The Gross Up Clauses in Commercial Leases Within the Context of WHT Regime in Nigeria

Proshare

Sunday, 21 December 2014 4.49 PM / By Olumide K. Obayemi and Esther I. Dejo-Ojomo

 

I.         Introduction

Generally, where one party to a transaction is uncertain as to the tax consequences, he may endeavour to shift his income tax risk to the other. Whether ' such a tax-shifting covenant can be arranged depends primarily on the bargaining positions of the parties. Whenever such tax-shifting covenants become a part of the bargain, the practical effect is to substitute the financial ability of the obligor for the uncertain tax risk.

 

It is very common with commercial lease transactions, all over the world, for the landlord to gross up the rents and/or operating expenses payable by the tenant. Nigeria is not left out as the decision in Total (Nig) Plc v. Moshood Adeleye Akinpelu (2004) 17 NWLR (Pt. 903) 509 has shown. İn fact, the divergent views posited by several tax practitioners on the legality and tax implications of gross up clauses have made the topic highly contentious all the more. On the one hand is the view of Messrs Olaniwun Ajayi, LP in their seminal collection titled Legality of Gross-Up Clauses in Nigeria as contained in legal Aspects of Finance in Emerging Markets (2005). On the other spectrum is that of Harvard-trained Afolabi Elebiju in his work: “Withholdig Tax: The A-Z of Grossing Up” in ThisDay Lawyer of Tuesday, February 16, 2010. Still, there is the view of Bidemi Olumide Olowosile in “”Re-Visiting Total v. Akinpelu- Filling the Gaps to Build the Taxpayer's Haven.”. Gross-Up clauses are not exclusive to leases alone, they occur in the context of salaries payable to expatriates and foreign consultants  as well as in PAYE income tax regimes

 

As would be seen below, the decision in Total v Akinpelu is at total variance with the decision in U. S. v. Boston & M. R. R., 279 U. S. 732 (1929) was also handed down by the United States Supreme Court in a case in which a lessee covenanted to pay specified rentals plus all the lessor's income taxes upon the rental. The lessor was held to have received taxable income amounting to the specified rental plus the income taxes thereon.

  

U. S. v. Boston, we submit, is good law and ought to be followed by all courts in Nigeria.

 

In the United States, gross-up clauses are employed in commercial leases to govern allocation and collection of operating expenses (i.e., fixed and variable expenses). Yet, property tax relief available under tax laws are another reason why landlords in the United State insert Gross Up clauses in leases. According to Edwards Wildman LLP:

 

Property tax relief arising as a result of increased vacancy may enable a landlord to modify its approach to recovery of operating expenses from tenants. Because of the expanding availability of such relief and the increasing frequency in which it is pursued, real estate taxes are most appropriately characterized as a variable expense when passed through to tenants pursuant to a ‘gross-up’ clause.”

 

We examine the nature of gross up clauses and their interplay with the Withholding Tax (WHT) system in Nigeria, the legality and otherwise and their tax implications within the background of Nigerian and other contemporary common law countries’ legal systems and posit that the system be retained since both parties to the lease derive benefits therefrom.

 

II.       Nature of Gross Up Clauses

In Nigeria, a typical Gross Up Clause in a lease is used to accelerate the total rents payable by the tenant as well, as to shift, to the tenant, all the taxes, levies and other charges on the property, and it usually reads thus:

 

To Pay all existing and future taxes, rates, assessments and outgoings of every description to which the premises, or the lessor or lessee in respect of the premises are or is or shall hereafter be liable.”

 

In the United States, the Gross Up Clause only covers the operating expenses where the building is not fully occupied. Unlike Nigeria, the American lessee does not need to pay the landlord’s taxes to the taxing authorities. The tenant may only need to pay part of the operating expenses of the vacant property just as if the property is fully occupied. Such a clause usually reads thus:

 

In the event that during all or any portion of any year during the term, the Building is not fully rented and occupied, Landlord shall make an appropriate adjustment in expenses that vary with occupancy for such year for the purpose of avoiding distortion of the amount of such expenses to be attributed to Tenant by reason of variation in total occupancy of the Building, by employing consistent and sound accounting and management principles to determine the amount of such expenses that would have been paid or incurred by Landlord had the Building been atleast ninety-five percent (95%) rented and occupied, and the amount so determined shall be deemed to have been such Expenses for such year.

