In tax, as in life, there are certain things or arrangements that simply refuse to fit any mould; that cannot be neatly categorised or boxed or filed. One of these strange phenomena is SARS’ treatment of produce (grapes) delivered by wine farmers or producers to co-operatives, cellars or other wine producing marketing entities.
The problem starts with paragraph 3(1) of the First Schedule to the Income Tax Act, requiring farmers to include the value of produce held and not disposed of at the end of the year of assessment in their income for that year.
The Merriam-Webster online dictionary defines “hold” as to have possession or ownership of or have at one’s disposal. “Dispose” can be defined as to transfer to the control of another (Merriam-Webster) or to get rid of by throwing away or giving or selling to someone else (Oxford).
A farmer harvests his chenin grapes somewhere in February and by the 28th he had delivered all of it to the co-operative cellar of which he is a member. His grapes are added to the other chenin delivered by his fellow members and the whole lot is crushed and de-stalked or extracted or whatever is done to grapes to get them ready for the fermentation process. Depending on the type of grape and the weather conditions and a number of other factors, all of this can be done before the end of the year of assessment.
Anyone not au fait with intricacies of how co-operatives operate or how SARS taxes farmers, would now come to the very simple conclusion that the grapes delivered by the farmer are no longer held and not disposed of because he no longer has possession of the grapes and he has handed them over to the cellar. The grapes cannot possibly be regarded as his produce “on hand” at year end.
Not so, it seems. Not according to SARS in any case, and certainly not according to the Western Cape Tax Court in the matter between Dr. A. and the Commissioner for SARS.
Before the end of the tax year Dr. A. had delivered all his harvested grapes to the co-operative of which he is a member. On the advice of his auditor he did not include any amount in his taxable income in respect of produce held and not disposed of. SARS however would have none of this and raised an assessment including in Dr. A’s income an amount of R789 338, arrived at by converting the tonnage of grapes delivered to liquid (an estimated 773 litres per ton as published by the South African Wine Information Systems (SAWIS)) and multiplying the result by an “estimated distilling wine price per litre” of R1.52.
Dr. A. objected to the assessment on two grounds; firstly that no amount should be included in his income as the grapes were not held and not disposed of, and secondly that, if this argument is rejected, the amount fixed by SARS is not fair and reasonable. He contended that the agreed selling price of R97.84 per litre should have been used instead of SARS’ estimated price of R1.52 per litre.
On the first argument, Judge Allie did not accept Dr. A’s contention and found that the grapes were in fact still held and not disposed of. In reaching this conclusion, the learned judge interpreted the relevant wording as follows:
“The complete phrase “held and not disposed of” makes it patently clear that the produce must have formed part of the farmer’s farming produce and the farmer must still have a legal right to the produce as at the financial year end.
It does not mean that the farmer must have had physical possession or control of the produce at the year end. If that was what the legislature intended, it would have used words that clearly conveyed that meaning.”
Referring to LAWSA’s comments on mixing and mingling of things, the court then came to the conclusion that after delivery of his grapes Dr. A. acquired a physical portion of the final mixture in proportion to the value of his solids. Now SARS did not argue, and the court did not find, that at any stage Dr. A. could have asked for his grapes (or the pulp or juice or half-fermented wine) back. Instead, the court made the following finding:
“Appellant exchanged his right to claim back and/or exercise control over the raw material, namely the grapes, for a claim sounding in money subject to provision for certain contingencies. The appellant’s claim to the value of the unprocessed grapes is subsumed by his claim to the net proceeds because the unprocessed grapes is an essential component of the wine.”
Treading very carefully, I dare to suggest that the court’s reasoning would not have been the same had the subject matter been anything but the “sui generis relationship between the co-operative and the farmer/member”.
Co-operatives are, at least in the context of taxation, unique creatures. In Dr. A. v CSARS the Tax Court seemed to treat it as akin to a partnership:
“If the appellant’s argument is taken to its logical conclusion, then no farming partnership would ever be required to account for closing stock because the partners own the partnership assets in undivided shares”.
