Modification of expense deductibility clause – Implications for taxpayers

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All over the world, it is standard practice in the field of taxation for qualifying expenses to be deductible for tax purposes. In Nigeria, those expenses are required by law to be wholly, exclusively, necessarily and reasonably (WREN) incurred in the production of the taxable income under consideration. Taxpayers were therefore simply required to meet the criteria for claiming deductibility of expenses for such deductions to be approved by the tax authority. However, for businesses with several income streams, it seems that there is the covert practice of recovering expenses incurred in respect of tax-exempt income for tax purposes. The effect of this is the unethical erosion of profits for tax purposes.

In order to address this problem, the recently enacted Finance Act, 2019 (the Act) modified Section 24 of the Companies Income Tax Act (CITA) Cap. C21 LFN 2004 (as amended). This article discusses the modification as well as the implications for taxpayers in Nigeria.

Section 24 Amendment

Prior to the amendment, Section 24 of CITA provides that:

“…for the purpose of ascertaining the profits or loss of any company of any period from any source chargeable with tax under this Act, there shall be deducted all expenses for that period by that company wholly, exclusively, necessarily and reasonably incurred in the production of those profits…”

With the amendment, Section 24 of CITA now reads as follows:

“…for the purpose of ascertaining the profits or loss of any company of any period from any source chargeable with tax under this Act, there shall be deducted all expenses for that period by that company wholly, exclusively, necessarily and reasonably incurred in the production of those profits chargeable to tax…”

Read also: Life after COVID-19…Diversification, tax cuts key to sustain economy – LCCI, NECA DGs

This modification seeks to close loopholes in the legislation regarding expense deductions. The amendment implies that companies will only be permitted to take a tax deduction for expenses incurred in generating taxable income. Expenses incurred in the generation of non-taxable income would no longer be allowed as a deduction from taxable income.

Implications for taxpayers

Currently, most companies with several income streams prepare non-segmented financial statements. Hence, it may be challenging to track expenses directly incurred in generating both taxable and non-taxable income. Moreso, many companies do not bother about further analysing the expenses associated with tax-exempt profits. This may now change as taxpayers with multiple income streams especially those with tax exempt sources of income may need to show the financial performance of each business segment

It is important to note that this is not an entirely new requirement for taxpayers. Section 55 (1a) of CITA requires taxpayers to file a self-assessment return which is expected to include “a true and correct statement in writing containing the amount of profit from each and every source computed”. Hence, it is not in doubt that the tax authority expects taxpayers with multiple income streams to diligently maintain separate accounts for each operating segment/income stream in the determination of its total profits that will be taxed.

Given the above, companies will be required to have in place, a mechanism to apportion costs related to the generation of both taxable and non-taxable business segments and revenue streams. Allocating these expenses and dealing with the associated complexities is an additional burden that will be borne by taxpayers as more resources will have to be deployed in terms of man hours, documentation and cost of engaging specialists in some instances.

How practicable is it to meet the requirements on segmentation of accounts? For International Financial Reporting Standards (IFRS) compliant companies that are also listed on the stock exchange, it may be easier since the IFRS on operating segments (IFRS 8) already requires an entity to report financial and descriptive information about its reportable segments. For others, it may be more difficult since they now need to put appropriate machinery in place to address this.

Review of practice/legal cases in other jurisdictions

It is instructive to note that the tax laws in some jurisdictions contain provisions that disallow expenses related to the generation of non-taxable income. Often, the contentious issue is around the basis of allocating expenses among different segments, whether tax-exempt or not. In countries such as the United States of America (USA) and India, it is mandatory for companies when rendering their tax returns, to allocate expenses indirectly allocable to both taxable and non-taxable income. The laws of the USA require that a reasonable proportion of expenses be allocated to each class of income. Indian tax laws also contain similar provisions on expense apportionment. Section 14A of the Indian Income Tax Act states that any expenditure incurred on earning an income that is already exempt and excludes the total revenue while computing the total income of the taxpayer should not be considered as a deduction.

In India, there have been tax disputes arising from the application of the tax law provision highlighted in the preceding paragraph. In February 2018, there was a Supreme Court (SC) ruling on a case that revolved around the issue of allocating deductible expenses to non-taxable income. The taxpayer was engaged in the business of finance, investment and dealing in shares and securities. It held the shares, as investment on capital, and, as trading assets for the purpose of acquiring/ retaining the controlling interest in other entities.

