Accrual intentions: IFRS and tax law’s awkward romance

IFRS and tax basics – Are there mutual interests?

From a corporate tax perspective, in practice the starting point for the tax calculation is profit before tax. This is generally determined by applying IFRS principles, and therefore a rudimentary understanding of accounting principles is useful in order to understand the adjustments that have (or haven’t) been made in arriving at profit before tax.

While in the main there are overlaps in how revenue and expenditure are recognised for tax and accounting, the core principles are quite disparate and nuanced.

Under IFRS¹, revenue could be recognised at a single point in time, or over the period of a contract (which may be a number of years). For insurance, these rules become far more complex, seeking to recognise economic substance over the service period, using intricate concepts like fulfilment cash flows and contractual service margin.

For tax purposes, ‘gross income’ is defined² to include “…the total amount, in cash or otherwise, received by or accrued to or in favour of such resident… excluding receipt or accruals of a capital nature…”. This definition is supported by a plethora of court cases on each element thereof.

There are numerous IFRS standards³ containing different rules for the recognition of expenditure, with principles ranging from matching of expenditure to related revenues, to accrual, reliable measurement, and whether or not the outlay provides future economic benefits.

For tax purposes, expenditure is deductible in terms of the so-called ‘general deduction formula’⁴, i.e. “…expenditure and losses actually incurred in the production of income, provided such expenditure and losses are not of a capital nature...” and “…expended for the purposes of trade…”. Again, these terms are supported by a number of court cases. 

Specific references in the income tax act to IFRS

We have highlighted below some key references to IFRS in the Income Tax Act (“IT Act”):

Section 22 – Trading stock

The cost price of trading stock, and therefore the related tax adjustments for opening and closing stock balances, are determined with reference to the costs that are allowable for IFRS purposes⁵. However, section 22(1)(a) of the IT Act is one of the few remaining provisions that provides the Commissioner with discretion to allow a reduction of this cost price of an amount he “…may think just and reasonable as representing the amount by which the value of such trading stock, not being any financial instrument, has been diminished by reason of damage, deterioration, change of fashion, decrease in the market value or for any other reason satisfactory to the Commissioner…”.

Interestingly, our Supreme Court of Appeal (“SCA”) has more than once rejected the so-called IFRS ‘net realisable value’ (“NRV”) as representing the reduced cost price of trading stock under section 22(1)(a), particularly where this reduction is made by way of a ‘blanket’ obsolescence approach, rather than being able to factually attribute the reduction to specific causes:

• SARS v Volkswagen SA⁶ (2018) – the court here rejected the use of NRV as a basis for the tax valuation of trading stock, emphasizing that the tax legislation requires independent justification for the diminution of the value of trading stock.
• SARS v Atlas Copco South Africa⁷ (2019) – relying heavily on the Volkswagen case, the court here ruled that the IFRS-based NRV could not override the requirements of section 22(1)(a), which require a just and reasonable diminution in value due to specific causes like damage or market decline.

The SCA in the Volkswagen case laid out some key observations regarding the interplay between IFRS and tax legislation:

• Although financial statements prepared in line with a group’s accounting policies offer valuable insight into a company’s financial position, they do not automatically determine the taxpayer’s liability for tax purposes.
• While there may be areas where accounting standards and tax provisions intersect, the scope and focus of accounting rules do not always align with the requirements of the relevant tax legislation.
• The calculation of NRV involves forecasting future market conditions, which means it incorporates anticipated costs and may result in deductions being applied to a prior tax period.
• Whether NRV indicates a reduction in the value of trading stock under section 22(1)(a) depends not on its recognition under IFRS, but on whether it meets the specific criteria for value diminution as interpreted within the framework of the section.

The references in section 22 to IFRS principles are accordingly viewed as a helpful guide, but not the be-all and end-all – one must still interpret the tax legislation as it is written.

This principle, sadly, does not appear to be applied in the remaining provisions discussed in this article, where the Commissioner’s discretion is largely also omitted from the IT Act.

Section 9D - CFCs

Section 9D deals with controlled foreign companies (“CFCs”).

The definition of a CFC here includes any foreign company where its financial results are consolidated into a resident company’s annual financial statements in terms of IFRS 10. The SA resident company in this instance may be required to include the net income of that foreign company in its own taxable income.

Section 11(j) and (jA) – Doubtful debt allowance

These sections provide for tax allowances on doubtful debts, and were amended in 2020 to make reference to the new financial instruments standard, IFRS 9.

Section 11(jA) applies to banks and banking groups (using the same terminology as section 24JB). It provides for allowances ranging from 25% to 85% in relation to the loss allowance relating to impairment.

Section 11(j) provides two different methods of determining the allowance on doubtful debts, based on whether or not a taxpayer applies IFRS 9 for financial reporting purposes.

This section uses terms set out in that standard (loss allowance relating to impairment, lifetime expected credit loss) in calculating the total allowance.

While not a blanket discretion for the Commissioner, this section does provide that a taxpayer may apply to the Commissioner for a tax directive permitting an increased allowance in certain circumstances.

