ADVANCED TAXATION

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 Acknowledgment
We gratefully acknowledge permission to quote from the past examination papers of the
following bodies: Kenya Accountants and Secretaries National Examination Board
(KASNEB).

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 v

ACKNOWLEDGMENT.................................................................................................................. ii

CHAPTER ONE............................................................................................................................ 1
ADVANCED ASPECTS OF THE TAXATION OF BUSINESS INCOME........................................ 3

CHAPTER TWO.......................................................................................................................... 39
TAXATION OF SPECIALISED ACTIVITIES................................................................................ 41

CHAPTER THREE...................................................................................................................... 81
TAX INVESTIGATIONS . ............................................................................................................ 83

CHAPTER FOUR...................................................................................................................... 107

TAXATION OF CROSS BORDER ACTIVITIES........................................................................ 109

CHAPTER FIVE........................................................................................................................ 133

T E X T
TAX PLANNING........................................................................................................................ 131

CHAPTER SIX.......................................................................................................................... 169

S T U D Y
TAX SYSTEMS AND POLICIES................................................................................................ 171

CHAPTER SEVEN.................................................................................................................... 189

PROFESSIONAL ETHICS IN TAXATION................................................................................. 191

CHAPTER EIGHT .................................................................................................................... 201

EMERGING TRENDS IN TAXATION ....................................................................................... 203

CHAPTER NINE........................................................................................................................ 219

REVISION AID ........................................................................................................................ 221
suggested solutions...................................................................................................... 231
Glossary of Terms .......................................................................................................... 273
Index ...................................................................................................................................... 277

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 vi A dvanced TA X AT I O N
T E X T
S T U D Y

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 ADVANCED ASPECTS OF THE 1
TAXATION OF BUSINESS INCOME

CHAPTER ONE

T E TX ET X T
S T U D Y T E X T
S T SU TDUYD Y

TAXATION OF
SPECIALISED
ACTIVITIES

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 2 A dvanced TA X AT I O N
T E X T
S T U D Y

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 ADVANCED ASPECTS OF THE 3
TAXATION OF BUSINESS INCOME

CHAPTER ONE
ADVANCED ASPECTS OF THE TAXATION OF
BUSINESS INCOME

1.1 Objectives

In this chapter, the student should be able to understand tax aspects of partnerships and
Limited companies. To enhance their understanding, various relevant case law examples have
been discussed.

1.2 Introduction

In the first taxation paper you were introduced with aspects of taxation of business income. In this
chapter, you will be introduced with concepts on advanced aspects of the taxation of business
income. Some of the issues to be discussed in this chapter are tax implications of various sources
of income for partnerships, and taxation of group of companies. In the next chapter you will cover

T E X T
the taxation of specialized institutions.

1.3 Key Definitions

S T U D Y
•• Partnership: The relationship that subsists between persons carrying on a business in
common with a view to profit.
•• Company: it’s an association of persons who contribute capital towards common
stocks for a common aim. Companies are incorporated under the Companies Act and
are legal persons.

1.4 Exam Context

This topic is highly examined. Students will be required to not only remember the content learnt
in their first taxation paper but also apply the knowledge learnt, in answering questions in this
paper.

1.5 Industrial Context

This topic will help businesses be able to deal with complicated and advanced aspects of taxation
of their businesses. The major beneficiary of the topic will be the finance manager, tax practitioners
and accountant who will apply the information in making key management decisions.

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 4 A dvanced TA X AT I O N

1.6 Partnerships

Provisions of the Income Tax Act Cap 470 Laws of Kenya

For purposes of imposing tax a "person" does not include a partnership. The income of a
partnership is assessed on the partners.
Under Section 4(b) of the Act, "the gain or profits of a partner from a partnership shall be the sum
of -
i. remuneration payable to him by the partnership together with interest on capital so
payable, less interest on capital payable by him to the partnership; and
ii. his share of the total income of the partnership calculated after deducting the total of
any remuneration and interest on capital payable to any partner by the partnership and
after adding any interest on capital payable by any partner to the partnership".
Where a partnership makes a loss as calculated in (ii) above, the gains or profits shall be the
excess, if any of the amount set out in (i) over his share of that loss.

Determining the existence of a Partnership

Under English and Kenya law a partnership is not a person but "the relationship that subsists
T E X T

between persons carrying on a business in common with a view to profit".

Whether a partnership exists or not is a question of fact. The basic criterion is whether two or
more persons carry on a business in common with a view to profits.
S T U D Y

This suggests that the persons involved bear the attribute of a proprietor and have a profit
motive.
Other useful guidelines include the following:
•• Usually a partnership deed or written agreement will be drawn up
•• There is a joint tenancy or tenancy in common
•• There is sharing of gross receipts or profits
None of these circumstances of itself would constitute conclusive evidence of the existence of a
partnership.
Common situations which pose difficulties in proving a partnership are:
1. Whether joint transactions may constitute a partnership; and
2. Whether the parties concerned are partners or merely employees.
1. Joint transactions - JOHN GARDNER & BOWRING & CO V CIR
G arranged during a coal strike to buy imported coal from B. The coal was invoiced to G at cost
and the net excess of his sales were shared with B.

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 ADVANCED ASPECTS OF THE 5
TAXATION OF BUSINESS INCOME

Judgement "whereas these cargoes of coal generally had been formally the simple transaction
of purchase and sale between the parties, they immediately became the subject of a transaction
in which both parties were interested, and in which when one of them had sold the coal, the sale
was not on his behalf but on behalf of the two together the net profit, so obtained was equally
divisible between them".
Held: The relation between these two parties constituted a partnership.

2. Employee or partner
The Deed of partnership does not necessarily constitute partners for income tax purposes.
Dickenson V Gross (Hmit)
A farmer named Dickenson, entered into a Deed of Partnership with his three sons with the
admitted intention of reducing income tax liability in respect of the profits. The deed provided
inter alia that two farms owned by D should be let to D and his sons at stated rentals, that
accounts should be made up annually, that the net profits should be divided equally between the
partners, and that the partners shall have the right to sign and endorse cheques on behalf of the
firm. No rent was paid and no accounts or books had been kept. No distribution of profits was
made. Cheques were signed by D and some business receipts were paid to his private bank
account.
Held: That as a partnership did not exist in fact, and that there was no partnership for purposes

T E X T
of income tax.

E v CIT
E carried on business as a sole trader. In June 1942 he admitted his three daughters and

S T U D Y
son as partners. A Deed was executed stating the partnership commenced on 1 June 1942.
The provision of the deed gave E sole and exclusive management and control of the business.
Neither the son nor any of the daughters contributed property, labour or skill to the partnership.
A Deed of covenant was executed whereby each of the daughters was to pay a fraction of her
partnership profits to her mother and other infant children of E.
Held: Both the local committee and the High Court ruled that there was no evidence that a
partnership in fact existed.

Sinclair J stated:
"The terms of the Deed of Partnership and the facts as a whole are, in my view, inconsistent with
the relation of a partnership. The other partners contributed neither property nor labour, nor skill.
The whole of the capital was provided by the appellant. The partners in fact drew no profit. It was
evident that the appellant intended to retain control, not only of the management of the business
but also of the share which he gave to the children.

CIT V Williamson
A farmer and his sons for several years leased and worked in a farm jointly, but without any deed
of partnership. He supplied the capital, conducted all buying and selling and controlled the bank
account which was in his name.
He made no regular payments to his sons but supplied them, on request, with such monies as
were necessary for their requirements. No record of these disbursements or the financial results
of the farm was kept.

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 6 A dvanced TA X AT I O N

The respondent appealed against additional assessment to income tax in respect of the farm,
raised on the basis that he alone was assessable.
Held: That the facts did not justify the inference that a partnership had existed.

Opinions
The Lord President (Clyde)
"My Lords the question before us is whether there was a partnership between the father and his
three sons in whose joint names the lease ... was taken ... No doubt the lease was in joint names
... That it is in vain to constitute a partnership and the whole capital belonged to the respondent
... There is no record of any kind to show the existence of any contractual relation of any sort.
The bank account was the respondent's bank account and his alone. It was never operated
by anybody but him ... The sons got no wages ... You do not constitute or create or prove a
partnership by saying that there is one. The only proof is proof of the relations of agency and of
loss and profits and of the sharing in one form or another of the capital".

Lord Sands
"Stated all the facts and circumstances of the case otherwise, except the matter of the lease,
appear to be against and, indeed almost exclusive of the idea of a partnership".
T E X T

Pratt V Strick
P agreed to purchase a medical practice. A Deed of assignment was exercised on 15 July 1929
whereby the vendor agreed to stay on in the practice for three months to introduce P to his
patients, with a view to maintaining the connection of the practice and generally to aid and assist
S T U D Y

him in the practice. It was agreed that the earnings and expenses of the practice during the three
months be borne by the vendor and purchaser in equal shares.
P contended that the practice was sold outright to him on 15 July 1929 and that his income tax
liability should be computed on the basis the practice was commenced anew by him on that
date.
Held: That there was an out-and-on sale of the practice on the 15th July, 1929, and that there
has been no partnership. The practice was assessable as a new business in the name of the
purchaser only, and the vendor was in receipt of remuneration for services rendered.

Waddington V O'callaghan (Hmit)

The appellant, who had for many years carried on, solely, a practice as solicitor, informed his son
on 31 December, 1928, that it was his intention to take him into partnership as from that date.
On 1 January, 1929, he instructed another firm of solicitors, by letter, to draft a partnership deed.
The deed was executed on 11 May 1929 to have effect from 1 January 1929.
No formal notice of the partnership was at any time given by advertisement, circular or otherwise.
No alteration of the name under which the practice was carried on, or in the business bank
account, was made until after the date of the partnership deed. From 31 December 1928 the son
was credited with the share of profits to which he was entitled under the partnership deed.
Held: The Partnership constituted by deed commenced on the date of the deed and that there
was no knowledge of the existence of a partnership before.

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 ADVANCED ASPECTS OF THE 7
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Steps in Computing tax on Partnership Income

1. Determine or compute the adjusted income or loss for the partnership in the normal way,
except that: -
(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) Wife’s 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 Shs
Net profit as per A/C XXX
Add back:
Partnership salaries XX
Interest paid to partners XX

T E X T
Goods taken by partners XX
Goodwill written off XX

S T U D Y
Partner's insurance XX
Legal fees on Partnership agreements XX XX
Less
Non taxable income X
Capital deductions allowed X (XX)
Adjusted partnership profits XXX

Income Allocation to Partners

Total Partner A Partner B
Shs Shs Shs
Salary XXX XX XX
Interest on capital XX XX XX
Interest on drawings (X) (X) (X)
Share of profit XX XX XX
XXX XX XX

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Note
The figure of the total profits to be shared is derived from the difference between the adjusted
profits plus interest on drawings minus salaries and interest on capital. It is apportioned to the
partners in their profit and loss sharing ratio.
Computing taxable income of a partnership where the partner has no proper books of
account
Jimna and Mwala are in partnership trading as Jimna Enterprises and sharing profits and losses
in the ratio of 2:1 respectively. The partnership has however not been maintaining proper books
of account.
The following information relates to the financial year ended 31 December 2007:
1. The firm’s assets and liabilities as at 1 January 2007 comprised:

Shs
Office equipment (net book value) 180,000
Motor vehicle (net book value) 480,000
Stock (cost) 95,000
Trade debtors 600,000
Trade creditors 480,000
Shop premises at cost (year of construction 2002) 1,200,000
T E X T

Bank balance 100,000

2. The following transactions were reflected in the bank statement of the partnership for the
year ended 31 December 2007:
S T U D Y

Debit Credit Balance

Shs. Shs. Shs
Balance brought forward (1 January 2007) 100,000
Additional capital from partners 800,000 900,000
Cash sales 965,000 1,865,000
Cash received from trade debtors 114,000 1,979,000
Cash purchases 705,000 1,274,000
Purchase of delivery van 620,000 654,000
Miscellaneous expenses 90,200 563,800
Electricity expenses 19,400 544,400
Sales assistant’s wages 58,000 486,400
Motor car running expenses 39,620 446,780
Drawings by partners 40,000 406,780
Interest on partners’ drawings 4,000 410,780
Sale of land 460,000 870,000
Salaries and wages 840,000 30,780
Advertisement 24,000 6,780
Farming revenue 360,000 366,780
Ledger fees 5,600 361,180
Insurance 36,000 325,180
Payment to trade creditors 448,000 (122,820)
Legal expenses 20,000 (142,820)
Closing balance on 31 December 2006: (142,820)Dr

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 ADVANCED ASPECTS OF THE 9
TAXATION OF BUSINESS INCOME

3. The cash sales deposited are after deducting Sh.3,000 per month taken as imprest by each
partner in order to pay for goods drawn from the firm. No entries have been made to record
the imprest or drawings of goods.
4. Trade debtors and creditors balances as at 31 December 2007 were Sh.1,200,000 and
Sh.160,000 respectively.
5. Salaries and wages include salaries to partners paid during the year amounting to Sh.165,000
and Sh.160,000 to Jimna and Mwala respectively.
6. Legal expenses comprise:

Shs
Conveyance fee for shop premises 5,000
Breach of trade agreement 3,600
Preparation of partnership deed 5,400

1. Miscellaneous expenses include estate valuation fee of Shs.4,000 in relation to insurance of

the shop premises.
2. Five percent of the trade debtors outstanding as at 1 January 2007 were uncollectible during
the year and were written off.
3. Stock as at 31 December 2007 amounted to Sh.128,000
Required:

T E X T
i)
Adjusted partnership profit or loss for the year ended 31 December 2006 (Hint: start
with sales) (12 marks)
ii) Allocation of the profit or loss in (b) (i) above to the partners.
(2 marks)

S T U D Y
(Total: 20 marks)

Attempted solution
Step 1: Compute the figures not provided. In this case, ascertain the sales and purchases
figure by drawing the relevant accounts.

JIMNA PARTNERSHIP
TOTAL DEBTORS ACCOUNT
Shs. ‘000’ Shs. ‘000’
Bal b/d 600 C/B 114
Credit Sales 744 Bad debts 30
____ Bal c/d 1,200
1,344 1,344

Total Sales: Cash Sales + Credit Sales

[(965,000 + 72,000) + 744,000] = 1,781,000
Goods drawn (6,000 x 12) = Shs.72,000 72,000
1,853,000

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 10 A dvanced TA X AT I O N

TOTAL CREDITORS
Shs. ‘000’ Shs. ‘000’
C/B 448 BAL B/D 480
Credit Purchases 128
BAL C/D 160
608 608

Step 2: Having obtained the total sales and total purchases figures, we can now use them to
compute the adjusted profit or loss for the partnership for the year 31 December 2006. The
applicable capital allowances must be deducted from the profit before arriving at the net taxable
profit.
T E X T
S T U D Y

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 ADVANCED ASPECTS OF THE 11
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ADJUSTED PARTNERSHIP PROFIT OR LOSS FOR THE YEAR TO 31 DECEMBER 2006

Shs. ‘000’ Shs ‘000’ Shs. ‘000’
Sales: Cash 1,037.00
Credit 744.00
Receipts for goods drawn (6,000 x 12 months) 72.00
1,853.00
Cost of Sales
Opening stock 95.00

Purchases – Cash 705.00

- Credit 128.00 833.00
Closing stock (128.00) (800.00)
Gross profit 1,053.00
Farming revenue 360.00
1,413.00
Allowable expenses:
Miscellaneous expenses 90.20
Electricity expenses 19.40
Sales assistants wages 58.00
Car running 39.62
Salaries and wages (840,000 – 325,000 515.00
Advertisement 24.00
Ledger fees 5.60
Insurance 36.00

T E X T
Legal expenses (20,000 – 14,000) 6.00
Bad debts written off 30.00
Wear and tear allowance 297.50 (1,121.32)
Net profit 291.68

S T U D Y
Shs. ‘000’ Shs ‘000’ Shs. ‘000’
Sales: Cash 1,037.00
Credit 744.00
Receipts for goods drawn (6,000 x 12 months) 72.00
1,853.00
Cost of Sales
Opening stock 95.00

Purchases – Cash 705.00

- Credit 128.00 833.00
Closing stock (128.00) (800.00)
Gross profit 1,053.00
Farming revenue 360.00
1,413.00
Allowable expenses:
Miscellaneous expenses 90.20
Electricity expenses 19.40
Sales assistants wages 58.00
Car running 39.62
Salaries and wages (840,000 – 325,000 515.00
Advertisement 24.00
Ledger fees 5.60
Insurance 36.00
Legal expenses (20,000 – 14,000) 6.00
Bad debts written off 30.00
Wear and tear allowance 297.50 (1,121.32)
Net profit 291.68

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 12 A dvanced TA X AT I O N

WEAR AND TEAR ALLOWANCE

III @ 25% IV @ 12½%
SHS ‘000’ SHS ‘000’
CLASS
Brought forward:
Office equipment (net) 180
Motor vehicle (net) 480

Addition: Delivery van 620 ____

Sub-total 1,100 180
Wear and tear allowance (275) (22.5)
825 157.5

Total wear and tear allowance (275 + 22.5) = 297.5

Note:
No written down values have been provided for wear and tear assets as at 1/1/2006. The net
book value has been used instead as representative of written down values at the beginning of
the year.
Step 2: Allocate the profits or losses to the partners according to the profit and loss sharing
T E X T

losses taking into considerations the provisions of Section 4 (b) of the Income Tax Act..

iii) ALLOCATION OF PROFIT IN (b) (i) ABOVE

S T U D Y

PARTNER JIMNA MWALA TOTAL

SHS ‘000’ SHS ‘000’ SHS ‘000’
Salary 165.00 160.00 325.00
Share of loss (22.21) (11.11) (33.32)
142.79 148.89 291.68

1.7 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 instalment tax before the end of the
accounting year. Therefore, the amount of tax payable shall be determined at the beginning of
each year. This is based on the lesser of:
•• The budgeted profits of the year or
•• 110% of the last year’s tax liability.
Once determined, the instalment tax is payable as follows.

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 ADVANCED ASPECTS OF THE 13
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1st instalment 25% of tax due by 20th day of the 4th month during the year of income.
2nd instalment 25% of tax due by 20th day of the 6th month during the year of income.
3rd instalment 25% of tax due by 20th day of the 9th month during the year of income.
4th instalment 25% of tax due by 20th day of the 12th month during the year of income.
final tax Actual tax payable minus total instalment tax paid on the last day of the
fourth month after the end of the year of income.
( tax balance)

However for firms in agriculture sector, instalment tax is payable as:

1st instalment 75% of tax due by 20th day of the 9th month during the year of income.
2 instalment 25% of tax due by 20th day of the 12th month during the year of income.
nd

final tax Actual tax payable minus total instalment tax paid on the last day of the
fourth month after the end of the year of income.
( tax balance)

1.7.1Corporation Tax Rates.

In Kenya, the corporate tax rate for a resident company is 30% whilst the tax rate 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 rates of taxes apply for the
following:

T E X T
i. Newly listed companies
Companies newly listed on any securities exchange approved under the Capital Markets Act

S T U D Y
enjoy favorable corporation tax rates as follows:
•• If the company lists at least 20% of its issued share capital listed, the corporation tax
rate applicable will be 27% for the period of three years commencing immediately after
the year of income following the date of such listing.”
•• If the company lists at least 30% of its issued share capital listed, the corporation tax
rate applicable will be 25% for the period of five years commencing immediately after
the year of income following the date of listing.”
•• If the company lists at least 40% of its issued share capital listed, the corporation tax
rate applicable will be 20% for the period of five years commencing immediately after
the year of income following the date of such listing.

The corporate tax rate applicable to the company may therefore change if the percentage of the
listed share capital exceeds 20% of the issued share capital. The applicable tax rate will depend
on the percentage of the issued share capital listed at the Nairobi Stock Exchange.

ii. Export Processing Zone Companies

Companies operating within EPZ have the following benefits:
1. A ten year tax holiday –This is an exemption from corporation tax for the first ten years
of trading.
2. A lower corporation tax rate of 25% for the subsequent years after the ten years tax
holiday.
3. An exemption from all Withholding tax on dividends and other payments to non residents
during the first 10 years.

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 14 A dvanced TA X AT I O N

4. Investment deductions are 100% of the capital expenditure claimable in the 11th year
after commencement of production.
5. Zero rated for purposes of VAT
6. 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
commissioner of income tax.
•• Emoluments paid to employees and resident directors of EPZ enterprises must subject
to PAYE deductions as required by law even during the period the enterprise is exempt
from tax.
iii. Resident companies mining specified minerals
Resident companies mining specified minerals under the Income Tax Act – for the first 4 years of
mining operations income is taxed 27.5% per year, while normal rates shall apply from the fifth
year of operations.

1.7.2 Tax Effects of Shortfall Distribution of Company Profits (Section 24)

The profits of a company after taxation may be distributed to the shareholders in full as dividends
or retained to provide finance, or be partly distributed and partly retained. If a company fails
T E X T

to distribute as dividends that part of its income which in the opinion of the Commissioner is
in excess of its requirements within a period of twelve months after the accounting period, the
Commissioner may direct that that income be deemed to have been distributed to the shareholders
as dividends.
S T U D Y

The Act requires that a company paying dividends to deduct tax at source and remit it to the
Commissioner. The company is entitled to recover such from the shareholder. When the profits
are subsequently distributed, they will not be taxed on the shareholders.
In practice, the Commissioner usually allows for the retention of 60% of the profits after tax
derived from trading income. Profits after tax from investment income are distributed in full. Non-
taxable dividends are also distributed in full.

Illustration
Limited made a pre-tax profit of Kshs.100m comprising of:
a. Trading profits Shs.60m
b. Investment income Shs.10m
c. Dividends from B. Limited (a subsidiary) Shs.30m

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 ADVANCED ASPECTS OF THE 15
TAXATION OF BUSINESS INCOME

State how much the company should distribute as dividends in order to comply with the Section
24 proviso (Assume corporation tax is 40%)
Trading Investment Non-taxable Total
Profits Income dividends
Kshs.—m Kshs—m Kshs—m Kshs—m
Pre-tax profits 60 10 30 100
Corporation tax (40%) (24) (4) __ (28)
Profits after tax 36 6 30 72
Maximum retention (60%) (21.6) NIL NIL (21.6)
distributable profits 14.4 6 30 50.4

1.7.3 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 37½% on incomes generated by their local branches. Like for resident companies,
such branches shall be allowed to deduct expenditure incurred in generation of income. In the
case of export processing zones enterprises. There is a tax holiday during the first 10 years of
their operations, followed by a lower tax rate of 25% during the next ten year period. For mining

T E X T
companies a lower tax rate of 27½% is applicable over the first five years of production. Special
withholding tax rates exist for certain specified income sources.
For the purpose of ascertaining the gains or profits of a business carried on in Kenya no deductions

S T U D Y
shall be allowed in respect of expenditure incurred outside Kenya by a non-resident person other
than expenditure in respect of which the commissioner determines that adequate consideration
has been given 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 extent the commissioner 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

1.7.4 A Group Comprising the Holding Company and Subsidiary Companies

Under the Income Tax Act, companies are treated as legal persons independently. There is
no lifting of the veil to consider them as part of one group for tax purposes. 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.

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 16 A dvanced TA X AT I O N

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 considerations. 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
company’s hands if it controls 12½% or more of the voting power of the paying company.
Real estate maybe transferred free of stamp duty where the beneficial ownership does not
change.

1.7.5 Compensating tax and Dividend tax account

Compensating tax was introduced in 1993 under Section 7 A of the Income Tax Act. It is an
additional tax imposed on companies and arise 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 Income Tax Act, the initial balance in the dividend tax
T E X T

account will be either-

(a) Zero; or
(b) Sum of the total taxes paid and tax on dividends received, less tax on dividends
S T U D Y

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 Kshs Kshs
Debit Credit
Dividend Tax Account Opening Balance b/forward as above (1 X
January 199x)
Total income taxes paid during the year X
Tax on total dividends received during the year X
(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) X

Balance carried forward (if debit) X

Compensating tax payable ( if credit) X
XX XX

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 ADVANCED ASPECTS OF THE 17
TAXATION OF BUSINESS INCOME

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.

Illustration
The following information was obtained from the books of Nyawira Ltd, for the year ended 31
Dec. 2008
Details Kshs.
Profit after Tax 4,200,000
Dividend paid 6,400,000
Dividend received 1,500,000

Additional information:
A tax refund of Kshs 360,000 was received by the company for the year ended 31 dec 2008
Required: Compensating tax, if any payable by Nyawira Ltd for the year ended 31 dec 2008.
Attempted solution
Computation of compensating tax

T E X T
DR CR
Income tax paid (0.3 x 4,200,000) 1,260,000

S T U D Y
(excluding dividend w/tax)
Dividend received (1,500,000 x 642,857
0.3/1-0.3)
Dividend paid (6,400,000 x 0.3/1- 2,742,857
0.3)
Tax refund 360,000
Compensating tax 1,200,000
3,102,857 3,102,857

Definition
Compensating tax as per section 7A of the Income 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.

1.7.6 Capital Deductions

Section 16 of the Income Tax Act expressly provides that in calculating the gains or profits of
a person no deduction can be made for expenditure of a capital nature. The same principle is
applied in disallowing capital losses, exhaustion of capital e.g. depreciation of fixed assets.
The substance of this principle is that on the other hand a disposal of a fixed asset is not a
revenue receipt and therefore excluded from the computation of taxable profits.

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 18 A dvanced TA X AT I O N

The distinction between capital expenditure and revenue expenditure is quite essential in the
study of capital allowances.
The scheme of capital allowances serves three main purposes:
1. To encourage new industrial enterprises;
2. To allow such deduction as may be just and reasonable as representing the diminution
in the value of fixed assets by reason of wear and tear during a particular year, of any
plant or machinery used for the purpose of a business; and
3. To encourage exportation.