 

The rationale forming the basis of the Gross Up provision is the desire of landlords to simulate an environment where the building is fully-leased with rent-paying tenants who are incurring all the variable expenses of the building, and so, a landlord will prefer that its tenants absorb all of the variable expenses of the building so that the landlord isn’t paying the expenses for the vacant space. Though this practice, at first glance, appears to  unfairly shift the downside of vacancy to the tenants, it is customary in most office submarkets and it is generally viewed among legal practitioners and businesspeople as equitable to both the landlord and the tenant.

 

III.      The Withholding Tax Regime in Nigeria

İn Nigeria, the Withholding Tax (WHT) regime is an advance payment of income tax which can be used to offset tax liability of a tax payer at the end of the period. A principle introduced into the Nigerian tax system more than 50 years ago, which from only applying to dividend, has now been extended to cover other investment incomes (i.e. interest and rent/royalties), services (i.e. consultancy, technical, management) and all contract arrangements via series of legislative amendments to the then principal legislation on companies income tax, petroleum profit tax and personal income tax. While it is not a separate form of tax, it is a collection mechanism adopted by the Tax Authorities to reduce the incidence of tax evasions/fraud by taxable person, and it helps to bring obscure transactions to the notice of tax authorities. Further, it makes tax payment less cumbersome to the taxpayer who may not have to bother himself going to the tax office and ensures a regular flow of tax revenue to the government, while, at the same time, reducing incidence of tax evasion. It enhances voluntary compliance, and it is compulsory payment on any relevant income in which WHT is applicable and must be paid by the person making a payment to a third person as he becomes an unpaid agent of the Relevant Tax Authority. Such a payment must be evidenced by a WHT credit note in the name of the person from whom deduction has been made.

 

As Elebiju rightly noted, there are essentially in pari materia provisions in Sections 69-75 of Personal Income Tax Act, Cap P8, Laws of the Federation of Nigeria (LFN) 2004 and amendment thereto (PITA), Sections 78 – 84 of the Companies Income Tax Act, Cap C21, LFN of 2004, (CITA), Sections 54 & 56 of Petroleum Profits Tax Act, Cap P13, LFN (2004); and Sections 30 & 40 of the Federal Inland Revenue Establishment Act No. 13 of 2007 (“FIRSEA”), together with the Rates e.t.c of Tax Deducted at Source (Withholding Tax) Regulations WHT Regulations made pursuant to CITA and PITA respectively.

 

Of particular importance are the following provisions governing WHT systemns which directly affect and/or implicate gross up clauses in leases as was in contention in Total v. Akinpelu

 

i.        Section 69(3) of the Personal Income Tax Act which provides that:

 

“In accounting for the tax so deducted to the relevant tax authority, the payer shall state in writing the following particulars which shall accompany the remittance, that is-

a.   The gross amount of the rent;

b.   The amount of tax being accounted for

c.   The name and address of the recipient and the period for which the rent has been paid or credited; and

d.   The address or accurate description of the location of the property concerned.”

 

ii.   Regulation 2 of the Personal Income Tax (Rates e.t.c of Tax Deducted at Source (Withholding Tax))Regulations which provide that:

 

“A deduction made from a payment shall not be regarded as an additional cost of the contract to be included in the contract price but as a tax due on the payment.”

 

iii.       Regulation 3 of the Personal Income Tax (Rates e.t.c of Tax Deducted at Source (Withholding Tax)) Regulations stipulates that:

 

“A person who deducts tax from a payment shall issue a receipt for the tax so deducted and a statement containing the following information, that is-

 

a.    The name and address of the person from whom the tax was deducted;

b.    The nature of activity or service in respect of which the payment was made;.

c.    The gross amount paid or payable

d.    The amount of tax deducted;

e.    The period to which the payment relates”

 

IV.       Transactions Subject to WHT and Applicable Rates in Nigeria

 

For ease of reference, it is better to outline the transactions subject to WHT in Nigeria and the applicable rates.


V.        Rules of Interpretation of Tax Statutes

 

The filed of taxation law is a specialized one which is subject statutory rules since taxation is creation of statutes. Thus,  over the years, the Courts have adopted certain canons of construction and interpretation in this regard. For instance, where there is doubt, it is resolved in favour of the taxpayer. If the doubt is with respect to an exempting provision, that provision is construed strictly and any ambiguity is construed against the taxpayer. Littman v. Barron (1951) 33 TC 373.

