TOPIC 3:DETERMINATION OF TAXABLE INCOME 3. 1Persons Those assessable or chargeable to tax are called persons by the Act.

The term person embraces individuals (natural persons) and artificial persons created by law . The persons liable to be are the following: a. All persons resident in Kenya whether or not they are Kenyan citizens. b. All persons not resident in Kenya but derive income from any property, trade, profession, vocation or employment in Kenya. A taxable person does not include a partnership. A partnership is not taxed on its income but the partners are taxed on their share of profit or loss from the partnership. Income arising from abroad, whether or not it is remitted to Kenya is not liable to tax here though exemptions to this rule are: i. If a business is established in Kenya and has branches in foreign countries, profits made by its foreign branches will be taxed in Kenya. ii. Resident individuals are taxed on all employment income wherever earned.

3.4.2Residence Residence is a matter of physical presence. A person can have only one domicile but he/she may be resident in several countries at the same time. Residence status of a person helps to find out who is responsible or liable to income tax in Kenya. There are conditions for being a resident in the case of an individual and also in the case of a body of persons. a. Individuals Sec 2 (1) defines a resident in relation to an individual as one who: i) Has a permanent home in Kenya and was present in Kenya for any period during the year of income under consideration or ii) Has no permanent home in Kenya but was present in Kenya for a period or periods amounting in total to 183 days or more during the year of income under consideration or iii) Has no permanent home in Kenya but was present in Kenya for any period during the year of income under consideration and in the two preceding years of income for periods averaging more than 122 days for the 3 years. b.Body of Persons

Resident in relation to a body of persons (e.g. companies) means that; i) ii) The body is a company incorporated under the laws of Kenya The management and control of the affairs of the body was exercised in Kenya in the years of income under consideration or iii) The body has been declared by the minister for finance by a notice in the gazette to be resident in Kenya for that year of income. c.Non Resident This means any person (individual or body of persons) not covered by the above conditions for resident.

Importance of Residence: From the point of view of an Individual 1. Kenya resident individual pay Kenya income taxes on their income from Kenya and world wide employment, but Kenya non residents pay Kenya income taxes only on their income from Kenya. 2. Kenya resident individual pay Kenya income taxes at graduated scale rates but Kenya non residents pay income taxes at special fixed rates on certain specified income or sources. 3. Withholding tax is deducted at source on all income of Kenya non resident individuals but Kenya residents individuals have withholding tax deducted on only some of their incomes S(35).

From the point of view of Companies: 1. Kenya resident companies are taxed at only 30% on their chargeable incomes whereas non-resident companies with branches in Kenya are taxed at 35% on their chargeable income. Non resident companies with no branches in Kenya are taxed on certain specified incomes at special fixed rates which are lower than the above two rates. 2. Non resident companies with no branches in Kenya have withholding tax deducted at source on all their source of income, but resident companies and non resident companies

with branches in Kenya have withholding taxes deducted at source only on income in the form of dividends and interest. It should be noted that non-resident companies without branches in Kenya are treated exactly like non-resident individuals.

3.4.3Taxable Income A tax payer is taxed on his chargeable or taxable income. This is the total income from all sources listed in the Act excluding income exempted by the Act. Such income maybe reduced by reliefs or allowances. The income which is taxed is income in respect of: i. ii. iii. iv. Gains or profits from business Income from any employment or services rendered. Income from use of occupation of any property e.g. rent. Dividend and interest

v. Pension charge or annuity and withdrawals from registered pension and provident funds. vi. An amount deemed to be income of a person under the Act or rules made under the Act.

Exemptions from Income Tax Sec 13 of the Act to be read with Part I of the 1 st schedule specifies the incomes exempt from tax as follows: 1. The part of income of the president of Kenya that is derived from salary, duty allowances and entertainment allowances paid or payable to him from public funds. 2. Income of parastatal bodies. 3. Income of a sporting association other than income from its investments. 4. The income of agricultural societies 5. The income of any local authority 6. Interest on tax reserve certificates issued by the Kenya government. 7. The income of a registered pension scheme. 8. The income of a registered trust scheme. 9. The income of a registered provident fund.

10. Investment of an annuity fund as defined in Sec 19 of the Income Tax Act of an insurance company. 11. Pensions or gratuities granted in respect of wounds or disabilities. 12. Interest on savings account held with the Kenya Post Office Savings Bank. 13. Interest paid on loans granted by the Local Government Loans Authority. 14. The income of a non resident person who carries on the business of air transport provided where in the country where the person is resident offers similar facilities to Kenya residents. 15. The income of registered individual retirement fund. 16. The income of a registered home ownership savings plan. 17. Interest upto a maximum of 300,000 earned by individuals on housing bonds from: i. ii. iii. iv. HFCK Savings and loans Kenya EABS Home loan and savings

18. Monthly or lump sum pension to a person who is 65 years of age or more.

Y tax or the tax on Y is charged on Y of a person for each year in accordance with Sec 3(1) of the Y Tax Act.