The capital allowances available in Kenya are:-

a. Investment Deduction Allowance
b. Wear and Tear Allowance
c. Industrial Building Allowance
d. Farmworks Deduction Allowance
e. Mining Deduction

We provide a summary of the capital allowances on the assumption that the same were covered
in detail in the taxation 1 level.
T E X T

(a) Investment Deduction

Based on eligible cost:
Rate %
S T U D Y

Building and machinery used for manufacturing purposes and hotel

buildings
100
Civil works and structures forming part of an industrial building used
for purposes of manufacturing
100
Ships 40
Filming Equipment (W.E.F 12th June 2009) 100
Satellite Towns Investments (W.E.F 12th June 2009) 150

‘Manufacturing’ for the purposes of investment deduction includes generation of electrical power
supply to the national grid. Investment deduction is granted to lessors on machinery that is
subsequently leased and used for the purpose of manufacture.
With effect from 12th June 2009,
•• For any expenditure to qualify for investment Deduction on machinery and buildings,
there must be a minimum expenditure of Kshs.200 million.
•• Filming equipment qualify for Investment Deduction of 100%
•• An incentive was introduced for an Investment in the Satellite towns adjoining Nairobi,
Mombasa or Kisumu at 150%

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 ADVANCED ASPECTS OF THE 19
TAXATION OF BUSINESS INCOME

(b) Wear and tear allowance

Based on cost net of any investment deduction and computed on declining balance basis:
Rate %
Heavy self-propelling machinery such as tractors and combine
harvesters
37.5
Computer and peripheral computer hardware, calculators, copiers
and duplicating machines
30
Other self propelling vehicles and aircrafts (cost of non-commercial
motor vehicles is restricted to KShs 2 million)
25
All other machinery including ships 12.5
Computer software (W.E.F 12th June 2009) 5
Telecommunication Equipment (W.E.F 12th June 2009) 20

With effect from 12th June 2009,

•• The Wear and Tear allowance for computer software is 5%.
•• The wear and Tear Allowance rate for telecommunication equipment is 20%
(c) Industrial buildings allowance

T E X T
Based on cost net of any investment deduction and computed on a straight line basis:
Rate %
Industrial buildings 2.5
Hotel buildings 10

S T U D Y
Hostels and buildings used for educational purposes 10
Hostels, Training and educational buildings (W.E.F 12th June 2009) 50
Rental residential buildings constructed in a planned
developed area approved by Minister for Housing 5
Rental residential buildings constructed in a planned 25
developed area approved by Minister for Housing(W.E.F 12th June
2009)
Commercial Buildings (W.E.F 12th June 2009) 25

With effect from 12th June 2009,

•• The IBD for commercial buildings is 25%
•• The IBD for hostels educational and training buildings was increased from 10% to
50%
•• The IBD for rental residential buildings in a planned development area increased from
5% to 25%
(d) Farm works allowance
Rate %
Computed on a straight-line basis 2006 – 33.3%
2007 to date 50%

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 20 A dvanced TA X AT I O N

(e) Mining allowance

Based on capital expenditure incurred in mining specified minerals:

Rate %
Year 1 40
Year 2 – 7 10

Illustration Question
a) The following is the summarised balance sheet of Faraja Ltd. as at 1 January 2006:
Shs. Shs.
Non-current assets:
Factory building (net book value) 5,680,000
Processing machinery (net book value) 2,420,000
Motor vehicles (net book value) 1,500,000
Furniture and fittings (net book value) 840,000
Office equipment (net book value) 670,000 11,110,000

Current assets:
Stock 1,240,000
T E X T

Trade debtors 760,000

Prepaid insurance 360,000
Bank balance 540,000 2,900,000
14,010,000
S T U D Y

Financed by:
Share capital (ordinary shares of Sh.20 9,000,000
each)
10% debenture stocks 2,400,000
15% bank loan 1,500,000 12,900,000

Current liabilities:
Creditors 1,000,000
Accrued general expenses 110,000 1,110,000
Total capital liabilities 14,010,000

Additional information:
1. All the non-current assets were acquired on 1 January 2004 when the company commenced
operations. The net book value of these assets as at 1 January 2007 were the same as their
written down values for capital allowance purposes.
2. Included in the processing machinery are machinery with a net book value of Shs.420,000
as at 1 January 2007. This machinery are used in designing and moulding products during
the manufacturing process.
3. Office equipment as at 1 January 2007 comprised the following assets at net book value:

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 ADVANCED ASPECTS OF THE 21
TAXATION OF BUSINESS INCOME

Shs.
Computers 240,000
Telephone 96,000
switchboard
Fax machines 120,000
Neon sign 36,000
Other office 178,000
equipment
4 One of the motor vehicles purchased on 1 January 2004 was a saloon car acquired at a cost
of Sh.1,200,000.
5. The reported profit of the company for the year ended 31 December 2007 was Sh.1,840,000
before accounting for capital allowances due for the year and interest expense. The reported
profit was based on cash sales.
6. The following transactions included in the bank statement for the year had also not been
accounted for in arriving at the reported profit:

Shs.
Receipts from trade debtors 2,800,000
Payments to trade creditors 1,400,000
Refund from trade creditors for purchases returned 360,000
General expenses 346,400

T E X T
Insurance 550,800
Cash sales deposited directly to bank account 140,000

S T U D Y
Insurance paid includes a pre-payment of Sh.50,800 for year 2008.
7. There were no closing balances of trade debtors and creditors as at 31 December 2007. All
payments from/to trade debtors and creditors were made through the bank account.
Required:
For the year ended 31 December 2007, determine for Faraja Ltd:
i) Capital allowances (8 marks)
ii) Adjusted taxable profit or loss (4 marks)
(Total: 12 marks)

Attempted Solution.

FARAJA LTD

i) CAPITAL ALLOWANCES FOR YEAR TO 31 DECEMBER 2006

a) INDUSTRIAL BUILDING DEDUCTION
Nature of building Qualifying Cost Residue b/f IBD @ 2½% Residue c/f
Shs. ‘000’ Shs. ‘000’ Shs. ‘000’ Shs. ‘000’
Factory building 6,140.541 5,680 153.514 5,526.486

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 22 A dvanced TA X AT I O N

b) WEAR AND TEAR ALLOWANCE

CLASS I @37½% II @ 30% III @ 25% IV @ 12½
S. ‘000’ SHS. ‘000’ SHS. ‘000’ SHS. ‘000’
W.D.V b/f:
Computers 240
Telephone switchboard 96
Fax machine 120
Neon sign 36
Other office equipment 178
Motor vehicles 1,500
Furniture and fittings 840
Processing machinery 2,420
Sub total 456 1,500 3,474
WTA (136.8) (375) (434.25)
319.2 1,125 3,039.75

SUMMARY OF CAPITAL ALLOWANCES

SHS. ‘000’
IBD 153.514
WTA II 136.8
T E X T

III 375
V 434.25
Total Capital allowances 1,099.564
S T U D Y

ii) ADJUSTED TAXABLE PROFIT OR LOSS FOR YEAR TO 31 DECEMBER 2006

SHS. ‘000’ SHS. ‘000’
Reported profit 1,840.00
Add: Credit sales 2,040.00
omitted
Cash sales omitted 140.00 2,180.00
4,020.00
Deduct
Purchases 400.00
General expense 346.40
Insurance (550.8 – 50.8) 500.00
Capital allowances 1,099.56 (2,345.96)

Adjusted taxable profit 1,674.04

DEBTORS ACCOUNT
SHS. ‘000’ SHS. ‘000’
Bal b/d 760 Bank 2,800
Credit Sales 2,040 _____
2,800 2,800

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 ADVANCED ASPECTS OF THE 23
TAXATION OF BUSINESS INCOME

CREDITORS ACCOUNT
SHS. ‘000’ SHS. ‘000’
Bank 1,400 Bal b/d 1,000
Balance carried down _____ Credit Purchases 400
1,400 1,400

1.8 Chapter Summary

•• Partnerships are not legal persons. Their incomes are taxed on the respective partners
at their graduated scale rates
•• Resident and non resident companies with permanent establishments are taxed at the
rates of 30% and 37.5% respectively.
•• There are special incentives available for newly listed companies, companies operating
in the EPZ and companies involved in mining specified minerals.
•• There are differences in the taxation of a branch of a foreign company compared to a
resident company.
•• Companies declaring dividend from untaxed profits are subject to compensating tax.

T E X T
•• There are five major types of capital allowances in Kenya, applicable to expenditure of
a capital nature incurred in the generation of income.

S T U D Y
1.9 Quiz

Questions one

Name the five capital allowances in Kenya

Question two

Distinguish between taxation of partnerships and private limited companies.

Question Three

List the incentives if companies operating in the EPZ zone.

Question Four

Explain the dates for instalment tax payment for companies.

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 24 A dvanced TA X AT I O N

Question Five

What is compensating tax?

T E X T
S T U D Y

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 ADVANCED ASPECTS OF THE 25
TAXATION OF BUSINESS INCOME

1.10 Answers to the Quiz

Questions one

Name the five capital allowances in Kenya

a. Investment Deduction Allowance
b. Wear and Tear Allowance
c. Industrial Building Allowance
d. Farmworks Deduction Allowance
e. Mining Deduction

Question two

Distinguish between taxation of partnerships and private limited companies.

i) A partnership is not considered as a separate taxable entity as a company, therefore,

T E X T
the taxable income of a partnership is allocated among the partners according to the
profit/loss sharing ratio. A company is considered to be a separate taxable entity and as
such it will bear its taxes.
ii) The partners in a partnership are taxed at the graduated scale rates which are lower than

S T U D Y
the corporate tax rates. The taxable income or loss of a limited company is taxable on
the company at a flat rate of 30% for resident and 37.5 % for nonresident companies.

iii) Partner’s salaries are not tax deductible while director’s salaries in a limited company
are tax deductible.
iv) Very important also to consider is that the losses made under a partnership are carried
forward by the Partners individually but not the firm while losses in a limited company
are carried forward by the company.
v) The company will be required to pay withholding tax when its declaring dividends to
its share holders while a partnership does not declare dividends. The partners may
withdraw and any such withdrawal will be taxed on the individual partner.
vi) Companies have compensating tax while partnerships are not subject to the same.
vii) Currently partnership can pay turnover tax at 3% on gross income if the company has
turnover of between Kshs.500,000 and Kshs.5m within one year. However, companies
are not subject to turnover tax.

Question Three

List the incentives if companies operating in the EPZ zone.

Companies operating within EPZ have the following benefits:
• A ten year tax holiday –This is an exemption from corporation tax for the first ten
years of trading.

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 26 A dvanced TA X AT I O N

• A lower corporation tax rate of 25% for the subsequent 10 years after the ten years
tax holiday.
• An exemption from all Withholding tax on dividends and other payments to non
residents during the first 10 years.
• Investment deductions are 100% of the capital expenditure claimable in the 11th
year after commencement of production.
• Zero rated for purposes of VAT
• There is a refund of import duty on raw materials to manufacture exports.

Question Four

Explain the dates for installment tax payment for companies.

Instalment tax is payable as follows.
1st instalment 25% of tax due by 20th day of the 4th month during the year of income.
2nd instalment 25% of tax due by 20th day of the 6th month during the year of income.
3rd instalment 25% of tax due by 20th day of the 9th month during the year of income.
4th instalment 25% of tax due by 20th day of the 12th month during the year of income.
final tax ( tax Actual tax payable minus total instalment tax paid on the last day of the
balance) fourth month after the end of the year of income.
T E X T

However for firms in agriculture sector, instalment tax is payable as:

1st instalment 75% of tax due by 20th day of the 9th month during the year of income.
S T U D Y

2nd instalment 25% of tax due by 20th day of the 12th month during the year of income.
final tax ( tax Actual tax payable minus total instalment tax paid on the last day of the
balance) fourth month after the end of the year of income.

Question Five

Compensating tax was introduced in 1993 under Section 7 A of the Income Tax Act. It is an
additional tax imposed on companies and arise 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.

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 ADVANCED ASPECTS OF THE 27
TAXATION OF BUSINESS INCOME

1.11 Past paper Questions analysis.

The topic has been tested very frequently in the previous years. The student is advised
to practice the questions so as to enhance understanding of the topic. The following is
an analysis on how the chapter has been examined in the past. The questions are listed in this
format: Month/year e.g. 6/01 represents June or May 2001.

06/00 Q. 1, 06/00 Q.2, 12/00 Q.1, 2, 3, 06/01 Q. 1, 06/01 Q. 5, 12/01 Q. 2(b), 12/01 Q. 5, 06/02
Q. 2, 06/02 Q. 5, 12/02 Q. 3, 06/03 Q. 2, 06/03 Q. 4 & 5, 12/03 Q.1 & 2, 06/04 Q.3, 06/04 Q.5,
12/04 Q.1, 12/04 Q.3, 06/05 Q.2 (b), 06/05 Q.3, 06/05 Q.4, 12/05 Q.1(a), 12/05 Q.2(a), 12/05
Q.3, 12/05 Q.5 (b), 06/06 Q.1, 06/06 Q.5(b), 12/06 Q.2, 12/06 Q. 4(b), 12/07 Q.2, 06/07 Q.3(a &
b), 06/07 Q.4(b), 12/07 Q.3(a & b), 12/07 Q.4(a), 12/07 Q.5(a), 06/08 Q.1, 06/08 Q.2, 06/08 Q.4,
12/08 Q.3, 12/08 Q.5(b).

1.12 Revision Questions.

T E X T
Tax Rates

S T U D Y
VALUE OF TAXABLE BENEFITS PRESCRIBED BY CIT (YEAR 2008)
Taxable Employment Benefits - Year 2008
RATES OF TAX (Including wife’s employment, self employment and professional income rates
of tax).
Year of income 2008
Taxable Employment Benefits - Year 2008
Monthly taxable pay Annual taxable pay Rates of tax % in
each shilling
(shillings) (shillings)
1 - 10,164 1 - 121,968 10%
10,165 - 19,740 121,969 - 236,880 15%
19,741 - 29,316 236,881 - 351,792 20%
29,317 - 38,892 351,793 - 466,704 25%
Excess over - 38,892 Excess over - 466,704 30%

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 28 A dvanced TA X AT I O N

Personal relief Shs. 1,162 per month (Shs. 13,944 per annum)
Prescribed benefit rates of motor vehicles provided
by employer
Monthly A n n u a l
rates rates
(Sh.) (Sh.)
Capital allowances: (i) Saloon, Hatch Backs and
Estates
Wear and tear allowances Upto - 1200 cc 3,600 43,200
Class I 37.5% 1201 - 1500 cc 4,200 50,400
Class II 30% 1501 - 1750 cc 5,800 69,600
Class III 25% 1751 - 2000 cc 7,200 86,400
Class IV 12.5% 2001 - 3000 cc 8,600 103,200
Industrial building allowance: Over - 3000 cc 14,400 172,800
Industrial buildings 2.5% (ii) Pick-ups, Panel Van
(Unconverted)
Hotels
2006 4.0%
2007 to date 10%
Farm works Upto 1750 cc 3,600 43,200
allowance
T E X T

2006 33%
2007 to date 50%
Investment deduction allowance: Over 1750 cc 4,200 50,400
   2003          - 70% (iii) Land Rovers/Cruisers 7,200 86,400
S T U D Y

   2004          - 100% OR 2% of the initial capital cost of the vehicle for

each month, whichever is higher.
   2006 to date 100%
Shipping investment deduction 40%
Mining allowance:
Year 1 40%
Year 2 - 7 10%

Commissioner’s prescribed benefit rates

Services Monthly rates Annual rates
  Sh. Sh.
(i) Electricity (Communal or from a generator) 1,500 18,000
(ii) Water (Communal or from a borehole) 500 6,000
(iii) Provision of furniture (1% of cost to employer)
If hired, the cost of hire should be brought to charge
(iv) Telephone (Landline and mobile phones) 30% of bills

Agricultural employees: Reduced rates of benefits

(i) Water                                                                            200                                 2,400
(ii) Electricity                                                                      900                               10,800

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 ADVANCED ASPECTS OF THE 29
TAXATION OF BUSINESS INCOME

Low interest rate employment benefit:

The benefit is the difference between the interest charged by the employer and the prescribed
rate of interest.

Other benefits:
Other benefits, for example servants, security, staff meals etc are taxable at the higher of fair
market value and actual cost to employer.

Question One

a. Briefly discuss the tax implication of the taxation of branches of foreign companies and
companies registered in Kenya.
(Dec 2008 4(a) adopted)
b. The management of Mazuri Limited has presented the following trading and profit and
loss account for the year ended 31 December 2007:

Ksh. ‘000’ Ksh. ‘000’

Sales 18,500
Less cost of sales:
Opening Stock 4,200

T E X T
Purchases 5,600
Cost of goods available for sale 9,800
Closing stock (2,400) (7,400)
Gross profit 11,100

S T U D Y
Other incomes:
Gain on sale of equipment 120
Interest on savings account 40
Refund of import duty 80
Gain on foreign exchange transactions 100
11,440
Expenditure:
Goodwill amortisation 25
Legal expenses 420
Salaries 2,000
Bad debts 500
NSSF contribution 60
General expenses 600
Advertising 300
Staff meals 190
Travelling expenses 180
Donations to a trade association 40
Property rates 45
Depreciation 150
Interest on long term 300
Interest on bank overdraft 80
Insurance 124
Cost of stolen stock 20
Branch closure costs 100 (5,134)
Net profit 6,306

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 30 A dvanced TA X AT I O N

Additional information:
1. The closing stock on 31 December 2007 was valued at a cost plus a mark up of twenty
per cent.
2. Legal expenses related to:

Ksh.
Preparation of the Memorandum of 150,000
Association
Conveyance fees on purchase of land 60,000
Acquisition of leasehold property 90,000
Settling customer disputes 100,000
Acquisition of a bank loan 20,000
420,000
3. The directors had withdrawn goods costing Ksh.600,000 (selling price Ksh.720,000) for
their personal use. These goods have been included in both purchases and sales for
the year ended 31 December 2007.
4. Sales (expense) includes:
Ksh.
Directors allowances 720,000
Christmas gifts to staff 600,000
T E X T

Golden handshake to a retiring director 400,000

5. Bad debts include:

Ksh.
S T U D Y

Loan to director 200,000

Estimated defaults by trade debtors 120,000

1. Advertising expense includes Ksh.100,000 for a neon sign

2. Twenty per cent of the travelling expenses relate to the private usage of company
motor vehicles.
3. Capital allowances were agreed with the revenue authority at Ksh.200,000.
Required:
i) Adjusted taxable profit or loss for Mazuri Limited for the year ended 31 December
2007. (12 marks)
ii) The tax payable by Mazuri Limited (if any) for the year ended 31 December 2007
(2 marks)
(Total: 14 marks)
(June 2005 Q.4)

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 ADVANCED ASPECTS OF THE 31
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Question Two

Christine, Atieno and Rose Njeri started a law firm as partners on 1 January 2007. They named
the firm Atieno Njeri and associates. The partners opened a joint account where Njeri deposited
Kshs. 3,000,000 and Atieno Kshs.2,000,000 as initial capital. They also agreed that profits and
losses would be shared in the ratio of their initial capital contributions. Further, they agreed
that interest on capital would be paid at the rate of 5% per annum based on the initial capital
contributions.
On 5th January 2007, the firm signed a six-year lease for an office at an annual lease payment of
Kshs. 200,000. The lease contract required the partners to deposit a lump sum to cover the lease
payment for the first two years of the lease term.
On 11th January 2007, the firm purchased the following assets for use in the business:
Asset Cost (Shs)
Motor vehicle (double-cabin pick-up) 2,500,000
Other Assets:
Furniture and fittings 280,000
Computers and printers 120,000
Telephone and fax machines 40,000
Reference books 16,000
Kitchen utensils (for office tea) 3,000

T E X T
Television Set 12,000
Fans 6,000
Carpets 22,000
Safe (Metallic) 25,000

S T U D Y
The firm did not maintain all the necessary books of account as required under the Income Tax
Act (CAP 470). However, the partners were able to obtain the following details of the transactions
for the year ended 31st December 2007:
1. Professional fees earned amounted to Shs. 8,200,000. Of this amount, Shs 3,700,000
was received in cash while the balance was directly deposited by clients to the firm’s
bank account.
2. The following monthly payments were made from fees received in cash before banking
the balance at each month end:
Shs.
Business mileage allowance to partners: Atieno 30,000
Njeri 25,000
Mobile phone airtime(for official use): Atieno 3,000
Njeri 3,000
Staff 2,000
Office tea and snacks 5,000
3. Analysis of the firms bank statement for the year showed the following summary of
payments:
Shs
Lease payment 400,000
Purchase of motor vehicle(double cabin pick up) 2,500,000
Purchase of other assets 524,000
Office expenses 2,921,000
Advertisement Commission 200,000

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 32 A dvanced TA X AT I O N

4. The office expenses amount shown in note 3 above was further analysed as follows:

Shs
Partner’s salaries
Atieno 600,000
Njeri 400,000
Salaries to staff 436,000
Contributions to retirement benefit plans
Partners 180,000
Staff 120,000
Contributions to medical Scheme
Partners 280,000
Staff 150,000
Premium on partners’ life insurance policies 210,000
Golf club membership for partners 50,000
Donations: Political Party 10,000
Red cross Society of Kenya 60,000
Tax consultancy fees 35,000
Subscriptions to Law Society of Kenya 40,000
Training fees
Partner’s Children school fees 140,000
Staff 80,000
T E X T

Motor vehicle Insurance 30,000

Other office expenses 100,000
S T U D Y

Required
a) Taxable profit(loss) of the firm for the year ended 31st December 2007. (14 marks)
b) Allocation of profit ir loss obtained in (a) above to the partners. (4 marks)
c) Tax payable (if any) by each partner for the year ended 31st December 2007.(2 marks)
(June 2008 1)

Question Three

Starlit company Ltd. has been operating in Kenya since 1 January 2003. The company is a
subsidiary of Mega Holdings Ltd. which is based in the United Kingdom.
The financial statements of Starlit Company Ltd. for the year ended 31 December 2005 are
presented below.

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 ADVANCED ASPECTS OF THE 33
TAXATION OF BUSINESS INCOME

Profit and loss account for the year ended 31 December 2005
Sh ‘000’ Sh ‘000’
Sales 97,440
Less cost 44,940
Gross profit 52,500
Less expense
Wages 30,000
Depreciation 7,500
Interest 1,500
General expenses 9,000 48,000
Net profit 4,500
Proposed dividend 600
Retained profit for the year 3,900

Balance sheet as at 31 December 2005

T E X T
Sh ‘000’ Sh ‘000’
Fixed assets (net) 92,350
Current assets

S T U D Y
Stock 6,000
Trade creditors 2,250
Bank balance 15,000 23,250
Total assets 115,600
Capital and liabilities
Ordinary share capital 87,000
Debentures 13,500
Retained profits 10,000
Current liabilities
Trade creditors 4,125
Accrued wages 375
Proposed dividend 600 5,100
Total capital and liabilities 115,600

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 34 A dvanced TA X AT I O N

Bank account for the year ended 31 December 2005:

Sh ‘000’ Sh ‘000’
Balance brought forward 1,500 Wages 30,375
Receipts from customers 98,250 General expenses 9,000
Payments to suppliers 43,125
Interest 1,500
Dividend 750
Balance carried down 15,000
99,750 99,750
Additional information
1. Included in sales was Sh.2,100,000 representing goods sold to the parent company. All
sales to the parent company are made at 10% below the normal selling price.
2. General expenses include:
Sh. ‘000’
Flotation cost on issue of debentures 1,400
Stamp duty on issue of debentures 800
Conveyance fees on purchase of land 2,000
T E X T

Foreign exchange losses relating to the

parent company’s transactions. 560
S T U D Y

3. The written down values of fixed assets extracted as at 1 January 2005 were as
follows:


Sh.
Industrial building 17,100,000
Computers 900,000
Processing machinery (imported from United Kingdom) 19,906,250
Office partitions 400,000
Lorries (each 3 tonnes) 4,500,000
Delivery vans 3,600,000
Pick-ups 2,500,000
Furniture and fittings 600,000
Office equipment 800,000

The company did not claim investment (ID) allowance on industrial building and processing
machinery in year 2003. However, the company claimed industrial building reduction (IBD) and
wear and tear allowances on the industrial building and processing machinery respectively
from years 2005 and 2006.

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 ADVANCED ASPECTS OF THE 35
TAXATION OF BUSINESS INCOME

Included in the cost of processing machinery was import duty of Sh.1,200,000 and freight charges
of sh.400,000.

Required:
(a) (i) Compute the investment deduction allowance that was due to the company in year
2003. (4 marks)
(ii) Calculate the total over or under-claimed wear and tear allowance in relation to the
processing machinery as at 31 December 2004. (4 marks)
(iii) Compute the industrial building deduction allowance due to the company in years
2003, 2004 and 2005. (2 marks)
(b) Determine the company’s adjusted taxable profit or loss for the year ended
31 December 2005. (10 marks)
(Hint: Start your computation with the reported profit) (Total: 20 Marks)
(June 2006 1)

Question Four

a. Discuss the Provisions of the Income Tax Act (Cap.470) relating to shortfall tax on non-
distribution of dividend. (10 marks)

T E X T
b. Samia Ltd reported the following income during the year ended 31 December 2007.

