Pre-trade expenditure and foreign exchange differences: The basics

Deductible expenditure and the ‘trade’ requirement

In order for expenditure and losses to be tax-deductible, they must meet the requirements of the so-called ‘general deduction formula’, i.e. section 11(a) read with section 23(g) of the Income Tax Act¹ (“IT Act”). Section 11(a) requires inter alia that the taxpayer is “carrying on any trade”, and section 23(g) prohibits the deduction of moneys that have not been “laid out or expended for the purposes of trade”.

While ‘trade’ is defined broadly in section 1(1) of the IT Act, the point at which one commences that trade is subjective, and open to interpretation. Our courts have handed down numerous judgments in this regard through the years, concluding that ‘trade’ must be active³, and cannot be passive, e.g. watching over investments, or involve the mere laying of plans³. The intention to trade does not constitute the commencement of that trade⁴, and trade requires that the taxpayer has the assets necessary to conduct that trade⁵. There is also no requirement that income be earned before a trade is commenced.

Pre-trade expenditure

While expenditure incurred prior to the commencement of trade is, therefore, not tax-deductible in terms of section 11(a), all is not lost. Section 11A of the IT Act permits the deduction of expenditure and losses actually incurred prior to the commencement of trade and in preparation for the carrying on of that trade, which:

a) would have been allowed as a deduction in terms of section 11⁶, 11D or section 24J of the IT Act, had the expenditure or losses been incurred after that person had commenced carrying on that trade; and

b) that expenditure or loss was not allowed as a deduction in that year or a previous year of assessment.

Pre-trade expenditure can therefore only be deducted where it would have been deductible in terms of section 11, 11D, and section 24J, had the taxpayer being carrying on a trade. Section 11 contains a number of specific deduction provisions, section 11D allows certain research and development expenditure, and section 24J deals with interest. Foreign exchange gains and losses are dealt with under section 24I, which is notably excluded here – this is dealt with in more detail below.

Practically, the qualifying pre-trade expenditure is ‘kept aside’ (i.e. excluded from the tax return) and deducted for tax purposes only in the year of assessment in which trade commences. Importantly, one cannot create a loss in accounting for this pre-trade expenditure deduction, as the deduction is limited to available taxable income in that year of assessment. Any balance remaining is carried forward to the following year of assessment, where this limitation is again applied.

Foreign exchange losses

Section 24I of the IT Act contains its own ‘trade’ requirement as regards companies, in that a company not carrying on a trade is not permitted to utilise these provisions as regards foreign exchange gains or losses⁷.

However, section 24I(7) contains special provisions which apply inter alia to companies not yet carrying on a trade. This subsection applies where:

a)     an exchange difference has arisen

               i.              on a debt (i.e. loan funding) utilised by that person in respect of the acquisition, installation, erection or construction of any machinery, plant, implement, utensil, building or improvements to any building; or

              ii.          on a debt utilised by that person in respect of the devising, developing, creation, production, acquisition or restoration of any invention, patent, design, trade mark, copyright or other similar property or knowledge;

b)     an exchange difference has arisen on a foreign exchange contract or foreign currency option contract entered into to hedge the debt incurred under a) above; or

c)      any premium or other consideration paid or payable in relation to a foreign currency option contract entered into to hedge the debt incurred under a) above.

Where such exchange difference arise or such premium or consideration is paid or payable in a year prior to the year of assessment during which such machinery, etc. or such invention, etc. was or is brought into use for purposes of such person’s trade, these can be carried forward and be taken into account in the year of assessment in which these are brought into use for the purposes of such person’s trade.

Practically speaking, let us say a newly incorporated company intends to construct a renewable energy asset, which will be its only income-generating asset. To fund the construction of this asset, it obtained a Pound-denominated loan from its UK parent. During the 18 month construction period, it incurred exchange losses on this loan funding. It is likely that the company will only be seen to commence trading once the renewable energy asset is constructed and ready to be brought into use. In terms of section 24I(7) of the IT Act, despite not yet having commenced a trade, the company can carry forward the exchange losses incurred on the loan funding during the construction period, which can then be deducted in full in the year of assessment in which the renewable assets are brought into use.

Unlike section 11A, section 24I(7) is not limited to taxable income. It, therefore, appears that one can create a tax loss through this exchange loss deduction mechanism.

The takeaway

While section 11A of the IT Act does not allow for the deduction of foreign exchange losses incurred prior to the commencement of trade, section 24I(7) does cater for the deduction of such exchange losses in very specific circumstances.

Taxpayers should be cognisant of the limitations in deducting pre-trade expenditure and exchange losses, as well as the interplay between these rules and the assessed tax loss limitation set out in section 20 of the IT Act.

¹_{No. 58 of 1962 (as amended)}

²_{ITC 1476 (1989) 52 SATC 141 (T)}

³_{C: SARS v Contour Engineering (Pty) Ltd (1999) 61 SATC 447 (E)}

⁴_{ITC 777 (1953) 19 SATC 320 (T)}

⁵_{ITC 697 (1950) 17 SATC 93 (T)}

⁶_{Excluding section 11(x)}

⁷_{Section 24I(3)}

Authors:

Greg Boy, Associate Director - Tax Consulting

Mike Teuchert, Partner - Tax Consulting