The Year of Income The year of income refers to a period of 12 months with reference to which the income of individuals and business units is assessed for tax purposes.Taxation year in Kenya is from 1 st January to 31st December of any particular year e.g. 1st January to 31st December 2011. If the accounting period of a business concern ends on a date other than 31 st December then the year of income of that business concern maybe treated according to that specific date. In this case also a period of 12 months must be taken for tax purposes. If a companys financial year ends on 30th June every year then the year of income of this company will be taken as from 1 st July to 30th June the next year e.g. 1st July 2010 to 30th June 2011.

Example Walters income for the 3 years is as follows: Employment Income Year to 31.12.2002 Year to 31.12.2003 Year to 31.12.2004 His Business Profits Year ended 30.06.2002 Year ended 30.06.2003 Year ended 30.06.2004 His taxable income will be as follows: For the year of income 2002 Kshs. 50,000 Kshs. 120,000 For the year of income 2003 Kshs. 65,000 Kshs. 140,000 For the year of income 2004 Kshs. 70,000 Kshs. 139,000 Kshs. 200,000 Kshs. 205,000 Kshs. 170,000 120,000 140,000 130,000 Kshs. 50,000 65,000 70,000

Section 27 of the Income Tax Act states that the accounting period not coinciding with the year of income i.e. 31 st December maybe taken according to the special dates in which the accounting period of some persons or business concerns ends. The year of income for a period of 12 months ending on a day other than 31 st December maybe, possible in the following cases as prescribed in Sec. 27 of the Act, then the accounting period will be treated as the year of income. 1. In the case of a company, all income earned during a specific period of 12 months. 2. Incase of individuals, all income earned during a specific period of 12 months except employment income. It must be noted that employment income will be shown separately and assessed for tax purposes for a period of 12 months from 1st January to 31st December as usual. 3. If a person prepares accounts of his business for a period longer or shorter than 12 months then the Commissioner may consider the income of such accounting period as the income of the year and charge tax accordingly. In this case some adjustments can be made if necessary.

4. In the case of a partnership, all income earned during a specific period of twelve months except the employment income of individual partners earned elsewhere. The employment income of the partners will fall within the normal year of income i.e. 1st January to 31st December. As per Finance Bill 1996, for incorporated businesses a prior notice of 6 months is required to change accounting date. For unincorporated businesses the accounting date will be 31 st December e.g. partnership and sole proprietors. Sec 3 (1) states that a tax to be known as income tax shall be charged for each year of income upon all the income of a person, whether resident or non-residentwhich accrued in or was derived from Kenya.

3.2Employed and Self Employed There is usually a distinction between employed and self employed persons. The income of an employed person is subjected to PAYE whilst that of self employed is not subjected to PAYE.

a.Employed: A person who works under an employment contract and mutuality of obligations exist between the employee and the employer i.e. A worker in a company. The employee is someone who; Who has to work certain hours Has to work in a certain way Is not allowed to sub contract Has most of the facilities provided (e.g. place of work, equipment etc) Is paid regardless of how well or poorly the work is done. Usually (but not always) has only one employer.

b.Self Employed When a person works from his own premises, in his own way and has no obligation to anyone (i.e. employer), then usually he will be considered as self employed. He/she is responsible to himself/herself for: Finding his own work and clients

Financing the business Controlling the way in which the business is run Suffering losses and enjoying profits Dealing with tax matters (i.e. VAT, PAYE for employees etc) Providing his own equipment.

Apart from businessmen, the actors, part to time lecturers, agency workers etc fall under this group. It is usually very difficult to claim any tax allowable personal expenses against employment income but self-employed persons usually have tax allowable personal expenses e.g. books, equipment, subscriptions etc to profit and loss a/c.

3.2.1 Taxable Employment Income Section 5 sub section 1(a) of the Income Tax Act specifies the basis on which an income from employment is liable to income tax in Kenya. These are as follows: a. Any amount paid to a person who is a resident in Kenya in respect of any services rendered by him whether in or outside Kenya. b. Any amount paid to a non resident person in respect of any employment or services rendered to any employer who is resident in Kenya or employment or services to an employer who is not a resident of Kenya but has permanent establishment in Kenya.