Shs.
Operating Income (before tax) 12,000,000

S T U D Y
Investment income 650,000
Rental income(gross) 1,600,000

Additional information:
1. Investment income comprised
Shs.
Dividend from a company in which Samia Ltd
Holds 20% of the share capital 100,000
Interest from fixed deposit accounts(net) 50,000
Interest from treasury bills(net) 500,000
650,000
2. Samia Ltd. declared a dividend of Kshs. 1,300,000 for the year ended 31 December
2007.
Required:
Determine the shortfall tax (if any) payable by Samia Ltd for the year ended 31 December
2007. (6 Marks)
(June 2008 2 (b))

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 36 A dvanced TA X AT I O N

Question Five

a) With reference to Section 7A of the Income Tax Act (Cap.470), define the term “compensating
tax” (2 marks)
b) The following information relates to ABC Ltd for the year ended 31 December 2007:

•• Profit before tax Sh.4,000,000

•• Import duty refunded by tax authority Sh400,000
•• Dividend distributed by ABC Ltd Sh8,800,000
•• Dividend received by ABC Ltd Sh.3,000,000
•• Corporation tax rate 30%
Required
Compensating tax payable by ABC Ltd. for the year ended 31 December 2007 (4 marks)
c) The Commissioner for Customs has powers to appoint and fix limits of customs areas for the
control of movement of persons and goods.
Identify four areas which may constitute a custom’s area (4 marks)
d) D. Mkasana is a director with Sabasaba Industries Ltd. where he controls 15% of the voting
capital. He also owns residential houses in addition to being a partner with his wife in a
flower business.
T E X T

The following information relates to his income for the year ended 31 December 2007.
1. Employment
•• Basic pay Sh.250,000 per month (PAYE Shs50,000)
S T U D Y

•• He was admitted to hospital in March 2006 and the employer paid the medical bill which
amounted to Shs.1,300,000
•• He was issued with additional 1,000 shares in the company at a price of Shs.50 per
share when the prevailing market price was Shs.80per share.
•• He enjoys free lunch and tea valued at Sh.8,000 per month.

2. Rental income

Shs Shs
Gross rent 1,960,000
Less: Structural alterations 600,000
Land rent and rates 48,000
Loan interest 200,000
Valuation of rental buildings 140,000
Commission to estate agents 28,000
Purchase of furniture and fittings for tenants 100,000
Painting before letting 96,000
Legal fees 24,000 (1,236,000)
Net rental income 724,000

Land rent and rates include Sh8,000 paid as deposit for water connection. Structural alterations
enhanced the value of the buildings. Legal fees relate to collection of rent arrears.

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 ADVANCED ASPECTS OF THE 37
TAXATION OF BUSINESS INCOME

3. Flower business
This is a partnership with his wife where they share profits and losses equally. The wife
runs the business on a full time basis. Sales proceeds for the year to 31 December 2007
amounted to Sh.8,000,000. The following expenses have not been deducted from the sales
proceeds:

Shs
Salary to wife (arm’s length 600,000
Construction of flower sheds 240,000
Purchase of pesticides 180,000
Foreign exchange losses 64,000
Other farm expenses 1,200,000

Required:

Total taxable income of D. Mkasana for the year ended 31 December 2007 (10 marks)
(Total: 20 marks)

T E X T
S T U D Y

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 38 A dvanced TA X AT I O N
T E X T
S T U D Y

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 TAXATION OF SPECIALISED ACTIVITIES 39

CHAPTER TWO
ONE

T E TX ET X T
S T U D Y T E X T
S T SU TDUYD Y

TAXATION OF
SPECIALISED
ACTIVITIES

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 40 A dvanced TA X AT I O N
T E X T
S T U D Y

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 TAXATION OF SPECIALISED ACTIVITIES 41

CHAPTER TWO
TAXATION OF SPECIALISED ACTIVITIES

2.1 Objectives

At the end of this chapter, the student is expected to be able to compute tax liability
under the following institutions. She/he should also be able to distinguish between any
of these institutions for tax purposes.
•• Leasing entities
•• Co-operative societies
•• Trade associations and clubs
•• Charitable institutions
•• Trust bodies, settlements and estates under administration
•• Petroleum, banking, insurance, sea and air transport undertakings
•• Unit trusts
•• Property developers and contractors
•• Application of relevant case law

T E X T
2.2 Introduction

S T U D Y
In the previous chapter, we studied advanced aspects of taxation of partnerships and companies.
In this chapter, you will be introduced to the taxation of other specialized activities or institutions
which include: leasing, banking, insurance, petroleum, trust, co-operative societies among
others. The tax concepts learnt in this topic will help you to be better equipped in answering
exam questions.
In the next topic we shall study concepts in tax investigation.

2.3 Key Definitions

•• Leasing entity: This is a firm or a company involved in the business of leasing

•• Lease: This is a contract by which a person owning assets grants to a leasee the right
to possess, use and enjoy such assets for a specified period of time, in exchange for
periodic payments. There may be finance or operating lease.
•• Co-operative society: A Cooperative Society is taken to be a body corporate having
its own existence separate from that of its members. It is, therefore, deemed to have its
own income even though some of the income is from transactions with its members. It

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 42 A dvanced TA X AT I O N

comprises a group of people who come together and pull resources for a common goal.
It is formed under the Co-operative Societies Act.
•• Trade Associations: A trade association is a body of persons which is an association
of persons separately engaged in any business with the main object of safeguarding or
promoting the business interests of such persons.
•• Club: A members club means a club or similar institution with all its assets owned by,
or held in trust for the members thereof. The income of clubs is made up of the gross
receipts, including entrance fees, and subscriptions and such receipts are taxed in the
name of the club at the corporation tax rate.
•• Charitable Institutions: This is an non profit making organization established in Kenya
which
• Is of public character and
• Has been established for purposes of the relief of poverty or distress of the public
or advancement of education.
•• Trust: Its an arrangement under which a person, the settler transfers property to another
person, the trustee or trustees, who is required to deal with the trust property on behalf
of certain specified persons, the beneficiaries.
•• Unit trust:- A Unit Trust or a mutual fund organization is one registered under the Unit
Trust Act. It sells units (equivalent to shares) to the public and invests the funds for a
return. The unit holder gets a return (interest) from the Unit Trust tax free.
T E X T

2.4 Exam Context

S T U D Y

Concepts explained in this topic are highly examinable. The student advised to master the content
and be able to apply the same in exam questions

2.5 Industrial Context

This topic is very practical. It will be helpful to tax or finance managers in various industries or
sectors. With the emergence of such institutions, the students will be able to apply the knowledge
learnt in this topic in computing taxable income.

2.6 Lease Hire Arrangements

A lease is classified as a finance lease if it transfers substantially all the risks and rewards
incident to ownership from lessor to lessee. All other leases are classified as operating leases.
Classification is made at the inception of the lease.
Any income derived from leasing activities is taxable at the corporate tax rate.

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 TAXATION OF SPECIALISED ACTIVITIES 43

2.6.1Corporation tax on lease hire arrangements

Whereas the leasing rules have defined the operating and finance leases, there is no distinction
between the two categories of leasing for corporate tax purposes. However, this distinction exists
for Value Added Tax (VAT) purposes.
Lease rentals are allowable expenses for corporate tax purposes. if the Commissioner is satisfied
that:
a. The sole consideration for the payment is the use of or the right to use the asset; and
b. The entire payment is income in the hands of the recipient.

However, lease-hire payments in respect of a non-commercial vehicle are not tax deductible.
Related costs such as maintenance are allowable expenses for tax purposes.
The lessee is entitled to claim VAT on expenses incurred on the leased asset.
The lessor enjoys wear and tear allowance deductions as long as the equipment was utilized
wholly and exclusively for generation of taxable income.
The lessor enjoys investment allowance and which is deducted from his profits in the same
tax year in which investment is made. The deduction is made at a rate of 100% of the cost of
investing in machinery and buildings provided these are used for the purpose of manufacturing.

T E X T
2.6.2 Withholding tax of lease hire arrangements

The lessee should withhold tax at a rate of 3% on any payment made to the lessor in relation

S T U D Y
to payment of lease rentals. In case the lessor is a non-resident with no branch in Kenya, tax is
withheld at a rate of 15% which is a final tax.
Effective 1 July 2003, lease rental payment in relation to aircrafts is exempted from withholding
taxes

2.6.3 Taxation of lease rentals

Finance Lease: Eventual ownership of the leased asset passes to lessee upon payment of 75%
of cost.
Operating Lease: Ownership remains with lessor throughout the entire lease agreement.
Leasing is included in the definition of supply as “The letting of taxable goods on hire, leasing
or other transfers”, which supply is taxable.
Leasing is considered as a service, and lease instalments, being payments for this service, are
subject to VAT. If equipment that is the subject of a lease is either exempted from VAT or attracts
zero VAT, then the lease payments are similarly exempted from VAT.
Leasing of land, residential buildings, and non-residential buildings are exempted from VAT. This
exemption does not apply with respect to car park services, conference or exhibition services.

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 44 A dvanced TA X AT I O N

Illustration
You are provided with the following information for Anne lease hire Ltd, a company in the business
of leasing vehicles for the year ended 31 December 2008.
Kshs’000
Lease payments 10,000
Leased vehicle repairs 1,000
Salaries for lease staff 400
Business license 20

Required:
•• Compute corporation tax payable.
•• Compute Withholding tax deductible.
Attempted solution
(a) Corporation tax payable
Anne Lease hire Ltd
Computation of corporation tax payable
KShs'000 KShs'000
Taxable Income 10,000
Allowable expenses
T E X T

Leased vehicle repairs 1,000

Salaries for lease staff 400
Business license 20 (1,420)
S T U D Y

Taxable income 8,580

Tax payable*30% 2574

(b) Withholding Tax payable

A company should withhold 3% of the payments and remit the tax by the 20th of the month
following the deduction. In this case, Kshs. 300, 000 should have been deducted in total and
remitted.

2.7 Co-operative societies ( Section 19A of the Income Tax Act)

Cooperative Societies are formed under the Cooperative Societies Act (Cap 490, Laws of Kenya).
A Cooperative Society is taken to be a body corporate having its own existence separate from
that of its members. It is, therefore, deemed to have its own income even though some of the
income is from transactions with its members. The accounts of Cooperative Societies must be
audited by a professional accountant.

2.7.1 Mutual Transactions

These are transactions engaged in by a Cooperative Society with its members and not
outsiders.

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 TAXATION OF SPECIALISED ACTIVITIES 45

Mutuality is recognised in general law that a person cannot make a profit from himself. This
means that any profit and income arising from a cooperative society’s transactions with its
members is tax exempt, e.g. In the case of a SACCO, interest from members loans is purely
mutual and is not taxable.
When a cooperative society gets involved in activities which are not its primary objectives,
then income derived thereof is taxable and the society become liable to tax, i.e
•• When the society acquires property and buildings etc, and receives rental income from
it.
•• When it acquires a farm from which the main produce is the product is the product of
the society as a farm owner.
•• When it deals with non members in the form of sale of stores, hire pf transport, etc.
•• When it has investment income such as dividends and interests.

2.7.2 Taxation of cooperative Societies

The income of cooperative societies became taxable from Jan, 1st 1985. For tax purpose,
cooperatives are broadly classified into:
••Those registered under the Companies Act i.e KFA, KCC 2000, KPCU, COOP
Bank.
•• Those Registered under the Cooperative Societies Act refereed to as Designated

T E X T
Cooperative Societies.
Cooperative Societies registered under the Companies s Act are taxed just like any other
company.

S T U D Y
Those registered under the Cooperative Societies Act (Designated Cooperative Societies) are
further classified as follows:-

i. Designated Cooperative Society other than designated Primary Society. ( Secondary

societies)
These are Apex and Union Cooperative Societies.
ii. Designated Primary Societies.
A primary society is a cooperative society registered under the Cooperative Societies Act.
The membership of which is restricted to individual persons.
Designated primary societies may be:-
•• Those carrying on the business of a savings and credit cooperative society. (SACCO)
•• Those not carrying on the business of a SACCO.

Secondary societies comprise of Apex and Unions. Apex societies have membership of
union societies whilst unions members are primary societies
iii. Primary Societies- Members are individuals

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 46 A dvanced TA X AT I O N

2.7.3 Taxation of Apex and Union Cooperative Societies (Designated Secondary

Societies)

Compute taxable income in the same manner just like for any other business i.e. Gross income
less allowable expenses. However, dividends and bonuses are allowable expenses against
adjusted income up to a maximum of 100% of adjusted profit and must not exceed adjusted
profit. Therefore the carrying forward of losses is not allowed.

Illustration
Kilimo Union Co-Op Society Ltd
Year 2001 Profit And Loss Account
SH’000’ SH’000’
Gross profit 32,000

Less expenses
Salaries and wages 4,400
Director’s fees 1,000
Rent and rates 1,200
Travel and entertainment 400
Donations 1000
Legal fees-bank overdraft 1,600
T E X T

Income tax paid 2,400

Bad debts reserve 800
Provision for leave passages 500
Loss on sale of investment 300
S T U D Y

Furniture and fittings 1,000

General expenses 2,200
Tax Consultation fees 140
Depreciation 2,000 (18,940)

Surplus income 13,060

Required
Compute the adjusted surplus. Note that the company has declared 90% of adjusted surplus
as dividends and bonus. Compute the tax payable by the cooperative.

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 TAXATION OF SPECIALISED ACTIVITIES 47

Solution
Kilimo Union Co-Op Society Ltd
Adjusted Surplus In Year 2001 And Tax Payable
SH’000’ SH’000’
Surplus as per the accounts 13,060.00

ADD-
Deductions not allowable
Furniture and fittings 1,000.00
Depreciation 2,000.00
Legal fees-bank overdraft 1,600.00
Income tax paid 2,400.00
Bad debts reserve 800.00
Provision for leave passages 500.00
Donations ( Note 1) 1,000.00
Loss on investment 300.00 9,600.00
22,660.00
Less: Deductions allowable

T E X T
Wear and tear on Furniture and fittings(12.5% x (125.00)
1,000)
Adjusted surplus 22,535.00
Less-Dividends and bonus @ 90% (20,281.50)

S T U D Y
Taxable surplus 2,253.50
Tax thereon@ 30% 676.05

Note 1: I have assumed that the donations are to charitable organizations.

2.7.4 Taxation of a Primary Society Other Than a SACCO

Taxable income for a primary society which is not a SACCO is computed in the same manner
as in the case of Apes and Union Societies except that dividends and bonuses are allowable as
declared for that year and distribute to its members (w.e.f. 1.1.2004).
Note
For dividends and bonuses to be allowable:
•• Dividends and bonuses must have approved by the AGM and the CIT.
•• They must have been authorised by the Commissioner of Cooperative development.
•• They must have been actually paid out in cash, cheque, dividend, and warrants or
credited to member’s accounts. If not paid out then the auditors should guarantee that
the amount will be paid.
•• Dividends paid out by designated cooperative Societies other than SACCO is non
qualifying hence are subjected to further taxation.

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 48 A dvanced TA X AT I O N

2.7.5 Taxation of a SACCO

(a) The income of a SACCO is made up of:

(b) Interest from the member’s loans.
(c) Interest income from third parties e.g banks, insurance companies and other financial
institutions.
(d) Rental income.
(e) Other gains chargeable to tax in the Act.

♦♦ Interest income from members is fully exempt from taxation.

♦♦ Administrative expenses to the SACCO are not allowable.
♦♦ Other incomes of a SACCO apart from interest from members is taxable after allowing
a prescribed percentage to cater for expenses relating to such income as follows:
• Interest from third parties is taxable up to 50% of Gross interest.
• Its gross rental income.
• Gains chargeable to tax under sec 3(2((f) of the Income Tax Act.
• Any other income chargeable to tax excluding royalties.
ILLUSTRATION
JARIBU SACCO
2001 PROFIT AND LOSS ACCOUNT
T E X T

SH’000’
INCOME
S T U D Y

Interest from members loans 6,000

Interest from KCB (net) 255
Rental income 2,500
Dividends from xyz ltd (Gross) 300
Dividends from Wananchi Co-op Society Ltd (net) 800
9,855
EXPENSES
Salaries and wages 2,450
Donations 300
Depreciation 600
Travel and entertainment 80
AGM and training 35
Insurances 100
Rent 200
Interest 140
Repairs and maintenance 120
General expenses 50
Bad debts written off 25 (4,100)
 
Surplus income 5,755

Required:- Compute the taxable surplus and tax liability.

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 TAXATION OF SPECIALISED ACTIVITIES 49

Attempted Solution
Jaribu Sacco
Year 2001 Taxable Surplus and Tax Liability

SH’000’
TAXABLE INCOME
Interest income from KCB (300x50%) 150
Rental income 2500
Dividends from Wananchi 800 x 100/85 x 50% 470.588
Total taxable surplus 3120.588
Tax thereon @ 30% 936.176
Less set off taxes

Notes
•• Withholding tax on KCB interest is not final tax.
•• Dividends from Wananchi cooperative Society is the non qualifying type hence taxed
further.
•• Dividends from XYZ Ltd (Gross) suffers withholding tax at source which is Final tax.

T E X T
2.8 Taxation of Trade associations

S T U D Y
A trade association is a body of persons which is an association of persons separately engaged
in any business with the main object of safeguarding or promoting the business interests of such
persons. However, members of taxable trade associations are allowed to deduct the subscriptions
in their income tax computation.
Generally trade associations are not considered to be carrying out trading activities. However,
they may engage in trade. Under section 21(2)of the Income Tax Act, such an association can
choose or elect by notice in writing to the CDT to be considered to be carrying out business
chargeable to tax in respect to any year of income. In which case, it’s gross receipts from
the transactions with members (including entrance fees and subscription fees) and with other
persons is deemed to be income from the business for that year of income at the corporate tax
rate.

2.9 Taxation of Clubs

Under Section21 of the Income Tax Act, a members club means a club or similar institution
with all its assets owned by, or held in trust for the members thereof. The income of clubs is made
up of the gross receipts, including entrance fees, and subscriptions and such receipts are taxed
in the name of the club at the corporation tax rate.
However, when ¾ or more of such investment is derived from members, the body will not be
taken to be carrying on business and no part of such non investment income will be taxed i.e
income from members is not taxable.

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 50 A dvanced TA X AT I O N

Investment income of a club such as dividends, interest, rents, capital gains etc are to be excluded
in the ¾ test mentioned above.-(sec 21(1)

2.10 Taxation of amateur sporting association

Under Paragraph 6 of the first schedule to the Income Tax Act, income other than income from
investment of an Amateur sporting association is not taxable. For this to be the case, the amateur
sporting association must be one:
•• Whose sole aim or object is to foster outdoor sports and control any outdoor sports.
•• Whose members consist of amateurs or affiliated associations the members of which
are amateurs.
•• Whose memorandum of association or by laws have provisions defining an amateur or
a professional and providing that no person other than an amateur shall be a member
of that association.

2.11 Taxation of venture capital enterprises

The term ‘ venture company’ refers to a company incorporated in Kenya in which a

venture company has invested and which at the time of the first investment by the
T E X T

venture company has assets with a market value or annual turnover of less than five
hundred million in Kenya shillings.
A venture capital company is a company incorporated in Kenya for the purpose of
S T U D Y

investing in new and expanded business.

Venture capital companies enjoy certain tax exemptions as follows:
•• Dividends received by a registered venture capital company is tax exempt. ( A registered
venture capital company is a venture capital company registered by the CDT as such)
•• Gains arising from trade in shares of a venture company earned by a registered venture
capital company within the first ten years from the date of first investment in that venture
company by the venture capital company are tax exempt.: Provided that the venture
company has not been listed in any securities Exchange operating in Kenya for a period
of more than two years

2.11.1 Registration of a venture capital company

Under the Income Tax Venture Capital rules, a ‘venture capital company ‘shall, upon application
for registration, be registered by the Commissioner for the purposes of this Act if the Commissioner
is satisfied that –
(a) It is incorporated in Kenya; and
(b) It is incorporated for the purpose of investing in new or expanding venture companies;
and
(c) It is approved by Capital Markets Authority; and
(d It is managed by a fund manager; and
(e) Seventy-five percent or more of its portfolio of investable funds is invested in the equity
shares of venture companies; and
(f) The primary activities of the venture company in which it has invested are approved
activities.

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 TAXATION OF SPECIALISED ACTIVITIES 51

2.11.2 Prohibited services

The primary activities of a Venture Capital Enterprise shall not include -

(a) trading in real property;
(b) banking and financial services; or
(c) retail and wholesale trading services

2.12 Taxation of Charitable trusts

A Charitable Institutions is defined as non profit making organization established in Kenya

which
•• Is of public character and
•• Has been established for purposes of the relief of poverty or distress of the public or
advancement of education.
The income of charitable trusts is exempt under paragraph 10 of the First Schedule to the Income
Tax Act. Under this section, the income of an institution, body of persons, or irrevocable trust, of
a public character established: solely for the purposes of:
•• The relief of the poverty or
•• Distress of the public, or

T E X T
•• For the advancement of religion or education established in Kenya
For the income to be exempt, any of the following conditions must also be met:
(i) the business is carried on in the course of the actual execution of those purposes; or
(ii) the work in connection with the business is mainly carried on by beneficiaries under

S T U D Y
those purposes; or
(iii) the gains or profits consist of rents (including premiums or similar consideration in the
nature of rent) received from the leasing or letting of land and chattels leased or let
therewith.
In summary, therefore, the income of a charitable trust is exempted from tax if:
(i) It is public in character
(ii) If it is established for relief of distress or poverty to the public.
(iii) If it is established to advance religion or education.
(iv) Its total income is used or spent for charitable purposes.
If a charitable trust runs a business then profits thereof is not taxed if proceeds are used for
purposes 2 and 3 above.

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 52 A dvanced TA X AT I O N

2.13 Taxation of Trust bodies, settlements and estates under

administration

The term ‘settlement" includes a disposition, trust, covenant, agreement, arrangement, or transfer
of assets, other than -(a) a settlement made for valuable and sufficient consideration;(b) an
agreement made by an employer to confer a pension upon an employee in respect of a period
after the cessation of employment with that employer, or to provide an annual payment for the
benefit of the widow or any relative or dependant of that employee after his death, or to provide
a lump sum to an employee on the cessation of that employment. It also does not include a
disposition, trust, covenant, agreement, arrangement, or transfer of assets, resulting from an
order of a court unless that order is made in contemplation of this provision;
The term "child" means a child under the age of nineteen years and includes a step-child, an
adopted child and an illegitimate child;
The term "settlor", in relation to a settlement, includes a person by whom the settlement was
made or entered into directly or indirectly, and a person who has provided or undertaken to
provide funds directly or indirectly for the purpose of the settlement, or has made with another
person a reciprocal arrangement for that person to make or enter into the settlement;

2.13.1Income Settled on Children

T E X T

Under section 25. of the Income Tax Act, where, under a settlement, income is paid during the life
of the settlor to or for the benefit of a child of the settlor in a year of income, that income shall be
deemed to be income of the settlor for that year of income and not income of any other person.
S T U D Y

Provided that it shall not apply to any year of income in which -

(i) the income so paid does not exceed one hundred shillings; or
(ii) the child attains the age of nineteen years.
The income which is dealt with under a settlement so that it, or assets representing it, will or may
become payable or applicable to or for the benefit of a child of the settlor in the future (whether on
the fulfilment of a condition, or the happening of a contingency, or as the result of the exercise of
a power of discretion, or otherwise) shall be deemed to be paid to or for the benefit of that child;
income so dealt with which is not required by the settlement to be allocated, at the time when it is
so dealt with, to any particular child or children of the settlor shall be deemed to be paid in equal
shares to or for the benefit of each of the children to or for the benefit of whom or any of whom
the income or assets representing it will or may become payable or applicable;
in relation to a settlor, only income originating from that settlor shall be taken into account as
income paid under the settlement to or for the benefit of a child of the settlor.
Where tax is charged on and is paid by the person by whom the settlement was made, that person
shall be entitled to recover from a trustee or other person to whom the income is payable under
the settlement the amount of the tax so paid, and for that purpose to require the Commissioner to
furnish to him a certificate specifying the amount of the tax so paid, and a certificate so furnished
shall be conclusive evidence of the facts appearing therein.

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 TAXATION OF SPECIALISED ACTIVITIES 53

Where the amount of the tax chargeable upon a person for a year of income is affected by
withholding tax deducted from the income, the amount by which the tax is affected shall, if
the amount of tax is thereby reduced, be paid by him to the trustee or other person to whom
the income is payable under the settlement or, where there are two or more of them, shall be
apportioned among those persons as the case may require; and if any question arises as to the
amount of a payment or as to an apportionment to be made under this subsection, that question
shall be decided by the Commissioner whose decision thereon shall be final.

2.13.2 Income deemed to be income of settlor

The income of certain settlements may be deemed to be income of settlor. Under Section 26.(1)
of the Income Tax Act, all income which in a year of income accrued to or was received by a
person under a settlement from assets remaining the property of the settlor shall, unless that
income is deemed under section 25 to be income of the settlor for an earlier year of income, be
deemed to be income of the settlor for the year of income in which it so accrued to or was received
by that person and not income of another person whether or not the settlement is revocable and
whether it was made or entered into before or after the commencement of this Act.
Further, all income, which in a year of income accrued to or was received by a person under a
revocable settlement shall be deemed to be income of the settlor for that year of income and not
income of another person.

T E X T
Where in a year of income the settlor, or a relative of the settlor, or any other person, under the
direct or indirect control of the settlor or any of his relatives or the settlor and any of his relatives,
by agreement with the trustees of a settlement in any way, whether by borrowing or otherwise,
makes use of income arising, or of accumulated income which has arisen, under the settlement

S T U D Y
to which he is not entitled thereunder, then the amount of that income or accumulated income so
made use of shall be deemed to be income of the settlor for that year of income and not income
of any other person.
A settlement is deemed to be revocable if under its terms the settlor -
(a) has a right to reassume control, directly or indirectly, over the whole or any part of the
income arising under the settlement or of the assets comprised therein; or
(b) is able to have access, by borrowing or otherwise, to the whole or any part of the
income arising under the settlement or of the assets comprised therein; or
(c) has power, whether immediately or in the future and whether with or without the consent
of any other person, to revoke or otherwise determine the settlement and in the event
of the exercise of that power, the settlor or the wife or husband of the settlor will or may
become beneficially entitled to the whole or any part of the property comprised in the
settlement or to the income from the whole or any part of that property:
• Provided that a settlement shall not be deemed to be revocable by reason only
that under its terms the settlor has a right to reassume control, directly or indirectly,
over income or assets relating to the interest of a beneficiary under the settlement
in the event that the beneficiary should predecease him.
• Where, under this section, tax is charged on and is paid by the settlor, the settlor
shall be entitled to recover from the trustees or other person to whom the income
is payable under the settlement the amount of the tax so paid, and for that purpose
to require the Commissioner to furnish to him a certificate specifying the amount of
the tax so paid, and a certificate so furnished shall be conclusive evidence of the
facts appearing therein.

