contributions to these funds are deductible, as long as it is incurred in the production of income.
A benefit fund includes any friendly society registered under the Friendly Societies Act or a medical
scheme registered under the provisions of the Medical Schemes Act.

5.3.9 Donations made to public benefit organisations (PBOs)

Textbook: section 4.3.11 Donations to public benefit organisations

Study section 4.3.11.

A donation deduction is only allowed if it is supported by a section 18A receipt/certificate issued by the
recipient of the donation. Any disallowed donations, in other words donated amounts that were more than
the limited deduction (10% of taxable income), can be carried forward to the next year and deducted then,
if the requirements are met.

Because the donation deduction is based on taxable income before this

deduction, this deduction must always be the last line of your taxable income
calculation.

5.3.10 Annuities paid to former employees

Textbook: section 4.3.12 Annuities paid to former employees on retirement

Study section 4.3.12.

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5.4 Prohibited deductions

Textbook: section 4.4 Deductions specifically not allowed in the determination of taxable income

You may ignore the following:

4.4.1 – Private and domestic expenditure (section 23(a) and (b) of the Income Tax Act)
4.4.8 – Expenditure relating to employment (section 23(m) of the Income Tax Act)

The Income Tax Act makes provision for expenses that simply may not be deducted. Even if the expense
meets the requirements of section 11(a), the taxpayer cannot claim a deduction for it for tax purposes.
Section 23 of the Income Tax Act provides a list of expenses that may not be deducted for income tax
purposes.

In this module, the following prohibited expenses are dealt with:

• Insured losses (section 23(c))

• Tax, penalties and interest on tax (section 23(d))
• Provisions (section 23(e))
• Expenses to produce exempt income (section 23(f))
• Non-trade expenditure (section 23(g))
• Restraint of trade payments (section 23(l))
• Fines and corrupt activities (section 23(o))

Study each section but ignore the relevant examples.

5.5 Prepaid expenses

Textbook: section 4.5 Prepaid expenditure – section 23H

It sometimes happens that a taxpayer makes a payment in the current year of assessment, where a portion
of the payment relates to services or goods that fall into the following year of assessment – this is called
a prepaid expense.

For example, an annual licence fee of R100 000 is paid on 1 January (i.e. until
31 December) and the company’s year-end is March. Only three months (January –
March) of the licence fee falls in the current year of assessment. So R100 000 x 3/12 =
R25 000 will be deductible in the current year of assessment (according to the general
deduction formula). You need to determine now whether the prepaid portion (R100 000 x
9/12 = R75 000) is deductible in the current year of assessment, according to the rules of
section 23H of the Act.

In terms of section 23H, prepaid expenditure may be claimed in the year of assessment that the full
payment is made if

• the prepaid amount relates to a period within six months after year-end OR
• the aggregate prepaid amount is less than R100 000

Therefore, if any of the two criteria above applies to the prepayment, then the whole expense (i.e. the
portion incurred in the year of assessment, as well as the prepaid portion) may be claimed in the year of
assessment in which it was paid.

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If these rules are applied to the above example, you can determine that the prepaid amount
relates to nine months after year-end (more than six months; thus not deductible in the
current year according to the first criterion) and that the prepaid amount is R75 000 (less
than R100 000; thus deductible in the current year according to the second criterion). Note
that only the prepaid expense (R75 000) is taken into account for the application of these
rules and not the full amount paid (R100 000). The prepaid expense of R75 000 will thus be
deductible in the current year of assessment, because one of the criteria was met.

The R25 000 incurred in the current year, as well as the R75 000 prepaid expense, may be
claimed in the current year. Although the full amount of R100 000 is thus deductible, you
must show the two portions of the amount (i.e. the current year expense and the prepaid
expense) separately in your tax calculation, since the deduction is allowed by separate
sections of the Income Tax Act. This is clearly illustrated in the solution to question 5.3 of
this learning unit.

Work through the example in section 4.5 of the textbook.

Did you notice that the R240 000 for the insurance premiums cannot be deducted in full
when it is paid, but must be spread over the year and matched to the period in which the
service was delivered? This is because the prepaid period, namely March 2023 to December
2023, is more than six months after the year-end, and the total prepaid portion of the
expense of R200 000 (R240 000/12 x 10 months prepaid) is greater than R100 000.

Although the example in the textbook shows the deduction of the service cost in 1 line as
the full amount, you must include it in 2 separate lines (current year and prepaid portion) in
your taxable income calculation (as mentioned above).

You can watch Video 2 uploaded in the LU 5 tab on the module page. This video was
recorded by the lecturers and it covers the deduction of a prepaid expense. Note that this
video is not a replacement for your study material, but merely an additional resource. You
must still study all the learning material in detail.