Section 23L – Limitation of deduction in respect of short-term insurance policies

This section disallows the deduction of a short-term insurance premium to the extent that it has not been or will not be treated as an expense for IFRS purposes in either the current or a future year of assessment.

Section 23M – Limitation of interest deductions in certain scenarios

The definition of ‘interest’ for purposes of this limitation includes any finance cost element recognised for IFRS purposes under a finance lease arrangement.

Section 24I – Foreign exchange differences

Generally, the tax treatment of foreign exchange differences will follow the accounting treatment. In certain instances where very specific requirements are met, such exchange gains or losses will be deferred until realisation of the underlying instrument.

One of these requirements is where any portion of the exchange item in question does not represent a current asset or current liability for IFRS purposes⁸.

The definition of ‘ruling exchange rate’ in section 24I also provides the Commissioner with the discretion to prescribe an alternative exchange rate, if that alternative rate is used for IFRS purposes for financial reporting.

In addition to these existing references, National Treasury has proposed amendments to section 24I(10A) to deny deferral of exchange differences where an exchange item is not recognised for financial reporting purposes under IFRS.  

Section 24J – Accrual of interest

The definition of ‘alternative method’ in this section permits a taxpayer to determine interest accruals using a method that is in accordance with IFRS, as opposed to the yield to maturity approach set out in section 24J.

Section 24JB – Treatment of financial instruments by banks and banking groups

This section deals with the treatment of certain gains and losses on financial instruments by banks and banking groups, seeking to simplify the tax treatment of these amounts by aligning the tax and accounting treatments thereof, given the complexity and volume of financial instruments generally in issue by such institutions.

References to multiple IFRS standards are made throughout this section, including IAS 32, IFRS 9, and IAS 12.

National Treasury has also proposed further amendments to this section for certain dividends relating to hedging instruments that are measured at fair value through profit and loss in terms of IFRS 9.

Section 25BB - REITs

This section deals with the tax principles for real estate investment trusts (“REITs”). These special rules apply to REITs, and any company that is a subsidiary of a REIT, as defined in IFRS.

The definition of ‘property company’ in this section is determined with reference to the value of assets as disclosed in the annual financial statements prepared in accordance with inter alia IFRS.

Additionally, there are special rules in instances where the debenture part of a linked unit is cancelled, and the issue price of the debenture is capitalised to stated capital for IFRS purposes.  

Section 28 – Short-term insurance

As alluded to in the introduction to this article, insurance tax rules are complex. This section makes reference to specific insurance-related terms set out in IFRS 17 (net earned premiums, insurance revenue, liabilities for incurred claims, liabilities for remaining coverage) in determining the taxable income of a short-term insurer.

It also requires various transition and phase-in tax adjustments as a result of the transition from IFRS 4 to the new insurance contracts standard of IFRS 17.

Section 29A – Long-term insurance

Determining the value of liabilities of a long-term insurer⁹ requires the calculation of ‘adjusted IFRS value’ in terms of section 29A of the IT Act. This calculation makes reference to a number of specific terms set out under IFRS 17.

As with section 28, it also requires a phase-in tax adjustment to the value of liabilities to take into account the transition from IFRS 4 to IFRS 17.

The takeaway

Taking the above into account, there are at least 11 sections in the IT Act that contain references to IFRS. These sections are not insignificant.

A key concern raised in the commentary provided to National Treasury on the latest draft tax laws amendments is that our tax legislation should not be made ‘subject to amendments to IFRS standards’. In effect, where these standards change, our tax legislation, by default, also changes.

As pointed out by the SCA in the Volkswagen case, financial reporting standards can provide valuable insight in determining the appropriate tax treatment, however, they should not automatically determine a taxpayer’s tax liability. Accounting treatment of income and expenditure does not always align with the general principles of tax, and therefore the IFRS treatment of these amounts is not always intuitive to tax professionals or those in industry responsible for tax reporting.

The decision by National Treasury to retract its proposed amendments to the hybrid equity instrument rules is a welcome one. Our tax legislation should stand on its own and not be held up by reporting frameworks which are not built on the same principles and are drafted by international bodies rather than our own tax legislators.

¹_{IFRS 15 – Revenue from Contracts with Customers}

²_{In section 1 of the Income Tax Act}

³_{Notably IAS 1, IAS 2, IAS 16 and IAS 38}

⁴_{Section 11(a) read with section 23(g) of the Income Tax Act}

⁵_{Under IAS 2: Inventories}

⁶_{C:SARS v Volkswagen S A (Pty) Ltd (1028/2017) [2018] ZASCA 116 (19 September 2018)}

⁷_{C:SARS v Atlas Copco South Africa (Pty) Ltd (834/2018) [2019] ZASCA 124 (27 September 2019)}

⁸_{Section 24I(10A)(ii)(aa)}

⁹_{Other than a non-resident reinsurer operating through a branch in South Africa, which is deemed to be a short-term insurer for tax purposes, and taxed under section 28 of the IT Act}

Authors:

Greg Boy, Associate Director

Graham Molyneux, Partner