Depreciation, to claim or to defer?

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1 Tax Services July 2018 Depreciation, to claim or to defer? Even though it is commonly referred to as income tax, the term is a misnomer. Income tax is actually a tax on taxable profits which arise from the difference between expenditure that is incurred and income that is generated. For tax purposes the expenditure can adopt either of two forms: tax deductions which are a result of business-related expenses and depreciation allowance which arises from capital expenditure. Capital expenditure results from the acquisition of a capital asset and such expenditure is not immediately deductible. Instead tax and accounting concepts requires such to be spread over the asset s estimated useful life. A proportionate amount of the cost is then allowed as a deduction against income every year until the assets is fully depreciated. The justification behind this is to (a) spread a large expenditure proportionately over a fixed period to match revenue received from it; and, (c) reduce the taxable income by charging the amount of depreciation against the total income. A question that often arises relates to the timing of such depreciation and when it should be taken: should one start taking the depreciation once he has incurred the expenditure (acquired the asset) or should one wait until the asset has started generating income? These questions were at the heart of a tax dispute between PanAfrican Energy Tanzania Ltd v Commissioner General (TRA) and the Court of Appeal of Tanzanian made a decision earlier this month. The facts of the case PanAfrican Energy is Tanzanian s first natural gas producer and supplies natural for use in commercial activities in Tanzania. The company is also involved hydrocarbon exploration activities and incurred US$9.2m in relation to two wells. Having determined that the expenditure qualified to be treated as a capital asset under the Act, PanAfrican Energy went ahead to claim the allowed depreciation in its 2009 income tax filings. TRA differed and argued that even though PanAfrican Energy had rightfully incurred the expenditure, any depreciation allowance arising from this asset should have been deferred until the asset had started generating income. Depreciation allowance was not claimable in the year in which the expenditure was incurred. Having lost at both the Tax Board and the Tax Tribunal, PanAfrican Energy appealed to the Court of Appeal of Tanzania against TRA s interpretation of the law. The relevant tax provisions and their interpretation by the parties Section 17 stipulates that expenditure that secures a benefit lasting longer than twelve months; or expenditure that is incurred in respect of natural resource prospecting, exploration and development is specifically not allowed and should be depreciated. The section allows a taxpayer depreciation allowance for a year of income from any business...in respect of depreciation of depreciable assets [a] owned and 1

2 [b] employed by the person during the year of income [c] wholly and exclusively in the production of the person's income from the business There is the argument that the words in section 17 lend themselves to an interpretation that leans towards deferral of depreciation allowance until the particular asset starts generating income. The stipulates that depreciation should be deducted when the assets are wholly and exclusively employed in the production of a person s income from business. This is the argument that was advanced by TRA. On the other hand, PanAfrican Energy argued that the word employed in section 17 when considered in the context of the oil and gas industry means that expenditure incurred towards prospecting, exploration and development activities secures the acquisition of assets and should therefore qualify for depreciation allowance when it is incurred. There was also the argument that Paragraph 1(3) of the Third Schedule is a special provision intended to cater for natural resource prospecting, exploration and development expenses. PanAfrican Energy also advanced the position that its Production Sharing Agreement with the Government granted it depreciation from its capital expenditure and further argued that since TRA had acquiesced to the tax treatment accorded by the company for the years 2007 and 2008 in relation to the same, they could not therefore seek to adopt a different position for The Court of Appeal s decision In a decision favouring the TRA, the Court of Appeal of Tanzania held that: depreciation allowance is not based on the fact that the Act requires pooling of assets the law entitles a person to depreciation allowance only upon meeting the two conditions stipulated the Act i.e. the depreciable assets must be owned and should employed in the production of the income in question. depreciation with respect to natural resource prospecting, exploration and development expenditure shall be allowed once the asset created starts generating income. the fact that depreciation allowance was not disallowed in prior years does not operate as an estoppel against an authority in the performance of a statutory duty. depreciation allowance under the Production Sharing Agreement cannot override the mandatory provisions of the Act. EALC s view We find the position advanced by the TRA, and which the Court of Appeal has confirmed, to be strange especially coming from the TRA. Section 4 of the Income Tax Act imposes tax on a person s income for each year of income, where the year of income is construed to be a twelve months period. In arriving at the taxable income, the Act permits a deduction of allowed expenses or depreciable expenses from assets employed in that year of income. From reading the relevant provisions there is the argument that deductions and depreciations must be taken in the year that it is incurred [i.e. the year of income]. If a taxpayer does not deduct or claim the depreciation for the particular year of income, then there is the argument that the right to deduct the claim is forfeited and extinguished because it was not taken in the particular year of income when it was incurred. This use-it-or-loss-it approach is the position that TRA officers have often advanced during their tax audits. From reading the Court s decision it does not appear that PanAfrican Energy advanced this argument to justify taking the depreciation in We should however point out that in July 2016 Tanzania introduced a tax new tax regime for the oil and gas industry which amongst other things requires that the depreciation entitled with respect to a particular year of income is required to be taken in that year and should not be deferred to a later year(s) of income. For the oil and gas 2

3 industry, this decision should impact years of income before July TRA s argument in this case is therefore strange because tax authorities around the world despise deferral especially when it could potentially come back to bite them. The sooner an entity takes depreciation allowance the sooner it depletes its capital assets and exhausts its allowed depreciation expenses which in essence shelter taxable income. Deferring the depreciation to a time when there is income means that the allowed depreciation expense then will reduce the taxable income. It maybe that TRA s position in this instance was influenced in part by the fact that PanAfrican Energy is in production. The decision means that in the period during natural resource prospecting, exploration and development expenditure, before July 2016 oil and gas companies should have not have employed any assets in the production of income; such expenses would be considered as work-inprogress for accounting purposes (IAS 2). This work-in-progress, which refers to materials and partly finished products that are at various stages of the production process, would only be classified according once the work is complete and the final is ready for production (IAS 16 or IAS 40). The decision by the Court of Appeal is not confined to the oil and gas industry, it applies to depreciation generally. If you would like to learn more about this or if you have any questions, please get in touch with our Tax Services team, Brian Kangetta at b.kangetta@ealc.co.tz or Joseph Thogo at j.thogo@ealc.co.tz. 3

4 Industry Cluster Speciality Lead Energy & Extractives Mining Oil and Gas Power Generation Thomas Sipemba e: Banking & Finance Banking Insurance Private Equity & Venture Capital Stella Ndikimi e: Manufacturing & Consumer Business Agriculture Retail and Consumer Business Hospitality and Leisure Brian Kangetta Principal, Tax e: Communication & Technology Telecommunication Information Technology Intellectual Property George Fernandes e: Real Estate & Infrastructure Conveyance Public-Private Partnerships Construction Stella Ndikimi e: Litigation & Arbitration Litigation Alternative Dispute Resolution (ADR) Tax Audits & Disputes Juvenalis Ngowi e: 4

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