5.6 Trading stock

Textbook: section 4.6 Trading stock

As you know by now, there are some differences between accounting and tax, each having a specific
meaning for its terms. With reference to trading stock, accounting distinguishes between a periodic and a
perpetual stock system. Smaller businesses that do not have electronic stock systems will usually make
use of a periodic stock system, whereas larger businesses with electronic stock systems will apply a
perpetual stock system. In the end, both systems will have the same effect on the net profit of the business.

Also, for financial accounting purposes, the cost of sales is calculated and then deducted from sales to
calculate gross profit. It is important to note that, for taxation purposes, the Act does not make provision
for the deduction of the cost of sales. Each of the three components (opening stock, purchases and closing
stock) must be shown separately in the calculation of taxable income. In all questions for this module, we
always assume a periodic stock system for accounting purposes. This means that we assume that all
purchases of trading stock is deducted in the year of purchase as an expense.

If an entity purchases trading stock, the expenditure meets the provisions of the general deduction formula
(section 11(a)) and, consequently, the purchases are considered expenditure deductible from income.

Section 22(1) of the Act provides specifically that closing stock is income in the hands of the entity and
section 22(2) provides that opening stock may be deducted.

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5.6.1 Trading stock and closing stock

Textbook: sections 4.6 Trading stock, 4.6.1 Section 22 and 4.6.2 Closing stock

Study sections 4.6, 4.6.1 and 4.6.2.

Work through the example.

In the example, you will notice that the mark-up (profit) of R40 000 is, in effect, what is
being taxed in the year in which the vehicle (stock) is sold.

Closing stock held and not disposed of at year-end must be accounted for at the lower of cost or
market value, if the market value is lower than cost because of damage, deterioration, or any other reason
satisfactory to the Commissioner.

5.6.2 Opening stock

Textbook: section 4.6.3 Opening stock

Study section 4.6.3.

Work through the example. Ignore the capital gain effect in the example, as we have
not dealt with capital gains tax yet.

In the example, the moment the company changes its intention with regard to land and
no longer holds the asset as a capital asset, but as trading stock, the market value of the
land as at the date of the change is included in the opening stock.

5.6.3 Cost of trading stock

Textbook: section 4.6.4 Cost for the purposes of section 22

Study section 4.6.4.

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You must be able to identify the costs that need to be included in the total cost of trading stock.

Work through the following example:

Manufacto (Pty) Ltd purchased stock for R60 000. It incurred handling fees of R3 500 and
paid a transporter R2 500 to deliver the stock.
Calculate the cost price of the stock for tax purposes.
Solution R
Purchase price 60 000
Plus: Handling fees 3 500
Transport 2 500
Cost price 66 000

5.6.4 Trading stock acquired for no consideration

Textbook: sections 4.6.5 Stock acquired for no consideration, 4.6.6, Periods shorter than a year of
assessment and 4.6.7 Private and domestic consumption

Study sections 4.6.5 to 4.6.7.

Work through the following example:

Trading stock, which costs the taxpayer R6 000, is removed by him for private use. The
market value of the stock at the date it was used was R8 000. What is the effect of this on
taxable income?
Solution
The taxpayer must include a recoupment (taxable amount) of what he was previously
allowed to deduct, namely R6 000 in taxable income.

If the taxpayer donated the trading stock, what would the effect be on taxable income?

Solution
If the donation qualifies for a deduction (for example if a section 18A receipt was obtained
for the donation), the taxpayer would recoup and include R6 000 (cost) in taxable income.
If the donation does not qualify for a deduction, the taxpayer would recoup and include
R8 000 (market value) in taxable income.

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5.7 Conclusion and integrated question

Textbook: sections 4.7 Conclusion and 4.8 Integrated question

Read the conclusion section. It contains an outline of a detailed tax liability calculation, which
includes items that are relevant to individuals, for example salaries, which you may ignore. Focus only on
those items that relate to companies, such as trading income and the relevant deductions discussed in
this learning unit.

Work though the integrated question in detail.

This is a good example of the kind of question you can expect in an assignment.

POINT TO PONDER

Would an expense be deductible if the underlying transaction had no profit motive?

