Tax Talk

Tax deductibility of damages In this series of articles, Cameron Kotze – the Tax Partner at Ernst and Young – discusses some topical tax issues for our readers.

THE tax deductibility of expenditure or losses incurred as a result of the payment of damages due to negligence must be determined by applying the provisions of the general deduction formula. The general deduction formula requires that there must be a very close connection between the trade or business carried on and the cause of the liability for the damages to ensure the expenses or losses paid for the damages are tax deductible.The tax courts have considered the facts in a number of cases where the taxpayer who paid damages to another party sought to deduct the payment for tax purposes.Some of the principles that are followed to determine whether the payment or loss for damages is tax deductible come from very old case law.The well-known term that the negligence must be an inevitable concomitant of the taxpayer’s trade was phrased by the judge in the case of Joffe & Co (Pty) Ltd v Commissioner of Inland Revenue.The taxpayer carried on the business as engineers in reinforced concrete.The taxpayer contracted to supply a client with a steel reinforcement required for a cantilever hood.The hood collapsed, killing an employee and the employee’s dependents instituted action against Joffe & Co.The court was satisfied that the collapse of the cantilever hood was caused by the negligence of Joffe & Co and the company was ordered to pay damages and costs of the case.Joffe &Co deducted the amounts paid from income.The court held that neither the damages nor the costs of the case were expenditure incurred in the production of income and were therefore not tax deductible.The tax courts have also considered whether the losses arising from the theft of a taxpayer’s money by the employees are tax deductible on more than one occasion.The courts have in the majority of cases held that losses suffered by the taxpayer are not tax deductible but in appropriate circumstances these losses may very well be deductible.In Commissioner of Taxes v Rendle the tax court sanctioned the deduction of losses of money belonging to clients of the taxpayer arising from actions by employees.The findings of the court confirm the principle that losses arsing from thefts by employees, except where the employee is a manager or director of the taxpayer, burglars or armed robbers are tax deductible.The tax court essentially held that the risk of theft by an employee who is not a manager or director is inseparable from the carrying on of the business.The test employed in the Rendle case has been confirmed by the tax courts a subsequent case.In this case two clerks misappropriated petty cash, moneys paid to the company, drew company cheques for their own use and ordered goods in the name of the company for their own use.The court found that the losses incurred by the taxpayer arose from the risk that was present when clerks were employed to perform duties that should have been entrusted to the accountant of the taxpayer.In the specific circumstances it would not have been practical to employ a more qualified person to perform the duties that were expected from the clerks.The facts of each case must be considered to determine the tax deductibility of the losses suffered by the taxpayer.If the facts indicate the losses are an inevitable concomitant of the way the taxpayer does business, the losses are probably tax deductible.* Should readers have queries, they are invited to send them to cameron.kotze@za.ey.com.The general deduction formula requires that there must be a very close connection between the trade or business carried on and the cause of the liability for the damages to ensure the expenses or losses paid for the damages are tax deductible.The tax courts have considered the facts in a number of cases where the taxpayer who paid damages to another party sought to deduct the payment for tax purposes.Some of the principles that are followed to determine whether the payment or loss for damages is tax deductible come from very old case law.The well-known term that the negligence must be an inevitable concomitant of the taxpayer’s trade was phrased by the judge in the case of Joffe & Co (Pty) Ltd v Commissioner of Inland Revenue.The taxpayer carried on the business as engineers in reinforced concrete.The taxpayer contracted to supply a client with a steel reinforcement required for a cantilever hood.The hood collapsed, killing an employee and the employee’s dependents instituted action against Joffe & Co.The court was satisfied that the collapse of the cantilever hood was caused by the negligence of Joffe & Co and the company was ordered to pay damages and costs of the case.Joffe &Co deducted the amounts paid from income.The court held that neither the damages nor the costs of the case were expenditure incurred in the production of income and were therefore not tax deductible.The tax courts have also considered whether the losses arising from the theft of a taxpayer’s money by the employees are tax deductible on more than one occasion.The courts have in the majority of cases held that losses suffered by the taxpayer are not tax deductible but in appropriate circumstances these losses may very well be deductible.In Commissioner of Taxes v Rendle the tax court sanctioned the deduction of losses of money belonging to clients of the taxpayer arising from actions by employees.The findings of the court confirm the principle that losses arsing from thefts by employees, except where the employee is a manager or director of the taxpayer, burglars or armed robbers are tax deductible.The tax court essentially held that the risk of theft by an employee who is not a manager or director is inseparable from the carrying on of the business. The test employed in the Rendle case has been confirmed by the tax courts a subsequent case.In this case two clerks misappropriated petty cash, moneys paid to the company, drew company cheques for their own use and ordered goods in the name of the company for their own use.The court found that the losses incurred by the taxpayer arose from the risk that was present when clerks were employed to perform duties that should have been entrusted to the accountant of the taxpayer.In the specific circumstances it would not have been practical to employ a more qualified person to perform the duties that were expected from the clerks.The facts of each case must be considered to determine the tax deductibility of the losses suffered by the taxpayer.If the facts indicate the losses are an inevitable concomitant of the way the taxpayer does business, the losses are probably tax deductible.* Should readers have queries, they are invited to send them to cameron.kotze@za.ey.com.