Tax deductions are misunderstood. Perhaps, the best way to understand them is to first recognise how income tax works. The income tax law imposes tax on all income irrespective of its source.
Conversely, whether and to what extent deductions are allowed depends upon legislative grace and only as there is clear provision, therefore, can a deduction be allowed. It is also important to distinguish between tax deductions and tax credits.
A tax deduction reduces the taxable income to which the applicable the 30 per cent tax rate is applied while a tax credit directly reduces the amount of tax that is payable.
This is how tax deductions and tax credits look like. If Barbara’s business has income of Sh10 million, she would be allowed to deduct expenses which she incurred in generating that income, in this case let us assume she incurred Sh6 million. This Sh6 million will be deductible for tax which means that the 30 per cent tax rate would be Sh1.2m; which is 30 per cent of the difference between the Sh10m and the Sh6m.
Thus, as opposed to being taxed on the Sh10m, the law recognises Barbara’s Sh6m as a tax deduction. Where available, a tax credit on the other hand would help reduce the Sh1.2m tax that is payable. It sounds clear cut and simple but unfortunately it is not. What should constitute a deductible expense for tax purposes has been the subject of many tax debates between taxpayers and tax authorities. This has been fuelled in large part by the fact that the legislation leaves the door wide open for interpretation.
Because businesses are different and that it would be restrictive to put into distinct pigeon-holes what should be tax deductible, the income tax legislation allows businesses to deduct expenditure that is wholly and exclusively incurred in the production of income.
This phrase lends itself to wide and varied interpretation, firstly depending on the nature of your business and secondly depending on whether one has on a taxman’s hat or a taxpayer’s hat.
While it is unequivocal that some expenses are incurred wholly and exclusively in the production of income (for example, office furniture, office rent, staff salaries), there has been an acrimonious debate on expenditure incurred towards donations and CSR activities.
In other jurisdictions, for an expenditure to be deductible, the expenditure must be both ordinary and necessary. An ordinary expenditure is one that is normal, common and accepted in that particular trade or business.
A necessary expenditure is one that is helpful and appropriate to that business. An expense does not have to be indispensable to be considered necessary. In many situations, it is pretty obvious what is ordinary and necessary for a business and common sense should be the yard-stick.
There is what has been referred to as the laugh test — as you enter the item on your tax return, can you do so without laughing about how you are being cheeky?
Expenditure incurred towards CSR activities takes many forms and it has been one of those areas where the taxman continues to differ with the approach adopted by taxpayers. The position on donations is less acrimonious because they can be construed to be a form of marketing or advertising expense that was incurred towards the production of income.
So if you have sponsored a charitable event in cash and kind through donated T-shirts bearing your business logo or adorned the event with banners bearing your business name, there is room to successfully argue that your activities amount to marketing or advertising and should be deductible for tax purposes.
The problem often arises where one makes donations directly to schools, hospitals, infrastructure and other important and essential social amenities. It would be stretching it if one argued that these were incurred wholly and exclusively in the production of income or that they were ordinary and necessary.
Thus, the law allows a deduction of these as an exception to the above rules about tax deductibility. One way of ensuring that the tax deduction is not lost is to channel such donations through recognised and registered charitable entities such as foundations or charitable organisations. This would perhaps explain why a number of organisations channel their CSR expenditure through foundations that they have set up to handle their CSR activities. This way, CSR donations can be tax deductible.
Thogo works with Deloitte East Africa can be reached at [email protected]