Manage your Practice: Lay-by agreements and tax

South African consumers have long been using lay-by agreements as a means of purchasing household goods, school uniforms and stationery for their dependants. According to National Treasury, ‘it has come to Government’s attention that, following the effects of the COVID-19 pandemic on household incomes and the current economic climate, most consumers are purchasing school uniforms and stationery by way of lay-by arrangements.’1 According to National Treasury, the provisions of section 24 of the Income Tax Act did not extend to cover the scenario of a lay-by agreement. According to National Treasury, this issue ‘is expected to increase as more consumers are choosing to enter into lay-by arrangements due to financial constraints’.

A seller under a lay-by arrangement is required to recognise an upfront inclusion (in gross income) of the full sale price. However, because lay-by arrangements generally last for periods much shorter than 12 months, the seller will not benefit from the debtors’ allowance contained in section 24(2) of the Act. This upfront inclusion of lay-by proceeds without any allowable deduction obviously creates an adverse tax result, and an amendment to section 24 was proposed and made in the Taxation Laws Amendment Act 2022.

In terms of this amendment, section 24 will now allow the supplier to make a deduction, and this will apply in respect of years of assessment commencing on or after 1 January 2023.

WHAT IS A LAY-BY OR A LAY-BY AGREEMENT?
A lay-by
National Treasury, in the Explanatory Memorandum to the relevant Taxation Laws Amendment Bill, explains it as follows:

‘Lay-by arrangements are sale arrangements that enable the consumer to purchase goods and pay for such goods over a period of time, generally between three to six months, without incurring interest. Lay-by arrangements are a form of a saving as they enable the larger population to purchase goods outside instalment sale credit arrangements, thereby reducing the level of indebtedness.’

Judge Cameron in a case before the Constitutional Court,2 in footnote 25, said the following:

‘Lay-by agreements, where a supplier agrees to sell goods, and accepts payment in instalments, while holding the goods until the consumer has paid the full price, are now covered by section 62 of the Consumer Protection Act.’

Section 62(1) of the Consumer Protection Act reads as follows:

‘If a supplier agrees to sell particular goods to a consumer, to accept payment for those goods in periodic instalments, and to hold those goods until the consumer has paid the full price for the goods −
(a) each amount paid by the consumer to the supplier remains the property of the consumer, and is subject to section 65, until the goods have been delivered to the consumer; and
(b) the particular goods remain at the risk of the supplier until the goods have been delivered to the consumer.’

It follows from the above that the supplier does not receive the amount for the supplier’s (or taxpayer’s) own benefit and consequently does not have to include it in its gross income. In this respect, it is irrelevant that business owner keeps the goods separate for the duration of the lay-by agreement as it remains the property of the supplier until the goods are delivered to the customer (after receipt of full payment).

If the lay-by agreement contains a suspensive condition, there will also be no accrual and consequently no inclusion in the gross income of the supplier of the amount of the ‘sale’. In practice, a lay-by agreement may well not have a suspensive condition and may only contain a resolutive condition. Jacobs, Stoop and Van Niekerk3 explain the position of cancelling the agreement as follows:

‘Should the consumer cancel the lay-by agreement before full payment of the purchase price, or default by not paying the full purchase price within sixty business days after the anticipated date of completion:

• the supplier may charge a termination penalty, provided that the supplier informed the consumer of the fact and the extent of the penalty before the consumer entered into the lay-by agreement;4
• the supplier may deduct the cancellation penalty from the monies already paid by the consumer and must then refund the consumer the remainder of the money.

The supplier must allow the consumer who defaults by not paying the full purchase price sixty days after the anticipated date of completion before he, she or it imposes a cancellation fee.´

However, whether the lay-by agreement contains a suspensive (or resolutive) condition is immaterial for purposes of income tax. Judge Wallis5 said the following:

‘… in the light of my conclusion that the previous judgment of this Court in Silverglen Investments on the effect of s 24(1) is binding authority on the point, it is unnecessary to canvas the potentially complicated question of whether there was an accrual in accordance with ordinary principles.’

What then are the income tax consequences of a lay-by agreement for the supplier?

THE INCOME TAX CONSEQUENCES OF A LAY-BY AGREEMENT
This is, and actually was always (as explained by National Treasury), governed by section 24(1) of the Income Tax Act. Whilst section 24(1) includes an agreement relating to the transfer of immovable property, for purposes of this article, we accept that the goods that are the subject of a lay-by agreement are ‘movable property’ and that the agreement does not include interest. Section 24(1) then provides as follows:

‘If a taxpayer, the supplier, has entered into any agreement with any other person, the consumer,

• in respect of any movable property
• the effect of which is that the ownership shall pass upon or after the receipt by the taxpayer of the whole or a certain portion of the amount payable to the taxpayer under the agreement,

then the whole of that amount shall for the purposes of the Income Tax Act be deemed to have accrued to the taxpayer on the day on which the agreement was entered into.’

Because of section 24(1), it is not necessary to consider whether there was an accrual to the taxpayer under the lay-by agreement. As Judge Wallis said, because ‘the agreements … provided for Milnerton Estates to pass ownership to the purchasers upon or after receipt of the whole of the purchase price … the purchase price was … deemed to be received in its entirety in the 2013 tax year, not the 2014 year, when payment was in fact made‘.

