TAX LAW: Profit tax and deduction of expenses

The treatment of expenses within the context of the Corporate Income Tax is fundamental for the accurate assessment of this tax, essential for defining the taxable base and complying efficiently with tax obligations in accordance with current legislation. The deductibility of expenses, subject to certain criteria and limitations, is crucial for taxpayers and entrepreneurs as it allows for the reduction of the tax base, provided these expenses meet specific principles.

The deduction of expenses in the Corporate Income Tax is not an absolute right of the taxpayer but is conditioned on demonstrating a direct link to revenue generation or the preservation of the production source—in other words, they must be necessary. This necessitates that expenses incurred by the company have a direct and undeniable relationship with income-generating activities, as established by the causality principle. According to doctrinal analysis, only expenses that are necessary and directly related to income generation or maintaining the company's productive capacity may be deducted.

It is crucial to deeply understand the nature and operational model of the business to determine which direct and indirect expenses are deductible. This detailed understanding is critical because the types of deductible expenses can vary significantly depending on each company's specific characteristics and industry sector. For instance, what constitutes a direct and essential expense in an industrial production entity may not apply to a technology services company. Moreover, distinguishing between necessary operational expenses and those that, while useful, are not essential for revenue generation requires meticulous analysis of internal operations and market demands. This discernment not only facilitates tax burden optimization within legal frameworks but also promotes more effective financial management aligned with the company's strategic objectives.

Within this framework, according to author Delgado Villanueva J. in her publication "Causality: Indispensable Criterion for Expense Deduction," featured in Business Update Magazine No. 326, four additional criteria complement and detail the concept of causality: reasonableness, necessity, proportionality, and normality of incurred expenses. Reasonableness requires a logical correspondence between the expense and the income obtained, ensuring coherence between expenditure and expected benefits. Necessity pertains to the indispensable link between the expense and productive activities, without which income generation would be affected or impossible. Proportionality evaluates the quantitative relationship between the expense and business activity volume, avoiding excessive deductions that do not reflect the company's operational reality. Lastly, normality relates to the habitual nature of expenses within business operations, excluding extraordinary or non-essential expenditures unrelated to the company's usual activities.

It is important to note that tax authorities possess extensive powers to verify, audit, investigate, and control expense deductions, requiring taxpayers to provide evidence demonstrating the necessity of expenditures. The exercise of these powers aims to ensure the accuracy and transparency of operations, allowing expense deductions when taxpayers demonstrate, through valid evidence, the direct and indirect necessity of the expenditure.

Additionally, tax regulations limit deductions for certain expenses associated with operations not directly related to taxable activities, such as personal consumption by owners, executives, or employees of the company. This reflects the legislator's intention to restrict expense deductions to those strictly related to income generation, preventing the erosion of the taxable base by concepts unrelated to business activities.

It is pertinent to mention that, in our interpretation, this principle primarily applies to expense deductibility under the Corporate Income Tax (CIT) and, in a complementary manner, can be used for Input Tax Credit (ITC) appropriation, governed by specific requirements designed to reduce the tax burden associated with Value Added Tax (VAT). Furthermore, in cases where Input Tax Credit cannot be appropriated due to untimely declaration of invoices or other reasons, taxpayers have the right to recognize such expenses as deductible in the calculation of Corporate Income Tax, excluding the 13% corresponding to VAT.

As observed earlier, deducting expenses in the Corporate Income Tax constitutes an essential tool for fiscal management, allowing for proper reflection of costs associated with income generation. However, it is imperative that taxpayers carefully adhere to criteria and limitations established by legislation and doctrine to ensure effective compliance with tax obligations and legality. Correct understanding and application of these principles not only facilitate accurate tax assessment but also mitigate potential tax liabilities, contributing to the financial stability and predictability of the company.

Víctor Manuel Vásquez Alfaro
Litigation and Corporate Lawyer