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Tax Appeal Tribunal’s decision on deductibility of expenses in determining Companies Income Tax in Nigeria

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Corporate income tax statutes are primarily designed to subject the bottomline of businesses, rather than their topline, to taxes. To achieve this goal, rules are laid down under which companies are able to deduct qualifying expenses incurred in producing assessable profits for tax purposes.

In Nigeria, aside from those non-allowable deductions specified in section 27 of the Companies Income Tax Act (CITA), all expenses are, pursuant to section 24 of CITA, deductible if they were incurred “wholly, exclusively, necessarily and reasonably in the production of…profits” (the WREN Test).

In spite of the seemingly clear provisions of the law on this subject, one issue which has remained of interest to all stakeholders in the taxation space in Nigeria is the correct yardstick for determining the deductibility of expenses, following the laid down rules. This problem is exacerbated by the fact that the test for deductibility is a question of fact, which in most cases is subject to varying interpretations and views by tax authorities, tax payers and even the courts.

A good illustration of this conundrum is seen in the Canadian case of British Columbia Limited v. Her Majesty The Queen [1999] S.C.J. No. 69, where the question was whether an over-quota levy imposed by the British Columbia Egg Marketing Board on a poultry farmer who had produced over-quota could be deductible in computing the taxpayer’s income tax. Although the Supreme Court of Canada unanimously agreed that the levy should be deductible, the justices were divided amongst themselves on the scope of the test for deductibility of expenses. Five members of the panel reasoned, inter alia, that: “The levy was incurred as part of the appellant’s day-to-day operations, and the decision to produce over quota was a business decision made in order to realize income. The characterization of the levy as a “fine or penalty” is of no consequence because the income tax system does not distinguish among levies, fines and penalties. If the expense is incurred for the purpose of gaining or producing business income, it is deductible. There is nothing in the language of s. 18(1)(a) [of the Income Tax Act R.S.C., 1985] to suggest that a penalty or fine should be “unavoidable” in order to be deductible. Nor should the deduction of fines and penalties incurred for the purpose of gaining or producing income from a business be disallowed for reasons of public policy. For courts to intervene in the name of public policy would only introduce uncertainty, as it would be unclear what public policy was to be followed, whether a particular fine or penalty was to be characterized as deterrent or compensatory in nature, and whether the body imposing the fine intended it to be deductible…” [see page 2 of the Judgment]

However, two members of the panel adopted a more restrictive approach to the question of deductibility, and decided that they: “… respectfully cannot agree that all types of fines and penalties are deductible as a matter of course. The distinction between deductible and non-deductible payment must…be determined on a case-by-case basis. The main factor in such a determination is whether the primary purpose of the statutory provision under which the payment is demanded would be frustrated or undermined. Statutory provisions imposing payments either as punishment for past wrongdoing or as general or specific deterrence against future law-breaking would be undermined if the fine could then be deducted as a business expense. In contrast, if the legislative purpose behind a provision is primarily compensatory, its operation would not generally be undermined by the deduction of the expense…” [see page 5 of the Judgment].

In this article, we will examine two recent judgments of Nigeria’s Tax Appeal Tribunal (TAT/Tribunal), namely MTN Nigeria Communications Plc v Federal Inland Revenue Service (2020) 50TLRN42 and Tetra Pak West Africa Limited v Federal Inland Revenue Service [Consolidated Appeal Nos.: TAT/LZ/CIT/030/2015; TAT/LZ/EDT/031/2015; TAT/LZ/CIT/032/2015; TAT/LZ/EDT/033/2015] with a view to identifying the salient points and principles highlighted by the TAT in relation to the proper application of the test for deductibility of expenses.

MTN Nigeria Communications Plc v Federal Inland Revenue Service
Following an audit of the books of MTN for the 2010-2015 Year of Assessment (YOA), the Federal Inland Revenue Service issued 32 notices of additional assessment on 6 July 2017 in respect of outstanding companies income tax (CIT), education tax (EDT), Pay-as-You-Earn (PAYE) Personal Income Tax, Withholding Tax (WHT) and Value Added Tax (VAT). The dispute on CIT arose because MTN treated as tax-deductible the sum of N330 billion imposed on it by the Nigerian Communications Commission (NCC) for MTN’s failure to disconnect its unregistered subscribers in the manner, and within the deadline prescribed by the NCC. MTN then challenged the additional assessments at the TAT.

The FIRS’ Argument
The FIRS took the view that the said sum was not deductible because penalties were punitive sums imposed for a breach of the law, and allowing the defaulting party to deduct same in computing its tax liabilities would amount to enabling that party to benefit from its own wrong.