Applied to a lay-by agreement, section 24(1) results in this fiction that the full amount payable by the purchaser is treated as having accrued to the supplier (not received as stated by the judge above), on the day the supplier entered into the agreement. Where this date and the date of receipt of the final payment fall within the same year of assessment that, is the end of the matter (from an income tax point of view). There is no adverse tax consequences due to the earlier inclusion.

The position however is different when the agreement was only finalised in a year of assessment subsequent to the year of assessment during which the supplier and customer entered into the agreement.

WHAT DEDUCTIONS ARE THEN AVAILABLE TO THE SUPPLIER (TAXPAYER)?
Deductions for purposes of determining taxable income
The new section 24(2A), the amendment to the Act, provides for a deduction of a portion of the amount deemed to have accrued and reads as follows:

‘In the case of a lay-by agreement as contemplated in section 62 of the Consumer Protection Act,6 2008 …, the Commissioner may make an allowance in respect of all amounts which are deemed to have accrued under such agreement but which have not been received by the end of the taxpayer’s year of assessment.’

Simply put, if the consumer purchased goods to the value of R600 from the supplier, and by the end of the supplier’s year of assessment has only made two of the required six payments, the supplier will be entitled to make a deduction of R400 under section 24(2A).

As can be expected, any allowance deducted under section 24(2A) shall be included in the income of that taxpayer in the immediately following year of assessment – see section 24(2B).

As the supplier agreed to hold the goods, and because the goods remain at the risk of the supplier until the supplier delivered the goods to the purchaser, the goods remain trading stock and consequently must be included in the taxpayer’s income (under section 22(1) of the Act). The taxpayer can make a deduction of the cost of the trading stock in the year of assessment that delivery takes place (under section 22(2)).

This means that the cost of the trading stock is future expenditure − see the definition in section 24C(1) of the Act. Section 24(1), deems the full amount (the R600 in the example) to have accrued to the taxpayer for purposes of this Act. It follows then that, for purposes of section 24C, the income of the taxpayer includes an amount that accrued in terms of any contract, the lay-by agreement. The question is whether that amount in part will be used by the supplier to finance future expenditure, which expenditure will be incurred by the taxpayer in the performance of the taxpayer’s obligations under that contract.

However, herein lies the problem: it must finance expenditure which will be incurred by the taxpayer after the end of the year of assessment during which the agreement was entered into. That may well not apply to a lay-by agreement. SARS practice generally prevailing7 is clear about this:

‘A similar issue arises with trading stock when a taxpayer has incurred expenditure in acquiring items of trading stock. Once the expenditure has been incurred it does not constitute future expenditure even if the trading stock is included in the taxpayer’s closing stock.’

It follows that no deduction of the cost of the trading stock is available to the supplier who is a party to a lay-by agreement if the trading stock was on hand or acquired by the taxpayer during the year of assessment the taxpayer entered into the agreement.

This is no different for other taxpayers in agreements other than a lay-by agreement. The section 24 allowance in those instances is determined by using the gross profit percentage, determined according to a method selected by the taxpayer.8

It follows that the amendment to section 24 does not address all the adverse tax consequences of the deemed earlier accrual of an amount to a taxpayer under a lay-by agreement. The other adverse tax consequences were always inherent in section 24, as ‘the object of which in essence is to subject the profit under the instalment credit agreement to tax on a cash-flow basis’.

The author submits if the intention was to address all the adverse tax consequences of section 24 in respect of lay-by agreements, the amendment should have removed lay-by agreements from the ambit of section 24 completely. One must remember the intention of the legislator when the allowance was restricted ‘to amounts owing in respect of agreements having a minimum term of 12 months’. It was because it ‘has been found that many short-term credit transactions are being entered into in such a way that the seller is being enabled to postpone his tax liability to an unnecessary extent’.

Where consumers are choosing to enter into lay-by arrangements due to financial constraints, one would not expect that the intention of the supplier is to postpone its tax liability.

CONCLUSION
It is not disputed that section 24 of the Income Tax Act applies to lay-by agreements and that the supplier (taxpayer), before the amendment of the section, was not entitled to make a deduction where the term of these agreements were for a period of less than 12 months. Following the amendment made to section 24 of the Act, the allowance is now available, but it does not address all the adverse tax consequences of the earlier inclusion of the full amount of that transaction in the gross income of the taxpayer.

NOTES
1 See the Explanatory Memorandum on the Taxation Laws Amendment Bill 2022, 16 January 2023.
2 Sebola and Another v Standard Bank of South Africa and Another (Socio-Economic Rights Institute of South Africa, National Credit Regulator and Banking Association South Africa as Amici Curiae).
3 Fundamental Consumer Rights Under the Consumer Protection Act 68 of 2008: A Critical Overview and Analysis [2010] per 24.
4 The penalty may not be charged should the consumer’s failure have been due to death or hospitalisation of the consumer. The Minister may prescribe a formula for calculating the maximum amount of the penalty.
5 In Milnerton Estates Ltd v CSARS (1159/2017) [2018] ZASCA 155, 20 November 2018.
6 Act 68 of 2008.
7 Interpretation Note 78: Allowance for Future Expenditure on Contracts.
8 See the practice generally prevailing: Interpretation Note 48 (Issue 3): Instalment credit agreements and debtors’ allowance.

AUTHOR
PJ Nel CA (SA), Project Director: Tax at SAICA