Income of Employed persons under the Income Tax Act The following items are included as part of income of an employed person: 1. Wages, salaries, leave pay, sick pay, payment in lieu of leave, commissions, loans, gratuity etc. 2. Subsistence, travelling, entertainment or other allowances received in respect of employment or services rendered. If incurred wholly and exclusively in the production of employment income then they will be deducted from an employees income. 3. Value of any benefit, advantage or facility of whatever nature granted in respect of employment or services rendered if it is excess of Kshs. 24,000 in any one year of income. This excludes premises provided for residential purposes and life insurance

premium paid for the benefit of an employee. Any benefit in kind in excess of Kshs. 24,000 in any year of income is taken as taxable benefit. 4. Insurance premium paid by an employer for any insurance policy or the life of his employee or any of his dependants is a taxable benefit. 5. An amount paid by an employer as a contribution on behalf of an employee or director to a provident fund which has not been registered according to the provisions of this Act. If it is a contribution to an approved provident fund or pension scheme then it is a non taxable benefit to employees. 6. Medical expenses: Where the employer has a written plan or scheme or practice provides free medical services to all his employees, then this is a non taxable benefit to full time employees and whole tax service directors of a company. If it is given to only some employees then it is a taxable cash payment. 7. Passages: If passages are paid by employer it is a taxable benefit to the employee. However it will not be taxed if the following conditions are fulfilled; i. ii. iii. iv. The employee is recruited from outside Kenya. He is in Kenya solely for the purpose of serving his employer. He is not a Kenyan citizen The amount is actually spent on passages.

8. Housing Benefits: The following conditions shall apply; i. If an employee is provided with a house, 15% of his total benefit from employment will be added as housing benefit. ii. If the employee is required to pay nominal rent for the house provided, then such rent shall be deducted from 15% to total benefit to arrive at the net value of the housing benefit. iii. If the actual rent is paid to the employees, housing benefit of 10% of gains from employment less rent shall be considered to arrive at housing benefit. iv. In the case of directors other than whole time directors, the housing benefit is taken as 15% of the directors total income excluding gains from property. v. vi. Whole time service directors are treated as other employees. If an employee occupies only the house for part of the year then the housing benefit will be reduced proportionally.

vii.

From the year of income 1994, if the gains or profits of an employee or a whole time service director are more than Shs. 600,000 p.a. excluding value of premises then housing benefit will be determined on the basis of higher of the value determined under section 5(3) (c). However, as per Finance Bill 1998, the sub section (5(3) has been amended to ensure that directors (whether whole time service directors or otherwise) who may have influence on a company pay their fair share of tax i.e. fair market rental value are taken into account.

9. Low Interest Benefit:Where an employee receives a loan from the employer by virtue of his employment at a low interest rate then this low interest benefit will be taxable. The interest benefit shall be the difference between what the employer charges and the interest rate based on market lending rates at the discretion of the commissioner for the year of income 1995 and onwards. However from 11th June 1998 as per Finance Bill 1998, the low interest benefit has been excluded from gains or profits from employment and a new tax known as fringe benefit tax has been introduced which is payable by the employer and not the employee. This excludes wants granted before this date which are subject to terms at the time of offer. They shall however be subject to 15% or the market lending rates whichever is lower. 10. Gratuity: This is taxed in the periods for which it was earned and NOT in the year in which the total amount was paid. Salary arrears paid to employees are taxed in the year to which they relate. However, if the arrears relate to more than immediate past four years, only the arrears for the immediate past four years will be liable to tax on those four years. The arrears for the period behind the past 4 years will be added together and taxed in the preceding fifth year.

11. Compensation for loss of employment: Any amount received as compensation for termination of contract of employment to service is taxable whether or not provision is made in the employment contract for the payment of such compensation. The tax payable on such compensation shall be calculated as follows:

a. Incase of a director who is not a whole time service director, the compensation is taxed in the year it is accrued or received by him. b. In the case of employees or whole time service directors: i) Whose contract is for a specific term of service then if terminated before the expiry of such period, the amount of compensation that is taxable is equal to the income that could have accrued to the employee in the unexpired period. Any amount paid in excess of this would be tax free. ii) Whose contract is for unspecified term then the compensation is assumed to accrue evenly over the period following termination at the rate per annum as earned just before termination until the amount is fully exhausted. iii) Whose contract is for unspecific term not providing for compensation, then the amount of compensation is taxed only during the 3 years following the termination of contract at an annual rate of salary drawn by the employee in the year of termination. Any amount paid in excess of three years salary is tax free.

