In some cases, businesses enter into various trade agreements that require legal documents such as contracts, partnership deeds etc.
Mostly, such documents usually detail the terms and conditions which generally informs the arrangement of the transactions. However, due to changes in tax laws such legal documents may end up not being aligned to the provisions of the tax laws, thereby not giving an accurate image of the true transaction on hand.
On the other hand, legal documentation may actually be crafted in a way that hides the true nature of transactions. Consequently, such transactions may result in taxpayers inadvertently failing to pay tax which may trigger penalties in case of a tax audit. It is therefore imperative that taxpayers consider the substance of the transaction when making critical decisions to avoid any arising penalties. Keep on reading and allow us to help you understand the importance of the substance over form principle in making crucial business decisions. In this article, words importing the masculine shall be deemed to include the feminine.
Substance over form
Generally, the substance over form principle ensures that the actual economic reality of any transaction takes precedence over any form in which the transaction is crafted or implemented. The principle is used in a wide range of situations including financial reporting. The said principle is adopted to ensure that entities provide an accurate and complete overview of their events and transactions to their stake holders. Accordingly, this allows priority consideration to be given to the economic impact of a transaction instead of its legal form, which could conceivably mislead people on its true intent. Simply put, the economic reality of a transaction denotes the substance whereas, the legal reality denotes the form. Hence, the courts of law as well as BURS considers the substance over form in tax matters.
Why the substance?
As alluded to above, giving priority regard to the legal or actual form that the actual economic impact of a transaction or agreement may actually mislead stakeholders of any transactions including tax authorities. Therefore, the said principle allows BURS to ignore an arrangement’s legal form and examine its actual substance, with the goal of preventing artificial structures from being used to avoid paying taxes. Based on this analogy, it is crucial for businesses and individuals to ensure that they consider the economic reality when venturing into business deals or new transactions or arrangements before a decision is made.
In most circumstances, tax authorities adopt the substance over form principle to restrict taxpayers from designing transactions on paper that result in an undue tax gain. As an example, Tiro a tax consultant may offer monthly tax services of P11,000 to his landlord and thereafter arrange to offset with his monthly rent of P10,000. Tiro will then have a lease that requires him to pay P1,000 to his landlord and deduct rent withholding tax of P50 instead of P500 (P10,000*5%). As you can see the economic reality is that Tiro is paying rent of P10,000 and liable to pay withholding tax of P500. However, the legal form states that Tiro is supposed to pay P1,000 and deduct P50 withholding tax resulting in gross underpayment of tax. Consequently, a tax audit may unearth such an arrangement resulting in penalties for both Tiro and his landlord.
Essentially, the substance over form is a key principle that should be applied in business arrangements. Relying entirely on legal documents may mislead decision makers which may result in additional taxes and penalties.
Well folks, we hope that was insightful. As us the two Yours Truly say goodbye, remember to pay to Caesar what belongs to him. If you want to consult, join our free Tax WhatsApp group or to know about our 9 Tax e-books, send us a text on the cell number below. You can read more tax articles on our website, www.aupracontax.co.bw under the ‘Tax articles’ tab.