General
1211. Problems encountered with disallowance of deductions
August 2004

Section 23(m) was introduced into the Income Tax Act ("the Act") in 2001 and became effective from 1 March 2002. In terms of the provision, an employee or office-holder is denied any deduction of expenditure incurred in the course of earning remuneration and claimed in terms of section 11, apart from:

· pension or retirement annuity fund contributions,

· legal expenses,

· the section 11(e) wear and tear allowance,

· bad and doubtful debts and

· qualifying premiums on income protection policies.

Although the provision is wide-reaching, it is not all-embracing. Yet, SARS have adopted an extremely rigid application of the provision and it is becoming evident that they have applied it incorrectly in many cases, resulting in an additional tax liability plus, in many cases, penalties and interest being imposed on the taxpayers concerned. SAICA recently met with SARS to discuss the problems encountered with their application of section 23(m) and the following points were raised in that meeting:

1. According to SARS’ Interpretation Note No. 13,

"the term ‘employment’, in this context, should be afforded its narrower meaning of an employer-employee (master-servant) relationship …and an independent contractor is therefore not affected by the prohibition on deductions".

In many instances, however, clients of an independent contractor may have withheld employees’ tax to avoid the risk of incurring penalties and then issued an IRP5 showing the income under code 3601 (remuneration). Because the code 3601 appears on the IRP5 and the tax return, SARS will apply section 23(m) to the independent contractor. This is clearly contrary to the Interpretation Note and the assessment is therefore incorrect. SARS have advised that the taxpayer should, in such a case, object to the assessment and indicate in the objection that she/he is an independent contractor.

For the 2005 year of assessment, SARS have introduced code 3616 that applies to remuneration paid to an independent contractor. It is essential that employers/clients ensure that the correct code is shown on the IRP5 as SARS automatically applies section 23(m) where code 3601 is used. Although the taxpayer may object to the assessment, much inconvenience could be avoided by using the correct code. Independent contractors should also ensure that the correct code is reflected on any IRP5’s they receive.

2. Some taxpayers worked as employees for part of the year of assessment and, for various reasons, carried on a different trade for the balance of the year. Again, because code 3601 appeared on the tax return (relating to the remuneration earned during the part of the year that the taxpayer was an employee), SARS applied section 23(m) for the whole year. The income derived by the taxpayer from his/her independent trade is, however, not related to employment and the expenses incurred during this period were not incurred in respect of remuneration. Consequently, section 23(m) should only apply for the part of the year that the taxpayer was in employment. It does not apply to the expenses incurred in respect of the independent trade.

3. Similarly, an employee may have carried on a separate trade in addition to his/her employment. Section 23(m) does not apply to expenses incurred in respect of the separate trade. This is confirmed in the Interpretation Note, which states:

"Expenditure, losses and allowances that relate to income other than ‘remuneration’ may therefore still be considered for deduction. An employee or office holder in receipt of two or more streams of income may thus be in a situation where the deduction of expenditure, losses or allowances relating to a ‘remuneration’ stream of income is prohibited, while expenditure, losses or allowances relating to another trade remain deductible."

It is important to ensure that income from a trade other than employment is shown in the correct part of the tax return to ensure that section 23(m) is not incorrectly applied to expenses incurred for the purposes of this trade. The taxable income from this trade should be shown under Schedule 5 on the IT12S and IT12SB forms and under Schedule 8 on the IT12BU form (and the supporting schedules must be attached to the return).

4. Certain SARS offices have disallowed deductions of the section 11(e) wear and tear allowance on the basis of section 23(m). This is clearly an incorrect application of the provision as the section 11(e) allowance is specifically excluded from the prohibition.

5. In some instances, employees may earn a fixed salary and commission and normally, commission would exceed the fixed salary. Section 23(m) does not apply to

"an agent or representative whose remuneration is normally derived mainly in the form of commissions based on his or her sales or the turnover attributable to him or her"

and this exclusion will apply provided that the commission exceeds 50% of the total remuneration. In certain circumstances and for various reasons, such as sickness, the commission may fall short of 50% of total remuneration in a particular year of assessment. Section 23(m) should not apply in that year as the word "normally" in this provision means that the agent or representative continues to benefit from the exclusion if there is a temporary change in the employee’s earnings mix.

6. There are some reports that SARS is determining "remuneration" inconsistently when calculating whether "commissions based on his or her sales or the turnover attributable to him or her" exceeds 50% of total remuneration. SARS have confirmed that the "remuneration" used in this calculation is not based on the definition of "remuneration" in the Fourth Schedule to the Act. Rather, it refers to "remuneration" in the ordinary sense. This, therefore, includes 100% (not 50%) of a travel allowance and an allowance paid to a holder of public office.

7. Non-executive directors of companies earn directors fees that are reflected on the IRP5 certificates under code 3615 or 3601 which, again, automatically triggers the application of section 23(m) by SARS. Although these directors are required to be independent of management and they do not have any benefits from the company other than the director’s fee, SARS treats them as employees. SAICA requested SARS to review this treatment but SARS has confirmed their interpretation that the term "director" includes both executive and non-executive directors and section 23(m) therefore applies to both types of directors.

The examples discussed above illustrate that many assessments involving the deduction of expenses by individuals may be incorrect. Members are advised to check these assessments carefully and lodge objections where section 23(m) has been incorrectly applied.

South African Institute of Chartered Accountants