12. If an employee is provided with house servants, company car and other specific services then these benefits are taxable. The taxable values of these benefit is determined by the commissioner for specific year. The following rates have been fixed for the year of income 2003 onwards. 3.2.2 WIFES INCOME Wifes income as per section 45, is considered as the income of the husband and this income must be added to the husbands income in order to ascertain his total income. The wifes income can be from any source e.g. employment, rent, business, profession, dividend etc. A married woman will be treated as living with her husband and her income taxed on the husband unless: a. They are separated under an order of court or a written agreement of separation b. They are separated in such circumstances that the separation is likely to be permanent. c. She is a resident person and the husband is non resident d. Where she opts to file a separate return with effect from 1.1.2006.

Wifes Employment Income and Self Employment Income For purposes of calculating tax payable, wifes employment and self employment income qualifying for separate taxation is segregated from the husbands income and the tax on it separately calculated at wifes employment income rate which is the same as individual rate of tax. The wifes income will not qualify for separate taxation if she is employed by any of the following; a. A partnership in which her husband is a partner. b. A company where the husband / or wife jointly control 12% or more of the voting power directly or indirectly of the company. c. A trustee or manager of a trust created by her husband.

Note:Self employment income for a married woman means business by the wife where husband is not a partner nor employs the wife. Wifes Professional Income Wifes professional income is also segregated from the husbands income and the tax on it separately calculated at wifes employment and wifes professional income rate which is the same as individual rate of tax. Such professions include; accountancy, medical, legal, survey etc. The wifes professional income will not qualify for separate taxation if it is from a partnership where her husband is a partner. The wifes loss is deemed to be the loss of the husband. The deficit at the time of marriage becomes the husbands deficit to be offset against future income of the wife which is taxed on the husband.

3.2.3 INCOME FROM PENSION The pension income received by a resident individual from a pension fund is taxable. Similarly the pension income received by a resident individual from any pension scheme outside Kenya in respect of employment or services rendered by the individual is also taxable. Finance Bill 1992 defines pensionable income as:

a. The employment income including employee benefits. It means that now all emoluments and benefits subjected to PAYE will now constitute pensionable income. b. The gains or profits from business earned as the sole proprietor or a partner of the business in the case of an individual eligible to contribution to a registered individual retirement fund.

Pension Schemes a. On maturity of employment The lump sum payment of the 1 st 360,000 is exempted from income tax. Incase of a benefit paid out of NSSF, the 1st 360,000 is exempt from tax and in addition 50% of amount in excess of 360,000 is also exempt from tax. With effect from the year 2004 the amount has been increased to Shs. 480,000.

b. On termination of employment The amount withdrawn on termination of employment is exempted from tax to a limit based on the lesser of: i. ii. The 1st 480,000 per full year of service with the employer. The first 480,000.

This provision is aimed at ensuring that an individual will not withdraw tax free amounts in excess of Shs. 480,000 even if the period of service is more than 10 years.

Provident Fund Schemes The amounts received against the registered provident funds are exempted from tax to a limit based on the least of: i. ii. The first 480,000 per full year of service with the employer. The first 480,000. From 1996, withholding tax will be at the following rates in excess of the tax free limits. 10% on the first 400,000 15% on the next 400,000 20% on the next 400,000 25% on the next 400,000

30% on the next 1,600,000 Upon the death of an employee who is a member or beneficiary of a registered fund; a. The widow, widower or dependants will qualify as a group for the same tax exempt amounts out of pension income and lumpsum payment. b. Where the registered fund provides for the payment or retirement benefits other than the payment of lumpsum to an estate, the first 1,400,000 of such lumpsum amount be exempt from tax.

Registered Home Ownership Savings Plan (HOSP) A registered home ownership plan means savings plan established by an approved institution and registered with the commissioner for receiving and holding funds in trust for depositors for the purpose of enabling individual depositors to purchase a permanent house. As per Section 22(c) a depositor will be eligible to deposit funds with a registered home ownership savings plan and an amount of Kshs. 4,000 every month is exempt from tax thus 48,000 per annum. 3.3Steps in Computation of Income Tax 1. Ascertain gross income from all sources 2. Deduct amounts allowable to such income that may not be taxable. 3. Ascertain net income 4. Calculate gross tax using tax rates as applicable to the particular year of income 5. Deduct relief allowable from gross tax 6. Ascertain net income tax for the year 7. For employed persons (PAYE) deduct PAYE from net income tax. The amount arrived at is the tax payable. Johns return shows the following income for the year 2004. i. ii. iii. Salary Shs. 250,000 per annum (PAYE 20,000) Wifes employment income shs. 60,000 as lady secretary Pension received from former employer 100,000 (PAYE NIL)

Required : Johns net tax liability for the year of income 2004 solution Salary First 116,160 @ Next 109,440 @ Next 24,400 @ 10% 15% 20% 250,000 11,616 16,414 4,880 31,912 12,672 (1,162 per month) 20,240 20,000 240

Gross tax liability Less relief Net Tax Liability Less: Tax Credit PAYE Tax Payable

3.4.PARTNERSHIPS For purposes of imposing tax a person does not include a partnership. The income of a partnership is assessed on the partners. Under the Income Tax Act Cap 470 under Section 4(b) the gains or profits of a partner from a partnership is the aggregate of: a. Remuneration payable to him/her b. Interest on capital receivable, less interest on (drawings) payable by the partner to the partnership. c. His/her share of adjusted partnership profits.

