IN  THE  SUPREME  COURT  OF  APPEAL
OF  SOUTH  AFRICA

REPORTABLE

Case No:  26/2001

In the matter between:
COMMISSIONER FOR THE

SOUTH AFRICAN REVENUE SERVICE

APPELLANT

and

SCRIBANTE  CONSTRUCTION

(PTY) LTD

RESPONDENT
___________________________________________________________

Coram:

HOWIE,  SCHUTZ JJA   et   HEHER  AJA
Heard:

3  MAY 2002
Delivered:
14 MAY 2002

Summary:   Income tax –  s s  11(a)  and  23(g) of Act 58 of 1962 –
dividends declared by company credited to shareholders’ loan accounts –
interest paid on such loans – whether taxable
______________________________________________________________
J U D G M E N T

HEHER  AJA/…

HEHER AJA:
[1] 
The respondent is a civil engineering construction company the
activities of which are mainly road building and earthmoving.  It has been a
family concern for more than fifty years.  Its shareholders are three family
trusts.  They have developed a number of practices designed to suit both their
own interests and those of the company.  One such is to leave dividends
“banked” in the company (which then credits their loan accounts with an
agreed rate of interest) until more advantageous investment opportunities
arise.
[2] 
During 1990 the company declared dividends of R6 573 076.  Of
this amount R3 199 834 was allocated to the shareholders’ loan accounts on
the understanding that no interest would be paid.  The balance of R3 373 242
was likewise credited but on the basis that it would bear interest at an agreed
rate.  No money was moved or changed hands.  The arrangements were
effected solely by book entries.  In fact, the cash funds of the company which

were available for the purpose of the distribution remained in the interest-
bearing call accounts held by the company.
[3] 
In its 1991, 1992 and 1993 returns for income tax the company
sought to deduct the interest which it had credited to its shareholders’ loan
accounts in respect of the dividends as expenditure incurred in the production
of income allowed by s 11(a) of the Income Tax Act, 58 of 1962.  The
appellant disallowed the deductions.  In amplification, he informed the
taxpayer that
‘[t]he distribution of previously produced income in the form of dividends can in no way
be seen to produce income or increase the income producing capacity of an operation.  In
the case of  Scribante Construction (Pty) Ltd it is clear that the interest was incurred as a
result of the dividend declaration and consequently is not-productive.’

[4] 
The company appealed successfully to the Income Tax Special
Court.  A further appeal by the Commissioner to the Full Court  of the Eastern
Cape Division was decided in the taxpayer’s favour by a majority.  The
matter now comes before this Court with special leave granted.

[5] 
The only evidence before the Special Court was that of the
company’s auditor, Mr Jacobs.   It was not seriously contested.  Aside from
the background which I have sketched, the salient facts which emerged are set
out in the next paragraph.
[6] 
When the company declared the dividend, the money held in the
call accounts was surplus  to its immediate operational requirements to the
extent of R3 373 242, which is why it was prepared to pay interest on that
amount but not beyond it.  During the years 1991, 1992 and 1993 the net
current accounts of the company (excluding cash on hand) were respectively
R1 346 996,  R2 984 216 and R1 587 971.  If the shareholders had been paid
out instead of lending the money to the company or had withdrawn all the
interest-bearing loans, the company would have been in a solvent condition
with sufficient available cash to meet its day to day requirements.  An
important aspect of the company’s business involved the furnishing of

contract guarantees (surety bonds) for construction work which it was to
undertake.  The ability of the company to reflect a substantial cash reserve in
its financial statements was of material assistance in readily obtaining the
issue of guarantees from financial institutions, thereby sharpening its
competitive edge when tendering for contracts and increasing its income
potential.  The interest earned by the company on  the call accounts
fluctuated.  In 1991 the average rate was 16% per annum,  in 1992  15.3% and
in 1993  11.3%.  Although the total interest on the loaned funds in the call
accounts over the three years amounted to R1 648 216,  the amount credited
to the shareholders loan accounts was only R1 516 108, the company
retaining the difference.  (The interest rate which the company had agreed to
pay the shareholders was apparently less than it in fact earned in each of the
first two years but greater in the third.)  The shareholders  disclosed  the
interest credited to their loan accounts and were duly assessed on it.   Jacobs

testified that the manner of treatment of the dividends by the company was a
common practice in private companies.
[7] 
The issues argued before us were whether the interest paid by the
company to the shareholders for the years in question was expenditure
incurred in the production of income as contemplated by s 11(a) of the Act
and whether the interest was laid out or expended by the company for the
purposes of trade within the meaning of s 23(g).
[8] 
The legal principles are well-established.
‘In regard to the general deduction formula, it is settled law that generally, in order to
determine in a particular case whether moneys outlaid by the taxpayer constitute
“expenditure incurred in the production of income”, important, sometimes overriding,
factors are the purpose of the expenditure and what the expenditure actually effects.   And
in this connection the Court has to assess the closeness of the connection between the
expenditure and the income-earning operations (see Commissioner for Inland Revenue  v
Nemojim (Pty) Ltd  1983 (4) SA 935(A)  at 947 G – H and the authorities there cited).’
Commissioner for Inland Revenue v  Standard Bank of  South Africa 1985 (4)
SA 485 (A) 498 F – G.

As Hefer JA pointed out in Ticktin Timbers CC v Commissioner for Inland
Revenue 1999 (4) SA 939  (SCA)  942 I

‘There can be no objection in principle to the deduction of interest on loans in suitable
cases.  Loan capital is the lifeblood of many businesses but the mere frequency of its
occurrence does not bring about that this type of expenditure requires different treatment.’