MTN’s Argument
MTN argued that the sum did not qualify as a penalty because, on the authority of NOSDRA v Exxon Mobil (2018) 13 NWLR (PT. 1636) 334 and Tope Alabi v FRSC [FHC/L/CS/123/13], only a competent court can impose a penalty, as punishment for an offence. The NCC was not a court. MTN also argued that the sum was incurred wholly, exclusively, necessarily and reasonably in accordance with section 24 of CITA for the purposes of its business as non-payment would have resulted in a revocation of its operating license, contempt of court and ultimately a blight on its corporate image. Even if the sum qualified as a penalty, it was incurred WREN for the purpose of producing the profits sought to be taxed. Moreover, section 27 of CITA, which deals with deductions not allowed, does not mention that penalties are not deductible.

The Judgment
The TAT held that although section 27 of CITA does not include penalties in the list of deductions not allowed, section 24 requires an expense (by whatever name called) to have been incurred wholly, exclusively, necessarily, and reasonably in producing a taxpayer’s profit, before such expense can be deductible.

The TAT declared that even though the disputed sum was incurred wholly, exclusively and reasonably in the circumstances (because it was paid to, inter alia, save MTN’s business), the payment did not meet the test of necessity because it was not unavoidable or inevitable. The Tribunal emphasized that the WREN Test is cumulative. An expense must meet the test in its entirety before it can become deductible. Therefore, the sum would have qualified for deduction only if it had met all the components of the WREN Test. As it did not meet the requirement of necessity, the payment would not be treated as a deductible expense. Had the payment met the WREN Test in full, it would have been deductible, notwithstanding its description as a penalty.

Tetra Pak West Africa Limited v Federal Inland Revenue Service
The FIRS assessed Tetra Pak West Africa Limited (TPWAL) to additional CIT and EDT for the 2011 and 2012 years of assessment. Sums deducted by TPWAL as school fees of dependents of expatriate staff, cost of training and education of members of staff, and demurrage payments for delays in offloading its cargos at the ports, were all disallowed by the FIRS for failing to meet the WREN Test. Aggrieved, TPWAL filed this appeal.

The FIRS’ Argument
The FIRS argued that school fees of the dependents of expats, the cost of which was treated by TPWAL as ‘other employee remuneration’ was disallowed because no convincing proof was provided to show compliance with section 24(d)(i) or (ii) of CITA. Section 24(d) allows any outlay or expenses incurred during the year in respect of (i) salary, wages or other remuneration paid to a company’s senior staff and executives; or (ii) any benefit or allowance not exceeding the limit prescribed by a collective agreement between the company and the employees concerned, provided that this agreement has been approved by the Federal Ministry of Employment, Labor and Productivity, and the Productivity, Prices and Income Board, as the case may be.

The FIRS also took the view that the cost of staff training should not be deductible because (a) the invoices tendered by TPWAL showed that the training was provided by a related company; and (b) the expense was not incurred WREN for the production of TPWAL’s profit. Regarding demurrage payments, the FIRS argued that those were ‘penalties’ imposed by ship owners on TPWAL for failing to evacuate cargos from the ports within the agreed time frame. The payments, it argued, did not meet the WREN Test because they were avoidable and would not have been incurred if TPWAL had acted timeously.

TPWAL’s Argument
To justify its treatment of school fees of the dependents of expatriate staff as ‘other remuneration’, TPWAL tendered a staff handbook, which showed that the school fees of dependents could indeed be paid as part of employees’ remuneration package. TPWAL also argued that the fact that staff training was provided by an affiliate company did not render the cost incurred non-deductible because TPWAL is a separate and distinct corporate entity; and the expense was incurred WREN because the training had an impact on productivity and profits.

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Regarding demurrage, TPWAL cited foreign case law, including Nahoomal Jyoti Prasad v Commissioner of Income Tax (2014) 13 TLRN 31, to support its argument that demurrage is a deductible expense and not a penalty. It also gave evidence to show that, in any case, the expense was incurred owing to reasons beyond its control, including red tape, congestion at the ports, inefficient port management and the poor state of port facilities.

The Judgment
The TAT decided that school fees of dependents of TPWAL’s staff were deductible because TPWAL tendered its staff handbook to prove that the payments were made as part of staff remuneration necessary for the company to make profit. The Tribunal also held that the cost of training of staff was deductible because, contrary to the FIRS’ argument, expenses incurred for the said purpose were vital to the production of a company’s profit. On the point of demurrage, the TAT agreed with the argument advanced by TPWAL and stated that demurrage, “not being a fine or penalty, is not imposed pursuant to a statutory provision”, and ought to be deducted as a business expense which is more compensatory than punitive in nature.

Thoughts on Both Cases
One takeaway from the MTN and TPWAL cases is that the TAT is prepared to look at the nature and purpose of expenses sought to be deducted vis-à-vis the facts and circumstances of each case, before determining the question of deductibility. In MTN’s case, the Tribunal stated that the description of the sum imposed by NCC as a penalty did not conclusively foreclose its being deductible if the WREN Test was satisfied. Nor was the fact that the sum was incurred in producing the taxpayer’s profits sufficient in itself to render the expense deductible.