WRAP-UP

• In order to calculate taxable income, expenses incurred by an entity need to meet the requirements of
either the general deduction formula or specific deductions before they can be deducted.
• The general deduction formula consists of two parts: positive in terms of what may be deducted
(section 11(a)), and negative in terms of what may not be deducted (section 23(g)).
• In practice, a taxpayer may need to substantiate, using case law, why a certain expense meets the
general deduction formula and has therefore been deducted in the taxable income calculation.
• If an expense does not meet the general deduction formula requirements, there may be a specific
deduction provision in the Income Tax Act, which may allow for a deduction.
• Certain expenses, for example prohibited deductions, may not be deducted in the taxable income
calculation.
• For taxation purposes, prepaid expenses are deducted when the benefit or service of the prepaid
expenses is rendered or received within six months after the taxpayer’s year-end, or when all prepaid
expenses are less than R100 000.
• Purchases of trading stock are deductible, with opening stock also being deductible and closing stock
being included in income when calculating taxable income.

Now that you have completed this learning unit, please revise the learning
objectives to make sure you have attained all of them.

This learning unit is one of the most important learning units in this module, as the general deduction
formula, specific deductions, prohibited deductions and trading stock are all important parts of the taxable
income framework that is used to calculate taxable income and ultimately, the tax liability of a taxpayer.

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Complete the self-assessment online quiz on general and specific deductions

in the
LU 5 tab on the module page.

This quiz will test your knowledge at an introductory level. It will introduce you to
the concepts and basic allowances covered in this learning unit. Please note that
you must also be able to answer long, calculation-type questions, in which you
will have to integrate the allowances covered in this learning unit.

Self-assessment questions – learning unit 5

Below are 3 questions that you can attempt.

The solutions, as well as additional questions and solutions, are provided in a separate document
(LU 5 Solutions to self-assessment questions and additional questions and solutions - uploaded in the
LU 5 tab on the module page), to give you an opportunity to attempt answering the questions first.

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QUESTION 5.1 (16 marks, 19 minutes)

Blueberry (Pty) Ltd is in the cell phone industry and it provides cell phone reception and call services. It
has an extensive customer base, which has been created over the past few years. The current financial
year ends on 30 June 2023. You may assume that current legislation applies to Blueberry (Pty) Ltd.

The following information relates to Blueberry’s activities for the current financial year:

(1) Gross income amounts to R4 590 000, before taking the information below into account.

(2) Blueberry’s employees belong to the company’s pension fund and medical aid fund. Blueberry
contributes to these funds on behalf of the employees. During the year, contributions on behalf of
the employees to the pension fund amounted to R110 000 and contributions to the medical aid
fund amounted to R135 000. Salary expenditure of R2 350 000 were also incurred for the year.

(3) The financial manager, Mr Grey, resigned on 1 June 2023. To prohibit him from trading in direct
competition to Blueberry, the company paid him an amount of R550 000 as compensation for his
restraint of trade for the following five years. The full amount was included in Mr Grey’s income on
his 2024 income tax return.

(4) The debtors clerk indicated that the list of doubtful debts amounted to R2 200 000 at the end of the
year. Of the total list of doubtful debts, R500 000 related to debtors older than 120 days and the rest
to debtors older than 60 days, but less than 120 days old. Blueberry (Pty) Ltd does not apply IFRS 9.
The doubtful debts allowance claimed in the 2022 year of assessment amounted to R760 000.

(5) Legal fees to the amount of R140 000 were paid for the following: R

– Collection of outstanding trade debtors 85 000

– Court cases in respect of employee remuneration claims 55 000

(Note: Employee remuneration is deductible for purposes of this question.)

(6) Penalties and interest paid to SARS amounted to R16 000 in respect of the current year of
assessment.

(7) Bad debts written off consist of the following:

R
– Loan made to director 80 000
– Trade debtors 122 000

(8) The following prepaid expenditure was incurred on 29 June 2023:

– Rental of the switchboard system for head office for the period from
1 July 2023 to 31 January 2024 40 000
– Deposit for the purchase of a delivery vehicle that will be delivered
on 1 September 2023 85 000

REQUIRED: MARKS

Calculate the taxable income of Blueberry (Pty) Ltd for the year of assessment ended 14
30 June 2023.

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QUESTION 5.2 (15 marks, 18 minutes)

Dikoloto Fela (Pty) Ltd (Dikoloto) is a residential property developer with a March year-end. Dikoloto’s
main business is selling residential property in the form of freestanding, full-title homes, sectional title
townhouses and full-title stands.

On 13 October 2023, hurricane Sally struck one of the towns in which Dikoloto operates and it destroyed
four unsold townhouses with an original cost of R4 500 000 in total. The insurance company paid Dikoloto
R3 900 000 in respect of this loss.

REQUIRED: MARKS
Discuss whether the expenditure and/or losses above are deductible by Dikoloto Fela (Pty)
Ltd in terms of the general deduction formula (section 11(a) read with section 23) for the
year of assessment ending 31 March 2024. Where applicable, briefly refer to the 15
applicable case law to strengthen your argument.