Determining the Existence of a Partnership Under English and Kenyan Law, a partnership is not a person but is the relationship that subsists between persons carrying on a business in common with a view to making profit(s). Whether a partnership exists or not is not a question of fact. The basic criterion is whether two or more persons carry on a business in common with a view to profits. Usually a partnership deed or written agreement will be drawn up by the partners but in some cases orally made.

Steps in computing tax on partnership income: 1. Determine or compute the adjusted income or loss for the partnership

a. Salary to partners is not allowable expense. b. Interest paid to partners is not allowable c. Interest paid by partners is not taxable d. Wifes salary is not allowable e. Drawings of commodities dealt with in the partnership are added back at cost. Note that no profit is to be made from another partner. 2. Allocate the income adjusted to the partner by first isolating salaries to partners, interest on capital (net) to partners, bonus to partners, commissions etc. The balance is either profit or loss to be shared out among partners according to profit sharing ratio or as per partnership agreement.

Format of Income Tax Computation of a Partnership Shs. Net profit/(loss) as per a/c Add back: Partnership salaries Interest paid to partners Goods taken by partners Goodwill written off Partners insurance Legal fees on partnership agreements xx xx xx xx xx xx xx Shs. xx

Less Non taxable income Capital deductions allowed (xx) (xx) (xx) Adjusted partnership profits /loss xxx

Income Allocation to Partners

Total Kshs Salary Interest on capital Interest on Drawings Share of Profit Taxable income xx xx xx xx xxx

Partner A Kshs xx xx xx xx xxx

Partner B Kshs xx xx xx xx xxx

Example: Mr. Unga, Mr. Safi and Mr. Ngano are partners trading under the name Ngano Safe enterprises. They share profits and losses in the ratio of 4:3:3. Given below is the P&L ac/ of the partnership as at 31/12/2003.

Nganosafe Profit & Loss A/C for the year ended 31.12.2003 Shs. Salaries and wages Rent, rates and taxes Office expenses Printing and stationery Installment tax paid Advertising Interest on capital Unga Ngano Safi Legal charges Commission to partners Unga Ngano Depreciation 45,000 35,000 92,000 60,000 70,000 80,000 82,000 280,000 Gross profit 150,000 Misc. receipts 204,000 Discounts 64,000 Rent from property 45,000 Profit on sale of shares 73,000 Interest on deposits Shs. 2,300,000 150,000 80,000 132,000 100,000 120,000

Bad debts General expenses Donation to famine relief General reserve Local taxes on property Electricity Show room expenses Net profit

68,000 99,000 100,000 120,000 12,000 46,000 117,000 1,040,000 2,882,000 2,882,000

The partners have provided the following information in support of the accounts: 1. It has been the practice to value the stocks at the cost price, however the closing stock (as at 31.12.2003 is Shs. 180,000) valued at market price which is less by 10% of its cost price. 2. Salaries and wage include salaries amounting to Shs. 40,000 paid to Safi. 3. Advertising includes Shs. 10,000 spent on advertising campaign to introduce a new product on the market. 4. Legal charges include a sum of Shs. 12,000 paid as a fine and penalty. 5. Capital allowances have been agreed with the commissioner of income tax at Shs. 90,000. 6. Mr. Ungas other income includes Shs. 120,000 from rent. He has brought forward business loss of Shs. 135,000 from the assessment of income of 2002 of the partnership . 7. Mr. Safi has got no other income. 8. Mr. Ngano has income of Shs. 200,000 from bet winnings. He has brought forward business loss of Shs. 135,000 from assessment of the year of income of 2002 partnership.

Required: a. Compute the taxable income from the partnership business. b. Allocate the profit amongst the partners.

c. Calculate the taxable income of each partner for the year of income 2003.

