Nigeria is not a very litigious society. A significant number of tax disputes are settled without the need for any form of adjudication, as parties are reluctant to go to court except where there is no choice. This probably has an impact on the development of the tax space in the country, as such legal challenges may have the potential to deepen the practice of taxation.
Notwithstanding, there were two landmark cases in recent months where the details of the rulings may have a significant impact on the nation’s energy sector. We review both cases below and discuss their wider implication for the sector.
Sahara Energy Exploration and Production Limited vs Federal Inland Revenue Service
Sahara disposed of its interest in an oil prospecting license, prior to its first accounting period, i.e., before it commenced the bulk disposal of chargeable oil or gas under a program of continuous production. The company did not file any capital gains tax (CGT) return, even though the disposal was made at a gain, as it argued that the transaction was not liable to CGT. Sahara contended that the transaction was under the purview of the Petroleum Profits Tax Act (PPTA), and so any tax due can only be accounted according to its provisions.
Paragraph 1(2)(b) of the PPTA provides “that expenditure is incurred in respect of an asset which has been disposed of by the company before the beginning of its first accounting period then any loss suffered by the company on the disposal of such asset shall be deemed to be qualifying petroleum expenditure incurred by the company on that day and be deemed to have brought into existence an asset owned by the company in use for the purposes of petroleum operations carried on by the company, and any profit realized by the company on such disposal shall be treated as income of the company of its first accounting period for the purposes of section 9 (I) (a) of this Act.”
Sahara argued that the disposal was of an asset used for the purpose of petroleum operations and was disposed of prior to the beginning of its first accounting period. Therefore, the gain on disposal would only be accounted for as income earned at the beginning of its first accounting period.
The Federal Inland Revenue Service (FIRS), however, did not agree with that position. It argued that the transaction was the disposal of an asset which fell under the purview of the CGT Act (CGTA) and so the company should have accounted for the CGT upon disposal, without any reference to the commencement or otherwise of its first accounting period. The FIRS referred to Section 3 of the CGTA that states:
“Subject to any exceptions provided by this Act, all forms of property shall be assets for the purposes of this Act, whether situated in Nigeria or not, including
(a) options, debts and incorporeal property generally;
(b) any currency other than Nigerian currency; and
(c) any form of property created by the person disposing of it, or otherwise coming to be owned without being acquired,
and without prejudice to the foregoing provisions, this section shall have effect, notwithstanding that the property is an asset in respect of which qualifying expenditure had been incurred under the Schedule to the Personal Income Tax Act, the Third Schedule to the Companies Income Tax Act or the Petroleum Profits Tax Act.”
Sahara and the FIRS were unable to come to any agreement on the matter and, in a rare instance, the matter was referred to the Tax Appeal Tribunal (TAT) for adjudication. The TAT, after listening to the arguments of both parties, ruled in favor of the FIRS. The TAT in its ruling stated that “in answering this question, we hold the view that for an asset to qualify as one contemplated by paragraph 1(2)(b), it must be tangible and be for petroleum operations. The asset in question is an intangible asset and not meant for petroleum operations.”
The TAT also stated that “the key words or phrases in the provisions of Section 3 of the CGTA are all forms of ‘property,’ ‘including’ ‘incorporeal property,’ ‘without prejudice,’ and ‘notwithstanding’. A community reading and interpretation of the key words/phrases reveal that all forms of property referred to or employed in Section 3 of CGTA include the Appellant’s intangible or incorporeal asset/property which are the subject of this appeal notwithstanding the provisions of the PPTA particularly, paragraph 1(2)(b).”
Some Questions Remain
The TAT ruling, though clear, leaves a few questions unanswered.
The first question is—what is the basis for the position that the “asset” referred to under paragraph 1(2)(b) is limited to only tangible assets? It is trite that tax laws are interpreted literally unless the literal interpretation would lead to manifest absurdity. No party is allowed to input words not specifically contained in the law. Unfortunately, there is nothing in the paragraph referred to that suggests that it was referring only to the disposal of tangible assets.
In fact, the paragraph does specifically state “for the purpose of this interpretation of qualifying expenditure…” in its introductory phrase. This indicates that the clarifications which follow describe what may constitute qualifying expenditure under the specific circumstances. Consequently, it is important also to consider the provisions of paragraph 1(d)(i), which clearly state that cost of acquisition of rights qualifies as capital expenditure. Therefore, its disposal under 1(2)(b) should also qualify for the same treatment. However, the TAT did not agree with this position.
The second question the ruling raises is whether the capital expenditure is meant for petroleum operations. The TAT had ruled that it was not so, but a review of Section 2 of the PPTA shows that petroleum operations “means the winning or obtaining and transportation of petroleum or chargeable oil in Nigeria by or on behalf of a company for its own account by any drilling, mining, extracting or other like operations or process, not including refining at a refinery, in the course of a business carried on by the company engaged in such operations, and all operations incidental thereto and any sale of or any disposal of chargeable oil by or on behalf of the company.” (emphasis ours)
This definition suggests that it is impracticable to win chargeable oil for your own account without acquiring the capital asset or rights over the asset. Therefore, it may be a hard sell to convince others that the asset which gives you the right to engage in petroleum operations is not meant for petroleum operations. What other operations would it be meant for?
