The income tax position on prepaid expenses

By Simbarashe Hamudi

COMPANIES tend to make prepayments because suppliers may insist on receiving payments before they make a supply. This is often a custom in the insurance industry, where they request for premiums before the insurer covers the insured against a risk.
Also, licences are often paid for in advance before granting right of use to the tenant. Customers may also make prepayments because they want to benefit from discounts and economies of scale.

Although prepayments constitute a very popular expenditure for most entities; some taxpayers are not conversant with how the expense is treated for income tax purposes. The purpose of this article therefore, is to unpack the income tax rules on prepaid expenses focusing on pre- and post-January 1, 2018 to help such taxpayers. The date January 1, 2018 is key in the discussion because the country effected legislative amendment on this date specific to this type of expenditure.

Prior to January 1, 2018, there was no specific provision which dealt with income tax treatment of prepaid expenditure as this could only be tested against the old general deduction formula, section 15 (2) (a) of the Income Tax Act (Chapter 23:06).
The section provided for deduction of expenditure or losses incurred in the production of income or for the purposes of trade exclusive of capital nature expenditure.
While prepaid expenditure would certainly satisfy most of s15 (2)(a) conditions, the only matter for consideration was whether the expenditure was deemed incurred in order for it to qualify for immediate deduction.
To this end, the definition of incurred is an important consideration in order to understand the income tax status of prepaid expenditure prior to January 1, 2018. It was held in ITC 542, 13 SATC 116 that “the words ‘expenditure actually incurred’ means (1) moneys actually paid out; or (2) moneys which a trader is legally liable to pay”.
The cases Nasionale Pers Bpk v KBI 1986 (3) SA 549 (A), 48 SATC 55 and Edgars Stores Ltd v CIR 1988 (3) SA 876 A, 50 SATC81, further held that an expenditure is actually incurred if the taxpayer is under a legal, unconditional liability to effect payment, even though the actual payment may only be made after the end of the relevant tax year.
Yet the problem with prepaid expenditure is that it is paid in advance of its due date. It was held in DEB (PVT) LTD vs Zimra that the premature discharge of a contingent liability in the preceding tax year simply meant that the taxpayer was discharging a liability that had not yet been incurred.
For this reason, prepaid expenditure is expenditure, which is conditional upon the happening of future uncertainty and is only incurred once such an event is has been fulfilled and this is when the taxpayer has become liable to pay the amount. It was also held in MAN V Zimra HH 78-20 that an incurral constitutes an unconditional legal obligation to pay.

Finance Minister, Mthuli Ncube

Therefore, one cannot be legally obliged to pay amounts that would be due and payable in the subsequent tax year. It can therefore, be concluded that prepaid expenses were disallowed for the periods prior to January 1, 2018 on the basis that the expenditure would be incurred when the payment became due and payable.
Meanwhile, the deductibility of prepaid expenditure post-January 1, 2018 is governed by an additional legislative content contained in section 15 (2) (a) (ii) of the Income Tax Act. The provision provides for the apportionment of prepaid expenses in the determination of taxable income over the years of assessments in which the goods, services or benefits are used up.
The effect is to deduct prepaid expenses in the tax period the expenditure relates in line with accounting practice which matches revenue and expenses to their respective periods.

Therefore, expenditure in respect of income to be received or accrued in the future years of assessment is reported when such income is accrued or received.
The provision brought about certainty in the income tax treatment of prepaid expenditure, thereby reducing any tax dispute, which characterised the period prior to January 1, 2018.
The amendment also brought about changes to the treatment of income received in advance or prepaid income. While it is an accepted general practice that income is taxed based on the earlier receipt and accrual, it is never intended that it should be taxed twice.
Therefore, when an accrual is disclosed in any tax return, the practice of the Commissioner is to tax the accrual and not to wait for the subsequent receipt which could happen in a future year.
With effect from January 1, 2018, however, prepaid income received for goods, services or benefits that will be used up in any subsequent year of assessment will not form part of gross income for the current year of assessment.
The implication of the exclusion is that it will only be taxed when the amount becomes legal due to the supplier thereby matching the tax practice to the accounting practice of accounting for income in the year in which it relates.
In conclusion, prepaid expenses are not immediately deductible for income tax purposes no matter the tax period.
In essence, the International Accounting Standard number 1 (IAS 1) is the basis for a prepayment being recorded as a current asset in the period of payment, and being later on recognised as an expense when the obligation to pay the expense falls due.
Hence, no adjustment is needed for tax if a prepayment is not recognised as an expense in the year of payment. In the same manner the amendment to the prepaid income rules also aligns tax and accounting practice.
You are therefore advised to align your treatment of prepaid expenses with the law especially for the period prior January 1, 2018 to avoid penalties emanating from non-compliance with the law and to take advantage of the new law by deferring taxation of prepaid income to the future period.
Hamudi is a tax partner at Baker Tilly. He can be contacted at simbarashe.hamudi@bakertilly.co.zw or +263 775399536