Pursuant to Colombian tax regulations, an expense will be deductible provided it is necessary, proportional and has a causal link with the taxpayer’s income-generating activity. In addition to this general rule, specific rules, requirements or limitations, may apply to the deductibility of certain expenses. For example, there are rules that limit the ability to deduct an interest expense based on equity thresholds (i.e. thin capitalization rule), even if the interest expense meets the aforementioned general requirements..

There are two relevant rules in the CTC regarding royalties for the exploitation of natural resources, namely: (i) article 107, which sets forth the general requirements for deductibility; and (ii) article 116, which states that taxes, royalties and contributions paid by decentralized entities are deductible, as long as they comply with the applicable requirements.

Article 116 has generated doubts and discussions regarding the ability of private companies to deduct royalty payments related to the exploitation of natural resources. For many years, the opinion of the DIAN was that these payments could not be deducted, since, in its opinion, it was a deduction available only to a certain group of taxpayers. However, in 2005 DIAN changed its opinion and concluded that these royalties were deductible for all taxpayers, in accordance with the provisions in article 116.

The 2005 ruling indicated that: 

“The royalties generated from the exploitation of non-renewable natural resources are deductible for the purpose of determining the liquid income, regardless of the kind of taxpayer, as long as they meet the requirements demanded by the tax legislation, as the case may be.” 

At that time, the tax authority stated that, due to the principle of equality, there was no reason to limit the deduction to decentralized entities only. DIAN also argued that this conclusion follows from the spirit or intend of the mentioned provision.

In light of the foregoing, several taxpayers included royalties as a deductible expense in their income tax returns, whilst others had even been including them prior to the cited ruling, under the general provision of article 107. Nevertheless, the concerns and doubts did not cease with the 2005 opinion. In fact, a group of individuals filed a claim for annulment against the 2005 ruling, arguing that article 116 of the CTC is clear enough to establish that only decentralized entities can deduct royalties. In the opinion of the claimants, article 116 does not contain any ambiguity and, therefore, DIAN could not interpret it differently on the basis of equality. 

The claim also argued that DIAN’s broad interpretation is not only contrary to the wording of article 116, but that it also contradicts the original purpose of the rule that led to that article (i.e. article 6 of Decree 1979/1974). Furthermore, the claimants were concerned about the reduction of fiscal revenues and the negative effect resulting from the unjustified deduction confirmed by DIAN. In turn, DIAN insisted that allowing the deduction for private taxpayers is consistent with the original intent that royalties should be deductible as long as they met the general requirements contained in article 107 of the CTC.

Throughout the process, several experts had the opportunity to express their opinions for or against DIAN’s view. Some considered that article 116 of the TC has an important context that should be considered and could be used to reach a broad interpretation, while article 107 of the CTC is also applicable to allow the deduction of any cost or expense (including royalties) that may be necessary, proportional and that has a causal link with the income-generating activity of the taxpayer. Others pointed out that article 116 of the CTC is clear and only allows concluding that this provision is only applicable to decentralized entities.

In this context, the State Council analyzed the appropriate interpretation method for article 116 of the CTC and assessed if the spirit and intention of the provision should trump a literal interpretation. Ultimately, it determined that it was important to consider the spirit, intend and purpose of the provision, but clarified that despite these considerations, article 116 of the CTC created a specific and restrictive rule of law, which only allows decentralized entities to deduct paid royalties. 

However, the State Council also clarified that, although article 116 is only applicable to royalties paid by decentralized entities, article 107 continues to be the general rule for all taxpayers. In other words, the State Council agrees with the claimants that article 116 has a restrictive interpretation, but clarifies that under article 107 a royalty expense can be claimed as a deduction as long as it meets the general requirements of law. 

In light of the State Council’s decision, it is important to make a case-by-case review to confirm whether a particular royalty is necessary, proportional and has a causal link with the taxpayer’s income-generating activity. Since these requirements must be met as a general rule, but are also applicable to the cases referred to in article 116, we consider that the decision of the Council of State does not actually modify the rules for the deduction of royalties.

In any case, it is important to follow-up on the development of this issue, since the claimants were clearly waiting for a different result. In their opinion, not only is article 116 inapplicable but the royalties themselves are not deductible. In this regard, they may look for a new ruling or opinion to confirm this.

For the time being, as long as there is no decision or rule stating otherwise, it seems reasonable to conclude that the deductibility of royalties paid by private taxpayers must be analyzed under article 107 of the CTC.