In TPWAL’s case, the Tribunal rejected the FIRS’ argument that the demurrage was imposed as penalty for failure to evacuate cargos after an agreed free period. The TAT noted that demurrage payments are by their nature contractual and compensatory, not being imposed by statute. Most importantly, the Tribunal found that the demurrage in this case met the WREN Test as the evidence showed they were not avoidable, having been incurred due to administrative and infrastructural challenges at the ports, which delayed the evacuation of the taxpayer’s cargos. As such, if the FIRS had tendered evidence supporting its argument that the expenses were avoidable, the Tribunal would have decided differently.

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The argument that penalties do not meet the WREN Test is one that the FIRS has maintained in previous cases. In Federal Inland Revenue Service v. The Shell Petroleum Development Company of Nigeria Ltd (SPDC) (2018) 39TLRN 13, the Federal High Court (FHC) upheld the FIRS’ argument that fees paid to the Minister of Petroleum Resources by SPDC for flaring gas in the course of crude oil production was not incurred wholly, exclusively and necessarily for petroleum operations. This decision of the FHC is unhelpful in our view because the Court did not consider whether, on the facts and circumstances of the case, the gas flare fees were avoidable or if SPDC could have carried out its operations without incurring the expense.

Nwodo is an Associate in the Tax, Corporate and Commercial, and Dispute Resolution Practice Groups of AELEX—a top-tier, full-service law firm

A similar decision was reached by the FHC in FIRS v Mobil Producing Nigeria Unltd [FHC/L/3A/2017], where the Court decided that gas flare fees were not deductible expenses because they constituted a penalty paid for flaring gas without the Minister’s permission. These decisions of the FHC show, with respect, a lack of appreciation of the relevant provisions of the Associated Gas Re-injection Act (AGRA). Although AGRA requires the permission of the minister before gas is flared, in practice, such Ministerial consent is rarely ever obtained before oil production. The minister’s certificate is usually issued in accordance with section 3(2) of AGRA to oil producers who show that utilisation or re-injection of gas is not appropriate or feasible; and the fees payable are determined by the minister based on the standard cubic meter of gas actually flared. As such, the gas flare fees paid to the minister are merely compensatory rather than punitive. To buttress this fact, the penalty, which the AGRA imposes for a violation of the law is a forfeiture of the concessions granted to the defaulter in the particular field in relation to which the breach was committed.

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In any event, assuming without conceding that gas flare fees constitute a penalty, we question the logic in disallowing it in the computation of income tax since the proceeds generated from the activity in respect of which the penalty was paid will be taxed. If the proceeds of a prohibited act are taxable, surely all expenses incurred in generating the income must also be deductible, except where the law provides otherwise. The Canadian Supreme Court held in this regard that: “…it is well established that the deduction of expenses incurred to earn income generated from illegal acts is allowed…Allowing a taxpayer to deduct expenses for a crime would appear to frustrate the Criminal Code, R.S.C., 1985, c. C-46; however, tax authorities are not concerned with the legal nature of an activity. Thus, in my opinion, the same principles should apply to the deduction of fines incurred for the purpose of gaining income because prohibiting the deductibility of fines and penalties is inconsistent with the practice of allowing the deduction of expenses incurred to earn illegal income.” [See page 23 of the judgment].

It is noteworthy that there is a temptation for judges to rely on public policy as a basis for denying a taxpayer’s entitlement to deduct expenses not disallowed by law. This will introduce a lot of uncertainty, as the extent to which the test of public policy should apply will be left to the imagination of the individual judge. To avoid creating this uncertain state of affairs, the Court in Edet v. Chagoon (2008) 2 NWLR (Pt. 1070) 85 at P. 105, paras. B-D, cautioned that: “Public policy is traditionally described as an unruly horse, and a Judge has neither qualification nor experience in such equestrian matters. Thus, to render a decision solely on public policy or public good is to plague the law with uncertainty, and it is against public policy to produce uncertainty in the law…”

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Another point to note from the MTN and TPWAL cases is that the duty continues to rest on a party who claims that an expense is deductible to provide ‘convincing’ evidence in support of that claim. In MTN, the TAT was not convinced that the sum imposed by NCC was a necessary business expense, and instead found that MTN had been negligent having failed to comply with regulations issued by its regulator.

Conclusion
The test for the deductibility of expenses is nuanced. As such, taxpayers must be aware that the Tribunal will be prepared to determine each case on its peculiar facts and circumstances and on the evidence presented by the parties. We note that the Finance Act 2019 has amended section 27 of CITA to include “any penalty prescribed by any Act of the National Assembly for violating any statute” in the list of expenses not allowed. As such, the mere characterisation of an expense as a fine or a penalty by the tax authorities, without reference to an Act of the National Assembly, will not be a conclusive determinant of the tax treatment of such an expense.

We consider the MTN and TPWAL cases commendable, and hope that other Zones of the TAT and appellate Courts in Nigeria’s judicature would toe the line of reasoning undergirding these two decisions when determining similar cases in future.

Nwodo is an Associate in the Tax, Corporate and Commercial, and Dispute Resolution Practice Groups of AELEX—a top-tier, full-service law firm.

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