 

According to Abiola Sanni, any such ambiguity had to be construed in favour of the tax payer. Thus, where silence became ambiguity then it should not be construed against the tax payer. (Abiola O. Sanni: “Interpretation of Tax Statute: An Examination of the Supreme Court Approach” in Guobadia, D. A. & Adekunle, A (ed) Uwais Court: The Supreme Court and the Challenge of Legal Development (Abuja: NIALS Press, 2006) 74). In Seaford Hot Estates Ltd vrs Asher [1949] 2 KB 481, it was held that a court faced with such a situation need not lament but should enforce the tax payers right to property (interest) in money held by the Revenue for so long no matter whether the tax payer was a defaulting one.

 

There is also the Strict Construction Canon under American Approach. Although not quite as old as the rule of lenity, a well-established canon is that ambiguity in statutes that impose tax liability, not just penalties, are construed against the drafter. The seminal case in that area is Gould v. Gould, 245 U.S. 151, 153 (1917), in which the Supreme Court held:

 

In the interpretation of statutes levying taxes it is the established rule not to extend their provisions, by implication, beyond the clear import of the language used, or to enlarge their operations so as to embrace matters not specifically pointed out. In case of doubt they are construed most strongly against the Government, and in favor of the citizen. 245 U.S. 151, 153 (1917).

 

That canon has also been applied in the context of regulations. Falconwood Corp. v. United States, 422 F.3d 1339, 1348 (Fed. Cir. 2005) (following Gould in interpreting reg. section 1.150275(d)(2)(ii)).

 

In contrast, rules that provide tax exemptions are strictly construed in favor of the government. Helvering v. Northwest Steel Rolling Mills Inc., 311 U.S. 46, 49 (1940).

 

VI.     Total (Nig) Plc v. Moshood Adeleye Akinpelu

The facts in Total v. Akinpelu are straightforward. In 1957, Late Bello Akinpelu had enterred into a Head Lease with Jean Wadu Gamra over a parcle of land at Mokola, Ibadan for a term of yars. Subsequently, Gamra, the Head-Lessee demised the residue of his lease of 50 years to Total vide a sublease. Contained in the Head-Lease were certain convennats that were enforceable against the lessees. Clause 2(2) of the Head-Lease containing the obligations of the sub-lessee to the Head-Lessor read thus:

 

To Pay all existing and future taxes, rates, assessments and outgoings of every description to which the premises, or the lessor or lessee in respect of the premises are or is or shall hereafter be liable.”

 

A supplemental lease was made subject to the above Clause 2(2) of the Head lease, and which reduced the period of revision of payable rent in the Head-Lease from 20 years to 10 years with rent at NGN135,000 per annum. Thus, for the period between 1996 and 2006, the rent due was calculated at NGN1,350,000.00.

 

The Head-Lessor died testate, and Moshood Akinpelu became the new Head-lessor. For the 10-year lease of 1996-2006, Total offered to pay NGN1,350,000.00, less the 10% withholding tax as imposed by Section 68 of PITA, since it would be criminally liable if it were to fail to deduct withholding tax. Moshood Akinpelu diagreed claimin that under Clause 2(2), Total was contractually obligated to pay all existing and future taxes, rates, assessments and outgoings of every description

 

The matter went to trial at the Ibadan High Court and the court held that Total was obligated to pay the full rent and the applicable 10% withholding tax, a total of $1,485,000.00. On appeal to the Court of Appeal, Total argued that the Section 68(1) of PITA iposes a legal obligation on Total to withhold 10% of the total rent payable with a criminal sanction for non compliance. In effect, Clause 2(2) of the lease has been frustrated by Section 68 of PITA.

 

In contrast, Akinpelu argued that the provision of Section 68 of PITA operates to point to Total where his duty lay, because if the 10% payabe on the income received on the rent had been built into the rent, Total would still have paid it and it would be of little concern to the FIRS as to the identity of the party making the payment of the WHT.

 

The Court of Appeal, per Honourable Justice Omage held that the obligation of Total to pay the grossed up amount of NGN1,485,000.00 was not frustrated by Section 68 of PITA. He also held that the tax statute is neutral as to the source or burden of payment of the WHT.