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 54 A dvanced TA X AT I O N

• Where, under this section, income is deemed to be income of the settlor, it shall
be deemed to be income received by him as a person beneficially entitled thereto
under the settlement.

2.14 Taxation of Petroleum companies

2.14.1 Introduction

In Kenya, petroleum companies are regulated by the Petroleum (Exploration and production)
Act, (Cap 308, Laws of Kenya). A "petroleum company" means a corporate body that carries out,
in addition to any other activities, operations under a petroleum agreement entered into under
the Petroleum (Exploration and Production) Act. A “contractor" means the person with whom the
Government concludes a petroleum agreement. A "petroleum service subcontractor" means a
non-resident person who provides services in Kenya to a petroleum company.
Under the Act, the Minister for Energy has power to authorise any person to commence
exploration activities in Kenya. Under Section 4 of the Petroleum Act, no person shall engage
in any petroleum operations in Kenya without having previously obtained the permission of the
Minister. All petroleum operations shall be conducted in accordance with the provisions of this
Act, the regulations made thereunder and the terms and conditions of a petroleum agreement.
T E X T

"petroleum operations" means all or any of the operations related to the exploration for,
development, extraction, production, separation and treatment, storage, transportation and sale
or disposal of, petroleum up to the point of export, or the agreed delivery point in Kenya or the
point of entry into a refinery, and includes natural gas processing operations but does not include
S T U D Y

petroleum refining operations. The term "petroleum" means mineral oil and includes crude oil,
natural gas and hydrocarbons produced or capable of being produced from oil shales or tar
sands;
The Government may conduct petroleum operations either—
(a) Through an oil company established by the Government to conduct those operations;
or
(b) Through contractors in accordance with petroleum agreements. A "petroleum agreement"
means the agreement, contract, or other arrangement between the Government and a
contractor to conduct operations in accordance with the provisions of this Act; or
(c) In such other manner as may be necessary or appropriate.

The Government may authorize a contractor to engage in petroleum operations within a specified
area, in accordance with the terms and conditions set out in the petroleum agreement.
Notwithstanding the provisions of this section, the Government may grant to any person, other
than the contractor, a permit for the prospecting and mining of minerals or other natural resources
other than petroleum or the conduct of operations other than petroleum operations within an area
which is the subject of a petroleum agreement, provided that the prospecting, mining and the
other operations shall not interfere with petroleum operations.

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 TAXATION OF SPECIALISED ACTIVITIES 55

2.14.2Income tax provisions on taxation of petroleum companies

Part 2 of the 9th schedule to the Income Tax Act provides guidance on the taxation of petroleum
companies.

Determination of income
(1) Under the section, in determining the gains or profits of a petroleum company for a year
of income for the purposes of this Act there shall be brought into account the value of the
production to which a petroleum company is entitled under a petroleum agreement in that
year of income.
(2) For the purposes of subparagraph (1), the value of production shall be the total of-
(a) The price receivable for that production disposed of by a petroleum company in sales
at arm's length; and
(b) The market value, calculated in accordance of production not disposed of by a petroleum
company in sales at arm's length.
Sales of petroleum at arms length
(1) A sale of petroleum is a sale at arm's length if the following conditions are satisfied -
(a) The price is the sole consideration for the sale;
(b) The terms of the sale are not affected by any commercial relationship, other than that
created by the contract of sale itself, between the seller or an affiliate and the buyer or

T E X T
an affiliate; and
(c) The seller or an affiliate do not have, directly or indirectly, an interest in the subsequent
resale or disposal of the petroleum or any product derived therefrom.
(2) For the purposes of this Schedule, the market value of petroleum shall be determined in

S T U D Y
accordance with the petroleum agreement entered into with the petroleum company but
where the terms of the petroleum agreement do not in any case provide a valuation, the
market value shall be -
(a) where petroleum is disposed of to third parties at arm's length, the amount actually
receivable for that sale, at the FOB point of export, or at the point that title and risk pass
to the buyer;
(b) in any other case-
(i) If there have been sales to third parties at arm's length during the current calendar
quarter, the weighted average per unit price paid in those sales, at the FOB point
of export, or at the point that title and risk pass to the buyer, adjusted for quality,
grade and gravity, and any special circumstances;
(ii) If there have been no sales to third parties at arm's length during the current
calendar quarter, the weighted average per unit price at the FOB point of export,
or at the point that title and risk pass to the buyer, paid elsewhere in arm's length
sales of petroleum of a similar quality, grade and quantity, adjusted for any special
circumstances of those sales.
Disposal of petroleum
Where a person disposes of petroleum and, for the purposes of ascertaining the gains or profits
of that person, the market value of the petroleum is calculated at arm’s length, the consideration
for the acquisition of that petroleum, for the purposes of ascertaining the gains, profits or losses
of the person acquiring that petroleum, shall be that market value.

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 56 A dvanced TA X AT I O N

Allowable deductions
(1) For the purposes of ascertaining the gains or profits for a petroleum company for a year of
income, there shall be deducted the expenditure referred to in subparagraph (2) incurred in
that year, but this shall not prevent other deductions authorized by the Income Tax Act, and
where an item of expenditure is specifically deductible under a provision of this Schedule,
that item shall not be deductible under another provision of the Income Tax Act.
(2) For the purposes of subparagraph (1), there shall be deducted –
(a) intangible drilling costs;
(b) Geological and geophysical costs;
(c) Payments to the Government, or any agency thereof, pursuant to the provisions of the
petroleum agreement entered into with the petroleum company;
(d) Production expenditure;
(e) Executive and general administrative expenses wholly and exclusively incurred in
Kenya by a petroleum company;
(f) Where a non-resident petroleum company operates in Kenya through a permanent
establishment in Kenya, only those reasonable executive and general administrative
expenses incurred outside Kenya by that person, including management or professional
fees, but limited to the amount that is attributable to the permanent establishment in
Kenya and is fairly and reasonably allocated thereto;
(g) Management or professional fees, including those paid to persons outside Kenya limited
to the amount that is attributable to the petroleum company and is fairly and reasonably
T E X T

payable thereby; and

(h) Interest paid, including interest paid by a non-resident petroleum company and fairly
and reasonably allocated to a permanent establishment maintained in Kenya by that
S T U D Y

company, but no interest paid shall be deductible unless -

(i) The payment does not exceed the amount that would have been payable on a loan
concluded at arm's length where the loan, repayment thereof, and the interest payable
constitute the only consideration for the making of the loan;
(j) the loan, in respect of which interest is paid, is applied for operations by the petroleum
company in Kenya, but where only part of the loan is applied in accordance with this
paragraph only the interest payable in respect of that part shall be deductible;
(k) Withholding tax on interest has been deducted and paid to the Commissioner.

(3) Where expenditure is incurred on an asset representing qualifying expenditure, there shall
be made, in ascertaining the gain or profits for the year of income in which that asset is first
brought into use in Kenya, or in which production commences, whichever is the later, and
the four following years of income, a deduction equal to one-fifty of the expenditure.
(4) Where a well which fails to discover petroleum is drilled and abandoned, the expenditure
incurred in drilling the well, which has not been deducted under another provision of this Act,
shall be deducted in the year of income in which the well is abandoned.
(5) Where in ascertaining the gains or profits of a petroleum company in a year of income, there
results a deficit, the amount of that deficit shall be an allowable deduction in ascertaining the
gains or profits of the previous year of income but the deficit may only be carried back -
(a) from a year of income which the petroleum company has ceased permanently to
produce petroleum; and
(b) for not more than three years of income from the year in which the deficit occurred

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 TAXATION OF SPECIALISED ACTIVITIES 57

Transactions with affiliates

Where a transaction takes place between a petroleum company and an affiliate, the income
chargeable, or the deduction allowable to that company, shall be deemed to be the amount that
might have been expected to accrue if that transaction had been conducted by independent
persons dealing at arm's length.

Assignment of petroleum agreement and disposal of assets

An assignment of a right under a petroleum agreement shall not give rise to Capital gains tax but,
subject to this paragraph, the consideration for the assignment shall be treated as a receipt of
the petroleum company, and tax shall be charged accordingly.
Further, where an assignment of a right under a petroleum agreement involves the disposal of
assets which represent qualifying expenditure, there will be deducted from the consideration for
the assignment the amount of the qualifying expenditure not yet allowed against income.
The assignment is of part only of the rights held by a petroleum company, or where not all
the assets which represent qualifying expenditure are included in the assignment, the amount
of qualifying expenditure not yet allowed against income which is to be deducted from the
consideration for the assignment shall be apportioned by the Commissioner.
The amount to be treated as a receipt shall be, in the case of an assignment at arm's length, the
consideration therefore and in any other case, the market value of that which is assigned, but
where part of the consideration consists of the undertaking by the assignee of a work obligation,

T E X T
no amount in respect thereof shall be taken into account under this paragraph.
Where a right under a petroleum agreement is assigned, the Assignee shall be treated as having
incurred, at the date of the assignment, qualifying expenditure equal to the lesser of the total

S T U D Y
amount of the consideration paid for the assignment and the market value of rights and assets
representing qualifying expenditure assigned.
Where a petroleum company sells, disposes or removes from Kenya an asset which represents
qualifying expenditure, otherwise than on an assignment of a right under a petroleum agreement,
and the net proceeds of the sale are –
(a) Less than the qualifying expenditure not yet allowed against income, a deduction, in
this Schedule referred to as a "balancing deduction", shall be made to the company, in
the year of income in which the sale or disposal takes place, equal to the difference;
(b) More than the qualifying expenditure not yet allowed against income, a charge, in this
Schedule referred to as a "balancing charge", shall be made to the company, in the year
of income in which the sale or disposal takes place, equal to the difference.
Where an asset representing qualifying expenditure is brought into use without being purchased,
or, without being sold, ceases permanently to be used, by a petroleum company, it shall be
deemed to have been purchased or sold at market value.

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 58 A dvanced TA X AT I O N

Taxation of petroleum service subcontractors

The profits or gains of a petroleum service subcontractor (PSS) in respect of services rendered
in Kenya to the petroleum company is specifically taxed in accordance with Part III of the 9th
Schedule regardless of any other provision of the Act. Some of the salient provisions of the
Schedule are inter alia:
“Paragraph 9: PSS shall be deemed to have made a taxable profit equal to 15%, assumed
profit rate, of all the moneys paid by a Petroleum company (taxable service fee), which
profits shall be taxed at the rates set out in the Third Schedule applicable to non-
resident companies which have a permanent establishment in Kenya.
The taxable service fee does not include moneys paid as reimbursement to PSS for the cost
of mobilization and demobilization and reimbursement of expenses.
Paragraph 10: when paying a taxable service fee, the petroleum company (PC) shall:-
♦♦ Deduct an amount of tax equal to the sum produced by applying the income tax rate
referred to in paragraph 9 to the assumed profit;
Paragraph11: the tax collected by the PC under this paragraph in a month shall be remitted
within 30 days to the Commissioner with a return of amounts paid and tax deducted,
hereinafter referred to as the “subcontractors return” showing…
♦♦ The total taxable service fee paid;
♦♦ The total tax deducted and remitted;
♦♦ The total amount paid for mobilization and demobilization; and
♦♦ The total amount paid for reimbursement of expenses.”
T E X T

In line with the above provisions, where for instance the Petroleum Company is required to
pay Kshs 100 to the Petroleum service subcontractor the assumed profits which are subject to
taxation for services deemed to have been rendered in Kenya shall be Kshs 15 (being 15% of
S T U D Y

Kshs 100). The taxes payable on this amount and for which the petroleum company is subject to
withhold and remit to the revenue authorities is Kshs. 5.625 (37.5% of Kshs 15).
The aforesaid taxes ought to be remitted to the tax authorities within 30 days by the PC with a
return referred in the Schedule as “the subcontractor’s return” in respect of that month amounts
as outlined above

2.14.3 Value Added Tax Rules on Taxation of petroleum companies

Some of the goods and supplies used by a petroleum companies to carry out its exploration
activities either by itself or by an subcontractor attract VAT at 16%. Under Section 23 of the VAT
Act, a petroleum company can apply for VAT remission on imports for exploration activities.

2.14.4 Customs & excise rules on taxation of petroleum companies

Under the Customs & excise rules, a petroleum company can make an application for duty
remission on its imports.

Illustration
Titanic Limited, a company incorporated in Kenya has recently concluded a petroleum agreement
with the government of Kenya. Under the terms of the petroleum agreement, the company has
been allowed to explore along the Kenyan waters and share the proceeds with the government
on a 50: 50 basis. The company has subcontracted TNM Ltd to carry out exploration surveys
along waters for a period of 3 months. You are provided with the following information with regard
to Titanic limited.

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 TAXATION OF SPECIALISED ACTIVITIES 59

Titanic Limited
Draft Income statement Kshs'000 Kshs'000

Production sales receipts 1,000,000

Geological and geophysical costs 20,000
Intangible drilling costs 10,000
Production expenditure 5,000
Salaries and wages to production staff 2,000
Entertainment of director's children 4,000
Payment to government ( 50:50 basis) 1,000
Executive and general admin expenses 1,000
Management fees to KLM consultancy 3,000
Professional fees to Ernst & Young for consultancy services 2,000
Service fee paid to TNM Ltd 200,000
Interest on loan at arm's length from Uganda Commercial
Bank 10,000
Exploration Machinery purchased 10,000 (268,000)
 
732,000

T E X T
Required;
•• Compute the taxable profit for Titanic Limited
•• Compute the amount of tax payable by TNM Ltd and the dates for the payment

S T U D Y
Attempted solution

Part 1
Titanic Limited
Computation of taxable profit
Kshs Kshs
Net profit as per the income statement 732,000

Add back disallowable expenditure

Entertainment of director's children 4,000
Exploration machinery purchased 10,000 14,000
746,000
Less
Capital allowance on machinery ( 12.5% of
10000) (1,250)
 
Adjusted taxable profit 744,750

Corporation tax payable at 30% 223,425

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 60 A dvanced TA X AT I O N

Part 2
TNM Ltd

Service fee paid 200,000

Assumed profit ( 15%) 30000
Corporation tax at 37.5% 11250

Titanic Ltd has got an obligation to withhold tax of the subcontractor of Kshs.11,250
and remit the same within 30 days of such withholding to the CDT.

2.15 Taxation of Banks

The Banking industry is a very dynamic and competitive industry. It involves the provision of
financial services. It is regulated by the Central Bank of Kenya Act (Cap 491, Laws of Kenya) and
regulations and the Banking Act (Cap 488, Laws of Kenya).
The taxation of the Banking industry as a company is provided for mainly under the Income
Tax Act, the Customs and Excise Act the East African Community Customs Management Act
2004, the Value Added Tax Act and the Stamp Duty Act. There is no fundamental difference
between the taxation of Banks and other companies. The allowable deductions and disallowable
T E X T

deductions are the same. Some unique features are:

•• Thin capitalization provisions do not apply to the Banking sector.
•• Where a bank which is a permanent establishment of a non-resident person holds
S T U D Y

outside Kenya any deposits, assets or property acquired from its operations in Kenya,
the gains or profits accruing from such deposits, assets or other property held outside
Kenya shall be deemed to be income accrued in or derived from Kenya.
Illustration
The management of Shamrock Bank Ltd. has sought your professional guidance in determining
the Bank’s tax liability for the year ended 31 December 2007.
The income statement of Shamrock Bank Ltd. for the year ended 31 December 2007 is given
below:

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 TAXATION OF SPECIALISED ACTIVITIES 61

Income Kshs. 000 Kshs. 000

Interest on loans and advances to customers 540,800
Interest on government securities 120,600
Interest on placements with other banks and institutions 40,650
Fees and commissions income 39,360
Rental income 2,190
Income from foreign exchange dealings 31,980
Gain on disposal of property and equipment 12,300
Other operating income 42,950
Total income 830,830

Expenses:
Salaries and employee benefits 360,400
Occupancy expenses 20,350
Deposit protection fund contributions 12,360

T E X T
Depreciation expense 43,700
Interest on customers’ deposits 202,450
Interest on deposits from other banks and institutions 80,200

S T U D Y
Director’s emoluments:
Fees
Other 11,200
Auditors’ remuneration: 3,600 14,800
Current year
Under provision for the previous year (2006) 2,100
Operating lease rental 300 2,400
Loss on disposal of equipment 16,300
Other administrative expenses 7,250
Provision for bad and doubtful debts 20,620
Provision for interest suspense 80,500
Total expenses 20,950
Loss for the year 882,280

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 62 A dvanced TA X AT I O N

Additional information:
1. Salaries and employee benefits comprise:
Sh. 000
Leave benefits 720
Pension contributions 1,460
Termination costs 2,860
Provision for staff leave accruals 4,920
9,960

2. Included in the Directors’ “other” emoluments are:

Sh. ‘000’
School fees for the Chairman’s children 1,200
Entertainment allowance (used on clients) 1,800
Travelling costs for a newly recruited expatriate 600
director

3. The movement in provisions for bad and doubtful debts during the year was as follows:
T E X T

Specific General Total

provisions provisions
Sh. ‘000’
Sh. ‘000’ Sh. ‘000’
S T U D Y

Sh. ‘000’ Sh. ‘000’ Sh. ‘000’

At 1 January 2007 630,500 630 631,130
Charge for the year 83,800 15,300 99,100
Released during the year (18,600) (18,600)
At 31 December 2007 695,700 15,930 711,630

4. Provision for interest suspense represents non-performing loans and advances on which
interest has been suspended. The management has confirmed that the loans and advances
are fully secured.
5. Capital allowances for the year ended 31 December 2007 amounted to Sh. 18,900,000.
6. Lease rental charges relate to office equipment leased from AB office solutions for use in the
entire bank network.
Required:
(a) (i) Taxable income of Shamrock Bank Ltd. for the year ended 31 December 2007.
(11 marks)
(ii) Tax payable (if any), on the taxable income computed in (i) above. (2 marks)

(b) Given the Shamrock Bank Ltd’s taxable income for the year ended 31 December 2006,
was assessed at Sh. 2,400,000, show how the tax computed in (a) (ii) above is to be paid,
inclusive of the due dates. (5 marks)

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 TAXATION OF SPECIALISED ACTIVITIES 63

(c) Explain the implication of Income Tax Act – section 15(7) (e) (specified sources of income)
on Shamrock Bank Ltd’s income. (2 marks)
(Total: 20 marks)

Attempted solution
(a) (i)
Shamrock Bank Ltd
Computation of Taxable income
Sh ‘000’ Sh ‘000’ Sh ‘000’
Reported net loss (51,450)
Add back disallowable expenses
Salaries – provision for staff leave accruals 4,920
School fees for chairman children 1,200
Traveling cost for expatriate 600
General bad debt provisions 15,300
Provision for interest expense 20,950
Depreciation 43,700
Loss on disposal of equipment 7,250 93,920
42,470

T E X T
Less capital allowances 18,900
Gain on disposal of property 12,300
Rental income 2,190 (33,390)

S T U D Y
Adjusted taxable income 9,080
Other incomes
Taxable Rental income 2190

NB - Assumed that income from forex dealing is realized hence taxable

- Assumed the pension fund is registered hence contributions allowable

(ii) Tax payable = 10,270,000 x 30% = 3,381,000

Kshs’000 Tax @30%

Business income 9,080 2,724
Rental income 2,190 657
   
11,270 3,381

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 64 A dvanced TA X AT I O N

(b) Year 2006 tax liability = 2,400,000 x 30% = 720,000

Year 2007 instalment tax = 110% x 720,000 = 792,000
Year 2007 actual tax = 10,510,000 x 30% = 3,153,000

20/4/2006 = 1st instalment = 25% x 792,000 198,000

20/6/2007 = 2nd instalment = 25% x 792,000 198,000
20/9/2007 = 3rd instalment = 25% x 792,000 198,000
20/12/207 = 4th instalment = 25% x 792,000 198,000
Total paid 792,000

30/4/2008 = final 15th instalment = 3,153,000 – 792,000 = 2,361,000

(c) Section 15(7) (e) of the Income Tax Act provides for the specified sources of income. The
income of the specified sources should be taxed separately. In the present case. Rental
income has been taxed separately. A loss from one source of income should not be offset
against the gains of another source of income.
T E X T

2.16 Taxation of insurance companies

S T U D Y

2.16.1 Ascertainment of Income of Insurance Companies

1. Life insurance business of an insurance company is treated as a separate business

from any other class of business.
2. The gains or profits of a resident insurance business other than life insurance business
compromise of:
a. Gross premium less any premium returned to the insured and premium paid on
reinsurance.
b. Other income including commission or expenses allowance received or receivable from
reinsurers and investment income.
c. A deduction in respect of a reserve for unexpired risk, at the end of the previous year.
d. Addition of reserve deducted for unexpired risks at the end of the previous year.
e. A deduction of claims admitted net of any claim recovered from reinsurance
companies.
f. A deduction of agency expenses.
g. Other deductions allowable under the Income Tax Act.
Non-resident insurance companies
Gains or profits include:
a. Gross premium receivable in Kenya less premiums returned to the insured and premiums
paid on reinsurance other than to the Head Office of the company.
b. Other income including commission and expense allowances received or receivable
from reinsurance other than from the Head Office of the company in relation to risks
accepted in Kenya.

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 TAXATION OF SPECIALISED ACTIVITIES 65

c. Income from investments representing reserves created for or from the business done
in Kenya.
Deductions
a. Reserve for unexpired risk at the end of that year of income in respect of policies whose
premiums are received or receivable in Kenya but after adding the reserve deducted in
the previous year.
b. Claims admitted in that year of income less any amount recovered from reinsurance
companies.
c. Agency expenses.
d. Head Office expenses which would have been allowable if the company had been a
resident company.

2.16.2 Life Insurance Business

The income from life insurance business comprises

1. Investment income of the life insurance fund except that part of the life fund which
relates to an annuity fund, less management expenses including commissions. The
investment income is defined as dividends and interest income but does not include
qualifying dividends.
2. The amount of interest received by the company on surrender of policies or on the

T E X T
return of premiums other than premiums in relation to a registered annuity contract,
registered trust scheme or a registered pension fund.

2.16.3 Amendment in the Taxation of Insurance Companies

S T U D Y
The taxation framework of insurance companies was amended as shown herein below. These
amendments will come to effect from 1.1.2009.
Section 19 of the Income Tax Act states as follows:
(5) The gains or profits for a year of income from the long term insurance business of a resident
insurance company, whether mutual or proprietary, shall be the sum of the following -
(a) The amount of the actuarial surplus recommended by the actuary to be transferable from
the life fund for the benefit of the shareholders, whether or not it is actually transferred;
and
(b) Any other amounts transferred from the life fund for the benefit of shareholders;
and
(c) 30% of management expenses and commissions that are in excess of the
maximum amounts allowed by the Insurance Act.

Where the actuarial valuation of the life fund results in a deficit for a year of income and
the shareholders are required to inject money into the life fund, the amount of money so
transferred shall be treated as a negative transfer for the purposes of subsection (5) (a):
Provided that the amount of the negative transfer shall be limited to the amount of actuarial
surplus recommended by the actuary to be transferable from the life fund for the benefit
of shareholders in previous years of income, whether or not it was actually transferred.

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 66 A dvanced TA X AT I O N

(6) The gains or profits for a year of income from the long term insurance business of a non-resident
insurance company, whether mutual or proprietory, shall be the sum of the following:-
(a) The same proportion of the amount of actuarial surplus recommended by the actuary
to be transferable from the life fund for the benefit of the shareholders, whether or not
it is actually transferred, as the actuarial liability in respect of its long term insurance
business in Kenya bears to actuarial liability in respect of its total long term insurance
business; and
(b) The same proportion of any other amounts transferred from the life fund for the benefit of
shareholders as the actuarial liability in respect of its long term insurance business in
Kenya bears to the actuarial liability in respect of its total long term insurance business;
and
(c) The same proportion of thirty per cent of management expenses and commissions
that are in excess of the maximum amounts allowed by the Insurance Act as the
actuarial liability in respect of its long term insurance business in Kenya bears to
the actuarial liability in respect of its total long term insurance business.

(6A) Where the actuarial valuation of the life fund results in a deficit for a year of income and the
shareholders are required to inject money into the life fund, the proportionate amount of the
money so transferred shall be treated as a negative transfer for the purposes of subsection
(6) (a):
T E X T

Provided that the amount of the negative transfer shall be limited to the amount of actuarial
surplus recommended by the actuary to be transferable from the life fund for the benefit of
shareholders in previous years of income, whether or not it was actually transferred.
S T U D Y

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 TAXATION OF SPECIALISED ACTIVITIES 67

Illustration
Afro Insurance Ltd. underwrites three classes of insurance. The management has provided you
with the details shown below on their operations for the year ended 31 December 2007:
Class of insurance Fire Motor vehicle Theft
Sh.’000’ Sh.’000’ Sh.’000’
Gross premium written 23,088 24,664 9,780
Reinsurance ceded 14,747 15,007 4,822
Unearned premium brought forward 4,205 6,293 1,466
Unearned premium carried forward 2,035 9,259 668
Claims paid 2,216 5,538 1,215
Claims outstanding brought forward 2,781 10,325 4,532
Claims outstanding carried forward 2,755 9,416 8,756
Legal expenses on claims 645 420 125
Depreciation 60 125 65
Gain on sale of motor vehicles previously
written off
- 50 -

T E X T
Specific bad debts
80 35 62
Management expenses
1,606 2,350 876
Commissions (net)

S T U D Y
255 1,546 890

Additional information:
1. Wear and tear deductions have been agreed with the Income Tax Department at
sh.454,000.
2. The company invested surplus funds and earned investment income as follows:

Sh.
Interest from Treasury bills (net) 2,040,000
Interest from fixed deposits in local bank (net) 762,450
Gross dividends from Zim-Re of Zimbabwe (a foreign company) 450,000
Dividends from KELP Ltd. 912,000

3. The company paid Sh.745,000 to ABC Investment Management Services, their fund
managers for professional services for the year ended 31 December 2007.
4. The company owns Afro House which houses its offices. Part of the office space is
rented out to other tenants. In the year to 31 December 2007, the company received
sh.2,200,000 net rental income from their estate agents. Property management fees
amounting to sh.2,400,000 for the year to 31 December 2007 had been deducted.
5. Afro Insurance Ltd. owns 80% of the ordinary share sin KELP Ltd. a locally incorporated
company.

