To: Breaking News From: Legal Advisor Date: 24 May 2024 Re: Deductibility of Certain Expenditures under Section 33(1) of the Income Tax Act 1993
Introduction
This legal opinion addresses the request from Breaking News, a local private television station, concerning the deductibility of two specific expenditures for the purposes of calculating its taxable income. The expenditures in question are (a) a contribution of M345,000 towards the rehabilitation of a house for an individual affected by a storm, and (b) legal costs of M150,000 incurred in an unsuccessful defence against a breach of industry regulations.
The central legal issue is whether these expenditures fall within the scope of the general deduction formula provided in section 33(1) of the Income Tax Act 1993 of Lesotho (ITA 1993). Specifically, this opinion will critically discuss whether each expenditure can be considered as having been incurred "in the production of income". This analysis will be based on the interpretation of the statute and relevant principles established in case law, primarily from jurisdictions such as South Africa, whose jurisprudence is highly persuasive in Lesotho.
The General Deduction Formula: Section 33(1) ITA 1993
Section 33(1) of the ITA 1993 provides the primary test for the deductibility of business expenses. It states:
> "Subject to this Act, in ascertaining the taxable income of any person for any year of assessment, there shall be deducted from the income of such person all expenditure and losses, not being expenditure or losses of a capital nature, wholly, exclusively and necessarily incurred by such person during the year of assessment in the production of his income."
For an expense to be deductible under this section, it must satisfy several cumulative requirements. The expenditure must:
- Not be of a capital nature;
- Be "wholly, exclusively and necessarily" incurred for the purposes of trade; and
- Be incurred "in the production of income".
This opinion focuses on the third requirement, as it is the most contentious in relation to the expenditures made by Breaking News. The phrase "in the production of income" has been the subject of extensive judicial interpretation. The leading authority is the South African case of Port Elizabeth Electric Tramway Co Ltd v Commissioner for Inland Revenue (1936), which established a crucial two-part test. The court held that one must consider:
- What was the purpose of the expenditure? In other words, what did the expenditure actually effect?
- Is there a sufficiently close link between the expenditure and the income-earning operations of the business?
The expenditure must be a necessary expense in the performance of the operations from which the taxpayer earns income. It must not be too remote from the source of income.
(a) The M345,000 Contribution for House Rehabilitation
Breaking News wishes to deduct the M345,000 contributed towards rebuilding the house of an old lady whose home was destroyed. This expenditure must be tested against the principles of section 33(1).
The argument in favour of deductibility would be that this contribution constitutes a form of public relations or marketing. As a television station, Breaking News relies on its public image and viewership to generate advertising revenue. By making this charitable donation and potentially reporting on it, the station could enhance its reputation as a socially responsible corporate citizen. This enhanced goodwill could, in theory, attract more viewers and, consequently, more advertisers, thereby leading to the production of income. From this perspective, the expenditure is not pure altruism but a strategic act designed to promote the business.
However, this argument faces significant challenges. The tax authorities are likely to argue that the connection between the expenditure and the production of income is too remote. The primary purpose of the payment appears to be philanthropic. While a secondary benefit of positive publicity may exist, the "wholly and exclusively" requirement in section 33(1) is strict. If an expenditure has a dual purpose, one for business and one for another reason (such as benevolence), it is generally not deductible unless the non-business purpose is merely an incidental and minor consequence. In this scenario, the charitable motive seems to be the dominant, if not sole, purpose.
In Commissioner for Inland Revenue v Nemojim (Pty) Ltd (1983), the court affirmed that the purpose of the expenditure is critical. If the purpose is not to produce income, the expense is not deductible, even if income happens to result from it. Here, the immediate purpose was to provide aid, not to launch a marketing campaign. The link to future income is speculative and indirect. It is an expenditure incurred out of social conscience rather than as a direct cost of conducting broadcasting operations.
Therefore, it is highly probable that the Lesotho Revenue Authority would disallow this deduction. The expenditure would likely be classified as a charitable donation made for reasons of social responsibility, not as an expense incurred "in the production of income". The connection to the station's income-earning activities is not sufficiently close to satisfy the test in Port Elizabeth Electric Tramway.
(b) The M150,000 Legal Costs for Breach of Regulatory Rules
Breaking News incurred legal costs of M150,000 while defending itself against an action brought by the Lesotho Communications Authority for a breach of regulatory rules. The station ultimately lost the case.
The deductibility of legal expenses generally depends on the nature of the action being defended. If the expenses are incurred to protect a taxpayer's existing business or its income-earning operations, they are typically considered to be incurred in the production of income. For example, legal costs to recover a trade debt would be deductible.
The issue here is complicated by the fact that the legal action arose from an alleged unlawful act, and the defence was unsuccessful. The established principle is that expenditure related to a taxpayer’s illegal activities is not deductible. Fines and penalties for breaking the law are not considered to be incurred for the purpose of trade, as it would be contrary to public policy for the state to subsidise unlawful conduct through tax deductions (Commissioner for Inland Revenue v Delagoa Bay Cigarette Co Ltd 1918).
The key question is whether the legal costs associated with an unsuccessful defence against such an action can be separated from the penalty itself. The authoritative South African case of Income Tax Case 1185 (1972) provides clear guidance. In that case, a taxpayer was charged with contravening a price control regulation. He incurred legal costs in unsuccessfully defending the charge. The court held that these legal costs were not deductible. The reasoning was that the expenditure was not a necessary part of the taxpayer's business operations. The court stated that conducting a trade does not involve breaking the law; therefore, the costs associated with the consequences of breaking the law are not incurred "in the production of income". The expense was connected to the unlawful act, not to the legitimate business of the taxpayer.
Applying this principle to the situation of Breaking News, the station was found to have breached the regulatory rules governing its industry. The breach itself is not part of its income-producing activity. The legal costs were a direct consequence of this breach. As the defence was unsuccessful, the costs are inextricably linked to the unlawful conduct. They were not incurred to protect the station's legitimate income-earning operations but were a result of stepping outside the legal framework within which those operations must be conducted.
Therefore, the M150,000 in legal costs is not a deductible expense under section 33(1). The expenditure was not incurred as a necessary concomitant of the station's trade but as a consequence of its failure to comply with the law.
Conclusion
Based on an analysis of section 33(1) of the ITA 1993 and the relevant case law, the legal opinion is as follows:
- The M345,000 Contribution: This expenditure is unlikely to be deductible. Its primary purpose appears to be philanthropic, and the link to the production of income is too remote and speculative to satisfy the "in the production of income" test. It also likely fails the "wholly and exclusively" test due to its dual purpose.
- The M150,000 Legal Costs: This expenditure is not deductible. As the legal costs were incurred in the unsuccessful defence of an action for breach of industry regulations, they are considered a consequence of an unlawful act, not an expense incurred in the production of income.
Breaking News should therefore be advised not to claim these amounts as deductions when calculating its taxable income for the relevant year of assessment.
References
Commissioner for Inland Revenue v Delagoa Bay Cigarette Co Ltd 1918 TPD 391.
Commissioner for Inland Revenue v Nemojim (Pty) Ltd 1983 (4) SA 935 (A).
Income Tax Case 1185 (1972) 35 SATC 122.
Lesotho. (1993) Income Tax Act 1993.
Port Elizabeth Electric Tramway Co Ltd v Commissioner for Inland Revenue 1936 CPD 241.