The taxpayer did not make disallowance under the relevant section of the law for any expenditure relatable to the investment in shares/ securities yielding non-taxable income on the premise that the purpose of the investment was to acquire/ retain the controlling interest or to hold the securities as stock-in-trade but not to earn any non-taxable income. The tax officer, dissatisfied with the taxpayer’s return, made a pro-rata disallowance of expenditure and restricted it to the amount of exempt income. The SC ruled that irrespective of the objective of the investment in shares, where a taxpayer earned an incidental exempt income, the applicable section of the law will be triggered which is based on the theory of apportionment of expenditure between taxable and non-taxable income.

While there were several issues for determination in this case, one takeaway is the fact that failure to allocate expenses to tax exempt income or failure to apportion those expenses in a manner considered reasonable and reliable by the tax authorities could result in adjustments that may need to be tested in court. It is key then, that taxpayers in Nigeria take the necessary steps to comply fully with the amended Section 24 of CITA.

Key steps to achieving compliance

Affected companies need to ensure that they adopt an accounting system that allows for effective apportionment of expenses/costs to their related income. Deductible expenses and costs which are directly related to any class or classes of taxable and non-taxable income will be directly allocated. However, where expenses are not directly allocable to either of the class of income, a reasonable and appropriate allocation parameter will be required.

A straight-forward approach of allocating deductible expenses could be based on the ratio of taxable income and non-taxable income. For instance, if a company has taxable income of ₦20 billion, non-taxable income of ₦10 billion and total deductible expenses of ₦5 billion. In allocating the deductible expenses to non-taxable income, the numerator will be non-taxable income (₦10b) and the denominator will the total income (₦30b). In this case, one third of the allocable expenses would be allocated to non-taxable income (₦1.67b) and disallowed while the remainder will be allocated to taxable income. However, this approach may not be applicable in all cases since the final decision will depend on the nature of both income and expenses while also considering the taxpayer’s lines of business.

Taking a cue from the OECD Transfer Pricing Guidelines (OECD Guidelines) on the cost allocation principles applied to intra-group services, an indirect charge method may be considered. It is stated that “to satisfy the arm’s length principle, the allocation method chosen must lead to a result that is consistent with what comparable independent enterprises would have been prepared to accept. It further stated that the allocation should be based on an appropriate measure of the usage of the service that is also easy to verify, for example turnover, staff employed, or an activity-based key such as orders processed. Whether the allocation method is appropriate may depend on the nature and usage of the service”.

Hence, the nature of the expense item will be a key determinant of how such expense will be allocated. Detailed analysis will therefore be required to apply appropriate allocation keys that produce reliable results which reflect the actual situation and will be acceptable to the tax authority.

It is evident that no one allocation method can reasonably be applied in all cases and circumstances. In some businesses, one allocation method may not necessarily be appropriate for allocating all types of deductible expenses. For example, in a business consulting company, the allocation key used to allocate personnel cost between the taxable and non-taxable income (e.g. Dividend income) may differ from that used in allocating cleaning expenses. Hence, each business model and line of income and expenses must be taking into consideration and appropriately analysed when selecting an appropriate allocation key.

It is equally important that companies invest in training their personnel especially those in the finance division who are involved in the day to day accounting functions of the organisation. This is necessary when matching expenses to income on a day to day basis. Conscious efforts should be taken to ensure that the allocation parameters identified for apportioning expenses will be admissible by the tax authorities in the event of an audit.


With the amendment introduced by the Act, expenses have to be matched only against taxable income before it can be allowed by the tax authority as deductible, in furtherance of the WREN principle. It is important that companies begin to structure their activities and financial accounts in such a way that each item of expense can be matched to the related income.

It is still unclear what approach will be adopted by the tax authority to determine acceptability of the basis used by companies in allocating cost to each line of business. While it may be costly to comply with this from the taxpayers’ perspective, the benefit will likely outweigh the cost of compliance in the long run when such companies are audited. Considering that the provisions of the Act will be applicable to tax returns due from 2020 year of assessment, now is the time for companies to begin to engage experts and work closely with them to ensure full compliance and mitigate possible future tax exposure.

Onyebezie is a Manager while Odesanya is a Semi-Senior Adviser in KPMG Advisory Services, Lagos. They may be contacted via e-mail at [email protected] and [email protected]

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