 

It is sufficient to say the statute  (Section 68 of PITA) did not compel the source of the money paid as tax.” Per Justice Omage in Total v Akinpelu,  (2004) 17 NWLR (Pt. 903) 509 at Page 522 Para.G

 

Further, Justice Omage also appeared to have held that the Statute needed to have stated expressly that the lease would be frustrated if the lessee is liable to a crimninal penalty:

 

In resolving the issue whether the clause in the covenant in the Deed previously referred to has been frustrated by the provisions of Decree No. 104, Section 68(1), or put in another way, does Decree No.104, which imposes a criminal sanction on the appellant, if he did not pay direct the appellant not to make payment of the 10% withholding tax on behalf of the respondent; the receiver of the rent; in accordance with his obligation under the covenant? The sure and reasonable response is that the Decree made no such provision. It really would not matter who made the payment, penalty attaches to the Appellant if it is not paid.” Per Justice Omage in Total v Akinpelu,  (2004) 17 NWLR (Pt. 903) 509 at Page 523 paras.F-H

 

It appeared as if the appellate court was oblivous to actual effect of a grossed up clause in substance when it also held thus:

 

Secondly; is there a provision in Decree No. 104 Section 68(1) or Section 70 which prohibits the provisions in the Deed that the appellant should pay the 10% withholding tax on behalf of the respondent? There is no such provision in Decree No. 104.” Per Justice Omage in Total v Akinpelu,  (2004) 17 NWLR (Pt. 903) 509 at Pages 523-524paras.H-A

 

The appellate court also failed to appreciate the difference between contractual rules and taxation principles:

 

In my view an agreement in a deed creates a binding obligation between the parties; in the absence of specific provisions affecting the obligation the provisions at the (sic) statute should not be used as an excuse to breach the obligation.” Per Justice Omage in Total v Akinpelu,  (2004) 17 NWLR (Pt. 903) 509 at Page 524 paras.B-C

 

The Court appeared to be oblivous of the unequal bargaining powers between the parties in commercial lease transactions which almost always tilt in favour of the lessors:

 

…it appears to me that rather than the provisions of Decree No. 104, Section 68(1) operating to frustrate the obligations of the appellant in the deeds of lease, the statutory provisions actually invests the appellant with the duty to ensure that the payment of the withholding tax is made to the Inland Revenue. Since the appellant had in the covenant in the deed undertaken to make the payment on behalf of the respondent, it requires only a turn of the mind and a determination of the appellant, to actually take the money from his purse and pay it in the name of the respondent; knowing that the alternative to payment of the rent due on the premises is a determination of the lease it should not be difficult to allow the mind to turn in order to make the payment of the withholding tax, to regard it as an extension of the agreed rent payable on the premises which he holds of the respondent.” Per Justice Omage in Total v Akinpelu,  (2004) 17 NWLR (Pt. 903) 509 at Page 524 paras. D-G

 

The Court also erroneouly held that a grossed up amount fulfills the rental amount under the lease agreement, even though the purposes of the Tax statute and contracual agreements are different and separate from each other

 

A supplemental issue to be considered is this, when the 10% withholding tax is deducted incompliance with the provisions of Decree No. 104, section 68(1) would the full rent agreed upon have been paid by the appellant on the premises? It is in my view and I so direct that though the law prescribed it, the deduction of 10% withholding tax on the rent paid, reduces the rent in the hands of the lessors – the respondent, the value of the rent agreed.” Per Justice Omage in Total v Akinpelu,  (2004) 17 NWLR (Pt. 903) 509 at Page 524 paras.G-H

 

As Decree No. 104 does not contain a provision restricting or forbidding the payment of the withholding tax payable by the respondent by another, and the appellant has covenanted on the pain of forfeiting the lease, discretion should dictate that the appellant should agree to pay as covenanted with the respondent from his pocket, the 10% withholding tax.” Per Justice Omage in Total v Akinpelu,  (2004) 17 NWLR (Pt. 903) 509 at Pages524-525 paras.H-A

 

Thus, according to Olowoshile, the judgment of the Court of Appeal in Total v. Akinpelu has the following effects on the Nigerian Tax Law jurisprudence:

 

1.    A party can by means of a contract by Deed effectively shift his tax obligation arising out of the contract to the other party; and

 

2.    The Taxman is least concerned who bears the burden of tax as much as the tax due on the transaction forming the Deed is paid.