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 68 A dvanced TA X AT I O N

Required:
(a) Compute the taxable profit or loss for Afro Insurance Ltd. for the year ended 31 December
2007. (16 marks)

(b) Compute the tax payable in (a) above. (2 marks)

(c) Comment on any information you have not used in your computations. (2 marks)
(Total: 20 marks)
T E X T
S T U D Y

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 TAXATION OF SPECIALISED ACTIVITIES 69

Attempted solution
(a)
Afro Insurance Ltd.
Computation of taxable profit for year ended 31 December 2007

Fire Motor Theft Total

Vehicle
Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’
Gross premium written 23,088 24,664 9,780 57,532
Reinsurance ceded 14,747 15,007 4,822 34,576

Unearned premium b/f 4,205 6,293 1,466 11,964

Unearned premium c/f (2,035) (9,259) (668) (11,962)
Gross income earned 40,005 36,705 15,400 92,110
Less allowable expenses
Claims paid 2,216 5,538 1,215 8,969
Claims outstanding b/f (2,781) (10,325) (4,532) (17,638)
Claims outstanding c/f 2,755 9,416 8,756 20,927
Claims incurred 2,190 4,629 5,439 12,258

T E X T
Commissions (net) paid 255 1,546 890 2,691
Management expenses 1,606 2,350 876 1,832

S T U D Y
Legal expenses 645 420 125 1,190
Specific bad debts 80 35 62 177
Total Expenses 4,776 8,980 7,392 18,148

Underwriting profit/loss 35,229 27,725 8,008 70,962

Total underwriting profit 70,962,000

Less wear and tear (454,000) 70,508,000

Investment income
Interest from Treasury bills 2,400,000
Interest from Fixed deposits 897,000
Less: investment mgt. Fees (745,000) 2,552,000

Rental income 2,200,000

Less mgt. Fees (2,400,000)
(200,000)
Total taxable profit 72,860,000

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 70 A dvanced TA X AT I O N

2.17 Taxation of sea and air transport undertakings

Firms or enterprises involved in sea or air transport undertakings are taxed in the ordinary way.
It is important to point out the following unique features:
•• Income of certain non resident persons deemed derived from Kenya-When one s on
the business of shipowner, charterer or air transport operator and a ship or aircraft owned or
chartered by him calls at any port or airport in Kenya, the gains or profits from that business
from the carriage of passengers who embark, or cargo or mail which is embarked, in Kenya
shall be the gross amount received on account of the carriage; and those gains or profits
shall be deemed to be income derived from Kenya; but this subsection shall not apply to
gains or profits from the carriage of passengers who embark, or cargo or mail which is
embarked, in Kenya solely as a result of transshipment.

•• Collection of tax from ship owner- In addition to any other powers of collection of tax
provided in this Act, the Commissioner may, in a case where tax recoverable by suin charged
on the income of a person who carries on the business of shipowner, charterer or air transport
operator, issue to the proper officer of Customs by whom clearance may be granted a certificate
containing the name of that person an the amount of the tax due and payable and on receipt
of that certificate the proper officer of Customs shall refuse clearance from any port or airport
in Kenya to any ship or aircraft owned by that person until the tax hasbeen paid.
T E X T

•• Exemptions- The income of a non-resident person who carries on the business of aircraft
owner, charterer or air transport operator, from such business where the country in which such
non-resident person is resident extends a similar exemption to aircraft owners, charterers or
S T U D Y

air transport operators who are not resident in such country but who are resident in Kenya.

Shipping Investment Deduction (SID)- SID is granted where a resident ship owner incurs
capital expenditure:
a. On purchase of new, unused power-driven ship of more than 495 tons; or
b. On purchase of and subsequent refitting for the purpose of shipping business of a used
power-driven ship of more than 495 tons.
The rate of shipping investment deduction is 40% (2/5) of Qualifying cost granted in the first year
of use.

Limitations
•• A ship only gets one SID
•• If ship is sold before 5 years of use, the SID earlier granted will be withdrawn and
the deduction will be treated as taxable income for year the withdrawal of SID takes
place.
•• Compensation by way of wear and tear allowance will be granted.
Illustration:
A ship of 500 tons was acquired on 1.1.2004 at Ksh.40, 000,000. It was sold in Year 2007 for
Kshs.36,000,000. Required: Compute capital allowances to claim for the years 2004 to 2007.

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 TAXATION OF SPECIALISED ACTIVITIES 71

Solution:
Capital Deductions Computation
1) SID Yr. 2004
Qualifying Cost SID @40% Residue of W.T.A
Sh. Sh. Sh.
40,000,000 16,000,000 24,000,000

2) W.T.A
Class IV @ 12.5%
SH.
Residue after SID 24,000,000
YR 2004 W.T.A (3,000,000)
21,000,000
YR 2005 W.T.A (2,625,000)
18,375,000
YR 2006 W.T.A (2,296,8705)

T E X T
16,078,140

Since ship was sold before 5 years had elapsed, SID earlier granted of Sh.16,000,000 will be

S T U D Y
reclaimed and compensation granted for wear and tear allowance, i.e.

Wear And Tear Allowance Compensation

Sh. Alternatively
Reclaimed SID 16,000,000 S.I.D withdrawn 16,000,000
Yr. 2004 W.T.A (2,000,000) less WTA for
14,000,000 2004, 2005 and 2006 5,281,250
Yr. 2005 W.T.A (1,750,000) Taxable S.I.D 10,718,750

12,250,000
Yr. 2006 W.T.A (1,531,250)
Taxable S.I.D balance in year 2007 10,718,750

2.18 Taxation of Unit trusts or collective investment schemes

A Unit Trust or a mutual fund organization is one registered under the Unit Trust Act. It sells units
(equivalent to shares) to the public and invests the funds for a return. The unit holder gets a
return (interest) from the Unit Trust tax free.

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The sale purpose of the unit trust or collective investment scheme is to carry on investments on
behalf of the unit holders or shareholders, where contributions are invested in shares traded in
any securities, operated in Kenya, the income of schemes will be exempted. The scheme will
pay withholding tax on dividends and interest received on behalf of employees at rates of 5%
and 15% respectively.
The Unit Trusts are supposed to invest in shares and the government hopes this will help develop
the capital market (buying and selling of shares mainly in the Nairobi Stock Exchange).
The withholding tax paid by a Unit Trust on interest and dividend is final tax, which means that the
Unit Trust is not taxed further on the income.
Where unit holders or shareholders in any unit trust or collective investment scheme are exempt
persons under the first schedule to the Act, the manager or trustee of the unit trust or collective
investment scheme shall maintain separate but identifiable account of the funds of such persons.
Business incomes of such bodies will also be exempt so long as the business income is applied to
investments in securities as mentioned above, income is from rental properties of the scheme and
that such business is carried on by the beneficiaries.

1.19 Property developers and contractors

In Kenya, there are no specific guidelines governing the taxation of property developers and
T E X T

contractors. We note that while there is no Capital gains tax, if a firm or a company has been
formed for purposes of property development. The adjusted profits therefrom will be taxed as
business income of the company.
S T U D Y

Tax is imposed under Section 3(2)(a)(iii). The word "property" is not defined in the Income Tax
Act. The Interpretation and General Provision Act defines property as:
"Property" includes money, goods, chosen in action, land and every description of property,
whether recoverable or immovable, and also obligations, easements and every description of
estate, interest and profit, present or future, vested or contingent, arising out of or incident to
property as herein defined".
Section 6 provides that "gains or profits from the use or occupation of property includes a royalty,
rent, premium or similar consideration received for the use or occupation of property.
"Royalty" means a payment made as a consideration for the use of or the right to use:
(a) A copyright of a literary, artistic or scientific work; or
(b) A cinematographic film, including film or tape for radio or television broadcasting; or
(c) A patent, trade mark, design or model, plan, formula or process; or
(d) Any industrial, commercial or scientific equipment.

Rent is not defined and is therefore assigned its normal and usual meaning.
Premium is not defined but usually refers to a reward or something extra above par. Another
expression used is "Key Money".
In A.C v C.I.T the decision by the Income Tax Department to charge key money was upheld by
the courts on the basis that it was received for the use of an asset.
The court ruled that it was revenue receipt and should be assessed in full in the year in which it
is received without spreading it over the lease term.

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 TAXATION OF SPECIALISED ACTIVITIES 73

Allowable deductions
Section 15 (i): All the expenditure incurred wholly and exclusively in the production of rental
income. This refers to the usual expenses of a revenue nature.
(a) Bad debts and specific provision for bad debts.
(b) Capital allowances under the second schedule, where appropriate e.g. Property let
furnished, the furniture qualifies for wear and tear.
(c) Expenditure incurred in the maintenance of the property.
(d) Expenditure of a capital nature on legal costs and stamp duty in connection with the
acquisition of a lease of premises to be used for business (letting out premises). The
lease should be for 99 years or less and should not be capable of extension beyond 99
years.
(e) Municipal rent and rates.
(f) Expenditure incurred on structural alteration to premises in order to maintain existing
rent.
(g) A reasonable amount representing the diminution in value of any implement, utensil or
similar article not being plant and machinery e.g. Crockery, cutlery, utensils, blankets,
sheets, towels etc.
(h) Caretaker wages and salaries.
The Overland Case
CIT v Overland Company Ltd. This case established the principle that all the expenditure incurred,

T E X T
including rates and interest, throughout the construction period up to the date the property is first
used should be regarded as capital outlay for which no deduction can be allowed.
Such expenditure is treated as a preliminary expense of a capital nature.

S T U D Y
The Low Shipping Company Case
(Low Shipping Company Ltd v CIR)
The Appellant company purchased a second hand ship when her Lloyd's survey was overdue.
The survey was deferred pending the completion of a voyage. On her return six months later the
survey was made and the company was obliged to spend large sums in repairs. The company
claimed that the whole cost of the repairs should be deducted.
Held: that except for such part of the cost of repairs as was attributable to the period during
which the ship was employed in the Appellant's trade, the expenditure in question was in the
nature of capital expenditure.
Partial Occupation by Owner
Where a portion of the property is occupied by the owner an apportionment of the relevant
expenses is made. The portion attributable to the owner is disallowed.
Temporary Vacancy
Where a let property remains temporarily vacant no adjustments of expenses is made. The
property should not remain vacant for more than six months.
Travelling costs
The cost of travel by the owner from his home to the property is not allowable.

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 74 A dvanced TA X AT I O N

Non-resident owners
No deductions are allowable from the gross rent received if the owner is non-resident. The rent
is taxed at source at the appropriate rate i.e. 30% of gross rent.

2.20 Chapter summary

•• The taxation of Petroleum companies and petroleum subcontractors is spelt

out under the 9th Schedule of the Income Tax Act. In addition to paying their
taxes, petroleum companies have an obligation of withholding tax to payments
made to the sub contractors.
•• The income of a charitable trust is exempted from tax if:
(a) It is public in character
(b) If it is established for relief of distress or poverty to the public.
(c) If it is established to advance religion or education.
(d) Its total income is used or spent for charitable purposes.
•• Cooperative Societies are considered to be body corporates and are taxed at the rate
of 30%.
•• The income of clubs is made up of the gross receipts, including entrance fees, and
T E X T

subscriptions and such receipts are taxed in the name of the club at the corporation
tax rate.
S T U D Y

2.21 Quiz

Question one

Distinguish between the taxation of trade association and clubs

Question two

Briefly discuss the taxation of armateur sporting associations.

Question three

List the allowable expenditure of a petroleum company while arriving at the taxable profit

Question four

List the applicable tax exemptions to venture capital enterprises

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 TAXATION OF SPECIALISED ACTIVITIES 75

2.22 Answers to Quiz

Question one

Distinguish between the taxation of trade association and clubs

Taxation of Trade associations

A trade association is a body of persons which is an association of persons separately engaged
in any business with the main object of safeguarding or promoting the business interests of such
persons.
Generally trade associations are not considered to be carrying out trading activities. However,
they may engage in trade. Under sec 21(2)of the Income Tax Act, such an association can
choose or elect by notice in writing to the CDT to be considered to be carrying out business
chargeable to tax in respect to any year of income. In which case, it’s gross receipts from
the transactions with members (including entrance fees and subscription fees) and with other

T E X T
persons is deemed to be income from the business for that year of income at the corporate tax
rate.

Taxation of Clubs

S T U D Y
Under Section21 of the Income Tax Act, a members club means a club or similar institution
with all its assets owned by, or held in trust for the members thereof. The income of clubs is made
up of the gross receipts, including entrance fees, and subscriptions and such receipts are taxed
in the name of the club at the corporation tax rate.
However, when ¾ or more of such investment is derived from members, the body will not be
taken to be carrying on business and no part of such non investment income will be taxed i.e
income from members is not taxable.
Investment income of a club such as dividends, interest, rents, capital gains etc are to be excluded
in the ¾ test mentioned above.-(sec 21(1)

Question two

Under Paragraph 6 of the first schedule to the Income Tax Act, income other than income from
investment of an Amateur sporting association is not taxable. For this to be the case, the amateur
sporting association must be one:
•• Whose sole aim or object is to foster outdoor sports and control any outdoor sports.
•• Whose members consist of amateurs or affiliated associations the members of which
are amateurs.
•• Whose memorandum of association or by laws have provisions defining an amateur or
a professional and providing that no person other than an amateur shall be a member
of that association.

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 76 A dvanced TA X AT I O N

Question three

Under the 9th schedule of the Income Tax Act, the following are the allowable expenditure for a
petroleum company:
•• intangible drilling costs;
•• geological and geophysical costs;
•• payments to the Government, or any agency thereof, pursuant to the provisions of the
petroleum agreement
•• executive and general administrative expenses wholly and exclusively incurred in
Kenya by a petroleum company;
•• management or professional fees, including those paid to persons outside Kenya limited
to the amount that is attributable to the petroleum company and is fairly and reasonably
payable thereby; and
•• interest paid, including interest paid by a non-resident petroleum company and fairly
and reasonably allocated to a permanent establishment maintained in Kenya by that
company,

Question four

Venture capital companies enjoy certain tax exemptions as follows:

T E X T

•• Dividends received by a registered venture capital company is tax exempt. ( A registered

venture capital company is a venture capital company registered by the CDT as such)
•• Gains arising from trade in shares of a venture company earned by a registered venture
S T U D Y

capital company within the first ten years from the date of first investment in that venture
company by the venture capital company are tax exempt.: Provided that the venture
company has not been listed in any securities Exchange operating in Kenya for a period
of more than two years

2.23 Past Paper Analysis

This topic covers a wide range of concepts. The student should be able to understand
each concept and be able to answer questions as they come. The following is an analysis
on how the chapter has been examined in the past. The questions are listed in this format:
Month/year e.g. 6/01 represents June or May 2001.
12/02 Q. 4, 12/03 Q. 3(d), 06/04 Q.2, 12/04 Q.2, 12/06 Q.1(b), 12/06 Q.5(c), 12/07 Q.2(b), 12/08
Q.2(b),

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 TAXATION OF SPECIALISED ACTIVITIES 77

2.24 Revision Questions

Question one- Lease hire arrangements

Discuss the tax implications of lease hire arrangements

Question two- Petroleum companies and EPZs

Write short notes on the taxation of:

(i) Petroleum companies and their sub-contractors. ( 4 marks)
(ii) Enterprises situated in export processing zones (EPZs). ( 4 marks)
( Tax 1 Dec 2003 Q 3)

Question three- Insurance companies

T E X T
Linda Insurance Company Ltd. is a resident insurance company carrying out both general and life
assurance businesses. The following information relates to the insurance company’s financial

S T U D Y
year ended 31 December 2007:
General Life assurance
insurance business
business
Shs. ‘000’ Shs. ‘000’
Investment income 13,780 16,400
Insurance premiums received 15,450 86,900
Commission and management fees - 13,600
Premiums returned on surrendered policies 374 -
Re-insurance commission 1,360 3,450
Interest paid out of Annuity Fund on surrender of - 23,670
policies
Premiums paid to re-insurance company 4,680 12,000
Agency expenses 1,350 1,960
Management expenses 1,934 2,456
Travelling expenses 1,800 2,400
Advertising expenses 364 820
General expenses 8,490 4,640
Bad debts (specific) 368 240
Income from exercise of subrogation rights 1,250 1,800
Interest on premiums returned 396 -
Recoveries on re-insurance 150 180

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 78 A dvanced TA X AT I O N

Additional Information:
Management expenses for Life assurance business include Sh.400,000 being salaries to pension
department employees and Sh.456,000 for trust scheme rent.
Investment income comprise:
General insurance Life assurance
business business
Shs. ‘000’ Shs. ‘000’
Interest on fixed deposit accounts (net) 780 400
Dividend received (net) 3,000 4,800
Rental income 10,000 11,200
13,780 16,400

3. General expenses include the purchase of:

General insurance Life assurance
business business
Shs. ‘000’ Shs. ‘000’
Computers 800 720
Furniture and fittings 1,260 860
T E X T

4. Reserves for unexpired risk were as follows:

General insurance Life assurance
S T U D Y

business business
Shs. ‘000’ Shs. ‘000’
1 January 2007 3,240 4,340
31 December 2007 1,760 5,370

5. Claims outstanding were as follows:

General insurance Life assurance
business business
Shs. ‘000’ Shs. ‘000’
1 January 2007 5,640 3,460
31 December 2007 6,200 2,880

Claims paid during the year ended 31 December 2007 amounted to Sh.7,600,000 for General
insurance business and Sh.6,900,000 for Life assurance business.

Required:
i) Determine the taxable income or loss of Linda Insurance Company Ltd. for the year of
income 2007 (14 marks)
ii) Tax payable (if any) by the insurance company (2 marks)
(Total: 20 marks)

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 TAXATION OF SPECIALISED ACTIVITIES 79

Question four - Trade associations, clubs, amateur

sporting associations

Write brief notes on the taxation of the incomes received by the following institutions:
(i) Charitable trusts (4 marks)
(ii) Amateur sporting associations. (4 marks)
(Dec 2005 Q 1)

Question five-Cooperative societies

(a) Ukulima Savings and Credit Co-operative Society Ltd. has presented you with the following
income and expenditure account for the year ended 31 December 2007:
Sh. Sh.
Income 2,252,500
Rental income 424,000
Investment income – dividends 5,750,500
Interest from loans to members 747,300
Interest from Savings and Loans Kenya Ltd. 9,174,300
Expenses

T E X T
Traveling 443,875
Printing and stationery 236,910
Legal expenses 132,500

S T U D Y
Medical expenses for staff 271,625
Salaries and wages 4,253,350
General office expenses 100,000 5,438,260
Net income 3,736,040

Required:
(i) The taxable income for the year and tax payable. ( 8 marks)
(ii) Comment on any information not used in (i) above. ( 2 marks)
(Tax 1 Dec 2001 Q 2)
(b) Explain the basic principles followed in the taxation of the income of cooperative
societies. ( 4 marks)
(Dec 2007 Q 2)

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 80 A dvanced TA X AT I O N
T E X T
S T U D Y

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 TAX INVESTIGATIONS 81

CHAPTER THREE
ONE

T E TX ET X T
S T U D Y T E X T
S T SU TDUYD Y

TAX INVESTIGATIONS

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 82 A dvanced TA X AT I O N
T E X T
S T U D Y

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 TAX INVESTIGATIONS 83

CHAPTER THREE
TAX INVESTIGATIONS

3.1 Objectives

At the end of this chapter, the student should know the procedure for tax investigation under the
following headings:
•• Tax evasion, tax avoidance and fraud
•• Events which may trigger an investigation
•• Back duty and indepth examinations
•• Methods of computing omitted and understated income
•• VAT refunds, false claims and accountant's certificate
•• Capital statements and ascertainment of income omitted or understated
•• Customs and excise investigations
•• Negotiation for settlement
•• Tax audit
•• Application of relevant case law

T E X T
3.2 Key definitions

S T U D Y
Tax avoidance is the use of existing law to reduce tax payable. It is legal and may be achieved
through taking advantage of the knowledge about tax to reduce the tax burden or liability.
Tax evasion is the use of fraudulent and dishonest means to reduce tax payable. Generally
speaking tax evasion is illegal.

3.3 Introduction

In the previous chapter, we studied concepts on taxation of specialised institutions. In this

chapter, we shall study the various approaches that can be used either by the enterprises or by
the revenue authority to investigate tax compliance of a company. The tax concepts learnt in this
topic will provide a practical basis in taxation. In the next topic we shall study concepts in cross-
border transactions.

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 84 A dvanced TA X AT I O N

3.4 Exam Context

The procedure of tax investigation learnt in this topic will be tested in the application questions in
the examinations. As such, a deep understanding of the same will be essential.

3.5 Industrial Context

This topic is designed to not only help the students tackle related exam questions, but also to
help tax experts, revenue authority experts and finance managers conduct any tax investigation.
With the aggressive nature of the revenue authority, different and more sophisticated approaches
are being adopted while undertaking the audits. As such, the content in this text may not be
exhaustive.

3.6 Tax evasion, tax avoidance and fraud

Tax avoidance is the use of existing law to reduce the tax payable. Tax avoidance is legal and
may be achieved through taking advantage of the knowledge about tax to reduce the tax burden
or liability. Some modes of tax avoidance include:
T E X T

•• Investment decisions: Do you buy an asset of capital nature and claim capital allowances
or incur revenue expenditure?
•• Personal investment decisions: Do you invest in debentures or ordinary shares?
S T U D Y

•• Employment income:Take light loans to build a house or buy a house?

•• Do you buy your own car and claim mileage or rely on the company car?
•• Production for domestic or international: EPZ for exports are zero rated for VAT, they
have a tax holiday of 10 years, import duty refund on raw materials imported, 25%
corporate tax rate for years from 11 to 20, ID of 100%
•• Financing decisions: Debt capital interest is allowable unlike equity where dividends
are disallowable.
•• Business ownership: Should it be a sole proprietorship, a partnership or a limited
company?
•• A limited company is a going concern, salary to directors is allowable, tax liability is
on the company, tax 30% for company, personal relief for individuals, interest on debt
capital is allowable unlike on partners capital which is disallowable.
Tax evasion is the use of fraudulent and dishonest means to reduce tax payable. Tax evasion is
illegal. It can also be defined as the reduction of tax liabilities by illegal means such as concealing
information or supplying false information Tax evasion may be achieved through:
▪▪ corrupt deals with tax officials,
▪▪ willful negligence in furnishing tax information(e.g. false returns),
▪▪ Non declaration of incomes.
▪▪ Alarming expenses, allowances and relief that one is not entitled to or
▪▪ Engaging in smuggling or black markets.
▪▪ Money laundering
▪▪ Barter trade transactions
▪▪ Lighting i.e. not declaring income related to extra employment
▪▪ Manipulation of accounts( creative accounting)

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 TAX INVESTIGATIONS 85

3.6.1 Anti-avoidance provision ( Sec 23 of the Income Tax Act)

Under S.23, the Commissioner of Income Tax is empowered to reject certain business transactions
when he is of the opinion that the main purpose or one of the main purposes for effecting a
transaction is evasion or reduction of tax liability. He can direct for necessary adjustment on
taxable income and issue an assessment accordingly. If the taxpayer disputes the adjustment
and the resulting assessment, the taxpayer can appeal to the Tribunal e.g.
•• A Director buying a car from the company at a throw away price. He would be taxed
on the difference between the low price he pays for the car and the market price for the
car.
•• A child paid very high salary for minor duties. The salary helps to spread tax payable but
the parent controls the child’s income. The Commissioner of Income Tax would disallow
the salary and tax it.
S.24-Anti-avoidance provision
Under S.24, the Commissioner of Income Tax is empowered to direct a company to distribute
dividends to its shareholders i.e. when there is dividend distribution shortfall e.g. Fair Ltd had
adjusted income for tax in 2005 of Kshs 10 million and dividend provided/declared was Kshs 1
million. Dividend distribution shortfall would then be calculated as follows:
Kshs ‘000

T E X T
Adjusted income for tax 10,000
Less tax thereof @ 30%

S T U D Y
(tax rate for the year) 3,000
7,000
Less: Allowable retention @60% 4,200
2,800
Less: dividend declared 1,000
Dividend distribution shortfall 1,800
Shortfall distribution tax = 1,800 x 5% = 90

The Commissioner of Income Tax can direct the company to distribute Kshs 1,800 to the
shareholders and deduct withholding tax accordingly. If a taxpayer disputes an assessment
resulting from forced distribution, the taxpayer can appeal to the Tribunal.

Tax avoidance: Principles emerging from case law

Section 23 of the Kenya Income Tax Act empowers the Commissioner to order the adjustment of
transactions which in his opinion are effected with the main aim of avoiding or reducing liability
to tax.
Such a direction can only be challenged by appealing to the Income Tax Tribunal. This decision
of the Tribunal is final and there is no right to further appeal.
However, the Commissioner rarely, if ever, does use such powers. Consequently, there is no
such litigation in respect of tax avoidance schemes in Kenyan courts.