Solution a. Ngano Safi Enterprises Computation of Taxable Income Kshs N.P as per P&L a/c Add: deductions not allowed Loss on valuation of closing stock (100/90 x 180,000) Salary: Safi Instalment tax paid Interest on capital: Unga Safi Ngano Fine and penalty Commission: Unga Ngano Depreciation Donation General reserve 40,000 45,000 60,000 70,000 80,000 12,000 45,000 35,000 92,000 100,000 120,000 719,000 Less: income exempt Rent from property Profit on sale of shares Interest on deposits (132,000) (100,000) (120,000) (352,000) 1,407,000 Less: capital allowances Adjusted partnership income b. Distribution of Income among Partners: (90,000) 1,317,000 20,000 Kshs 1,040,000

This is done as per their profit / loss sharing ratios 4:3:3 (Unga : Safi : Ngano)

Particulars

Total Kshs

Unga Kshs 60,000 45,000 394,800 499,800

Safi Kshs 40,000 70,000 296,100 406,100

Ngano Kshs 80,000 35,000 296,100 411,100

Salary Interest on capital Commission Share of balance Taxable income

40,000 210,000 80,000 978,000 1,317,000

c. Calculations of taxable income Particulars Total Kshs Income from partnership Add Rent from property (4:3:3) Rental income Less: Business loss b/f Taxable income 270,000 1,299,000 135,000 537,600 445,700 135,000 315,700 132,000 120,000 52,800 120,000 39,600 39,600 1,317,000 Unga Kshs 499,800 Safi Kshs 406,100 Ngano Kshs 411,100

3.5.LIMITED COMPANIES Limited companies in Kenya can either be private or public. There are no fundamental differences in the taxation of either private or public companies. Companies incorporated in Kenya are expected to pay installment tax before the end of the accounting year hence the amount of tax payable shall be determined at the beginning of each year. This is based on the lesser of: i. ii. The budgeted profits of the year or 110% of the last years tax liability.

Once determined, the installment tax is payable as follows: 1st installment 25% of tax due by 20th day of 4th month during year of income

2nd installment 25% of tax due by 20th day of 6th month during year of income 3rd installment 25% of tax due by 20th day of 9th month during year of income 4th installment 25% of tax due by 20th day of 12th month during year of income Final tax Actual tax payable minus total(tax balance) installment tax paid on the last day of 4 th month after end of year of income. However, for firms in the agriculture sector, installment tax is payable as: 1st installment 75% of tax due by 20th day of 9th month during year of income 2nd installment 25% of tax due by 20th day of 12th month during year of income Final tax -Actual tax payable minus total (tax balance) installment tax paid on the last day of the 4th month after the end of year of income.

Corporation Tax Rates In Kenya, the corporate tax rate for a resident company is 30% whilst that for a permanent establishment of non resident company is 37.5%. A non resident company can have a permanent establishment in Kenya by opening a branch. However different tax rates apply for the following;

1. Newly Listed Companies Companies newly listed on any securities exchange approved under the capital markets act enjoy favourable corporation tax rates as follows: % of issued share capital listed Computation rate tax Period commencing

immediately after year of income (yrs)

Listed shares exceeds 20% of 27% issued share capital Listed shares exceeds 30% of 25% issued share capital Listed shares exceeds 40% of 20% issued share capital

3 years

5 years

5 years

2. Export Processing Zone Companies Companies operating within EPZ have the following benefits: i. A tax year tax holiday this is an exemption from corporation tax for the first 10 years of trading. ii. A lower corporation tax rate of 25% for the subsequent years after 10 years tax holiday.

iii. An exemption from all withholding tax on dividends and other payments to non residents during the first 10 years. iv. Investment deductions are 100% of the capital expenditure claimable in the 11 th year after commencement of production. v. Zero rated for purposes of VAT

vi. There is a refund of import duty on raw materials to manufacture exports.

Note: EPZ enterprises must submit annually returns of income and supporting accounts to the CIT. Emoluments paid to employees and resident directors of EPZ enterprises must be subject to PAYE deductions as required by law even during the period the enterprise is exempt from tax.

3. Resident Companies Mining Specified Minerals Such companies under the Inzome Tax Act for the first 4 years of mining operations, their income is taxed at 27.5% while the normal rates shall apply from the 5th year of operations.

4. Taxation of Branches of Foreign Companies Non resident companies with branches in Kenya are liable to pay corporation tax at a comparatively higher rate of 37% on incomes generated by their local branches. No deductions shall be allowed in respect of expenditure incurred outside Kenya by a non resident person for purpose of ascertaining gains or profits of a business carried on in Kenya except as determined by the CIT and in particular no deduction shall be made in respect of expenditure on remuneration for services rendered by the non resident director who is not full time director of a non resident company.

