INSIGHT: Fines and Penalties—Tax Deductible?

Recent cases in Nigeria have triggered the question of whether fines and penalties are tax deductible for tax purposes.

The Cases

The Nigerian Communications Commission (“NCC”) fined MTN Nigeria $5.2 billion 2015 for failure to deactivate some unregistered customers. Based on subsequent negotiations, the Federal Government reduced the fine to $3.2 billion. MTN claimed the related expense in its tax returns.

However, the Nigerian tax authority rejected the claim and therefore disallowed the expense for tax purposes.

In a related matter, the Federal High Court (“FHC”) ruled in the case between Federal Inland Revenue Service v Mobil Producing Nigeria Unlimited (2018) 37 TLRN 1 (that gas flaring charges were not tax deductible simply because there was no documentary evidence of the Minister’s written permission to flare gas.

Section 3 of the Associated Gas Re-injection Act (“AGRA”) requires the Minister for Petroleum Resources to give a written permission to flare gas and for the Minister to issue gas flaring certificates subsequent to the payment of the relevant fees.

Tax Provisions on Tax Deductions

Section 24 of the Nigerian Companies Income Tax Act, 2004 (“CITA”) provides that: “For the Purpose of ascertaining the profits or loss of any company of any period from any source chargeable … there shall be deducted all expenses for that period by that Company wholly, exclusively, necessarily and reasonably incurred in the production of those profits.”

Section 10 of the Petroleum Profits Tax Act, 2004 (“PPTA”) contains similar provision, except that it excludes “reasonably” from the provision and includes the phrase whether incurred “within or without Nigeria.”

Sections 27 and 13 of the CITA and PPTA respectively provide for specific expenses that are not allowable for tax. Fines and penalties are not listed in those sections.

The question, therefore, is how do you treat expenses for tax purposes even in the light of the judgment by the FHC?

Analysis of the Issue

As stated above, there is no provision in any tax law that fines and penalties incurred are not deductible for tax purposes. The overriding principle for determining whether an expense is deductible for tax purposes should be whether that expense satisfies the Wholly, Reasonably, Exclusively and Necessarily (“WREN”) Test.

Simply put, the relevant question to ask is whether the expense helps in generating profits. If the answer to this is in the affirmative, then it should be an allowable tax expense. It has nothing to do with whether allowing such expense is consistent with public policy.

The argument for disallowing such expense under public policy assumes that even if fines and penalties are allowable expenses, such interpretation has to be modified in such a way as to bring it in conformity with public policy.

In other words, the fine or penalty should be disallowed because the main reason for its imposition is to punish those who intentionally or without reasonable care violate the law.

However, it is interesting to note that the proceeds of a criminal act are subject to tax, though the act itself may be repugnant to public policy.

It should also be noted that, in determining the profits from such criminal act, the expenses incurred to earn the income will be tax deductible.

It is a known fact that tax authorities will not be concerned with the legal or illegal nature of such activity. Rather, their focus will be on whether income has been generated from such activity.

It is therefore my opinion that the same principle should apply to the deduction of fines and penalties. Otherwise, disallowing such expense will not be consistent with the tax code and certainly will be inconsistent with the practice of allowing the deduction of expenses incurred to earn income from illegal activities.

However, allowing such expense will align with the equity canon in tax, which requires tax to be levied on citizens on the basis of equality.

In the case between British Columbia Limited v Her Majesty The Queen, it was held that the over-quota fine levied against the taxpayer qualified for tax deduction as it was incurred as part of business operations, and more importantly it generated income that was subject to tax.

The MTN and Mobil cases will be examined in light of the principle highlighted in the British Columbia case.

In the MTN case, it is an established fact that failure to deactivate those 5.2 million unregistered subscribers generated taxable income for the company. If the company had deactivated them, such income would have been lost.

Consequently, any attempt to disallow the fines paid as a result of the non-compliance with NCC regulation will certainly result in misalignment with the WREN principle. It is irrelevant whether allowing the deduction of the fine will dilute the impact of the sanction. If it is the intention of the law for such fine to be disallowed for tax purposes, it would have been explicit to this effect.

In the Mobil case, it is the excess gas that cannot be utilized or captured that is flared. Even companies that have sufficient gas processing capabilities and an immediate market to sell the gas still need to flare because of safety concerns and the need to prevent over-pressure in the oil wells. If the excess gas is not flared, it may result in explosion and loss of oil. Consequently, gas flaring provides opportunity for the oil company to lift the related crude oil, which is subsequently sold.

Of course, it can be argued that, rather than flare the gas, an oil company can allow the gas to escape into the environment. This is really not an option because it is not environmentally friendly and can also cause significant safety issues.

Therefore, obtaining the approval of the Minister for Petroleum Resources for gas flaring is irrelevant, since flares are necessary safety requirements. Of course, the AGRA requires the approval of the Minister before such gas is flared. However, the AGRA provides for a payment of gas flaring fees where a company decides to flare.

Consequently, any company that incurs flaring charges should be able to deduct such expenses on the basis that income from oil would have been lost if the flaring had not taken place. The argument, therefore, that the gas flaring fees should be disallowed simply on the basis that there was no written permission of the Minister is contrary to the canon of equity in tax and is definitely not consistent with the provisions of the tax laws.

It is a known fact that no company has received the written permission of the Minister to flare gas for a very long time. This writer is not aware of any situation where the Minister has queried any oil producing company for gas flaring without his written permission. Shouldn’t lack of objection by the Minister for supposedly illegal act constitute consent?

It does not matter to the tax authorities whether one derives income from legal or illegal activities. What matters is that appropriate tax is paid on any income earned as long as such income is not exempt from tax. In computing such tax, the appropriate principles must be followed; that is, expenses incurred in generating the income, as long as they are not specifically disallowed for tax purposes, must be taken into consideration.

Planning Points

To the extent that there is no law that provides for the disallowance of fines and penalty for tax purposes, such expenses must qualify for tax deduction.

The assumption that the deduction of such expenses provides the taxpayer with a benefit by diluting the impact of the sanction is not tenable since the main purpose is to generate income that is subject to tax.

It does not matter whether the payment giving rise to the income is deemed to be contrary to public policy. Where the courts intervene on the basis of public policy, it would create unnecessary difficulties and uncertainties.

As long as the taxpayer can establish that the payment of such fines and penalties was in fact incurred for the purpose of generating income, then it must be allowed for tax purposes.

Adewale Ajayi is a Partner with KPMG In Nigeria.

He may be contacted at: adewale.ajayi@ng.kpmg.com