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 86 A dvanced TA X AT I O N

However, the following principles have emerged from UK Case Law and which may well be
applied in Kenya:

1. The “Duke of Westminster” Principle.

Lord Tomlin stated: “Every man is entitled, if he can, to order his affairs so that the tax
attaching ... is less than it would otherwise be.
2. The “Ramsay” Principle:
This was established in a Capital Gains Tax Case in relation to composite transactions.
At the time, the most prevalent scheme to avoid tax (especially Capital Gains Tax) was to enter
into a series of transactions, which would facilitate the following:
(a) Conceal the sale of property subject to Capital Gains Tax (CGT)
(b) The exchange of shares for shares, which would not have CGT implications.
This interdependent series of transactions would normally be “circular and self- cancelling”.
The Ramsay doctrine provides that whether a series of transactions is genuine or artificial would
be dependent on the end result. Transactions which have no commercial purpose are treated as
a fiscal nullity. The preordained series of transactions are disregarded if they have no business
purpose other than achieving the preordained end.
The same principle was extended in CIR vs Burmah Oil Co. Ltd.
T E X T

3. Francis Vs Dawson
Facts of the Case
George Dawson and family owned two private companies which they wanted to sell. If they were
S T U D Y

sold in UK at a gain, it would be subject to Capital Gains Tax.

Dawson wanted to sell to W Ltd a UK company. He was advised to sell by an exchange of shares
for shares with an offshore company, G Ltd.
G Ltd then sold its shares in the two companies to W Ltd. The scheme succeeded on the grounds
that the end result led to “enduring legal consequences” and therefore the individual transactions
had a business purpose and not artificial as in the Ramsay Case.

3.7 Events which may trigger an investigation

The following are some of the circumstances that trigger audits by the Kenya Revenue
Authority:
(a) Self confession.
(b) Third party information
(c) Informers e.g. friend, a spouse, former spouse.
(d) Information from related company audits.
(e) Non compliance in the industry.
(f) Cessation of business or a large part of the business.
(g) Non compliance detected via compliance check
(h) Staff of the entity
(i) Public media (TV, Newspapers, magazines)
(j) Registrar of companies or business names.
(k) Large public company e.g. KCC

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 TAX INVESTIGATIONS 87

(l) Government parastatals.

(m) Local authorities.
(n) Investigation using the PIN number.

3.8 Back duty and indepth examinations

The obligation to declare all incomes for tax purposes rests with the taxpayer whether or not he
has been specifically told to do so by the Domestic Taxes Department.
Back-duty refers to collection of all kinds of tax in arrears. The Income Tax Act requires every
person assessable to tax to notify his liability within four months after the end of the year of
income. Return forms/materials will be sent to taxpayers in the Domestic Taxes Department
records though the Department is not obliged to issue necessary returns/materials.
Tax arrears normally arise under the following conditions:
1. Under declaration of income (incomplete and incorrect returns)
2. Non-declaration of income
3. Taxpayer claims expenses, allowances, reliefs he is not entitled to.

An offence will have been committed by a taxpayer under the above mentioned circumstances
and his affairs will be dealt with as a back-duty case i.e. back-duty investigation will be instituted

T E X T
into the affairs of the taxpayer. Penalties may be charged including interest charges. Where the
above circumstances are due to:
i) Gross or wilful negligence on the part of the taxpayer and his accountant, or;

S T U D Y
ii) Fraud on the part of the taxpayer

Sources of information resulting to back-duty will be from: -

- Taxpayer himself
- Informers
- Public media
- Income tax departments
- Farming organisations
- Registrar General’s office
- Licensing Department offices etc.

Determination of income through back-duty cases

1. The taxpayer can declare income acceptable to the department supported by accounts and
other relevant documentation.
2. A capital statement may be prepared as sufficient estimation of growth in assets and
therefore estimate income for such taxpayer if there are no reliable records/accounts. A
capital statement consists of details of assets and liabilities as at a given date or period.
This would show changes in total worth of a taxpayer between two or more periods. The
capital statement also considers capital losses or gains, living expenses, income tax paid
etc.
Where the capital statement covers more than one year, the resultant figures will be divided by
number of years involved giving rise to a uniform figure as estimate measure per year.

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 88 A dvanced TA X AT I O N

Capital statements must appear reasonable to be acceptable by the Income Tax Department and
must

Steps
1) Add all assets of taxpayer both tangible and intangible for a given period. Deduct all liabilities
both personal and business used to finance the assets. Net result will be Net assets for the
period.
2) Calculate the growth or loss in Net assets for each time period by taking the Net Assets
of the period and comparing it with the Net Assets of the previous period. This represents
additional assets that the taxpayer acquired or disposed in the time period.
3) Deduct any non-taxable income that was used to finance the above growth in Net assets –
e.g. income or assets from a legacy or inheritances, capital gains, gifts, money from friends
and relatives.
4) If looking for only the undeclared business profits taxable, then deduct any non-trading
business income from growth in Net assets. The net figure would represent Net Business
savings.
5) Add to the balance (4) living expenses such as water & electricity, income tax paid, interest
on loans, premium on various types of insurance, rents and rates as supported by bills or
invoices. Add also personal expenses such as food, services, clothing, toiletries, medical
expenses, house servant, holidays, amusements, private motor vehicle running and
maintenance costs, harambee contributions, donations and any cash stolen from house or
T E X T

shop etc.
6) If capital assets are sold at a loss, add the loss. If sold at a profit, deduct the profit. Deduct
any income declared during the year – balance is undeclared income.
7) Other considerations
S T U D Y

•• Taxpayers’ standard of living/lifestyle/cost of living, property and assets alienated to

other persons.
•• Any remittances abroad
•• Marital status or status in society
•• Dwelling place.
Procedure:
Determine the capital at the beginning and end of the period. An increase in capital may be due
to: -
a) Fresh capital introduced (not income).
b) Profit earned (may or may not be taxable)
c) Gifts, awards, windfall gains (may not be taxable)

A decrease in capital may be due to: -

a) Capital withdrawn
b) Losses (allowable or non-allowable)

The increase in capital is adjusted for the following items:

Deduct:
Legacies, gifts not taxable, income already taxed at source and not subject to further taxation, relief
and allowances, windfall gains, inherited wealth/property, life policies matured/surrendered.

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 TAX INVESTIGATIONS 89

Add:
Taxes paid, gifts or donations made, non-allowable losses e.g. loss on sale of investments/
assets, personal expenditures, unexplained payments.
Further information that may be required
1. Are there other expenses not deductible?
2. Does the taxpayer have any other income source?
3. Does the taxpayer lease the freehold land or does he farm it and what is the income?
4. Why has the taxpayer not claimed capital allowances?
5. Does the taxpayer have a life insurance policy with a Kenyan company? If so, how much
are the premiums he pays?

3.9 VAT refunds, false claims and accountant's certificate

Refund of tax

If, for any tax period, a person has overpaid tax, i.e. the input tax claimed exceeds the output tax
for the period, the excess amount is carried forward to be set-off against output tax for the following
period. However, if this position is a regular feature of the business then the Commissioner shall

T E X T
refund the excess amount.
No tax is refundable if the registered person is not up to date in the submission of VAT returns.
The claim for refund must be made on the appropriate form within a period of 12 months.

S T U D Y
The Commissioner VAT may refund tax under the following circumstances:
•• Where payment has been made in error e.g. overpayment of VAT, use of wrong rate,
miscalculation etc.
•• Where input tax persistently exceeds output tax and this is a regular feature of the
business.
•• Where goods are imported, VAT charged and then exported before being used, VAT
paid will be refunded.
•• When payment for supply of goods/services have been received (bad debts) under
Sec. 24. A refund for bad debt is made within 5 yrs.
•• VAT refund for bad debt is claimable if:
(i) The debtor had been declared legally insolvent or
(ii) The debt has been outstanding for more than 3 years.
•• Where input VAT was charged on goods purchased, civil works, building constructed
etc. for making/manufacturing taxable supply before an individual became registered.
Such claim for refund is made in form VAT 5 within 30 days from the date of approval of
registration by the Commissioner VAT.
•• Where refund is in public interest in the opinion of the Minister for Finance. Such a
claim is made in for VAT 4 within 12 months of paying VAT.
•• Refund of input tax on capital investments incurred where the input tax exceeds
Kshs1,000,000 and investments are used in making taxable supplies.
Documents accompanying claim for refund under Sec. 24 (bad debts)
•• Confirmation from liquidator that debtor has become insolvent and proof of debt
amount.

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 90 A dvanced TA X AT I O N

•• Copies of relevant tax invoices issued at the time of supply to the insolvent debtor,
•• A declaration that the debtor and taxpayer are unrelated companies/persons.
•• Records/documents showing input tax paid by the taxpayer e.g. VAT account, bank
pay-in-slips etc.
VAT refund audit procedure
•• Under legal notice issued 18/11/99, tax refunds and claims for tax relief exceeding Kshs
1,000,000 shall be accompanied by the auditor’s certificate.
•• The certificate should state that the claim is true and the amount claimed is properly
refundable under VAT Act.
•• The following audit procedure is followed by the auditor before issuing such a VAT
refund certificate.
(It is not exhaustive and may require tailoring to suit circumstances).
1. Review and document the adequacy of the system of recording and accounting for VAT.
2. Ensure that the VAT 4 corresponds with the supporting VAT return and that the entries in the
return agree with the books of account.
3. Establish why the trader is in refund position (e.g. trader in an exporter, inputs taxed at
higher rate than outputs, significant capital expenditure, seasonal trading/purchases, etc).
The reason for the refund must be soundly based.
4. Check if the trader is subject to partial exemption rules, and if so, whether the rules have
been applied correctly as required by regulation 17, especially the annual adjustment.
T E X T

5. Select a sample of invoices from VAT 4 and perform the following tests where applicable:
•• Input tax has been claimed within 6 months after the issue of the invoice.
•• The invoices meet the requirement of Regulation 4.
•• Simplified tax invoices have not been used to claim relief.
S T U D Y

•• The invoices are not photocopies or fax copies.

•• Ensure that input tax in respect of imported goods is properly supported by a Customs
Entry form and contained within an original KRA receipt for payment of duty and VAT.
•• Ensure that tax has been properly accounted for in respect of imported services (reverse
charge).
•• Ensure the input tax does not relate to items scheduled on the blocking order VAT
Order, 1994.
•• Ensure input tax has not been claimed in advance.
•• Trace the invoices to the relevant ledger accounts.
•• Confirm that the expenditure is business related and not private.
6. Obtain the workings supporting the output tax on the VAT return, if any, and select a sample
and perform the following tests where applicable:
•• Check that the correct rate of VAT was applied.
•• Ensure that sales were accounted for in the correct tax period.
•• Trace the invoices to the relevant ledger accounts.
•• In the case of exports, ensure a payment has been received in respect of the goods or
services exported and the proper documentation supporting export is in place.
•• Ensure that VAT has properly been accounted for in respect of miscellaneous sales.
7. Ensure, where applicable, that VAT on intra-group transactions has been properly accounted
for.
8. Ensure all VAT returns were submitted on time. If not, compute the penalties and interest to
be deducted from the claim, if the trader has not done so.
9. Prepare a statement analysing the current claim.

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 TAX INVESTIGATIONS 91

The impact of VAT audit will focus on:

♦♦ Assessment of VAT not correctly charged.
♦♦ Disallowance of input tax incorrectly claimed.
♦♦ Identification of other offences and errors.
♦♦ Levying of penalties and interest for the default and errors.
♦♦ Educating taxpayers thereby ensuring better compliance in future.

3.10 Capital statements and ascertainment of income omitted or

understated

A capital statement may be prepared as sufficient estimation of growth in assets and therefore
estimate income for such taxpayer if there are no reliable records/accounts. A capital statement
consists of details of assets and liabilities as at a given date or period. This would show changes
in total worth of a taxpayer between two or more periods. The capital statement also considers
capital losses or gains, living expenses, income tax paid etc.
Where the capital statement covers more than one year, the resultant figures will be divided by
number of years involved giving rise to a uniform figure as estimate measure per year.
Capital statements must appear reasonable to be acceptable by the Income Tax Department and
must

T E X T
Steps:
1) Add all assets of taxpayer both tangible and intangible for a given period. Deduct all liabilities
both personal and business used to finance the assets. Net result will be NET ASSETS for

S T U D Y
the period.
2) Calculate the growth or loss in Net assets for each time period by taking the Net Assets
of the period and comparing it with the Net Assets of the previous period. This represents
additional assets that the taxpayer acquired or disposed in the time period.
3) Deduct any non-taxable income that was used to finance the above growth in Net assets –
e.g. income or assets from a legacy or inheritances, capital gains, gifts, money from friends
and relatives.
4) If looking for only the undeclared business profits taxable, then deduct any non-trading
business income from growth in Net assets. The net figure would represent Net Business
savings.
5) Add to the balance (4) living expenses such as water & electricity, income tax paid, interest
on loans, premium on various types of insurance, rents and rates as supported by bills or
invoices. Add also personal expenses such as food, services, clothing, toiletries, medical
expenses, house servant, holidays, amusements, private motor vehicle running and
maintenance costs, harambee contributions, donations and any cash stolen from house or
shop etc.
6) If capital assets are sold at a loss, add the loss. If sold at a profit, deduct the profit. Deduct
any income declared during the year – balance is undeclared income.

A capital statement may be required where:

•• no accounting records are kept by the taxpayer
•• taxpayer maintains incomplete records
•• when a self assessment has been filed but indepth assessment has to be carried out.

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 92 A dvanced TA X AT I O N

3.11 Customs and excise investigations

Under Customs & excise, the revenue authority can carry out a post clearance audit.

Post clearance audits

According to the taxpayer’s charter, a taxpayer may be selected for a post clearance audit
on all Customs related transactions. The scope of audits may include visits to the taxpayer‘s
premises. The taxpayer will be notified in advance of the intention to carry out an audit before its
commencement. However, under certain circumstances depending on the factors surrounding
the case, it may be necessary to conduct a surprise audit. The audit may be completed within 14
days from the date of commencement of audit.
•• A post clearance audit is mostly conducted where fraud is suspected.
•• This examination is carried out after the completion of import clearance.
•• The audit inquiry is carried out at the importer’s offices, and is made not only of the
importer but also of other people concerned.
•• The audit is done in order to:
• Check whether the importer’s own initiative declaration was true and correct.
• See whether the basis of assessment and other matters contained in the declaration
T E X T

of imported goods were correctly established.

• Confirm whether the declared value of the imported goods was correct
Customs audits verify:-
S T U D Y

•• Tariff classification,
•• Valuation,
•• Country of origin,
•• Financial information and
•• Documentation the importer is required to maintain.

3.12 Tax audit

The Kenya Revenue Authority may carry out either a compliance check or a comprehensive
audit. A compliance check is like a spot check to confirm summaries from the ledger/ returns with
the taxpayer’s sales and purchases journal. A comprehensive audit is an audit covering many
types of taxes and multiple issues in the accounts of a taxpayer.
KRA may select a taxpayer for audit on Income Tax, Pay As You Earn (PAYE), Value Added Tax
(VAT), Excise or Customs duty or any other tax administered by the Authority. Sometimes the
taxpayer may be selected for audit in respect of multiple taxes. In most cases, the audits will be
field audits i.e. they will be carried out in your premises. In the majority of cases, the taxpayer
will be notified in advance of the intention to carry out an audit before the commencement of the
audit. However, under certain circumstances depending on the factors surrounding the case, it
may be necessary to conduct a surprise audit. In order not to inconvenience the taxpayer, and
subject to the taxpayer’s co-operation with KRA officers, KRA shall endeavour to complete the
audit within:
•• 10 days from the date of commencement of single issue audits.
•• 30 days from the date of commencement of comprehensive audits.

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 TAX INVESTIGATIONS 93

•• One day for a general inspection of an excise factory.

•• 7 days for any other tax administered by the authority.

If the taxpayer has been selected for audit by the Large Taxpayer Office or the Investigations
Department all the multiple taxes will invariably be audited. It is expected that the audit by the
Large Taxpayer Office will take no more than two months to complete. Cases under investigation
will be completed within a period of between two to six months. Complex cases may take a
longer period to complete.
The taxpayer may also be subjected to a compliance check (e.g. computation and intelligence
information) to verify certain information. A visit by a KRA official to check on the taxpayer’s
compliance does not amount to a comprehensive audit.
An audit is considered complete when the findings have been fully explained in writing to the
taxpayer giving specific details on how additional tax liability if any, has been arrived at. The
taxpayer will also be informed in writing if the audit results in no additional tax.
The commissioner general, a departmental commissioner or headquarters tax programmes will
require that the taxpayer be re-audited if it is discovered that the taxpayer’s case was settled
irregularly, or is dissatisfied with the manner in which the case was completed.

Objections

T E X T
The taxpayer is entitled to object to an assessment (Income Tax, VAT, Customs and Excise
Duty, or other assessment issued under KRA) if you believe you have been assessed wrongly
or unfairly. You must exercise your right to object within a specific period and comply with the
requirements, which include submission of returns together with all supporting documents for the

S T U D Y
objection to be valid. You may also attach your own workings accompanied by new evidence,
which can be taken into consideration in reviewing the objection.
Once you have filed a valid notice of objection KRA shall conduct an impartial review of your case.
KRA shall acknowledge your objection within 7 days and endeavour to resolve the objection
within 30 consecutive days.
Complex cases may take more than 30 days to resolve.

3.13 Chapter Summary

•• Tax avoidance is the arrangement of a person’s financial affairs so as to legitimately

reduce a tax liability.
•• Tax evasion is the illegal arrangement of financial affairs so as to minimise a tax
burden.
•• The revenue authority has powers to carry out a comprehensive audit and a compliance
audit across all types of taxes.
•• The taxpayer has an avenue to object, or appeal against an assessment.

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 94 A dvanced TA X AT I O N

3.14 Quiz

Question one: Tax avoidance and evasion

Distinguish between tax avoidance and tax evasion.

Question two: Audit

What are the two types of audits that can be carried out by KRA?

Question three: VAT refund

Describe the procedure for a VAT refund audit.

T E X T

Question four: Customs investigation

Describe how a customs and excise investigation is carried out.

S T U D Y

Question five

List the circumstances that may trigger an audit.

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 TAX INVESTIGATIONS 95

3.15 Quiz answers

Question one: Tax avoidance and evasion

Tax avoidance is the arrangement of a person’s financial affairs so as to legitimately reduce a

tax liability.
Tax evasion is the illegal arrangement of financial affairs so as to minimise a tax burden.

Question two: Audit

KRA may carry out either a compliance check or a comprehensive audit. A compliance check is
like a spot check to confirm summaries from the ledger/ returns with the taxpayer’s sales and
purchases journal. A comprehensive audit is an audit covering many types of taxes and multiple
issues in the accounts of a taxpayer.

T E X T
Question three: VAT refund audit

S T U D Y
VAT refund audit procedure
•• Under legal notice issued 18/11/99, tax refunds and claims for tax relief exceeding
Kshs1,000,000 shall be accompanied by the auditor’s certificate.
•• The certificate should state that the claim is true and the amount claimed is properly
refundable under VAT Act.
•• The following audit procedure is followed by auditor before issuing such a VAT refund
certificate. (It is not exhaustive and may require tailoring to suit circumstances).
•• Review and document the adequacy of the system of recording and accounting for
VAT.
•• Ensure that the VAT 4 corresponds with the supporting VAT return and that the entries
in the return agree with the books of account.
•• Establish why the trader is in refund position (e.g. if trader is an exporter, inputs taxed
at higher rate than outputs, significant capital expenditure, seasonal trading/purchases,
etc). The reason for the refund must be soundly based.
•• Check if the trader is subject to partial exemption rules, and if so, whether the rules have
been applied correctly as required by regulation 17, especially the annual adjustment.
•• Select a sample of invoices from VAT 4 and perform the following tests where
applicable:
a. Input tax has been claimed within 6 months after the issue of the invoice.
b. The invoices meet the requirement of Regulation 4.
c. Simplified tax invoices have not been used to claim relief.
d. The invoices are not photocopies or fax copies.
e. Ensure that input tax in respect of imported goods is properly supported by a
Customs Entry form and contained within an original KRA receipt for payment of
duty and VAT.

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 96 A dvanced TA X AT I O N

f. Ensure that tax has been properly accounted for in respect of imported services
(reverse charge).
•• Ensure the input tax does not relate to items scheduled on the blocking order VAT
Order, 1994.
•• Ensure input tax has not been claimed in advance.
•• Trace the invoices to the relevant ledger accounts.
•• Confirm that the expenditure is business related and not private.
•• Obtain the workings supporting the output tax on the VAT return, if any, and select a
sample and perform the following tests where applicable:
•• Check that the correct rate of VAT was applied.
•• Ensure that sales were accounted for in the correct tax period.
•• Trace the invoices to the relevant ledger accounts.
•• In the case of exports, ensure a payment has been received in respect of the goods or
services exported and the proper documentation supporting export is in place.
•• Ensure that VAT has properly been accounted for in respect of miscellaneous sales.
•• Ensure, where applicable, that VAT on intra-group transactions has been properly
accounted for.
•• Ensure all VAT returns were submitted on time. If not, compute the penalties and
interest to be deducted from the claim, if the trader has not done so.
•• Prepare a statement analysing the current claim.
T E X T

The impact of VAT Audit will focus on:

♦♦ Assessment of VAT not correctly charged.
♦♦ Disallowance of input tax incorrectly claimed.
S T U D Y

♦♦ Identification of other offences and errors.

♦♦ Levying of penalties and interest for the default and errors.
♦♦ Educating tax payers thereby ensuring better compliance in future.

Question four: Customs investigation

According to the taxpayer’s charter, a taxpayer may be selected for post clearance audit on
all Customs related transactions. The scope of audits may include visits to the taxpayer‘s
premises. The taxpayer will be notified in advance of the intention to carry out an audit before its
commencement. However, under certain circumstances and depending on the factors surrounding
the case, it may be necessary to conduct a surprise audit. The audit may be completed within 14
days from the date of commencement..
•• Post clearance audit is mostly conducted where fraud is suspected.
•• This examination is carried out after the completion of import clearance.
•• The audit inquiry is carried out at the importer’s offices, and is made not only of the
importer but also of other people concerned.
•• The audit is done in order to:
• Check whether the importer’s own initiative declaration was true and correct.
• See whether or not the basis of assessment and other matters contained in the
declaration of imported goods were correctly established.
• Confirm whether the declared value of the imported goods was correct.

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 TAX INVESTIGATIONS 97

Customs audits verify:

•• tariff classification,
•• valuation,
•• country of origin,
•• financial information and
•• documentation the importer is required to maintain.

Question five

(a) The following are some of the circumstances that trigger audits by the KRA:
(b) Self confession.
(c) Third party information
(d) Informers e.g. a friend, a spouse, or former spouse.
(e) Information from related company audits.
(f) Non-compliance in the industry.
(g) Cessation of business or a large part of the business.
(h) Non compliance detected via compliance check
(i) Staff of the entity
(j) Public media (TV, newspapers, magazines)
(k) Registrar of companies or business names.

T E X T
(l) Large public company e.g. KCC
(m) Government parastatals.
(n) Local authorities.
(o) Investigation using the PIN number.

S T U D Y
3.16 Past paper Analysis

The following is a list of past exams and questions in which the topic was featured. The questions
are listed in this format: Month/year e.g. 6/01 represents June or May 2001.
06/00 Q.4, 12/04 Q.5 (d), 12/06 Q.2. 06/06 Q.3 (b) 12/06 Q.4(a), 12/06 Q.5(a), 06/07 Q.3(c),
06/07 Q.5(b), 12/07 Q.1(b).

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 98 A dvanced TA X AT I O N

3.17 Revision questions

Question one

(a) You have recently been appointed by an individual running his own business to act on
his behalf in a back duty investigation. Following preparation of a capital statement for a
number of years you have agreed with the District Assessor handling the case, the additional
amounts to be assessed and calculations showing the amount of tax interest on overdue tax
and penalties arising on the additional amounts assessable.
Your client is puzzled as to how the back duty investigation began. He has also asked
whether the Income Tax Department will accept a settlement of less than the full amount.
Required:
Write a letter to your client advising him:
(i) Of the information the assessor might have received which resulted in an investigation into
his affairs. (3 marks)
T E X T

(ii) Of the circumstances of the case which the Income Tax Department might take into
consideration in deciding whether to accept a payment of less than the full amount due.
(2 marks)
(b) Your client, Sophia Town, has owned a general retail store since 1 April 2003. The Tax
S T U D Y

Assessor has recently begun an investigation into her affairs as he is not satisfied that she
has been making full declaration of income in recent, years. On your advice, Sophia decided
to co-operate fully with the Income Tax Department and after discussing the matter with her
and investigating her records you have managed to prepare the following statements:

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 TAX INVESTIGATIONS 99

Year ended: 31 March 31 March 31 March 31 March

2004 2005 2006 2007
Kshs Kshs Kshs Kshs
Sales (recorded) 40,000 50,000 60,000 65,000
Cost of sales 34,000 42,500 45,000 58,000
Gross profit 6,000 7,500 15,000 7,000
Bank deposit interest
(undeclared)
300 700 800 1,200
6,300 8,200 15,800 8,200
Expenditure:
Items for which
receipts are
available 3,510 3,820 4,840 5,120
Other items 1,490 1,680 1,760 2,080
5,000 5,500 6,600 7,200
Net profits

T E X T
(assessed to tax) 1,300 2,700 9,200 1,000

S T U D Y
You ascertain that the bank deposit account was opened in May 2003. Your calculations reveal
her gross profit percentage should be 33⅓% on cost. Sophia informs you that she banked 1/11 of
her takings in a National Savings Bank ordinary account which earned interest at 5% per annum
throughout the period under review. The National Savings Bank account which had not been
declared on her tax return form was opened on 31 December 2003 and undeclared takings were
banked annually on 31 December each year. Sophia’s turnover fluctuates very little from month
to month. Of the expenditure for which no receipts are available you have satisfied yourself that
60% is genuine business expenditure, while the other 40% is of a doubtful nature. Sophia also
has casual dealings in antiques which have not been declared to the Income Tax Department.
Her antique dealings also commenced in April 2003.