 

İn evaluating the correctness of the Total v. Akinpelu decision, it is apposite to consider the various school of thouhts on the imposition of WHT on gross up rents in nigeria.

 

VII.     Messrs Olaniwun Ajayi’s Position

As stated above, Messrs Olaniwun Ajayi, LP in their seminal collection titled Legality of Gross-Up Clauses in Nigeria as contained in legal Aspects of Finance in Emerging Markets (2005), had argued that Regulation 2 of CITA (WHT Regulations) provided that

 

a deduction made from a payment shall not be regarded as an additional cost to the contract price as tax due on the payment

 

This, they submitted, makes grossing-up illegal to the extent that it shifts the tax burden in breach of the above Regulation.

 

VIII.   Afolabi Elebiju’s Position

In contrast, Afolabi Elebiju in his work: “Withholdig Tax: The A-Z of Grossing Up” in ThisDay Lawyer of Tuesday, February 16, 2010 had posited that whilst penalties are prescribed for failure to deduct or remit WHT, there are no penalties for grossing-up, notwithstanding the use of the word--“shall” in Regulation 2 of CITA (WHT Regulations). Further, Elebiju argued that

 

the absence of penalty makes Regulation 2 of advisory import for gross-up purposes. Furthermore, Regulation 5, sections 82 CITA and 40 FIRSA and section 74 PITA.... respectively reinforce the view that [the FIRS] is more interested in substantive offences [i.e.,]  failure to deduct/remit WHT - than who bore the burden of WHT remitted.”

 

Therefore, given the FIRS’ myriad of responsibilities and limited resources which makes optimisation of efforts imperative, it is understandable that the Revenue’s primary concern would be that correct WHT amount come into its coffers, and this is because remittance is of more practical importance to the Revenue than deduction – because remittance (if at all), follows deduction, argued Elebiju:

 

At best, the ‘penalty’ against grossing-up in Regulation 2 is that the Revenue may add back the WHT amount to the taxable profits of the payer; but this regulatory response (of disallowed WHT ‘expense’), does not make grossing-up illegal.”

 

In conclusion, Elebiju argued that the Legality of Gross-Up Clauses article draws distinction between: (a) phraseology stating that the payee’s payment shall not be subject to WHT; and (b) that payer increase the amount payable such that payee would receive the (same) gross amount, even after provision has been made for WHT, concluding that as to the question wherher by grossing-up, the payee has received more tax benefit than it is entitled to, this would be addressed when payee submits its tax returns and reports its entire income at year end.

 

IX.       Bidemi Olumide Olowosile’s Position

According to Bidemi Olumide Olowosile in “”Re-Visiting Total v. Akinpelu- Filling the Gaps to Build the Taxpayer's Haven,” (available at: http://www.scribd.com/doc/8901648), gross up clauses are tax avoidance schemes:

 

Put simply, the tenor of these clauses are to the effect that in the event that any law, regulation or any other obligation would demand that the sum payable under the contract is to be subject to any deduction, withholding or tax on the transaction, the sum payable or the recipient of the sum(payee), the sum payable shall be increased to a sum that would ensure that, after the making of such deduction, withholding or tax, the payee shall receive, on the due date for such payment, a sum equal to the sum which it would have received had no such deduction, withholding or tax had been so deducted or paid. It is no gain saying that the effect of a Gross-up Clause is to effectively shift the burden of tax to the paying party under a contract. It is indisputably a tax avoidance scheme.

 

Thus, he proposed that efforts must be made to distinguish withholding tax from other similar concepts. As such,  Olowosile argued that since withholding Tax is not a “withholding or deduction” but an income tax that is withheld or deducted at source from any sum payable by a Nigerian company, it follows that where the parties had intended that the Clause be applied to Withholding Tax, such must be clearly stated as there is no euphemism for Tax. This is because as we have seen above one of the rules of statutory interpretation is that of strict interpretationd thus, provisions that are claimed to relate to tax are strictly interpreted as the Courts would only give effect to the clear wordings of the provision. Olowosile therefore surmised that:

 