In Commissioner for Inland Revenue v Giuseppe Brollo Properties (Pty) Ltd
1994 (2) SA 147 (A)  152 I – 153 G Nicholas AJA said
‘In a case concerning the deductibility or otherwise of interest payable on money
borrowed, the enquiry relates primarily  to the purpose for which the money was borrowed.
That is often the “dominant” or “vital” enquiry, although the ultimate use of the borrowed
money may sometimes be a relevant factor.   Where a taxpayer’s purpose in borrowing
money upon which it pays interest is to obtain the means of earning income, the interest
paid on the money so borrowed is prima facie an expenditure incurred in the production of
income.  See Commissioner for Inland Revenue v  Allied Building Society 1963 (4) SA 1
(A) at 13 C – G.’

Counsel for the appellant submitted that, properly analysed, the loan to the
company was merely the means of financing the dividend.  He argued that
there was never any intention of paying the dividend  out to the shareholders.
I do not agree.  I have already referred to the uncontested practice of the
shareholders in using the company as a banker.  In that context the crediting
of the loan accounts constituted an actual payment as if the dividends had
been deposited into an account held by a shareholder at a banking institution.

Counsel pointed out that if the funds had been taken out of the company the
acquisition of contract guarantees would have been more difficult.  That is
true, but it is only relevant if one assumes that the dividend declaration was
not what it purported to be.  On the contrary, Jacobs’s evidence as to what
motivated the company and it shareholders was never put in issue:   the
availability of profits in the form of surplus cash, the desire of the
shareholders to know where they stood financially vis-à-vis  the company and
each other, and a perception that changes in the income tax laws were
imminent which would have the effect of taxing undistributed profits in the
hands of the company.  Of these considerations the existence of the surplus is
the decisive factor in the present context.  It serves to distinguish the
authorities relied on by counsel for the appellant in which, in all the cases, the
taxpayer was unable to pay a dividend from its own funds:  Guiseppe Brollo
Properties  at 150 I ,  154 H;  Ticktin Timbers at 943 D – E,  944 I – 945 C;

Commissioner for Inland Revenue v Elma Investments CC 58 SATC 295
(1996) at 297 in fine.  The evidence was that the cash generated in the course
of the company’s business would have been sufficient for its operating
requirements even if the dividends had not been lent to it.  The argument that
the company could not actually afford to divest itself of the dividends which it
declared and therefore they were effectively retained by it was therefore
misplaced.  A company is not to be criticized for declaring and distributing
dividends simply because it might otherwise put the funds to use  profitably.
The declaration of a dividend is a commercial decision regulated by the  terms
of the company’s statutes and the rules which have been developed in
practice:  see the authorities referred to in Commissioner for Inland Revenue v
Dirmeik 1996 (2) SA 736 (C) at 740 C – I.   I find nothing in the evidence to
suggest that the declaration and distribution concerned in this case were
motivated by anything but bona fide commercial considerations.

[9] 
The same can be said of  the crediting of the loan accounts.  The
shareholders were under no apparent compulsion, commercial or otherwise, in
agreeing to lend the money to the company.  Each remained free to withdraw
his loan at the discretion of the directors.   The reliance by the appellant on
the Guiseppe Brollo Properties case supra at 153 F – G and Commissioner
for Inland Revenue v Elma Investments CC  at 297 was ill-founded:  once the
declaration of the dividend is not part of a broader scheme but is an
independent commercial decision taken in the context of a company which
has the resources available for distribution as a dividend, it becomes
inapposite to compare the financial strength of the company before the
declaration with the position after it borrowed the money in order to
determine whether an additional expense or added burden has resulted.  In
fact the company was not poorer.  As a result of the arrangement it benefited

by the loan as it could not have done if the shareholders had used the money
or invested it elsewhere as they were fully entitled to do.
[10] There is no doubt that the interest paid by the company enabled it
to secure (even if only temporarily) the shareholders funds which could
otherwise have been moved elsewhere.  Equally it is certain that the
availability to the company of the funds substantially increased its
competitiveness and,  temporarily,  its income in the form of the interest
which it retained.    Those two considerations simply stated provide the
sufficiently close link between the expenditure and the income earning
operations having regard to the purpose of the expenditure and what it
actually effects,  Commissioner for Inland Revenue v Genn & Co (Pty) Ltd
1955 (3) SA 293 (A) at 299 G.   The fact that the company could have
operated quite adequately without the funds is not the only pertinent factor.  It
was enough that they served for the more efficient performance of its

operations:  Port Elizabeth Electric Tramway Co v Commissioner for Inland
Revenue 1936 CPD 241 at 246. The interest paid to the shareholders on their
loan accounts was plainly an actual expense which enabled the company to
produce income both in the form of its allocation of the interest earned and
through the commercial advantages which possession of the loan funds
generated.   Section 11(a) was thereby satisfied.
[11] Seen from the perspective of the company, the only purpose of
paying interest on the loan accounts was to secure for the company the benefit
of the continued availability of the funds for use in its trading activities.  In
addition,   borrowing money and re-lending it at a higher rate of interest,
thereby making a profit, constitutes the carrying on of a trade:  Burgess v
Commissioner for Inland Revenue 1993 (4) SA 161 (A).  That is analogous to
the way in which the company managed the loan funds, at least during 1991

and 1992.  It follows that the deductions which the company claimed were not
struck by s 23 (g).
[12] The appeal is dismissed with costs.

J A  HEHER

ACTING JUDGE OF APPEAL

CONCUR:
HOWIE
JA
SCHUTZ
JA