‘Certainty’ is one of the central themes of a good tax system. Certainty of tax rules allows tax payers to plan their tax affairs properly. However, tax rules cannot be static, due to the dynamic and increasingly complex nature of business transactions. This is why, in developed tax jurisdictions, tax rules are reviewed, clarified, or amended, on a regular basis by either the tax authorities or the legal court system.
One tax rule that is a subject of continuous dispute and review in many jurisdictions is the proper identification/classification of income as either revenue or capital for tax purposes. As Lord (Sir) John Anthony Dyson, a former Justice of the United Kingdom (UK) Supreme Court[1], said in Inland Revenue Commissioners v John Lewis Properties Plc[2], “The question whether a payment is to be regarded as capital or income has troubled the courts for a very long time. There are statements of the highest authority which indicate that classification cannot be made by the application of something akin to a simple litmus test. Various guidelines have been given from time to time. But it has repeatedly been emphasised that much depends on the nature of the transaction and the matrix in which it is set.”
Disputes between tax payers and tax authorities with respect to this rule normally arise in countries where different tax rates apply to both classes of income, and where the tax laws do not provide sufficient guidance in identifying the incomes. This is a common area of dispute in Nigeria.
Generally, the term ‘revenue income’ is used to define income earned from trade or business carried on by an entity, i.e., income from sale of goods or provision of a service in the ordinary course of its business. Often, there are a number of markers in a transaction that indicate that a trade has occurred. In Nigeria, the Federal Inland Revenue Services (FIRS), in its information circular on “What constitutes trade for tax purposes”[3], listed some of the indictors of a trade to include: profit-seeking motive, repetitive nature of the transaction, and the manner of acquisition and sale of the item. Any income that is incidental to trade is considered part of the trading/revenue income. However, the evidence of one or more of these indicators in a transaction is not always conclusive that a trading activity has occurred.
Based on the above definition, it should logically follow that, any income that is not from trade or business of an entity is capital in nature. However, it is not that simple! Two questions typically arise in this regard:
- Aside from passive investment incomes (e.g., dividend, interest on bonds, etc.), is it possible to disassociate any other income of a company from its trade (directly or indirectly)? Normally, the object clause of a company is as comprehensive as possible, to accommodate all potential business related activities that the company can engage in.
- If the answer to the above question is yes, what is the basis for such separation?
Complicated by law
In Nigeria, and in many other tax jurisdictions, revenue incomes are subject to corporate income tax (CIT). The CIT Act, 2004 (amended in 2007), governs the imposition of CIT in Nigeria. Sections 9(a) and (d) of the CIT Act stipulate that tax is chargeable on “the profits of any company accruing in, derived from, brought into, or received in, Nigeria in respect of‐
- any trade or business for whatever period of time such trade or business may have been carried on;
- any source of annual profits or gains not falling within the preceding categories;…”
The above provisions of the CIT Act suggest that any annual profits or gains of a company, whether from its trading activities or not, should be assessed to CIT, including investment incomes which are listed as taxable incomes in sections 9(c) and 9(d) of the CIT Act.
However, the capital gains tax (CGT) Act, 2004, imposes CGT on gains arising from disposal of chargeable assets. The CGT Act defines a chargeable asset as all forms of property (section 3). Although, the Act does not define the term ‘property’, it however gives examples of it to include: options, debts, incorporeal property, and foreign currencies.
Based on legal precedence, as documented in the Black’s Law Dictionary[4], property is used to “denote everything which is the subject of ownership, corporeal or incorporeal, tangible or intangible, visible or invisible, real or personal; everything that has an exchangeable value or which goes to make-up wealth or estate. It extends to every species of valuable right and interest, and includes real and personal property, easements, franchises, and incorporeal hereditaments [Samet v.Farmers’ & Merchants’ Nat. Bank of Baltimore, C.C.A.Md., 247 F. 669, 671; Globe Indemnity Co. v. Bruce, C.C.A. Okl., 81 F.2d 143, 150]”.
The above definition further exacerbates the debate, especially with regard to companies engaged in the buying and selling of goods. Normal trading inventories will qualify as property, therefore, would the profit from sale of such inventories be subject to CGT or CIT? Additionally, there are some overlaps in the list of taxable incomes under the CIT Act and CGT Act. For example, consideration received for use or exploitation of any asset (i.e., rent, royalty, etc.) is listed as a chargeable income under the CGT Act, as well as under the CIT Act. So, which tax should apply, and in what circumstance?