However, a co-operative is not identical to a partnership. The Income Tax Act includes it in the definition of “company”, and the Co-Operatives Act 14 of 2005 defines a co-operative as an autonomous association of persons united voluntarily to meet their common economic and social needs and aspirations through a jointly owned and democratically controlled enterprise organised and operated on co-operative principles.
Regardless, what matters is SARS’ policy in respect of co-operatives and more specifically the treatment of produce delivered by participants to a co-operative’s pool. It appears from the facts of Dr. A’s case that the guiding principles are contained in a draft document issued by SARS in 2006. The stated purpose of the guidelines is to assist wine farmers or producers who are participants in pool arrangements to determine their portion of the value of produce held in a pool on their behalf by co-operatives, cellars or other wine producing/marketing entities. From this document it appears than in the case of a pool arrangement a co-operative is neither a partnership nor a company, but rather an agent acting on behalf of the members of the co-operative:
“However, it is the view of SARS that where a pool operator processes and/or sells produce as an agent on behalf of the participants, ownership of the pooled products vests in the pool participants until the produce or the final products that are manufactured from the produce is sold by the pool operator on behalf of the pool participants.”
If this policy is followed to its logical conclusion, a producer will have to keep track of all sales by the cellar or co-operative and adjust his “produce on hand” every time a bottle or box or any other measure of wine made from his grapes is sold. He would also have to determine exactly what his share or contribution to that batch of wine was, do some reverse calculation to convert the fermented litres back to tonnes (or kilograms or grams) and reduce his stock accordingly.
Well not according to the SARS guidelines:
“Payments received from a pool operator must, however, continue to be included whenever they are received and no adjustments must be made to the value of a pool participant’s produce held in a pool…”
So it seems that the principles of agency and proportionality adopted by SARS only apply to the tax treatment of the produce. When it comes to the matter of payments to pool participants, the normal rules relating to receipt and accrual of income apply. As far as the stock is concerned, the produce held and not disposed of at the end of the tax year will be allowed as a deduction (opening stock) at the beginning of the next year of assessment. In other words, as far as the produce is concerned, the co-operative is an agent holding the stock on behalf of the farmer. But the farmer is not taxed on his income only as and when the wine made from his grapes is sold. He is taxed whenever he receives a payment from the co-operative or when a payment accrues to him in terms of the agreement with the co-operation.
The SARS document provides guidelines for the determination of the fair value, considered to be the lower of production cost or market value, of produce held by a pool participant. The so-called “practical approach” is based on the production cost of the stock and comprises six steps; too comprehensive to include in this article. There is however a note that seems to summarise or explain the methodology:
“Pool operators record participants’ delivery inputs in metric tons and use that as a basis to distribute pool proceeds and costs. The total liquid stock measured in litres, held by every pool at the end of the year of assessment of the pool operator has to be divided by the pool operator between the pool participants in an appropriate manner based on tonnage delivered at inception.”
Should there be reason to believe that this method does not reflect the realisable value of the stock, a pool operator may apply to SARS to use an alternative, market value based, approach. The guidelines then identify certain acceptable methods of value determination, including reference to prices per litre of specific cultivars negotiated with producers at the beginning of the harvest season or the current price of distilling wine as per organisations like SAWIS and VINPRO.
Back to the case of Dr. A. where, ironically, the SARS auditor raised an assessment based entirely on estimates and had to suffer the consequences before the Tax Court:
“The amount of R789 338 relied on by the respondent is manifestly erroneous, unfair and unreasonable. The error arose out of employing an illogical and incongruous methodology. No evidence was adduced on behalf of respondent in support of the error.”
So in this regard at least the court found in favour of Dr. A. and referred the determination of the value of the produce back to SARS for “further consideration and re-assessment”.
From a tax point of view, co-operatives and particularly pool arrangements are the stuff of nightmares filled with shape-shifters, creatures that defy description and ghoulish formulas. In recent years, many wine cellars and co-operatives have converted to companies and at least as far as the determination of a wine farmer’s produce held and not disposed of is concerned, this is a very good thing indeed.
Specialist Tax Consultant