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 100 A dvanced TA X AT I O N

Preparation of capital statements reveals the following:

1 April 31 March 31 March 31 March 31 March
2003 2004 2005 2006 2007
Kshs Kshs Kshs Kshs Kshs
Assets at cost:
Shop premises fittings and
stock
25,000 30,000 32,000 36,500 40,000
Debtors and cash
500 2,500 4,500 6,000 7,000
Bank deposit account
- 2,800 7,620 9,040 13,150
National Savings Bank
Account
- 3,000 7,900 14,045 21,122
Investments (legacy from
deceased aunt)
__ _- __ _- 7,000 7,000 7,000

Liabilities 25,500 38,300 59,020 72,585 88,272

Loan from friend to purchase

shop
T E X T

Creditors (20,000) (20,000) (20,000) (20,000) (20,000)

_____- (2,000) (6,000) (8,000) (11,000)
S T U D Y

(20,000) (22,000) (26,000) 28,000 (31,000)

5,500 16,300 33,020 33,020 57,272

Close questioning of Sophia reveals that no stock of antiques is held on the above dates and she
has no other assets of significance for investigation.
Sophia’s outgoings in the year concerned may be deducted from the following information:
Year ended 31 March 31 March 31 March 31 March
2004 2005 2006 2007
Kshs Kshs Kshs Kshs
Personal drawings 3,140 5,200 6,240 9,800
Tax and national 105 120 525 2,420
insurance
-
Cash gifts to enable
2,000 12,000 -
her mother to buy a
house

Sophia inherited Kshs 10,000 of 10% debentures in Akamba Limited on the death of her aunt on
1 July 2004 The debentures were valued at 70% for probate purposes and interest is paid half-
yearly on 30 June and 31 December. Sophia is a widow and living with her mother.

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 TAX INVESTIGATIONS 101

Required:
(i) Prepare schedules which will form the basis of your negotiations with the Income Tax
Department on the question of undeclared income. (13 marks)
(ii) Suggest what factors the Assessor will take into account in negotiating penalties and
interest on the lost tax. (7 marks)
July 2000 Q 3

Question two

Mr. Dickson Maelfu is a businessman with interest in the manufacturing sector. He is facing a
back-duty investigation by the revenue authority which suspects that he has been under-declaring
income for four years from year 2004 to year 2007.
You are the head of the team from the revenue authority conducting this investigation. Mr. Maelfu
has submitted to you records of his private and business assets and liabilities from 1 January
2004 to 31 December 2007 as shown below:
1 January 31 31 31 31
December December December December
2004 2004 2005 2006 2007
Kshs Kshs Kshs Kshs ‘000’ Kshs

T E X T
‘000’ ‘000’ ‘000’ ‘000’
Assets and
Liabilities
Factory 36,000 48,000 48,000 52,000 54,000

S T U D Y
building
Plant and 24,000 28,000 36,000 36,000 38,000
machinery
Commercial 9,000 12,000 12,000 15,000 18,000
vehicles
Stock in trade 3,600 4,200 8,000 9,000 7,000
Trade debtors 2,960 3,540 2,640 2,530 2,980
Private 9,240 13,600 13,600 13,600 13,600
residence
Trade 7,280 8,640 9,420 8,360 7,890
creditors
Bank loan 10,900 10,000 9,870 7,640 9,840
Loan from an 800 700 600 870 640
uncle
Mortgage loan 3,780 3,780 3,780 3,780 3,780
Bank balance 3,400 5,400 3,600 3,760 4,670

Additional information:
1. There were no disposals of fixed assets during the period under investigation.
2. The bank balance on 31 December 2005 included Kshs 400,000 inherited from a
relative on 31 October 2005.
3. His living expenses for each of the four years were as follows:

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 102 A dvanced TA X AT I O N

Year ended 31 December:

2004 2005 2006 2007
Living expenses (Kshs) 70,000 120,000 90,000 150,000

4. Interest on the mortgage is at a rate of 15% per annum.

Required:
i) The taxable income of Mr. Maelfu for each of the four years ended 31 December 2004,
2005, 2006 and 2007. Ignore capital allowances. (8 marks)
ii) Comment on any four areas on which you would seek further clarification from Mr.
Maelfu before concluding your investigation. (4 marks)
(Dec 2007 Q 5)

Question three

Mr. Pesa provided the following accounts with his returns for 2007:
Mr Pesa Trading and profit and loss account for the year ended 31 December 2007
T E X T

Kshs Kshs
Sales 12,040,000
Less: Cost of goods sold 11,530,000
S T U D Y

Gross profit 510,000

Less: Salaries expense 1,200,000
Office rent 220,000
Advertising 97,500
General expenses 60,000
Motor upkeep 137,500
Printing and stationery 94,500
Travelling expenses 100,000
Provision for bad debts 175,000
Depreciation expense 30,000
Interest on capital 265000
Net discounts 10,000 2,389,500
Net loss 1,879,500

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 TAX INVESTIGATIONS 103

Mr. Pesa
Balance sheet as at 31 December 2007
Assets: Sh.
Cash at bank 1,910,000
Cash in hand 85,000
Sundry debtors (less provisions) 1,298,800
Stocks 2,500,000
Fixtures and fittings (depreciation Sh.10,000) 190,000
Office car (depreciation Sh.20,000) 80,000
6,063,800

Equity and liabilities Sh. Sh.

Capital 6,200,000
Add: Addition 200,000
Interest on capital 265,000
Less: Loss for the year (1,879,500)

T E X T
4,785,500
Less: Drawings 660,000 4,125,500

S T U D Y
Outstanding liabilities 14,500
Salaries outstanding 100,000
Rent payable 20,000
Sundry creditors (less discount 1,803,800
sh.46,200)
6,063,800

An indepth investigation has been commenced and you, as the assessor in charge, has been
provided with the following information in support of the above accounts.

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 104 A dvanced TA X AT I O N

1. Balances as at 31 December:
2006 2007
Sh. Sh.
Cash at bank 300,000 1,910,000
Cash in hand 40,000 85,000
Stock-in-trade 2,200,000 2,500,000
Sundry debtors - 3,500,000
Sundry creditors 2,340,000 1,850,000
Fixtures and fittings 200,000 -
Office car 100,000 -

2. From past financial statements, the line of business of Mr. Pesa maintains a steady gross
profit rate of 25% on sales.
3. The bills outstanding as at 31 December 2007 were:

Sh.
T E X T

Petrol 2,500
Advertising 7,500
Printing 4,500
S T U D Y

4. The motor car and fixtures are depreciated by 20% and 5% respectively. Capital allowances
have been agreed at Sh.32,000.
5. 5% interest is allowed on capital.
6. Provision was made at 5% for doubtful debts and 2½% on creditors for discounts.
7. The cash book analysis shows the following figures among others:

Kshs Kshs
Receipts from customers 13,500,000 Motor upkeep 135,000
Discounts allowed on them 140,000 Printing and stationery 80,000
Further capital introduced 200,000 Drawings 660,000
Salaries to 30 November 1,100,000 Payments to creditors 11,200,000
2007
220,000 Discounts allowed by 120,000
Office rent to 30 November them
90,000 100,000
2007
Travelling expenses
60,000
Advertising
General expenses

8. Specific bad debts were Sh.215,000.

Required:
(a) Using the information provided, validate the accuracy or otherwise of the figures in the
accounts and prepare a computation of adjusted taxable income.

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 TAX INVESTIGATIONS 105

Provide all supporting details. (16 marks)

(b) Specify the tax consequences of incorrect returns of income. (4 marks)
(Total: 20 marks)

Question four

(a) It may be advantageous for a trader whose turnover is below the legislated turnover
limits under the sixth schedule to the VAT Act to register for VAT voluntarily. Under what
circumstances could this be beneficial? (3 marks)
(b) Under what circumstances is a VAT refund properly due? (6 marks)
(c) What is the procedure for obtaining the refund in (b) above? (3 marks)
(d) The management of Kasuku Rolling Mills Ltd. appointed your firm their auditor with effect
from 1 January 2007. The senior partner of your firm assigned you the responsibility of
dealing with the company’s tax affairs. You have just completed performing the audit of the
company’s VAT refund claim. You have also confirmed that the VAT refund is properly due
under the VAT regulations.
Prepare a draft VAT audit refund certificate for your senior partner’s review. (6 marks)
(e) After your firm issued the VAT refund certificate in (d) above, the VAT department made
their own independent investigations and established that the company’s refund claim was
grossly misstated.

T E X T
What are the consequences of this error to the management of Kasuku Rolling Mills Ltd. and
to your audit firm? (2 marks)
(Total: 20 marks)

S T U D Y
(May 2002 Q.3)

Question five

(a) Explain the circumstances under which a tax authority may conduct a PAYE audit on a
business. (8 marks)
(December 2006 Q 5)
(b) What circumstances may trigger a Pay As You Earn (PAYE) audit? (5 marks)
(December 2002 Q 1)

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 106 A dvanced TA X AT I O N
T E X T
S T U D Y

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 TAXATION OF CROSS BORDER ACTIVITIES 107

CHAPTER FOUR
ONE

T E TX ET X T
S T U D Y T E X T
S T SU TDUYD Y

TAXATION OF CROSS
BORDER ACTIVITIES

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 108 A dvanced TA X AT I O N
T E X T
S T U D Y

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 TAXATION OF CROSS BORDER ACTIVITIES 109

CHAPTER FOUR
TAXATION OF CROSS BORDER ACTIVITIES

4.2 Objectives

•• Distinction between trading in and trading with a country

•• Double taxation agreements; theory, design and application
•• Regional perspective with reference to the East African Community (EAC) and the
Common Market for Eastern and Southern Africa (COMESA)
•• Most favoured nation status
•• Withholding tax provisions
•• Transfer pricing
•• Application of relevant case law

4.1 Introduction

In the previous chapter, we studied tax investigations. In this topic, we will discuss the various

T E X T
issues arising from the taxation of cross border activities. The world is slowly becoming a global
village and as such there is an increase of cross border transactions that need to be regulated.
Further, the concept of double taxation is crucial in the overall economic policy of a country. It

S T U D Y
refers to the imposition of comparable taxes in two or more states on the same income/same
subject matter for identical periods of a named taxpayer. Income tax is imposed in Kenya on any
person, whether resident or non-resident if the income accrued in or was derived from Kenya.
This means that expatriates working in Kenya will be taxed in Kenya and also in their countries
of origin. Where rates of tax are high, double taxation can be a serious obstacle to growth in
international trade.
In the next topic, we will cover concepts of tax planning.

4.5 Key definitions

Off shore taxation (Tax havens)

Refers to the principle of harmonising Company law, Trust law, Banking and Tax regulations with
a view to attract investors. The measures put in place have to be tax effective as compared to
those established in the average countries in the world.

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 11 0 A dvanced TA X AT I O N

4.3 Exam Context

The student is expected to demonstrate an understanding of the various taxation issues affecting
cross border transactions. Further, the student should be able to identify any tax charged in
excess of the expected amount where double taxation is evident. Questions on this topic have
been preffered by the examiner in recent exam sittings.

4.4 Industrial Context

In the recent past, we have had many companies and individuals complaining of double taxation
of their taxable gains. The student is expected to identify this problem and perform computations
to solve it.

4.6 Taxation of cross border activities

These are the various transactions or activities that are exercised by a Kenyan resident in
another country and vice versa. The issue here is: How is the income earned or derived from
such transactions brought to charge?
T E X T

The taxation of income of a person is based on the concept of residence.

Resident and non-resident persons

S T U D Y

There are conditions for being a resident in case of an individual and also in case of a body of
persons.
a) Resident in relation to an individual means that the individual:
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 three years.

b) Resident in relation to a body of persons means that:

i) The body is a company incorporated under the laws of Kenya; or
ii) The management and control of the affairs of the body was exercised in Kenya in the
year of income under consideration; or
iii) The body has been declared, by the Minister for Finance by a notice in the Kenya
Gazette, to be resident in Kenya for any year of income.

c) Non-Resident:
▪▪ Means any person (individual or body of persons) not covered by the above conditions
for resident.

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 TAXATION OF CROSS BORDER ACTIVITIES 111

Note
▪▪ Residents have some tax advantages over non-residents which relate to tax reliefs,
rates of tax, and expenses allowable against some income.

(Income) Accrued in or derived from Kenya

▪▪ The income which is taxable is income arising from or earned in Kenya.
▪▪ Under certain conditions, some business and some employment income derived from
outside Kenya is taxable in Kenya.

Significance of the concept of residence

Residential status of an individual and body corporate is important in the following ways:
•• Kenya resident individuals pay Kenya income taxes on their incomes from Kenya and
worldwide employment, but Kenya non residents pay Kenya income taxes only on their
income from Kenya.
•• Residents pay income taxes at graduated scale rates but non residents pay income
taxes at special rates on certain specified incomes or sources.
•• Resident companies are taxed at the rate of 30% on their taxable income while non
resident companies with a branch in Kenya are taxed at a higher rate of 37.5%.
•• Withholding taxes are deducted at source on all income of Kenyan non-residents but

T E X T
residents have withholding tax deducted on only some of their incomes.
•• Non residents companies with no branch in Kenya have withholding tax deducted at
source on all their incomes while resident and non resident companies with branches in
Kenya have withholding tax deducted from only their dividend and interest income.

S T U D Y
4.7 Distinction between trading in and trading with a country

Trading in a country is where a person conducts their business within the domestic jurisdiction
of a country. For example, a foreign company establishing a business in Kenya as a branch and
then conducting its business activities in Kenya.
Trading with a country happens in situations where a person or the government enters into
trading relations with another country.

4.8 Double taxation agreements; theory, design and application

Double taxation arrangements may take the form of:

a) Bilateral conventions or agreements relief
b) Unilateral relief
a) Conventions and agreements
These are bilateral agreements for relief from double taxation. This involves countries affected
negotiating an agreement with a view to minimise or eradicate effects of double taxation. Most
double taxation agreements are based on the Organisations for Economic Cooperation and
Development (OECD) recommended models articles. Each agreement is peculiar to itself
depending on how it was negotiated.

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 11 2 A dvanced TA X AT I O N

A double taxation agreement/treaty would have articles addressing the following:

1. Persons to which the convention applies
2. Taxes covered
3. Definition of terms
4. Rules for determining tax residence (fiscal domicile)
5. Incomes affected by the agreement
6. Tax on capital
7. Diplomatic and consular officials
8. Termination of the agreements, etc.

Most countries usually give the country in which the income arises prior right of levying tax.
b) Unilateral relief
Due to the difficulty involving double taxation negotiations, it is possible for an individual country
to remove the burden of double taxation from international trade by opting to give relief for foreign
taxation on a unilateral basis i.e. without regard to whether the other taxing country extended
relief or not. This may be triggered by a representation by the business community.
A unilateral approach is usually a last resort where negotiations have proved difficult due to
political and other reasons. It is possible to have both arrangements in place to take care of
different income sources and persons. Up to 1972, there existed the commonwealth income tax
relief confined to member countries. The authority was contained in the East African Income tax
T E X T

Management Act and is not available in the Kenya Income Tax Act.
Double taxation agreements are reached with the following in mind:
1. Attraction of foreign investors through tax incentives
S T U D Y

2. Encouragement of mobility of labour to attract expertise

3. Tax incentives as loss of revenue to government
4. Level and areas of economic interaction between states concerned
5. Overall cost and benefit principle
6. Political climate/relations

Authority to grant double taxation in Kenya

The Income Tax Act section 41-43 gives authority to grant double taxation itself.
S41:
Authorises the Minister for Finance to make arrangements with other countries for relief from
double taxation.
S42 (3):
Double tax relief shall be granted provided that “the tax chargeable upon the income of a person
in respect of which a credit is to be allowed ... shall be the amount by which the tax chargeable
... in respect of his total income”
S42 (4):
“The amount of credit allowed shall not exceed the tax chargeable”. For example, if the foreign
tax is equivalent to Kshs160,000 and the tax chargeable in Kenya is Kshs100,000, the amount
of relief from the foreign tax shall be limited to Kshs100,000.

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 TAXATION OF CROSS BORDER ACTIVITIES 11 3

S42 (5):
Relates to the treatment of foreign tax on dividends not specifically covered under special
arrangements with another country. In such a case if the dividend is paid to a company, which
controls 0% or more of the voting power of the company paying the dividend, a credit shall be
obtained in the same way as if a special arrangement existed.
S43:
Any claims for allowance by way of credit should be made to the commissioner within six years
from the end of the year of income to which it relates.
Kenya has tax treaties for relief from double taxation on income arising in Kenya with the following
countries: United Kingdom, Germany, Denmark, Norway, Sweden, Zambia, Canada and India.
Withholding tax on payments to countries with which Kenya has double tax treaty are as
follows:
Non-   United Germany Denmark,  India
resident Kingdom & Norway,
rates Canada Sweden,
where no Zambia
specific
rate exists
20% Management & Professional fees 12.50% 15% 20% 17.50%

T E X T
20% Royalties 15 15 20 20
30% Rent: - Immovable property 30 30 30 30
15% - other than immovable 15 15 15 15

S T U D Y
10% Dividends 10 10 10 10
15% Interest 15 15 15 15
5% Pension and retirement annuities 5 5 5 5
20% Entertainment and sporting event   20 20 20
20% Promoting entertainment or sporting 20 20 20 20
events

Note:
Credit will be given after such taxpayer proves:
(a) That tax was actually deducted in that other country.
(b) The tax so deducted is not more than the tax he would have paid in Kenya if he had
been wholly charged in Kenya, i.e. tax credit is limited to the amount by which his tax
increases because of inclusion of the income from foreign country.
(c) The time limit for claims is six years since the occurrence of the tax liability.
(d) With effect from 1 January 2002, a taxpayer with foreign employment income shall
be granted double taxation relief whether Kenya has an agreement with that other
country.
Illustration 1:
Chris Ouma, a married Kenyan resident, had income of Kshs360,000 for year of income 2007
and also received income from Zambia net of tax Kshs180,000. The tax deducted in Zambia was
Kshs 60,000. Kenya has a double taxation relief treaty with Zambia.

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 11 4 A dvanced TA X AT I O N

Required:
a) The double taxation relief in Kenya
b) The tax payable by Ouma in Kenya.
Solution
(a) Kenyan and foreign income
= 360,000 + 240,000 = Kshs600, 000
Tax liability thereon
121,968 @ 10% 12,196.8
114,912 @ (15%+ 20%+25%) 68,947.2
(600,000 – 466,704) @ 30% 39,988.8 108,935.2
Less tax on Kenyan income of Kshs360, 000
Kshs 121,968 @10% 12,196.8
Kshs 114,912 @(15% + 20%) 40,219.2
(Ksh360, 000 – 351,792) @ 25% 2,052
(54,468)
Kenyan tax on foreign income 54, 467
T E X T

Foreign tax on foreign income 60,000

S T U D Y

Double taxation relief is Kshs 54, 467 (the lower of the two)
(b)

Gross tax liability 108,935

Less personal relief (13,944)
Double taxation
relief (54,467)
Net tax liability 40,524

Double taxation relief shall be the Kshs 54,467, i.e. the lower of foreign tax and increase in
Kenyan tax by inclusion of foreign income in tax computation – (Kshs 60, 000 or KShs 54,467)
Double tax treaties are important to multinational corporations, which have international trade
spread across several countries. These corporations derive benefits by exploiting national law
so as to maximise their results. Negotiating tax treaties internationally facilitate an enabling trade
environment for companies operating in these countries.

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 TAXATION OF CROSS BORDER ACTIVITIES 11 5

4.9 Regional perspective with reference to the East African

Community (EAC) and the Common Market for Eastern and
Southern Africa (COMESA)

4.9.1 East Africa Community (EAC)

The East African Community (EAC) is the regional intergovernmental organisation of the republics
of Kenya, Uganda, the United Republic of Tanzania, Republic of Rwanda and Republic of Burundi
with its headquarters in Arusha, Tanzania
The first major step in establishing the East African Federation was the East African Customs
union signed in March 2004 and commenced on 1 January 2005. Under the terms of the treaty,
Kenya, the region's largest exporter, will continue to pay duties on its goods entering the other
four countries until 2010, based on a declining scale. A common system of tarrifs will apply to
goods imported from third-party countries.
The EAC was originally founded in 1967, but collapsed in 1977.It was officially revived on7 July
2000. EAC is one of the pillars of the African Economic Community. In 2008, the EAC, after
negotiations with the South African Developement Community (SADC), and the Common Market
For East and Central Africa (COMESA) agreed to an expanded Free Trade Area covering the

T E X T
member states of all three.
At the moment, the member states of the EAC have negotiated the East African Community
Customs Management Act (2004) agreeing on common tariffs.

S T U D Y
East African Community Customs Management Act (2004)

This is an Act that came into force in 2005 following the revival of the East Africa Community
Customs Union. Customs control is therefore under the East Africa Customs Union and excise
duty will be under the control of respective partner states. Under the Union, goods traded within
the partner sates will be zero rated except for certain specified items from Tanzania and Uganda
albeit for a transition period only.
Goods are classified under the Harmonised System Convention (HSC) that forms the basis for
tariff classification of goods traded in the international market as listed in Annex 1 to the Protocol
on the Establishment of the East African Community Customs Union.

4.9.2 Common Market for Eastern and Southern Africa (COMESA)

The Common Market for Eastern and Southern Africa, is a preferential trading area with 19
member states stretching from Libya to Zimbabwe. COMESA was formed in December 1994,
replacing the Preferential Trade Area which had existed since 1981. Nine of the member states
formed a Free Trade Area in 2000 (Djibouti, Egypt, Kenya, Madagascar, Malawi, Mauritius,
Sudan, Zambia and Zimbabwe), with Rwanda and Burundi joining the FTA in 2004 and the
Comoros and Libya in 2006.
COMESA is one of the pillars of the African Economic Community.

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 11 6 A dvanced TA X AT I O N

In 2008, COMESA agreed to an expanded free-trade zone including members of two other
African trade blocs, the East African Community (EAC) and the Southern Africa Development
Community (SADC).

4.10 Most favoured nation status

Tax policy is used to promote international trade by grouping countries into trade blocs. Countries
belonging to trading blocs enter into treaties harmonising the customs and excise duty rates in
order to make exports and imports price within the bloc attractive as compared with the same
commodities outside the particular trade bloc. The inter-state transactions will be governed/
facilitated by terms of agreements in their particular area to the exclusion of outsiders. Uniform
customs tariffs would be geared towards increased welfare, economies of scale obtained,
increased competition results in higher production and improved quality of products, flow of
investments in the region. It provides good ground for emergence of customs union, common
market and economic union. Trade blocs include the European Union, The East African
Community, COMESA, ECOWAS (West Africa), The North American Free Trade Area (USA,
Mexico & Canada), Southern Africa Development Community (South Africa, Botswana, Lesotho,
Swaziland).

Most favoured nation status

T E X T

Trade agreement legislation can be based on the most-favoured nation principle. This is non-
discriminate principle extended to all trade partners such that any reciprocal tariff reductions are
negotiated. Member countries who are signatories of the most-favoured nation status benefit
from negotiations to boost international trade. The problem with this arrangement is that tariff
S T U D Y

negotiations may be on certain few commodities only. Also benefits may leak to other non-
member countries hence diluting the real purpose of the arrangement.

Off shore taxation (Tax havens)

Refers to the principle of harmonising Company law, Trust law, Banking and Tax regulations with
a view to attract investors. The measures put into place have to be tax effective as compared to
those established in the average countries in the world.
Some of the benefits extended to investors include:
-- Tax free bank interest
-- Tax free dividends paid by companies domiciled in these countries.
-- Fixed corporate tax based on level of capital investment.
-- Attractive corporate tax rates including nil tax for specified periods
-- No capital gains tax
-- Tax free profit repatriations etc

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 TAXATION OF CROSS BORDER ACTIVITIES 11 7

The countries most involved in utilising the principle of tax haven are those with resources
requirement and depend on the financial investment attracted:
Examples of tax havens: Other tax havens:
-- Seychelles -- Netherlands
-- Gibraltar -- British Virgin Islands
-- Bahamas -- Isle of Man (UK)
-- Cyprus -- Channel Islands (UK)
-- Panama -- Liechtenstein

T E X T
S T U D Y

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 11 8 A dvanced TA X AT I O N

4.11 Withholding tax provisions

Income subject to withholding tax or tax at source for non-resident persons

Certain incomes derived from Kenya and paid to non-residents with no permanent establishment
in Kenya are taxed at source at special non-resident tax rates as follows:

WITHHOLDING TAX RATES

Tax Rates
Payments Residents Non-Residents
Notes % %
Dividends 5% 10%
Interest - Housing Bonds (a) 10% 15%
-Other sources (b) 15% 15%
Insurance Commission (c)
-Brokers 5% 20%
- Others 10% 20%
Royalties 5% 20%
Pension and retirement annuities (d) 0%-30% 5%
Management and professional fees (e) 5% 20%
Sporting or entertainment income 20%
Real estate rent 30%
T E X T

Lease of equipment 3% 15%

Contractual fee (e) 3% 20%
Telecommunication service fee (f) 5%
S T U D Y

Notes:
(a) Qualifying interest in respect of Housing Bonds is limited to Kshs 300,000 per
year.
(b) Withholding tax on interest income received by a resident individual from the
following sources is final:
! Banks or financial institutions licensed under the Banking Act.
! Building societies licensed under the Building Societies Act.
! Central Bank of Kenya.
(c) Commissions payable to non-resident agents for purposes of auctioning
horticultural produce outside Kenya are exempt from withholding tax.
(d) Tax deducted at source on withdrawals from provident and pension schemes
in excess of the tax-free amounts made after the expiry of 15 years or on the
attainment of the age of 50 years, or upon earlier retirement on health grounds
is final.
(e) Withholding tax on payments to resident persons for management and professional
fees applies to payments of Kshs 24,000 or more in a month to both registered
and non-registered business. The tax rate in respect of consultancy fees payable
to citizens of the East African Community partner states is 15%.
(f) The tax is subjected to payments made to non-resident telecommunication service
providers and is based on gross amounts.