To address the above questions, the CGT Act makes reference to capital sum received as a qualifier for application of CGT (section 6 of the Act). Essentially, CGT will only apply if a capital sum is received from the sale, lease, transfer, assignment, compulsory acquisition or any other disposition of a chargeable asset. A capital sum received by a beneficiary, even where there is no disposition of a chargeable asset, is also liable to CGT. The Act simply defines capital sum as any consideration received in money or money’s worth, used in the calculation of CGT. This definition encompasses all potential forms of compensation receivable in any business transaction!
What is a capital sum?
From the foregoing, it is obvious that a proper definition or understanding of the term ‘capital sum received’ is central to distinguishing between a revenue and a capital income for tax purposes. Yet, it is difficult to find a proper definition of this term in literature with regard to taxation (the definitions of this term in literature refer to insurance compensation/pay-out).
Over time, a number of principles have been established to distinguish between a revenue sum and a capital sum received for tax purposes. These principles, which are drawn from decided cases and practice in other tax jurisdictions, may provide guidelines in evaluating incomes as revenue or capital. The commonly applied principles are discussed below:
- Existence of a profit motive: This principle is typically applied when there is a disposal of a chargeable asset/property between a seller and buyer (i.e., in trading transactions). If the underlying purpose of a transaction is to make a profit, then the proceeds from such transaction would be revenue in nature, rather than a capital sum. This principle supports the treatment of income from sale of trading inventory as a revenue income.
However, this does not mean that every transaction that results in a profit will automatically be considered as revenue in nature. The motive of the seller would have to be evaluated. For instance, if a company realises a profit from the sale of an asset in line with its normal asset retention/disposal policy, the proceeds from such sale may be considered a capital sum. Conversely, if the asset was sold purely because of its high market value, the proceeds from the sale will be a revenue income.
The application of this principle has been established in a number of judicial decisions, globally. For example, in the case between the Commissioner for the South Africa Revenue Service (CSARS) and Founders Hill (PTY) LTD (FH) [CSARS v Founders Hill (case no. 509/10) [2011] ZASCA 66 (10 May 2011)], the Supreme Court of Appeal of South Africa (SCA) ruled that the income earned by FH from disposal of surplus land was revenue in nature, due to the fact that a profit motive was established from the arrangement of the sale. In this case, the respondent (FH) was established by its parent company, AECI Ltd, to acquire the surplus land held by the latter solely for the purpose of realizing the land. FH contended that the gains made from the sale of the land was capital in nature because the land was a capital asset held for advantageous disposal, not a stock-in-trade held for profit. The SCA, however, held that the land was a stock-in-trade for the company, because the sole objective of the company was to realise the land on behalf of its parent company.
In a similar case in Nigeria between Arbico Limited (Arbico) and the Federal Board of Inland Revenue (FBIR), [Arbico v FBIR, (case no. 2 All NLR 303) (1996)], the Supreme Court in Nigeria (SCN) held that the profit made by Abico from a single sale of building was a trading profit, rather than a capital profit. The SCN supported the findings of the lower courts that the sale of the building by Arbico was driven by the opportunity to make a profit, which the company did in pursuit of its business objective. Arbico, a building contractor, acquired a piece of land and developed it for the purpose of accommodating its expatriate employees. However, the building was subsequently sold to the Federal Government of Nigeria after completion. The company contented that the income was capital in nature, because it did not arise from its normal business activity, and that the building was a capital asset of the company.
This principle can sometimes be based on subjective evaluation. Therefore, a critical assessment of the facts and substance of the transaction must always be carried out. It is not always sufficient to solely rely on the professed intention of the seller. Some indicators of profit motive include; the repetitive nature and frequency of the transaction, recognition of a super-profit, the accelerated/impromptu nature of the sale, for example, if an item/asset is disposed for a profit before it is fully depreciated or amortised. These indicators are not conclusive evidence in themselves; hence, the circumstance of each transaction must be discussed with the seller before reaching a conclusion.
- Surrogatum principle: This is a Canadian income tax principle, and is typically applied to a compensation received, e.g. for a loss or breach, termination of contract, insurance claims, court settlement, etc. It considers the substance of the event that gave rise to the compensation, and assesses the impact of the event on the business of the beneficiary.
