Commissioner for the South African Revenue Service v Atlas Copco South Africa (Pty) Ltd

Atlas Copco SA (Pty) Ltd, a member of the Atlas Copco Group (headquartered in Sweden), sold and leased machinery and equipment to the South African mining and related industries. The parent company had implemented a Finance Controlling and Accounting Manual (FAM) policy ("The Way We Do Things") that required all group companies to write down closing stock by 50% if it had not sold in the preceding 12 months, and by 100% if it had not sold in 24 months. The taxpayer applied this policy by writing down its closing stock by these fixed percentages for the 2008 and 2009 tax years. The taxpayer's trading stock comprised six categories: slow-moving stock, overstock, demostock, Dynapac stock, standard cost items, and goods in transit. SARS rejected the write-downs, adding back R30,191,000 for 2008 and R33,402,000 for 2009, on the basis that there was no actual diminution in value at year end as required by section 22(1)(a) of the Income Tax Act 58 of 1962. SARS also levied interest under section 89quat. The Tax Court upheld the taxpayer's appeal, accepting that the net realizable value (NRV) calculated in accordance with IAS2, IFRS and SA GAAP provided an acceptable method for determining the value of trading stock for purposes of section 22(1)(a). SARS appealed to the Supreme Court of Appeal.

• Whether the net realizable value (NRV) as determined in accordance with IAS2, IFRS and SA GAAP is an appropriate method for valuing trading stock for purposes of section 22(1)(a) of the Income Tax Act
• Whether a group policy that writes down stock by fixed percentages based on aging analysis complies with section 22(1)(a) of the Income Tax Act
• The proper interpretation and application of section 22(1)(a) of the Income Tax Act regarding the valuation of trading stock at year end
• Whether SARS properly exercised its discretion in refusing to allow the deductions claimed by the taxpayer
• Whether the application of a time-based write-down policy constitutes evidence of actual diminution in value as contemplated by section 22(1)(a)

The appeal was upheld with costs, including those of two counsel. The order of the Tax Court was set aside and replaced with an order dismissing the appeal and confirming the additional assessments for the 2008 and 2009 years of assessment.

Section 22(1)(a) of the Income Tax Act 58 of 1962 requires an actual diminution in the value of trading stock to have occurred during the tax year before SARS may grant a just and reasonable allowance from cost price. The section is couched in the past tense and requires a backward-looking inquiry into events that have already occurred, not a forward-looking assessment of potential future events. The use of net realizable value (NRV) as determined by IAS2, IFRS and GAAP, which is explicitly forward-looking and based on estimated future selling prices and costs, is not consonant with the requirements of section 22(1)(a). Cost price is the baseline against which any claimed diminution in value must be measured. A rigid group policy that writes down stock by fixed percentages based solely on aging analysis (50% for stock unsold for 12 months, 100% for stock unsold for 24 months), without evidence that the value of the stock has actually diminished by reason of damage, deterioration, change of fashion, decrease in market value or other satisfactory reason, does not comply with section 22(1)(a). While accounting principles serve valuable purposes for financial reporting, they do not necessarily accord with or satisfy the requirements of tax legislation, which must be interpreted according to their own terms.

The Court noted that while it is understandable that a company holding thousands of items of trading stock cannot individually value each item, the practice of sampling is a well-recognized method of dealing with high-volume trading stock, though this was not what the taxpayer did in this case. The Court observed that the taxpayer's external auditor had described the group policy as "a very aggressive policy" and noted that products sold below cost during the audit were sold at approximately 24-26% below cost on average, which was far from the fixed 50% or 100% write-offs applied under the group policy. The Court remarked that historical evidence of actual selling prices ought to have featured in the determination of whether there was diminution in value, but the taxpayer chose instead to apply a fixed percentage based purely on aging analysis. The Court also noted the taxpayer's difficulty in explaining the sheer volume of stock on hand and inconsistencies in its treatment of different stock categories, with some categories being treated as if the group policy applied even though it did not.

This case is significant in South African tax law as it confirms and applies the principles established in CSARS v Volkswagen regarding the valuation of trading stock for income tax purposes. It clarifies that: (1) section 22(1)(a) of the Income Tax Act requires proof of actual diminution in value during the tax year, not merely the application of accounting standards or forward-looking valuations; (2) the use of net realizable value (NRV) as determined by IAS2, IFRS and GAAP, while appropriate for financial reporting, does not automatically satisfy the requirements of section 22(1)(a); (3) a rigid, time-based write-down policy based solely on aging analysis, without evidence of actual diminution in value, is insufficient; (4) cost price is the baseline against which any diminution in value must be measured; (5) the inquiry under section 22(1)(a) is backward-looking (what happened during the tax year) not forward-looking (what might happen in future); and (6) for tax purposes, the fiscus is concerned with trading stock as a whole, not selective write-downs of particular items. The judgment reinforces the distinction between accounting principles used for financial reporting and the requirements of tax legislation.