Expenses pertaining to exempted tax income

Muscat: Continuing with KPMG’s contribution to a fortnightly series of articles on tax issues, this week, we discussthe tax treatment of expenses incurred by earning tax exempt income.
As a general principle, tax laws in most jurisdictions allow expense deduction actually incurred by a taxpayer to earn taxable income.
In the Omani context, Article 54 of Omani tax law, while allowing such expense deduction, expressly restricts deduction of expenditure, if corresponding income is tax exempt. Income in this context is usually the ‘active income’ of the taxpayer, which entails incurrence of legitimate expenditure so as to earn such income. However, there are certain ‘passive incomes,’ such as dividends, interest that are incidental to passive activities. For such‘passive incomes,’there is often a challenge in determining expenses for such an income.
Under the law, income from certain activities, as well as passive activities is exempt from tax.
The issue that is often debated with the tax authorities is the quantum of expenses attributable to such exempt incomes. While there are certain expenditures directly attributable to such passive incomes(for example, interest paid on borrowed capital utilised towards making investments), the challenge arises in allocating general and administrative expenses.
In the absence of any prescribed mechanism in the law, tax authorities use their judgment to attribute such expenses to exempt passive income. The argument that such expenses should not be attributed to passive activities, particularly when they are incidental to the taxpayer’s primary and significant activity, which is subject to tax, has not found favour.
In respect of dividends, the tax authorities have generally attributed general and administrative expenses using an ‘asset based approach,’by computing a ratio of investments generating dividends for the total assets of a company.
In some recent cases, tax authorities have also adopted an ‘income based approach,’i.e. the ratio of dividend income to total income, resulting at times in a higher dis-allowance at the hands of taxpayers. In the context of passive investment incomes, this income-based approach to computing expenditure dis-allowance is not sound as it does not factor the key premise that the taxpayer’s control is limited only over the underlying investments and not over income yielded from such investments, the latter being independently decided by the board of directors of the investee companies.
Considering that the quantum, periodicity, and most importantly the certainty of earning passive income is beyond the control of the investing taxpayer, the application of this income-based formula could give absurd results in different tax years. It needs to be also appreciated that the incurrence of general and administrative expenses are often of a fixed nature incurred on a continuous basis regardless of any income being earned.
A more appropriate approach would be to adopt the asset-based approach. Further, one should take the average of such exempt investments and total assets,both reflected in their original cost, ignoring fair value adjustments as per accounting standards’ requirements.
In the case of unlisted securities, since income from their disposal is taxable, it becomes imperative that part of the expenditure, arrived at in accordance with the asset-based approach discussed above, should be considered as attributable to the taxable gains arising at the time of disposal.
Accordingly, an equitable and transparent formula should be considered by the tax authorities on these lines to ensure consistency in tax treatment of both income streams i.e. dividends and capital gains across the life of investment.
Certain threshold could be considered in cases where the tax payer’s primary and significant activity is subject to tax, below which no dis-allowance of any indirect general and administrative expenses are made.
Until Oman’s tax authorities formally introduce rules and prescribe a fair formula to compute such dis-allowance as prevalent in other tax jurisdictions, the asset-based approach should be adopted as a fair and acceptable basis so as to provide certainty to taxpayers and promote anon-adversarial tax regime in Oman.