On executive and general administrative expenses except to the extent the CIT may determine to be just and reasonable. No deduction shall be allowed in respect of interest, royalties or management or professional fees paid or purported to be paid by the permanent establishment to the non resident person. Sales abroad by a branch of goods produced in Kenya will be deemed to generate income derived in Kenya and such income is taxable in Kenya. A branch does not suffer any withholding tax on remittances of profits to head office.

5. A group Comprising the Holding Company and Subsidiary Companies Under the Income Tax Act companies are treated as legal persons independently. As such the law does not permit any form of consolidated return combining the profits and losses of affiliated companies or the transfer of losses from loss making to profit making members of the same group of companies. Where assets qualifying for wear and tear allowances are transferred between companies under common control, the sale consideration is deemed for tax purposes to be the open market value of those assets. However, if this treatment would give rise to a taxable balancing adjustment in the computations of the transferor company, the two companies may jointly elect for tax written down value to be substituted as the sale consideration. This election is possible only if both companies are resident in Kenya. Dividends paid by one resident company to another one exempted from tax in the recipients companies hands if it controls 12% or more of the voting power of the paying company. Real estate may be transferred free of stamp duty where the beneficial ownership does not change.

Shortfall Tax on Non Distribution of Dividends (Sec.24) The profits of a company after taxation may be distributed to the shareholders in full as dividends or retained to provide finance or to be partly distributed and partly retained. If a company fails to distribute as dividends that part of its income which in the opinion of the CIT is in excess of its requirements within a period of 12 months after the accounting period, the CIT may direct that the income be deemed to have been distributed to the shareholder as dividends.

In such a case the company will have to deduct tax at source (withholding tax) and distribute the shortfall to the shareholders.

In practice, the commissioner usually allows for the retention of 60% of the profits after tax derived from the trading income. Profits after tax from investment income are distributed in full. Non taxable dividends are also distributed in full.

Companies excluded from Shortfall Regulation i. ii. Companies that are subsidiaries of each other. Companies that are subsidiaries of foreign companies and have no resident shareholders.

iii. Companies which have 51% or more of the shares held by non residents.

Circumstances where Companies will be entitled to more than 60% Permissible Retention i. Where the companies authorized capital is fully issued and therefore it cannot obtain further funds from shareholders and can only rely on its internal reserves to finance its investment plans. ii. The company does not have any liquid funds. iii. The company has liquid funds but is reserving them to clear maturing obligations e.g. loans, mortgages or plans to purchase plant and machinery, building etc. iv. The company is expanding its business and trading operations and requires additional commitment in inventory. v. The company has committed itself to purchase another business as long as the company to be purchased is not a company that is a source of raw material of a distribution company for its products. vi. Any company controlled directly or indirectly by the government of Kenya. Calculation of Shortfall Dividends Steps to be followed: i. ii. iii. iv. Show each type of income in a separate column. Deduct corporation tax where applicable Deduct permissible retention The balance is the distributable dividend

v. Deduct the actual dividend declared and the remaining balance (if any) is the shortfall of dividends.

Example: XYZ made a pre-tax profit of Kshs. 100 million comprising of: a. Trading profit Shs. 60m b. Investment income Shs. 10m c. Dividends from B limited (a subsidiary) Shs. 30m (the company owning more than 12 % of ordinary shares) State how much the company should distribute as dividends in order to comply with Sec. 24 proviso (Assume Corporation Tax is 40%).

Solution Trading Profits Investment Income Non Taxable Total Dividends

Kshs (millions) Kshs (millions) Kshs (millions) Kshs (millions) Pre-tax profits Corporation Tax 40% Profits after Tax Maximum Retention 60% Distributable Profits 60 (24) 36 (21.6) 14.4 10 (4) 6 Nil 6 30 30 Nil 30 100 (28) 72 (21.6) 50.4

Distributable profits will be 50.4 to shareholders but this amount is liable to withholding tax. Shareholders need not be taxed again.

Compensating Tax and Dividend Tax Account Compensating tax was introduced in 1993 under Section 7A of the Income-Tax Act. It is an additional tax imposed on companies and arises if a company pays dividends from untaxed profits.

Untaxed profits would occur in cases where the company declares dividends out of profits arising from sale of fixed assets, investments or other gains that are not taxable. Note that capital gains tax was suspended in 1985 and stands suspended to date.

