Gross Income
1592. Settlement Discounts
January 2008 – Issue 101

 

 

It would be wrong to assume that the effect of the recent decision by the high court in GUD Holdings (Pty) Ltd v C: SARS (2007) 69 SATC 115 is that taxpayers will not be taxed on so-called "settlement discounts".

 

It is trite law that not only amounts physically received during a tax year, but also accrued amounts are included in gross income. Case law interprets the words "entitled to" as having an unconditional right to payment irrespective of whether payment may be claimed.

 

It is of the utmost importance that taxpayers disclose not only amounts physically received in their tax returns, but also all amounts accrued. If only received amounts are disclosed, it would constitute a non-disclosure of income exposing a taxpayer to both criminal and civil liability (which may include under section 76 a 200% penalty).

 

Uncertainty exists whether a taxpayer who provides discounts to its customers for prompt payment has to include the full debt or only the discounted debt in its tax return. The problem can be illustrated by the following example: At the end of the 2007 year of assessment a taxpayer has R1m of outstanding debtors. Some of the debtors will be entitled to a discount if they pay within 30 days after year end (referred to as "settlement discounts"). However, at the end of the 2007 year of assessment no certainty exists which of these debtors will pay within the 30 days-period. The question is thus whether the taxpayer is obliged to disclose the R1m in its 2007 tax return or whether it may deduct the settlement discounts from the R1m.

 

It should be noted that where the full amount was included in gross income in the first year of assessment but only the discounted amount is received in the second year of assessment, the taxpayer would be entitled to claim a bad debt allowance under section 11(i) of the Act. However, notwithstanding the fact that a deduction may be claimed in the second year, the taxability of the full amount in the first year may pose significant cash flow problems.

 

In the Gud Holdings case the facts were briefly that the taxpayer carried on business as manufacturer and distributor of automotive parts and its customers were almost exclusively wholesalers. In terms of the taxpayer’s standard conditions of sale so-called "prompt payment discounts" were offered to its customers, which provided that a lower price could be paid, if payment was made by the 25th of the following month. The exact wording of the clause in the contract which provided for these discounts read:

 

"Should payment be made by PURCHASER to SELLER not later than the 25th day (or earlier full business day) of the month following the month during which delivery takes place, the PURCHASER shall be entitled to deduct a settlement discount from his payment, in accordance with the SELLER’s discount scheme, which may be revised by the SELLER from time to time."

 

The taxpayer, in its accounting records had raised provisions with the effect that for the 2003 year of assessment only the portion of the gross selling price remaining after the deduction of the settlement discount was included in gross income.

 

SARS thought that the law is clear (see ITC 1645 (1998) 61 SATC 31) and issued an additional assessment which included the whole amount, including the prompt payment discount. SARS’ view was upheld by the Tax Court but overturned by the High Court.

 

The judgment of the Tax Court, reported as ITC 1815 (2006) 68 SATC 312 without reference to earlier decisions on the issue held on the basis that at the end of the year of assessment the seller was entitled to the full purchase price. This full price and not merely the discounted price accrued to him.

 

On appeal to the High Court the decision was overturned. Although at first sight the decision of the High Court seems to be incorrect it is submitted that a closer look at the facts of the case indicates that this decision is indeed correct. The court did not refer to ITC 1645, but held on the facts of the present case that the discount was wrongly labelled as a discount and in essence was "not so much a ‘discount’ as a penalty which will be added for late payment"

 

As GUD Holdings was not at the end of the first year of assessment entitled to the full purchase price, this amount did not accrue to it, but only the discounted amount. Although the court did not attempt to distinguish the present facts from the facts in ITC 1645. On the assumption that the court correctly analysed the facts in GUD Holdings a clear distinction between the facts of the two cases does exist. In the former case the full purchase price, for example, R100 was payable but if early payment was received a lower price could be paid. If these facts are compared with those in GUD Holdings, it is clear that in the latter case the customers were only obliged to pay the lower amount, for example R90, but if they did not pay by a certain date that it had to pay an additional penalty.

 

It is understood that SARS has decided to accept the decision in GUD Holdings and will not lodge a further appeal to the Supreme Court of Appeal.

 

The lesson to be learned from the GUD Holdings case is that taxpayers should carefully consider the structuring of prompt payment discounts given to their customers. If these discounts are structured in such a way that the full amount is payable but if payment is made before a certain date, a lower amount is payable, the full amount has to be accounted for at the end of the first year of assessment. However, if the discount is structured in the form of a penalty to be paid if payment is not received by a certain date, the penalty will not have to be accounted for in the first year of assessment. Obviously, it may be a difficult task to determine whether a settlement discount was indeed a discount or an added penalty for late payment. It is also clear that it would be wrong to conclude that the decision in Gud Holdings overturned the decision in ITC 1645 and that the portion of a debt which potentially represents a settlement discount does not accrue to a creditor. The facts of each case have to be analysed to determine whether a creditor was entitled to the whole outstanding debt at the end of the year of assessment or only to the outstanding debt minus the settlement discount.

 

For the sake of completeness it should be mentioned that SARS did not rely on the proviso to the gross-income provision, which stipulates that where a taxpayer is entitled to an amount at the end of the year of assessment, the full amount accrues to him/her and not the present value of the amount. As on the facts of the case, the seller had no entitlement to the full purchase price, and it is submitted that SARS was correct in not relying on this proviso.

 

 

University of Johannesburg

 

IT Act:S 1 definition of "gross income",

IT Act:S 11(i),

IT Act:S 76