This principle was applied in the case between River Hills Ranch Ltd., Bar M Stock Ranch Ltd., Avalon Ranch Ltd.(collectively referred to as taxpayers) v Her Majesty the Queen (revenue authority) (case no. 2009-1597(IT)G) (2 August 2013)]. The taxpayers received a compensation from their contractor on termination of a contract that led to the complete cessation of their businesses. The Canada Revenue Authority assessed the payment to income tax, but the taxpayers objected to the assessment and argued that the income was capital in nature. The court held that even though the terms of the contract suggested that the compensation was for expenses incurred in providing service to the contractor, the actual substance was that the payment was to compensate the taxpayers for loss of contract which represented their entire business, hence, the income was capital in nature and should be taxed as such.
In essence, if an event materially impacts the operations of a company, or its assets, any compensation received in respect of such event would be deemed a capital sum. On the other hand, if the event does not materially affect the operations or assets of the company, any compensation received will be considered as part of its operating income, and would therefore be treated as a revenue receipt.
- The incidental principle: This principle is used to evaluate incomes that are not related to the disposal of an asset by a seller, i.e., where an income is received by the seller/beneficiary without a corresponding disposal of an asset or property. In applying this principle, it is important to consider how the gain or income originated, and the underlying purpose for/substance of the transaction. In some instances, the impact of the income on the business may also be considered (similar to the evaluation under the surrogatum principle).
This principle was applied by the UK Court of Appeal – Civil Division, in the case between Inland Revenue Commissioners v John Lewis Properties Plc (Case number: A3/2001/1543)[5]. The Court ruled that a lump sum payment received by John Lewis Properties Plc (the tax payer) from a Bank, for surrender of it rights to rental income for a period of five (5) years to the Bank, was a capital income. The court concluded that the substance of the transaction was a temporary sale of interest in the underlying assets (i.e., the landed property) which produced the rental income for the Bank.
The taxpayer owned some properties which it leased to a related party. In 1995, the taxpayer executed a deed of assignment with a Bank to assign its right to receive the rents on the properties for a period of 5 years to the Bank. In return, the Bank paid a lumpsum / upfront amount of £25m, which represented the discounted value of the 5 year rent on the date of the assignment. Also, the tax payer (and its related party) claimed roll-over relief for capital gains on the full amount received. It is important to note that this transaction structure was a well-recognized tax avoidance scheme adopted by property owners in the UK at the time (so that they could pay CGT instead of income tax on potential rental income).
In Nigeria, this principle was espoused in the case between United Dominions Trust (UTD) Bank (Nigeria) LTD (UDTN) v FBIR [(case no. APP/COMM/237) (1 December 1976)]. In this case, the Body of Appeal Commissioners (BAC) held that foreign exchange gain realized by UDTN was revenue rather than capital in nature[6]. UDTN had obtained a long-term pound sterling denominated loan from its parent company, UTD London, to finance the hire-purchase of cars for Government employees. However, due to the devaluation of the English pound sterling, UDTN made an exchange gain on settlement of the loan obligation.
The BAC posited that the loan from UTD London which gave rise to the exchange gain, was obtained by UTDN for the purpose of its hire purchase business and was not intended to form part of the company’s capital structure. The ratio decidendi in this case was a consideration of the intention of the parties with respect to the loan, i.e., whether the loan was intended to form part of the capital structure of the borrower, or to be used as its trading stock or to buy trading stock.
Conclusion
Based on the above, there is an urgent need for the Nigerian tax authority to, as much as possible, clarify the rules for identification of capital and revenue incomes for tax purposes. However, the principles discussed above should serve as a guide to the tax authority and tax payers when evaluating various business incomes for tax purposes, subject to express limitations imposed by the relevant pieces of legislation. A careful, contextual and dispassionate application of these principles will help parties reach an agreeable position in cases of disputes regarding proper classification of income for tax purposes. The correct decision must be based on the facts of the transaction, not on conjecture of the parties.
[1] https://www.supremecourt.uk/about/former-justices.html
[2] This case is discussed in a subsequent section of this article.
[3] FIRS information circular no. 2010/02
[4] The Black’s Law Dictionary, Revised Fourth Edition, Henry Campbell Black, M.A., 1968, Page 1382
[5] Citation/reference: Court of Appeal – Civil Division, December 20, 2002, [2003] Ch 513,[2002] EWCA Civ 1869,[2003] STC 117,[2003] 2 WLR 1196
[6] We did not find evidence that this judgement was subsequently appealed by the tax payer to superior courts.
