Not all expenditure incurred by a business is allowed against the income of the business. According to S. 15(1) of the Income Tax Act, all expenditure incurred wholly and exclusively in the production of income should be deducted from that income. Therefore, the test of whether or not an expense is permitted is the purpose for which it is incurred – it must be wholly and exclusively for the production of taxable profits. Some expenses are expressly permitted and others excluded. As a general rule, capital expenditure is not allowed.
It is not always easy to tell whether or not certain expenses are incurred wholly and exclusively in the production of income. If expenses are incurred in unsuccessfully suing for recovery of monies allegedly owed, can it be argued that those expenses were incurred in the production of income yet no income is received by the business? What of money embezzled by a cahier or a director?
There is a rich body of case law from the Commonwealth dealing with these questions and others. Though the laws of the countries referred to might be different today, they were decided at a time when the statutes of those countries did not expressly permit the expenses discussed here but contained general guidelines just like section 15 of the Income Tax Act of Kenya today. The cases dealt with the interpretation of provisions which though slightly different in wording have the same meaning as our section 15.
Let us look at some troublesome expenses:
Fines and penalties for breach of the law
What is the position on fines and penalties suffered for breaches of the law in the course of conducting business? Fines and penalties imposed for breach of the law are disallowable. Such fines and penalties are intended to punish the person on whom they are imposed and to allow them would be to allow the burden of his wrongdoing with the rest of the society. The severity of a penalty or fine would also be reduced. This was the decision of the House of Lords in the English case of McKnight v. Sheppard (1999) 71 TC 419. It stated:
“But the reason (for fines being disallowed) in my opinion is much more specific and relates to the particular character of a fine or penalty. Its purpose is to punish the taxpayer and a court may easily conclude that the legislative policy would be diluted if the taxpayer were allowed to share the burden with the rest of the community by a deduction for the purposes of tax… By parity of reasoning, I think that the Special Commissioner and the judge were quite right in not allowing the fines to be deducted.”
Expenses on legal actions generally
Legal expenses incurred in actions filed by a person to remedy breach of a business contract or to defend an action for alleged breach of a business contract are allowed irrespective of the outcome of the action. It does not matter that the action or defence is successful or not so long as the expense was incurred for the purpose of the business. The House of Lords in the previously mentioned case of McKnight v. Sheppard stated as follows:
“Can there be a distinction between the costs of a successful and an unsuccessful defence? It might be argued that, as a matter of policy, the unsuccessful defendant should have to bear his legal costs personally in the same way as the penalty itself. But I think there would be great difficulties about giving effect to such a rule. It might not be easy to tell which costs had been expended successfully and which unsuccessfully... More important, it is fundamental that everyone, guilty or not guilty, should be entitled to defend themselves.”
The House of Lords also established that the nature of the action is not relevant. In other words legal expenses will be allowed not only in civil actions but also where a business is being defended in a criminal action. The case actually concerned a criminal action. The House of Lords decided that the legal expenses incurred in the defence were expended wholly and exclusively in the production of income.
The Canadian Exchequer Court in Reader's Digest Association (Canada) Ltd. v. MNR (1966) 66DTC5416 also allowed the deduction of legal expenses incurred by a taxpayer in unsuccessfully resisting imposition of excise tax on his income. The court reasoned that the expenses were incurred to protect future income.
In civil cases, damages are also allowed where a person defends an action unsuccessfully. The amounts allowed also include those paid to settle a civil suit. However, if the damages imposed are punitive damages they are not allowed, Golder v. Great Boulder Proprietary Gold Mines Ltd (1952) 33TC75.
Costs of appeal against a tax assessment
It has been established that legal and accountancy expenses incurred in an appeal against a tax assessment are not allowed because they cannot be said to have been incurred wholly and exclusively in the production of income. The authority on this position is the case of Allen v. Farquharson & Bros Co (1932) 17TC59. In the case, the company sought to be allowed to deduct legal expenses incurred in connection with an appeal against an assessment. The High Court in finding that the legal costs were not allowable stated that it is not enough that the expense arise out of, or be connected with the trade. It must be incurred for the purpose of earning the profits of the business. Justice Finlay reasoned that this was an application of profits after they were earned rather than an expense to earn those profits.
Expenses in preparation of accounts
Book keeping is a necessary part of business. There is no doubt that book keeping expenses are expenses incurred wholly and exclusively in the production of income. So these are allowed. Accounting statements are also prepared for various business reasons including raising loans, monitoring etc. and therefore expenses on them can be said to be prepared in the production of income. Can the same be said of expenses in preparation of tax accounts? Following the court’s reasoning in Allen v. Farquharson, it cannot be said that expenses re incurred in the production of income for two reasons; first, by the time they are incurred profits have already been earned and secondly, preparation of these accounts does not lead to an inflow of income.
However, tax authorities including the Kenya Revenue Authority allow expenses incurred in preparation of tax accounts. This practice was approved by in the English case of Smith’s Potato Ltd v. Bolland (Inspector of Taxes) (1948) 30TC267. The House of Lords first noted that just like expenses in an appeal against a tax assessment, expenses in preparation of accounts for tax purposes are not incurred to earn income. It then stated that these expenses should be allowed because the necessity to prepare these accounts is an obligation imposed by law. Without such an obligation the expense would not be incurred. The House of Lords had the following to say:
“If there were no obligation to ascertain and pay either of these taxes, there would be no necessity for making up accounts on Income Tax principles, it would suffice to make up the ordinary commercial accounts. The computation of accounts for tax purposes is therefore not directly associated with the carrying on of the business. It is an obligation imposed upon the Company for another and extraneous purpose, that is, for the purpose of ascertaining the tax to be paid out of profits. It is not, at any rate directly, undertaken for trade purposes but to satisfy the Revenue authorities.
It is true that as a matter of convenience the cost of making up accounts for the Inland Revenue is allowed by the authorities as a deduction from profits, as is the cost of making up the strictly business accounts of the trade, but this is not a matter of principle but of expediency.”
The House of Lords was of the opinion that it is in the interest of the revenue authority that tax accounts are prepared accurately. Though it stated that strictly in law there was no principle under which the expenses were allowed, it concluded that the advantages of allowing the costs outweigh the disadvantages.
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