The third question is whether the transaction is subject to CGT. There is no doubt that there was a disposal of an asset which should ordinarily be subject to CGT. However, it is important to consider that paragraph 1(2)(b) may not be referring to a balancing charge. The company making a disposal of asset incurred prior to the commencement of its first accounting period would not have had the opportunity to claim any tax depreciation on the asset. The value of the asset would be unchanged at the time of disposal, therefore the base for CGT and balancing charge would be the same.
The intention of balancing adjustments is not to tax capital gains, but to ensure that any value other than the actual cost incurred in the purchase and subsequent use of the asset is adjusted for in the tax returns. It therefore may be difficult to argue that the paragraph is only interested in the balancing adjustment, as there is likely none.
Section 12 of the CGTA provides that “there shall be excluded from the consideration for a disposal of assets taken into account in the computation of the gain accruing on that disposal any money or money’s worth charged to income tax as income of, or taken into account as a receipt in computing income or profits or gains or losses of the person making the disposal for the purposes of the Personal Income Tax Act, the Companies Income Tax Act or the Petroleum Profits Tax Act, which Acts are hereafter jointly referred to as “the Income Tax Acts.”
It appears that the consideration and gain which should be liable to CGT is the same which would be subject to PPT; can we conclude therefore, that the consideration is excluded from being liable to CGT, under the CGTA?
The final question—the answer to which may have played a significant part in the position taken by the FIRS and TAT—is what happens to a company which invests in an oil prospecting license and disposes of it without ever reaching its first accounting period? Will its income be exempt from any tax? If that income is not liable to CGT but PPT when it commences its first accounting period, what happens to the income, if it never commences operations? Would it be exempted from any tax?
It may be that the FIRS and the TAT felt unable to answer “yes” to that question, and so decided that such a company had to pay the only tax available, which is CGT. However, maybe there is another question—are we able to interpret tax laws to get to a suitable conclusion if any other conclusion appears to indicate that a taxpayer may not be liable to pay any tax?
CHI Limited vs the Federal Inland Revenue Service
CHI Limited had written to the tax policy department of the FIRS requesting confirmation that it could claim against its output value-added tax (VAT) the VAT incurred on the purchase of natural gas and diesel, short-term spares and other manufacturing consumables used in the direct manufacturing of its products. The company argued that the VAT Act provides for the claim of input VAT on any good which forms stock in trade used in the direct production of a new product. According to CHI, stock in trade is not restricted to inventory alone and extends to tools, equipment, materials, and other items used in the direct production of the new product on which the output tax is charged.
The FIRS disagreed and argued that the claim of input VAT should only be restricted to items which qualify as raw materials used in the direct production of the new product. The FIRS’ view had been predominant for years, and until it was challenged in court, it was difficult to consider any alternative.
However, the TAT ruled in favor of CHI and stated that stock in trade was not limited to inventory but extends to all tools, equipment, materials and other items used in the direct production of a new product on which the output tax is charged.
This ruling will have a far-reaching effect on several sectors, not least the power sector. The three primary sources of fuel used in power generation in Nigeria today are gas, water, and sunlight. Power generating plants which use gas have typically been able to claim input VAT on the cost of gas purchased and nothing else. However, plants which use water and sunlight have not been able to claim an input VAT, as none is incurred on their primary source of fuel.
This ruling, however, should change that for all three categories. Power generation is highly capital-intensive with a significant amount of sophisticated equipment and materials required in running the plant for it to generate its product—power. Therefore, companies in the sector would now have to review their operations and identify which of their input VAT costs which they had hitherto expensed would qualify as part of their VAT on stock in trade which they can directly apply against their output tax.
It is important to note that expensing input VAT meant that a company was only able to obtain a maximum of 32.5% of the value of the cost incurred (the combined income tax rate), while it can recover the entire 100% if it had claimed the amount using the input VAT mechanism. The 68% differential would be significant for a sector that has been grappling with serious cash challenges since its full privatization.
Furthermore, it is important to note that the TAT ruling did not establish a new law. It only clarified the interpretation of an existing law, so it does have retrospective effect, as companies can go back—provided it is within the six-year window—to review their records and refile their returns, including claims for input VAT where they had acted in error in the past.
Tax disputes and challenges which get to the courts are rare in Nigeria. However, they define the sector and open a new vista of opportunities and in some cases, questions for stakeholders in the sector. These are landmark cases and the questions they pose, and the answers we derive from them, are relevant for the continuing discourse on tax practice in Nigeria.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Martins Arogie is a Partner and Oluwadamilola Daramola is a Senior Adviser at KPMG in Nigeria.