QUESTION 5.3 (11 marks, 13 minutes)

Beauty (Pty) Ltd is a business that manufactures jewellery. It is not regarded as a small business
corporation, as defined, for income tax purposes. Beauty (Pty) Ltd’s accountant has asked for your
assistance with the following items regarding calculating taxable income.

Beauty (Pty) Ltd's year of assessment ended 31 March 2024.

Taxable income before the items below have been taken into account is R2 910 000.

Outstanding items Notes R

– Annuity to dependant of retired employee 180 000
– Legal expenses 1 25 000
– Bad debts 2 45 000
– Restraint of trade 3 200 000
– Insurance 4 12 500

Notes
R
1. Beauty (Pty) Ltd incurred the following legal expenses:
• Labour negotiations 20 000
• Legal appeal to SARS regarding imposed tax 5 000
25 000
2. Bad debts written off consist of the following:
• Trade debtors 25 000
• Loan to an employee to buy a motor vehicle 20 000
45 000

The financial accountant tells you that, included in the list of debtors at year-end, is an amount of
R22 000 that is considered doubtful (the debtor is 90 days old). A doubtful debts allowance of R3 750
was claimed for tax purposes for 2023. Beauty (Pty) Ltd does not apply IFRS 9.

3. On 1 May 2023, the managing director of Beauty (Pty) Ltd decided to take early retirement.
Subsequently, Beauty (Pty) Ltd paid him an amount of R200 000, restraining him from doing the same
business after retirement for a period of two years.

4. Beauty (Pty) Ltd paid an annual insurance premium of R50 000 for the period from 1 January 2024
to 31 December 2024.

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QUESTION 5.3 (continued)

REQUIRED: MARKS

Calculate the taxable income of Beauty (Pty) Ltd for its year of assessment ended
31 March 2024. 11

We could assess this learning unit in assignments by asking you to

• list the requirements of the general deduction formula, together with the applicable case law
• apply the requirements of the general deduction formula to a practical situation, providing reasons why
an amount should be deducted or not (with or without reference to case law)
• discuss and calculate, with regard to a case study, which expenses may be deducted in terms of the
general deduction formula (section 11(a)) or which and how much may be specifically deducted in
terms of an available specific deduction
• determine, with regard to a case study, which expenses may not be deducted
• apply the correct tax treatment with regard to trading stock when calculating taxable income

Solutions to some of the self-assessment questions in learning unit 5

List of tests used to determine whether amounts are of a capital nature or not:

Gross income General deduction

Subjective tests • The true nature of the transaction
• Nature of the receipts • The closeness of the connection to the income-
earning operations or income-earning structure
• Sale of assets
• Creating an asset or advantage that provides an
• Intention
enduring benefit
• Continuity
• Once and for all expenditure
• Change of intention
• Nature of the business that is carried on
Objective tests
• Manner of acquisition
• Period for which the asset is held
• Manner of disposal
• Nature of the asset disposed of
• Reason for the receipt
• Legal nature of the transaction
• Accounting treatment of the transaction

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ANNEXURE: PRESCRIBED CASE LAW RELEVANT TO THE GENERAL DEDUCTION FORMULA

(LEARNING UNIT 5)

Atherton v British Insulated and Helmsby Cables Ltd (1926)

Burgess v CIR 1993 (4) SA 161 (AD); 2 All SA 511 (A) (55 SATC 185)
Edgars Stores Ltd v CIR 1988 (3) SA 876 (AD) (50 SATC 81)
George Forest Timbers Co Ltd, CIR v 1924 AD 516 (1 SATC 20)
Golden Dumps, CIR v 1993 (4) SA 110 (AD) (55 SATC 198 (A))
Joffe and Co (Pty) Ltd v CIR 1946 AD 157 (13 SATC 354)
Nasionale Pers Bpk v KBI 1986 (3) SA 549 (AD); [1986] 2 All SA 397 (A) (48 SATC 55)
New State Areas Ltd v CIR 1946 AD 610 (14 SATC 155)
Port Elizabeth Electric Tramway Co Ltd v CIR 1936 CPD 241 (8 SATC 13)
Rendle, COT v 1965 (1) SA 59 (SRAD) (26 SATC 326)
Sub Nigel Ltd v CIR 1948 (4) SA 580 (AD); [1948] 4 All SA 352 (A) (15 SATC 381)

Notes:
1. For ease of reference the list is presented in alphabetical order according to the name the case is
known by. Therefore, CIR v Golden Dumps is listed as Golden Dumps, CIR v.
2. Only prescribed case law may be referred to when answering a question in an
assessment.

_______________________________
End of Learning Unit 5

©
Unisa

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