By Simbarashe Hamudi
COMPANIES often make prepayments because suppliers may require payment before they provide the goods or services.
This is common in the insurance industry, where policyholders typically pay premiums before the insurer covers the insured risk.
Prepayments also occur in other transactions, such as licensing arrangements, where a tenant may pay in advance to secure the right of use. In addition, customers may choose to prepay to obtain discounts or to benefit from economies of scale.
Even though prepayments are widespread, not all taxpayers understand how prepaid expenses should be treated for income tax purposes. The purpose of this article is to unpack the income tax treatment of prepaid expenses, with special focus on the law applicable both before and after January 1, 2018, because that date marks an important legislative amendment affecting this type of expenditure.
Before January 1, 2018, the Income Tax Act did not contain a specific provision that dealt directly with the income tax treatment of prepaid expenditure. Taxpayers instead relied on the general deduction rule in section 15(2)(a) of the Income Tax Act. That provision allows a deduction for expenditure or losses incurred in the production of income or for the purposes of trade, provided the expenditure is not of a capital nature.
While prepaid expenditure may appear to meet the general requirements, the real issue was not merely whether it was incurred for business purposes, but whether it could be said to be “incurred” in the year in which the payment was made. For that reason, the meaning of “incurred” became central to determining whether a taxpayer could claim an immediate deduction.
The court’s decision in Edgars Stores Ltd v CIR (1988) clarified that an expenditure is treated as actually incurred when the taxpayer is under a legal and unconditional liability to make payment, even if the actual payment occurs after the end of the relevant tax year. This approach ensured that deduction depends on when the taxpayer becomes legally obligated to pay, not necessarily when the money is released.
Prepaid expenses were generally disallowed for the periods prior to January 1, 2018 in circumstances where the payment was made before the legal obligation to pay had arisen. The logic was that the expenditure would only be incurred when it became due and payable, rather than at the time the taxpayer advanced payment. As a result, taxpayers who claimed deductions immediately upon prepayment faced a significant risk of having those deductions denied when the tax position was assessed under the older rules.
After January 1, 2018, the treatment of prepaid expenditure became more certain because the Income Tax Act introduced an additional legislative provision. The deductibility of prepaid expenditure was then governed by section 15(2)(a)(ii), which provides for the apportionment of prepaid expenses. Under this rule, prepaid expenditure is deducted over the years of assessment in which the goods, services, or benefits are used up. This apportionment ensures that the tax deduction occurs in the correct tax period, rather than being claimed entirely in the year the payment is made. In effect, this legislative change brings the income tax treatment closer to the economic reality of the transaction, by aligning deductions with the timing of consumption or utilisation of the prepaid benefit.
The apportionment method also helps mirror the way businesses match revenue and expenses. When a taxpayer pays in advance for something that will be provided over time, the accounting treatment typically spreads the expense across the relevant periods in which the benefit is received or used. The post-2018 tax rule therefore supports a consistent approach: prepaid expenditure is not simply ignored until the supplier performs; instead, it is deducted gradually as the benefit is used. This reduces the likelihood of disputes that existed under the pre-2018 position, where the “incurred” requirement often created uncertainty and disagreements.
The legislative amendment did not only address prepaid expenses; it also changed how taxpayers should treat income received in advance, or prepaid income. In general, income tax is based on the earlier receipt and accrual. However, the tax system does not intend that the same income should be taxed twice. Accordingly, where an accrual is properly reflected in a return, the Commissioner’s practice has been to tax the accrual and not wait for the subsequent receipt. This prevents double taxation and ensures the taxable event is recognised correctly in the relevant year.
With effect from January 1, 2018, prepaid income received for goods, services, or benefits that will be used up in a subsequent year of assessment is excluded from gross income for the current year. The consequence is that the prepaid income is taxed later, when the amount becomes legally due, again aligning taxation more closely with the period to which the income relates.
In conclusion, prepaid expenses are not necessarily immediately deductible for income tax purposes, regardless of when the payment is made. The key difference between the pre-2018 and post-2018 positions is the mechanism used to determine when deductions are allowed. Before January 1, 2018, deductions were heavily dependent on whether the expenditure had been “incurred”, with emphasis on the existence of an unconditional legal obligation to pay. After January 1, 2018, section 15(2)(a)(ii) introduced a clearer rule requiring taxpayers to apportion prepaid expenses over the periods in which the related benefits are used up. The accounting treatment of prepayments as current assets at the time of payment, followed by recognition as expenses when the obligation matures, is therefore broadly reflected in the tax outcomes as well.
Taxpayers are therefore advised to align their tax treatment of prepaid expenses with the law applicable to the relevant period. For tax years prior to January 1, 2018, the stricter interpretation relating to when expenditure is incurred must be carefully applied to avoid under-reporting or incorrect deductions. For periods after the amendment, taxpayers should take advantage of the clearer apportionment approach by matching deductions to the years in which the goods, services, or benefits are consumed.
Where prepaid income is involved, the post-2018 rules should also be considered so that prepaid income is taxed in the correct future year rather than too early, thereby reducing the risk of penalties and preventing tax adjustments arising from an incorrect timing approach.
Hamudi is Tax Partner at Baker Tilly Central Africa, based in Harare, Zimbabwe. He can be contacted at +263 775 399 536 or simbarashe.hamudi@bakertilly.co.zw