What courts consider a ‘process of manufacturing’
The definition of process of manufacturing for tax purposes can be surprisingly complex and sometimes counterintuitive. The Supreme Court of Appeal has recently ruled that the production of a product that is neither useful nor wanted can still be classified as a manufacturing process. This intriguing ruling challenges traditional perceptions and emphasises the importance of understanding the nuances of section 12C of the Income Tax Act. This article delves into the specifics of this paradoxical decision that provides a tax benefit for an unwanted product and explores how tax professionals can navigate these complexities to benefit their clients.
APPLICATION OF SECTION 12C ALLOWANCES
Section 12C of the Income Tax Act
Section 12C provides a special wear and tear allowance for certain new or used assets that are owned by the taxpayer and brought into use for the first time. The allowance is not apportioned for the period of use in a year of assessment and is calculated as 40% of the asset’s cost in the first year of assessment and 20% for each of the subsequent three years. If the asset is not new or unused then the allowance is 20% in each of the five years. The critical requirement is that the asset must be used in a process of manufacture or a similar process.
Defining a product of manufacture
In the case of Enviroserv Waste Management (Pty) Ltd v The Commissioner for the South African Revenue Service, it was established that leachate, a contaminated liquid generated from water percolating through a waste disposal site, qualifies as a product of manufacture. Despite the decomposition and biodegradation processes transforming the waste into non-hazardous material and leachate, which is a raw material and an unwanted product, the Supreme Court of Appeal affirmed that the end product need not be useful or wanted. The key criterion is whether the output is essentially different from the input, a condition that leachate meets, thereby confirming its status as a product of manufacture.
What constitutes a process of manufacture?
Although the Income Tax Act does not explicitly define ‘process of manufacture’, court guidelines help determine whether an activity qualifies. The courts have emphasised that a process of manufacture involves producing something fundamentally different from its original components. This assessment includes examining the change in nature, form, shape, or utility of the input materials. For example, the preparation of KFC’s fried chicken, despite involving additives and standardised procedures, does not qualify as a process of manufacture merely due to its large-scale production or the uniformity of the end product. The courts held that cooking normally involves the introduction of additives and does not become a process of manufacture merely by being conducted on a large scale or merely because it results in a standardised product.
Plant used in a process of manufacture
The Income Tax Act distinguishes between allowances claimed for immovable property used in the process of manufacturing and movable property used in the process of manufacturing. If an asset is an immovable property used for manufacturing, it qualifies for a deduction of either 2% or 5%, depending on the construction date, under section 13.
However, if the asset is an immovable property not used directly for manufacturing but serves as a permanent structure utilised in the course of a taxpayer’s trade, particularly in processes ancillary to manufacturing and required by law to protect the environment, it is classified as an environmental waste disposal asset under section 37B. Like section 13, section 37B(2)(b) permits a 5% allowance.
Conversely, if the asset is movable property used directly in the process of manufacturing, it qualifies for a deduction under section 12C. Section 12C allows for an accelerated allowance for new or unused plant, machinery, or utensils, provided these assets are movable. In the Enviroserv case, the Commissioner contended that Enviroserv should not be eligible for a section 12C allowance as the cells in its landfill are not considered movable plant for purposes of that section. Enviroserv’s landfill cells are built through excavation and the installation of a drainage system, where the waste is treated to alter its physical, biological, or chemical characteristics, thereby reducing its environmental impact.
The Commissioner argued that Enviroserv’s cells are not plant but buildings and should quality as an environmental waste disposal asset in terms of section 37B, as they are ‘immovable property structured for waste disposal’. The Commissioner contended that these cells should be entitled to claim a 5% allowance instead of the accelerated 40%:20%:20%:20% allowance as the various constructed layers of the cells are permanent structures, not fixtures, implements, machinery, or apparatus used in any industrial/manufacturing process, and that the landfill cells handle resultant pollutants outside the ongoing process.
However, the Supreme Court of Appeal disagreed with the Commissioner. The Supreme Court of Appeal emphasised the functionality test to determine if an apparatus, fixture, or machinery qualifies as plant and not building. This test involves assessing whether the asset is integral to the business operations. The correct approach is to determine if the apparatus, fixture, or machinery is utilised in conducting the business’s activities. In Blue Circle Cement Ltd v CIR, it was held that plant must meet both functional and durability tests. The functional test evaluates how the asset is used and whether it promotes the taxpayer’s business activities. Additionally, ‘plant’ implies a degree of durability, excluding items quickly consumed or worn out after a few operations.
Direct vs ancillary use in manufacturing processes
The courts have clarified that for an asset to be considered used ‘directly’ in a manufacturing process, it must be an integral part of the process, without any intermediary steps. Determining the start and end points of the manufacturing process is crucial in assessing whether an asset qualifies for the section 12C allowance. If an asset is indispensable to the process, it is not considered ancillary. In the Enviroserv case, the Supreme Court of Appeal emphasised that assets necessary for achieving the desired manufacturing results cannot be deemed ancillary.
CONCLUSION
Navigating the complexities of section 12C can unlock substantial tax benefits for businesses engaged in manufacturing processes.. By comprehending the specific definitions and requirements laid out by the courts, tax professionals can ensure their clients take full advantage of these allowances. This knowledge not only aids in compliance but also maximises potential tax savings, highlighting the importance of expertise in this area.
AUTHOR Jane Ndlovu CA(SA), MCom (Wits) is Senior Lecturer at Wits Margo Steele School of Accountancy
This article was first published by Accountancy SA in their September Edition at the following URL: http://magazine.accountancysa.org.za/asa-september-2024?m=52861&i=829822&p=1&ver=html5
