FORUM (Spotlight Weekly)

Deductible Expenses For Assessing Income Tax

By Rup Khadka

Income tax is levied on net income. This means that not all income accrued from sources brought into the income tax net is taxable. A part of income is deducted from the gross income in respect of various expenses incurred in connection with generating taxable income.

Business expenses are the principal deductible expenses. Business expenses are those expenses that are directly incurred in earning gross receipt during a year. They are thus deemed necessary expenses and are deducted from gross receipts.

For example, cost of trading stock disposed of during a tax year is deductible. However, the cost of capital nature is not deductible. Instead, depreciation on capital goods is deductible during the period of useful life of an asset. If it is not possible to establish the useful life of an asset, then depreciation cannot be allowed.

Start-up expenses related to the business is deductible. Similarly, some head office expenses or expenses of a subsidiary are deductible. Since it is difficult to check actual expenses made by a head office or a subsidiary, there is also a practice to fix certain percent of income as expenses.

Repair and maintenance expenses, commission, and advertisement expenses are also deductible. Similarly, various taxes like custom duties, excise duties, Value Added Tax (VAT), and property taxes are deductible. In some countries, taxes paid on the acquisition of capital assets are added to the cost, capitalized and depreciated. Social securities charges, which are levied in addition to taxes, are also deductible.

Similarly, insurance premiums are also deductible. Legal or litigation fees are deductible as well. In some countries they are capitalized and amortized. For example, legal fees for negotiating long lease are capitalized and depreciated. Depreciation is also a deductible item. Losses are deductible. Doubtful accounts of a business are deductible as well.

Treatment of entertainment and promotional expenses is a problematic area in the field of deduction. Such expenses may include travelling expenses, promotion, public relations, convention/meetings, gifts to the customers, and business lunches for clients. They are sources of misuse also. It is difficult to establish what is business expense and what is not in this field. In order to minimize abuse and avoid disputes, it is necessary to specify deductible expenses or to fix ceiling such as up to the limit of equal to or one and half of allowances fixed for government employees of similar status.

Donations to specified activities are deductible although they are not directly related to the acquisition of income. There are different practices regarding the deductibility of donations in different countries. In some countries, donations to specified activities, which need to be promoted, are deductible fully. In some countries, there are limits in terms of a maximum account or as a percentage of total turnover or net income.

Wages and salaries made to employees are also deductible. Similarly, interest, royalties and rent are deductible if they are related to the business. However, distribution of profit cannot be treated as expense. It is the result of the business. So profit is not deductible, be it the payment of dividends or the transfer of amounts to reserves.

Expenses that are not made for preserving or enhancing taxable transaction are disallowed. For example, non-trading expenses and personal expenses are disallowed. Expenses, which are very subjective, are not deductible in order to avoid manipulation. Expenses, incurred in generating exempt income or final withholding taxes are also not deductible. Fines and penalties, which are paid for non-compliance of laws, are not deductible. Income tax is also not deductible.

There are different practices around the world regarding business deductions for the purpose of income tax. Some countries adopt an itemized system of deduction. Under this system, deductible and non-deductible items are specified in the law. Under this system no deductions is allowed unless a particular expense is specifically included in the list of deductible expenses. Such a system ensures uniform treatment of all taxpayers, particularly in countries where tax administration is young and weak and the accounting system is not well established.

However, it is not possible to provide an extensive list of possible expenses of all types of businesses. Those expenses, which are not included in the list of deductible expenses, are disallowed, which means that tax is not levied on net income but on gross income. Further, some clever taxpayers manipulate those expenses, which are not included in the list, by giving fake names while other taxpayers who do not do so or cannot do so are discriminated against thereby resulting in unequal treatment of equals.

So under the modern income tax system there is a provision to allow taxpayers to deduct all business expenses related to their taxable income. Under this system, all business expenses related to taxable income are deductible. No list is given in the law of deductible expenses. This approach is based on the presumption that taxpayer is the best person to have the exact idea of his business expenses and he is the one who takes proper decision regarding the types of business expenses and their volumes.

It is desirable to adopt a more liberal policy regarding deductible expenses in the context of broad based and low-rated income tax system. Further, the expenses of one taxpayer might be the income of another taxpayer. So, there may not be any, or at least big, impact on revenue, unless the receivable income is exempt from income tax.

A tax expert, Dr. Khadka is associated with the VAT Project.