Companies are required to maintain a dividend tax account to monitor the incidence of compensating tax. According to the tax act, the initial balance in the dividend tax account will either be: a. Zero or b. Sum of the total taxes paid and tax on dividends received, less tax on dividends distributed and tax refunded by the company with respect to 1988 to 1992 years of income. Thereafter the account is adjusted in the same way for each subsequent year of income as follows:

Dividend Tax Account Format Particulars Dividend tax account opening balance b/f as above (1st Jan 199x) Total income taxes paid during the year Tax on total dividends received during the year (dividends x 0.3/0.7) Total refunds by KRA of taxes previously paid and included in the x calculation of income taxes earlier paid Tax on total dividends distributed (dividends x 0.3/0.7) Balance carried forward (if debit) Compensating tax payable (if credit) xx x x x xx Debit Kshs Credit Kshs x x x

A credit balance is carried forward to the next year while a debit balance indicates the compensating tax payable. Where the tax is paid in a given year the balance carried forward to the next year is zero. The tax is due for payment by the last day of the 6th month following the end of the accounting period.

Example: The following information was obtained from the books of Nyachio Ltd for the year ended 31 st December 2008.

Details Profit after tax Dividends paid Dividends received

Kshs 4,200,000 6,400,000 1,500,000

Additional Information A tax refund of Kshs. 360,000 was received by the company for the year ended 31/12/2008.

Required: Compensating tax, if any payable by Nyachio Ltd for the year ended 31/12/2008.

Solution Computation of Compensating Tax Dr Income tax paid (0.3 x 4,200,000) (excluding dividend withholding tax) Dividend received (1,500,000 x 0.3/1-0.3) Dividend paid (6,400,000 x 0.3/1-0.3) Tax refund Compensating tax 2,742,857 360,000 1,200,000 3,102,857 3,102,857 642,857 Cr 1,260,000

Definition of Compensating Tax Compensating tax as per section 7A of the Y Tax Act is an additional tax imposed on companies arising where tax paid plus tax on dividends received is less than tax on dividends paid and tax refunds by the company.

Tax paid excludes withholding tax on qualifying dividends but includes compensating tax.

Taxation of Companies ABC Ltd has presented the following trading and P&L a/c for the year ended 31/12/2007 Kshs. 000 Sales Less: cost of sales Opening stock Purchases Cost of goods available for sale Closing stock Gross profit Other incomes Gain on sale of equipment Interest on savings account Refund of import duty Gain on foreign exchange transactions Expenditure Goodwill amortization Legal expenses Salaries Bad debts NSSF contribution General expenses Advertising Staff meals Traveling expenses Donations to a trade association Property rates Depreciation 25 420 2,000 500 60 600 300 190 180 40 45 150 120 40 80 11,400 4,200 5,600 9,800 (2,400 (7,400 11,100 Kshs. 000 18,500

Interest on long term loans Interest on bank overdraft Insurance Cost of stolen stock Branch closure stocks Net profit

300 80 124 20 100 (5,134) 6,306

Additional information 1. The closing stock on 31/12/2007 was valued at a cost plus a mark up of 20% 2. Legal expenses related to: Preparation of memorandum of association Conveyance fees on purchase of land Acquisition of leasehold property Settling customer disputes Acquisition of a bank loan 150,000 60,000 90,000 100,000 20,000 420,000 3. The Directors had withdrawn goods costing Kshs. 600,000 (selling price Kshs. 720,000) for their personal use. These goods have been included in both purchases and sales for the year ended 31/12/2007 4. Sales (expenses) include: Kshs Directors allowance Christmas gifts to staff Golden handshake to a retiring director 5. Bad debts includes: Loan to director Estimated defaulters by trade debtors 720,000 600,000 400,000 Kshs 200,000 120,000

6. Advertising expense include Kshs. 100,000 for a neon sign 7. 20% of the traveling expenses relate to the private usage of company motor vehicles. 8. Capital allowances were agreed with the revenue authority at Kshs. 200,000

Required i. ii. Adjusted taxable profit or loss for ABC Ltd for the year ended 31 st Dec, 2007. The tax payable by ABC Ltd (if any) for the year ended 31/12/2007

ABC Ltd adjusted taxably Y for the year ended 31/12/2007 Kshs 000 Profit as per P&L a/c Add: disallowable expenses Preparing memorandum of association Conveyance fees Bank loans (processing) Bad debts: Loan to directorsGeneral bad debts Advertising neon sign Travelling expenses private 20% of 180 Goodwill amortization Donations to trade association Cost of goods withdrawn Depreciation Less; allowable / deductible expenses (items) Capital allowances Sales to directors Overstated closing stock (2,400 2,400/1-20) Gain on sale of equipment Interest on savings a/c Refund of import duty Taxable income Tax thereon 30% of 6,238,000 = 1,871,100 (200) (720) (400) (120) (40) (80) (1,569) 6,238 200 120 100 36 25 40 600 150 (1,501) 150 60 20 Kshs 000 Kshs 000 6,306