Compensation for Losses: Which ‘Hole’ is Filled?

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Many taxpayers assume that compensation for losses is of a capital nature. It depends…

There are no hard and fast rules for determining whether a particular gain is of a capital or a revenue nature. Each case needs to be decided on its own facts.

The distinction is important because of the lower effective rate of tax applicable to capital gains. Therefore, if a taxpayer wishes to save tax, it would be desirable for a particular gain to be taxed as capital rather than as revenue.

However, the courts have provided guidance as to how a case is likely to be decided based on a particular set of facts. In this second part, we look at compensation for losses, and how the courts determine that a few more tests applied by the courts when making a determination between capital and revenue.

Which hole is being filled?

One test applied by the courts is the so-called “filling which hole” test, which usually comes in whenever one received compensation for a particular incident. An example of such compensation would be when you experience a theft and are compensated by an insurance company for having lost the items stolen.

The test applied in this case is whether the compensation was intended to fill a hole in the taxpayer’s profits, or whether it was intended to fill a hole in their assets, and was first examined in Burmah Steamship Co Ltd v IRC [1931 SC 156, 16 TC 67].

Going back to our insurance example, the theft could have involved trading stock, some cash, certain shop fittings, and computer equipment. However, deciding whether to treat compensation proceeds as capital or revenue depends on the nature of the taxpayer’s business.

In this example, the trading stock was purchased for resale, and had it been sold in the normal course of business, the resultant proceeds would have been of a revenue nature. The treatment is therefore the same when receiving insurance compensation as it would have been had a normal sale taken place. In both cases, the taxpayer would be entitled to claim a deduction equal to the cost of the stock.

In the case of the cash, it would normally represent either a past sale of stock which would have been recorded as revenue, an injection of loan or equity capital, or conversion of one form of asset into another (e.g. when your customers pay their accounts). In all of these cases the cash itself is a capital asset; therefore, the compensation received for the loss of such cash would be a capital asset.

The replacement of lost cash in the case of a bank is more likely to be treated as a revenue receipt because of the nature of a bank’s business. However, in this case, the net effect would be tax-neutral since the bank would claim a corresponding deduction for the lost cash.

The loss of the shop fittings and computer equipment would represent a hole in the taxpayer’s income-earning structure, and the compensation for the loss thereof would be regarded as capital. However, if the taxpayer had claimed any deduction for wear and tear in respect of such assets, such wear and tear would need to be recouped (i.e. written back) for tax purposes.

In the case of a taxpayer who trades in shop fittings or computer equipment, the compensation received in this example would be for the loss of trading stock, and the tax treatment would be the same as for any other trading stock for which compensation has been received for the loss thereof.

Whether or not a resource is renewable is also a determinant in whether compensation proceeds are capital or revenue. The courts held in Estate A G Bourke v CIR [1991 (1) SA 661 (A), 53 SATC 86] that compensation received by a taxpayer for the destruction by fire of a pine forest destroyed by fire was of a revenue nature.

The court reasoned that since pine trees do not renew themselves, they were regarded as trading stock, whereas the soil itself would be considered the income-earning structure or asset.

Citing the example of an apple orchard, the court said that the apples would represent stock, while the apple trees represented the income-earning structure. The loss of the pine trees was therefore related to the loss of the apples, rather than to the loss of the apple tree itself.

Compensation for restraint-of-trade is always a hot topic for discussion.

If the individual concerned is genuinely restrained from carrying out their chosen occupation for a specified period in a particular area, any compensation received would be capital, according to the decision handed down in Taeuber and Corssen (Pty) Ltd v SIR [1975 (3) SA 649 (A), 37 SATC 129].

However, salary payments (such as exit bonuses) disguised as restraint payments, or restraint agreements whereby the parties clearly have no intention of adhering to the terms thereof, will certainly come under SARS’ scrutiny.

WRITTEN BY STEVEN JONES

Steven Jones is a registered SARS tax practitioner, a practicing member of the South African Institute of Professional Accountants, and the editor of Personal Finance and Tax Breaks.

While every reasonable effort is taken to ensure the accuracy and soundness of the contents of this publication, neither writers of articles nor the publisher will bear any responsibility for the consequences of any actions based on information or recommendations contained herein.  Our material is for informational purposes.

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