In the absence of a definition to the contrary in the contract, “Sums payable” could mean ‘on after-tax basis.’ Where in a contract such as these, where there is doubt as to the import of the words used, the Court would adopt the construction least favourable to the person putting forward the instrument or document (fortissime contra Proferentes)

 

We therefre agree with Olowoshile that the Court of Appeal in Total v. Akinpelu did not decide on the following nor were they contemplated by the Court in arriving at its decision:

 

1.    On how Total was to report and remit the Withholding Tax to the Taxman in the light of the PITA deduction and remittance requirement;

2.    On the import of Regulation 2 of the Personal Income Tax (Rates e.t.c of Tax Deducted at Source (Withholding Tax)) Regulations 

3.    Whether with respect as to how Total was to report and remit the Withholding Tax to the Taxman, the provisions of  Section 69(3) of the Personal Income Tax Act and Regulation 3 of the Personal Income Tax (Rates e.t.c of Tax Deducted at Source (Withholding Tax)) Regulations must be taken to account.

 

X.        Gross Up Clauses in Nigeria Shift the Burdens of Tax in Nature

The decision in Total v Akinpelu is totally untenable. İt is an impermissible incme tax shifting technique by which the landlord with his superior bargaining powers out-muscles the lessee to agree to pay a tx liability appropriately chargeable to the Landlord. There are several situations in which one party, A, may pay the income taxes of another, B, are of course not confined to employer-employee and landlord-tenant relations. In any purchase and sale transaction a vendee may promise to pay the vendor's income tax. A corporation may pay the stockholder's income tax on dividends. A trust indenture may provide that the trustee pay the beneficiary's income tax on the income distributed to the beneficiary.  A tax-shifting covenant may be employed in connection with the settlement of lawsuits. A plaintiff may be willing to compromise a claim for a lesser amount provided that the amount received is not income, but may be unwilling to compromise for such lesser sum if the total received is taxable income. See Louis M. Brown Shifting the Burden of Income Taxes by Contract , 96 U. Pa. L. Rev. 822 (1948).

 

İn this regard, we may note that the initial tax consequence of a tax-shifting covenant has been considered by the United States Supreme Court in Old Colony Trust Company v. Commissioners, 279 U. S. 716 (1929), where an employer agreed to pay, in addition to an employee's salary, the income taxes that might become due and payable upon such salary. The question certified by the Circuit Court of Appeals for answer by the Supreme Court was:

 

"Did the payment by the employer of the income taxes assessable against the employee constitute additional taxable income to such employee?"

 

The Court in Old Colony Trust held that it did.

 

Appplied to Total v Akinpelu, payment of a 13th instalment of NGN135,000.00 by Total to Akinpelu to make gross payment of NGN1,485,000.00 would also constitute additional taxable income to Akinpelu.

 

On the same day, that the Old Colony Trust decision was handed down, a similar decision in U. S. v. Boston & M. R. R., 279 U. S. 732 (1929) was also handed down by the United States Supreme Court in a case in which a lessee covenanted to pay specified rentals plus all the lessor's income taxes upon the rental. The lessor was held to have received taxable income amounting to the specified rental plus the income taxes thereon.

 

There is now the principle that payment by one person of another's income tax may result in taxable income.

 

A dangerous ad infinitum pyramiding of tax may make the above rule nonsensical. For instance if A pays rent to B the landlord and A lao pays the tax assessable against B, it follows that the imposition of a tax upon B, measured by the principal plus the tax sum, means of course that B is subject to a further income tax on the amount of the tax sum. Carried one step further, there may be an additional tax imposed on this sum. At every step there may be a further tax imposed on the preceding tax sum. Now if A is obligated to pay all the income taxes of B, arising out of the initial payment, the ultimate obligation of A might be extremely burdensome.

 

The principle in U. S. v. Boston & M. R. R., are also encapsulated in Regulation 2 of the Personal Income Tax (Rates e.t.c of Tax Deducted at Source (Withholding Tax))Regulations which provides that: “A deduction made from a payment shall not be regarded as an additional cost of the contract to be included in the contract price but as a tax due on the payment.”

 

Nigerian tax jurisprudence must adopt a policy shift from Total v Akinpelu.in that payment of tax by the weaker party must be taxable in the hands of the partty with stronger bargaining power. The court can not stay neutral in the face of illegality, tax avoidance tactics and tax burden shifting.

READ MORE:
Related News
SCROLL TO TOP