Note: Various reduced rates of withholding tax apply to countries with double tax relief treaties
with Kenya.

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 TAXATION OF CROSS BORDER ACTIVITIES 11 9

The incomes of the non-residents are taxed gross, that is, no expenses are allowed against the
income.
The withholding tax must be remitted to the Domestic Taxes Department within 20 days of its
being deducted. There is no further tax for the non-resident after the withholding tax is paid as
far as our country is concerned.

4.12 Transfer pricing

Transfer pricing for goods or services is important in international taxation and will be subject to
specific laws. Transfer pricing is widely in use by multinational entities, which are involved, in
international trade in several countries.
Laws guiding multinational corporations ensure that transfer pricing is not abused because several
nations have a tax interest in their operations. There is a pending bill in parliament regarding
Transfer pricing and the tax implications for multinational companies.
Transfer pricing is a problem of apportioning taxable income among various jurisdictions where
an enterprise engages in more than one country or it belongs to a group of companies that are
located in more than one country and have relations with one another. This phenomenon is as old
as international trade and as old as the existence of tax boundaries. It is an issue that may arise
in relation to any type of income, such as the purchase or sale of goods, the provision of services,

T E X T
the payment of royalty fees and of interest on loans for instance.
The real culprit is transfer pricing manipulation; a phenomenon discouraged by governments. The
fixing of prices based on non-market criteria results in saving company tax by shifting accounting

S T U D Y
profits from high tax to low tax jurisdictions. This amounts to moving one nation’s tax revenue to
another.
Transfer pricing also leads to balance of payments distortions between the host country and home
country bordering on undermining sovereignty of the host nation.
Transfer pricing has become a critical consideration in location of production as well as employment
because multinational corporations tend to open subsidiaries in countries where production is most
profitable and the tax burden is less. Therefore, a country with no transfer pricing controls would
be most attractive to foreign investors. It is for this reason that the Asiatic locations of Hong Kong
and Singapore have succeeded in attracting foreign direct investments.
Most countries enforce tax laws based on the arms length principle as defined in the Organisation
for Economic Co-operation and Development (OECD) model. The following methods or definitions
are based on the OECD guidelines:

i) Uncontrolled price method (CUP)

This method compares the price at which a controlled transaction is conducted to the price at
which a comparable uncontrolled transaction is conducted.

ii) Cost plus method (CP)

Is a method generally used for the trade of finished goods and determined by adding an appropriate
mark-up to the costs incurred by the selling party in manufacturing/purchasing goods and services
provided with the appropriate mark-up being based on the profits of other companies comparable
to the tested party.

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 120 A dvanced TA X AT I O N

The method is generally accepted by the tax customs authorities, since it provides some indication
that the transfer price approximates the real cost of item.

iii) Resale price method (RP)

This method is similar to cost plus method except it is found by working backwards from
transactions taking place at the next stage in the supply chain, and is determined by subtracting
an appropriate gross mark-up from the sale price to an unrelated third party with the appropriate
gross margin being determined by examining the conditions under which the goods or services
are sold and comparing said transactions to other third party transactions.

iv) Profit split method (PS)

Is the method applied when the businesses involved in the examined transaction are too
integrated to allow for separate evaluation and so the ultimate profit derived from the endeavour
is split based on the level of contribution of each of the participants in the project.
If, for example, Company A sent three researchers to its subsidiary to aid in the development
of a product designed for use in country X market while the subsidiary allocated six identically
compensated researchers to aid in the development of the product, then we would expect that
the subsidiary pays 3/6 that is 50% of the ultimate profits as a royalty fee for the technical
knowledge provided by Company A’s researchers.

v) Transactional net margin method (TNMM)

T E X T

Is a method that uses arm’s length operating profit – that is earnings after all operating expenses,
including overhead, but before interests and taxes earned by one of the entities in the transaction.
Relative operating profit relative to sales, costs or assets allows comparisons between different
S T U D Y

transactions and is a more robust measure of an arms length result.

Other available methods include advance pricing agreement between the tax authorities and
the tax payer and also mutual agreement procedure for purposes of relief from international tax
grievances.

4.13 Chapter Summary

•• A resident individual is taxed on worldwide employment income while a non-resident

individual will be taxed on the income accrued in or derived from Kenya.
•• Countries are encouraged to negotiate double taxation agreements to be able to agree
on preferential tax rates and as such help to improve trading relations.
•• Transfer pricing is a concept that regulates the prices between related entities or
transactions. The transfer pricing rules were introduced in Kenya in 2005.

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 TAXATION OF CROSS BORDER ACTIVITIES 121

4.14 Quiz

Question one

Discuss the significance of residence in cross-border transactions.

Question two

Discuss the concept of the ‘Most Favoured Nation’

Question three

What is withholding tax?

T E X T
Question four

List the various transfer pricing methods that can be adopted.

S T U D Y
Question five

Discuss the meaning of double taxation unilateral relief.

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 122 A dvanced TA X AT I O N

4.15 Quiz answers

Question one

Residential status of an individual and body corporate is important in the following ways:
•• Kenya resident individuals pay Kenya income taxes on their incomes from Kenya and
worldwide employment, but Kenya non residents pay Kenya income taxes only on their
income from Kenya.
•• Residents pay income taxes at graduated scale rates but non-residents pay income
taxes at special rates on certain specified incomes or sources
•• Resident companies are taxed at the rate of 30% on their taxable income while non
residents companies with a branch in Kenya are taxed at a higher rate of 37.5%.
•• Withholding taxes are deducted at source on all income of Kenyan non-residents but
residents have withholding tax deducted on only some of their incomes.
•• Non resident companies with no branch in Kenya have withholding tax deducted at
source on all their incomes while resident and non-resident companies with branches
T E X T

in Kenya have withholding tax deducted from only their dividend and interest income.

Question two
S T U D Y

Most Favoured Nation Status

Trade agreement legislation can be based on the most-favoured nation principle. This is non-
discriminate principle extended to all trade partners such that any reciprocal tariff reductions are
negotiated. Member countries who are signatories of the most-favoured nation status benefit
from negotiations to boost international trade. The problem with this arrangement is that tariff
negotiations may be on certain few commodities only. Also benefits may leak to other non-
member countries hence diluting the real purpose of the arrangement.

Question three

The Income Tax Act requires that withholding tax or tax at source be deducted at the point when
payment is made in respect of interest, dividend, insurance commission, employment income,
pension and farming income subject to Presumptive Income Tax (PIT), etc. The income subject
to withholding tax may be received by a resident or non resident person.
The importance of deducting withholding tax is that it makes tax collection easy and it also
ensures that some incomes do not escape taxation. The withholding tax should be viewed as
income tax paid in advance.

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 TAXATION OF CROSS BORDER ACTIVITIES 123

A person making payments of incomes subject to withholding tax is legally required to deduct the
withholding tax or the tax at source at appropriate rates before effecting the payment and:
a) Remit the tax so deducted to the Domestic Taxes Department;
b) Pay the payee the amount net of tax; and issue the payee with a certificate of the
withholding tax or tax paid at source e.g. interest certificate or a dividend voucher. For
any given year of income, the payee is assessed on gross income and is given credit
for the tax paid at source except in cases where the withholding tax is the final tax.

Question four

Most countries enforce tax laws based on the arms length principle as defined in the Organisation
for Economic Co-operation and Development (OECD) model. The following methods or definitions
are based on the OECD guidelines:
i) Uncontrolled price method (CUP)
This method compares the price at which a controlled transaction is conducted to the price at
which a comparable uncontrolled transaction is conducted.
ii) Cost plus method (CP)
Is a method generally used for the trade of finished goods and determined by adding an appropriate
mark-up to the costs incurred by the selling party in manufacturing/purchasing goods and services

T E X T
provided with the appropriate mark-up being based on the profits of other companies comparable
to the tested party.
The method is generally accepted by the tax customs authorities, since it provides some indication

S T U D Y
that the transfer price approximates the real cost of item.
iii) Resale price method (RP)
This method is similar to cost plus method except it is found by working backwards from
transactions taking place at the next stage in the supply chain, and is determined by subtracting
an appropriate gross mark-up from the sale price to an unrelated third party with the appropriate
gross margin being determined by examining the conditions under which the goods or services
are sold and comparing said transactions to other third party transactions.
iv) Profit split method (PS)
Is the method applied when the businesses involved in the examined transaction are too
integrated to allow for separate evaluation and so the ultimate profit derived from the endeavour
is split based on the level of contribution of each of the participants in the project.
If, for example, Company A sent three researchers to its subsidiary to aid in the development
of a product designed for use in country X market while the subsidiary allocated six identically
compensated researchers to aid in the development of the product, then we would expect that
the subsidiary pays 3/6 that is 50% of the ultimate profits as a royalty fee for the technical
knowledge provided by Company A’s researchers.
v) Transactional net margin method (TNMM)
Is a method that uses arm’s length operating profit – that is earnings after all operating expenses,
including overhead, but before interests and taxes earned by one of the entities in the transaction.
Relative operating profit relative to sales, costs or assets allows comparisons between different
transactions and is a more robust measure of an arms length result.

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 124 A dvanced TA X AT I O N

Other available methods include advance pricing agreement between the tax authorities and
the tax payer and also mutual agreement procedure for purposes of relief from international tax
grievances.

Question five

Due to the difficulty involving double taxation negotiations, it is possible for an individual country
to remove the burden of double taxation from international trade by opting to give relief for foreign
taxation on a unilateral basis i.e. without regard to whether the other taxing country extended
relief or not. This may be triggered by a representation by the business community.
A unilateral approach is usually a last resort where negotiations have proved difficult due to
political and other reasons. It is possible to have both arrangements in place to take care of
different income sources and persons. Up to 1972, there existed the commonwealth income tax
relief confined to member countries. The authority was contained in the East African Income tax
Management Act and is not available in the Kenya Income tax Act.

4.16 Past paper analysis

T E X T

The following is a list of questions in which the topic was tested in past examinations. The
questions are listed in this format: Month/year e.g. 6/01 represents June or May 2001.
S T U D Y

12/00 Q.4, 12/01 Q.1, 12/02 Q. 2 (a), 06/05 Q2(a), 06/06 Q.4(a & b), 06/06 Q.5(a), 06/07 Q.1(a
& b),12/07 Q.1,(a), 12/07 Q.3(c), 12/08 Q.1, 12/08 Q.2(a).

4.17 Revision Questions

Question one

Outline the benefits which may accrue to a country from being a signatory to the most favoured
nations status agreement (4 marks)
(June 2005 Q 2)

Question two

Kenya has entered into double taxation agreements with a number of countries. Explain the
meaning and implications of a double taxation relief. (4 marks)
(Dec 2003Q 3)

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 TAXATION OF CROSS BORDER ACTIVITIES 125

Question three

a) With reference to Sections 46 and 47 of the Income Tax Act (Cap 470), explain how the
incomes of the following persons are assessed for tax.
i) Incapacitated persons
ii) Non resident persons
b) Mr. Dan Mbazo, a citizen of Zambia is employed by Southnet International Ltd, a company
based in Lusaka Zambia. Southnet International Ltd opened a branch in Nairobi Kenya on 1
January 2007 and posted Mr. Mbazo as the branch operation manager on the same date.
The following information relates to Mr. Mbazo’s employment for the year ended 31 December
2007 (All amounts are stated in Kenya Shillings (Kshs))
1. His basic pay commencing 1 January 2007 was Kshs 200,000 per month
2. He was booked by the employer in a hotel for the month of January pending the
availability of a suitable residential house. The employer paid Kshs 50,000 to the hotel
for his accommodation and meals.
3. On 1 February, he rented a house in a Nairobi suburb for a monthly rent of Kshs35,000.
It is the employer’s policy to reimburse half of the rent paid by an employee.
4. In March, he relocated his family from Lusaka to Nairobi. The employer paid Kshs25,000
for the air tickets used by the family.
5. Commencing 1 July, he received a monthly entertainment allowance of Kshs12,000
from the employer which he spent on visiting local tourist sites.

T E X T
6. In August, passages of Kshs110,000 were paid by the employer for Mr. Mbazo to attend
a two week seminar in Cape Town, South Africa. While in South, he purchased a motor
vehicle costing Kshs 2,000,000 for his use in Kenya. The total fuel and maintenance
costs of the motor vehicle to 31 December 2007 amounted to Kshs 120,000. Three

S T U D Y
quarters of the vehicle usage related to official duties.
7. On 1 October the employer effected the following changes on Mr. Mbazo’s basic pay
and benefits with effect from 1 October 2007:
• His basic pay was increased by 25 per cent
• A comprehensive insurance cover for his motor vehicles for an annual premium of
Kshs 80,000 payable on 1 October each year
• A medical cover for self and family to a maximum of Kshs 2,000,000. Monthly
contributions by the employer to the scheme amounted to Kshs 8,000
8. On 30 December he received a cheque of Kshs150,000 from the employer for being
the best foreign-based employee for the year ended 31 December 2007
9. The PAYE remitted from his pay for the year ended 31 December 2007 amounted to
Kshs 200,000.
Required:
i. Comment on the residence of Mr. Mbazo (for tax purposes) for the year ended 31
December 2007 (2 marks)
ii. Calculate the taxable income of Mr. Mbazo for the year ended 31 December 2007
(12 marks)
iii. Compute the tax payable (if any) from the income calculated in (ii) above (2 marks)
(Total: 20 marks)
(June 2005 Q 1)

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 126 A dvanced TA X AT I O N

Question four

a) Discuss the concept of double taxation treaties with specific reference to its application in
your country (8 marks)
b) Daniel Otwori, a resident of Kenya, earned income from the countries listed below during the
year ended 31 December 2007:
•• Income from Kenya: Kshs1,765,000
•• Income from United Kingdom (UK): UK£4,800 net. Tax deducted amounted to
UK£960.
•• The average exchange rate during the year was 1 UK£ = Kshs 140. A double taxation
agreement exists between Kenya and United Kingdom.
Required:
The double taxation relief (in Kenya Shillings) due to Daniel Otwori for the year ended 31
December 2007 (4 marks)

c) J.Karimi has been operating a wholesale business in Nairobi. The following details related
to the business for the month of April 2007:

Kshs
T E X T

Sales at standard rate 24,000,000

Purchases at zero rate 6,000,000
Purchases at standard rate 20,000,000
Electricity bill paid 16,000
S T U D Y

Water bill paid 4,000

Export sales 10,000,000
Exempt sales 14,000,000
Salaries and wages 4,800,000
Purchases of electronic tax register 150,000
Legal fees 60,000

Additional Information:
1. Sales at standard rate include goods sold to the Ministry of Health for Kshs4,000,000
2. The wholesaler issued debit notes amounting to Kshs800,000 in respect of sales at
standard rate.
3. Goods at standard rate valued at Kshs600,000 were returned during the month to the
wholesaler.
4. Purchases at standard rate include a photocopier acquired at a cost of Kshs100,000.
5. One of the debtors of the business was declared bankrupt and the business wrote off
Kshs500,000 which was outstanding from the debtor at the end of the month.
6. Legal fees include Kshs10,000 relating to VAT appeals.
Required:
The VAT payable (or refundable) by the business for the month of April 2007
Note: The amounts above are stated exclusive of VAT at the rate of 16% where appropriate
(8 marks)
(Total: 20 marks)
(June 2007 Q 1)

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 TAXATION OF CROSS BORDER ACTIVITIES 127

Question five

Related companies may understate their taxable profits by engaging in transfer pricing. With
reference to Section 18 (3) of the Income Tax Act (Cap. 470), briefly explain three transactions
that may constitute transfer pricing.
(June 2006 Q 5)

T E X T
S T U D Y

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 128 A dvanced TA X AT I O N
T E X T
S T U D Y

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 TAX PLANNING 129

CHAPTER FIVE
ONE

T E TX ET X T
S T U D Y T E X T
S T SU TDUYD Y

TAX PLANNING

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 130 A dvanced TA X AT I O N
T E X T
S T U D Y

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 TAX PLANNING 131

CHAPTER FIVE
TAX PLANNING

5.1 Objectives

At the end of this chapter, students should be able to discuss the following concepts:
•• Tax planning for individuals and companies
•• Employment versus self-employment
•• Identifying opportunities to alleviate, mitigate or defer the impact of direct or indirect
taxation
•• Remuneration packages
•• Corporate structure and dividend flows
•• Anti - avoidance provisions
•• Transfer of real properties
•• Pricing policy
•• Uses of tax incentives
•• Disposal of business operations and restructuring of activities

T E X T
5.2 Introduction

S T U D Y
In the last chapter, we studied the various tax issues affecting cross border transactions. In this
chapter, we will cover tax planning aspects. Tax planning is the arrangement of the affairs of a
taxpayer in such a way as to minimise tax liability at lowest cost without contravening any tax
law or regulations. It is determination, in advance, of the tax effect of proposed business actions
and requires a deeper understanding of the tax legislation and sound knowledge of case law
in taxation. Among the many advantages, tax planning helps organisations to fully comply with
applicable tax laws. In the next topic, we will study the various tax systems and policies.

5.3 Key definitions

Tax planning - Tax planning is the arrangement of the affairs of a taxpayer in such a way as to
minimise tax liability at lowest cost without contravening any tax law or regulation
Tax avoidance - The reduction of tax liabilities by legal, although possibly artificial means.
Tax evasion - The reduction of tax liabilities by illegal means such as concealing information or
supplying false information.

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 132 A dvanced TA X AT I O N

5.4 Exam Context

The student is expected to demonstrate an understanding of the taxation laws. This paper
mainly tests the application of the concepts discussed here. Questions on this topic rarely miss
in examinations.

5.5 Industrial Content

The student is expected to use his knowledge in taxation to effectively implement tax control
measures to ensure adherence to tax law. This helps an organisation to control costs hence
ensuring profitability.

5.6 Tax planning concept

Tax planning is the arrangement of the affairs of a taxpayer in such a way as to minimise tax
liability at lowest cost without contravening any tax law or regulations. It is determination, in
advance, of the tax effect of proposed business actions.
Tax planning requires:
T E X T

▪▪ A deeper understanding of the tax legislation; and

▪▪ A sound knowledge of case law in taxation.
S T U D Y

Tax consultancy is therefore basically tax planning involving offering tax advice to clients in
various situations. Tax revenue departments have to ensure the following through proper tax
planning: -
▪▪ Taxpayers comply fully with tax laws and regulations; and
▪▪ Revenue collection is maximised.

A careful study of decided cases is important in:

i) Highlighting tax planning schemes;
ii) Provision of judicial interpretation of the legislation;
iii) The judgement in a particular case will show strengths and weaknesses of a particular
scheme.
Aims of tax planning
1. To achieve compliance with tax laws since non-compliance with tax laws is costly due to
penalties and interest charges.
2. To ease administration as in working out arrangements, methods of accounting, records to
be kept, reports to be prepared etc.
3. To achieve the most advantageous financial position out of a business transaction to be
measured in terms of direct tax savings from planning and financial benefits by way of cash
flow effects.

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 TAX PLANNING 133

5.6.1 Tax planning for individuals

The tax planning measures of an individual would depend on whether they are employed or
unemployed. The following tax planning measures are allowable for employees.

Owner Occupier Relief

According to Section 15 (3) (b) of the Income Tax Act, interest paid by a person on amount borrowed
from specified financial institution (includes a bank, insurance company or building society) for
the purchase of or improvement of premises that he occupies for residential purpose shall be
deductible against total taxable income of the person. The maximum allowable interest is Kshs
150,000 per annum (Kshs 12,500 per month).
An employer should ensure that mortgage interest paid by the employees is allowed for deduction
in the payroll of all eligible employees.

Insurance Relief
An employer should notify employees who have taken individual life assurance covers or education
policies with a maturity of 10 years (with effect from 1 January 2003) and maybe paying out of
payroll premiums on the same that they are eligible to claim insurance relief and effect the same
through the payroll. The deductible amount paid is subject to a maximum of Kshs. 60,000 per
annum (Kshs. 5,000 per month).

T E X T
Non-cash Benefits
Increasing the non-taxable benefits may reduce tax on employees especially where such benefits
are allowable for corporate tax purposes. Examples of benefits that the company could consider

S T U D Y
introducing or expanding include the following:-
Medical services
This entails the reimbursement to staff of medical expenses incurred for self and dependants
or access to designated hospital facilities where the company holds an account. There is no
maximum limit of the same under the law.
Staff development and training
Training costs directly paid to a training institution for an employee in relation to the
employees’ responsibilities at the work place and for the benefit of the company’s business
are allowable for corporate and PAYE purposes.
Mileage reimbursement for use of personal car on the company business
This benefit is tax efficient in comparison to the car benefit and provision of staff transport
which are taxable on the employees.
Meals for low income employees
Meals provided to low income employees on employers premises are a non taxable benefit
on the employees. A low income employee is a person earning not more than Kshs. 29,316
per month.
School fees
Generally, where the employer pays school fees for the employee’s child, dependant or
relative, such payment becomes a taxable benefit on the employee if not already taxed on
the employer. However, educational fees for dependants of low income employees paid or
foregone by an educational institutional employer are not taxable on either the employer
or the employee. A low income employee is defined as one earning not more than Kshs.
29,316 per month, i.e. employees at income tax bracket of 20% and below. (Effective date:
13 June 2008)

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 134 A dvanced TA X AT I O N

5.6.2 Tax planning for companies

Companies may lay strategies for tax planning. Some of the reasons companies or entities
should plan for their taxes are:
▪▪ Tax is a major expense in company’s P&L;
▪▪ To take advantage of the available tax incentives.
▪▪ To minimise tax penalties and interest;
▪▪ The KRA aggressiveness in collecting taxes;
▪▪ To improve cash management and forecast;

There are many strategies that companies can adopt in tax planning. Some of the tax planning
opportunities are:

a) Tax compliance
One of the best strategies for tax planning for companies is tax compliance. The company should
ensure that it complies with its obligation to pay corporate taxes, to deduct advance taxes, to pay
withholding taxes and to file returns. This will avoid unnecessary penalties and interest being
levied on the company for non-compliance in case of an audit by the revenue authority.

b) Use of Capital allowances;

T E X T

The company should explore the provisions of the Income Tax Act on capital allowances. As such,
the company should always claim the proper capital allowances on the qualifying costs of the
assets. This will reduce taxable profits of the company and as such lead to a good tax planning
measure. The company may seek consultancy advice to help utilize the capital allowances.
S T U D Y

c) Tax losses used to reduce taxable income

Tax losses or tax deficits of a company can be carried forward to be offset against future income
from the same source. Following an amendment in the 2009 Finance Bill, the carry forward of tax
losses is only allowed for the year of income it arose and four subsequent years. The company
should be able to use tax losses to plan their taxes.

d) Tax refunds used to reduce tax payable;

The company should utilise tax refunds to reduce tax payable. Tax refunds arise from overpayment
of taxes. It can be overpayment of VAT, corporation tax among others. The refund is allowed
upon application and approval by the CDT. One can apply to offset a recoverable or a refund from
one form of tax against tax payable in another form.

e) Lower tax rate on listing at NSE.

Companies can list their shares to make use of preferential tax rates. Companies newly listed on
any securities exchange approved under the Capital Markets Act enjoy favourable corporation
tax rates as follows:
•• If the company lists at least 20% of its issued share capital, the corporation tax rate
applicable will be 27% for the period of three years commencing immediately after the
year of income following the date of such listing.”
•• If the company lists at least 30% of its issued share capital, the corporation tax rate
applicable will be 25% for the period of five years commencing immediately after the
year of income following the date of listing.”

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 TAX PLANNING 135

•• If the company lists at least 40% of its issued share capital, the corporation tax rate
applicable will be 20% for the period of five years commencing immediately after the
year of income following the date of such listing.
The corporate tax rate applicable to the company may therefore change if the percentage of the
listed share capital exceeds 20% of the issued share capital. The applicable tax rate will depend
on the percentage of the issued share capital listed at the Nairobi Stock Exchange.

f) Instalment tax payment

Under the Income Tax Act, companies are required to pay instalment taxes when they expect to
receive taxable income in that year of income. The payment of instalment tax is a good means
of cash management since it helps avoid a situation where a company pays a huge tax balance.
Further, the company can opt to use either the previous year basis or the current year basis while
estimating instalment tax payable. Whichever method is selected, the company should adopt a
good approach to the management of cash flows.

g) Application for tax exemptions or remissions

The company can explore the avenue of applying for tax exemptions or tax remissions.

h) Applications for waiver of penalties and interest

The Income Tax allows the taxpayer to apply for waiver of any penalties and interests charged.
The commissioner can waive up to Kshs 1,500,000 while the Minister of Finance can waive any

T E X T
amount upon application. The taxpayer should therefore pay the principal tax and make the
application for waiver of penalties of interest - it will be upon the commissioner to grant.

S T U D Y
5.7 VAT planning

VAT legislation tends to be complex thus making compliance difficult. Penalties resulting from
non-compliance with VAT law are punitive. Tax losses may result by failure to plan vatable
transactions. Some of the VAT planning options are:
1. VAT should be loaded on the taxable goods and services and passed on to the
customer.
2. VAT compliance- payment of VAT by 20th of the following month.
3. Use of VAT set off where the company is in refund situation and has taxes payable.
4. Use of tax remission scheme such as Tax Remission for Exports Office (TREO)
5. VAT remission on capital investments.
6. Whilst VAT is supposed to be paid even on unpaid invoices, the company may, as a
cash flow management tool, reduce its debt collection period.
7. VAT is not a cost to the company. The company should ensure that input tax is claimed
on a timely basis.
8. Claiming for refund of VAT on bad debts. These are debts over three years but not more
than five years. Evidence of recovery efforts is however required.

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 136 A dvanced TA X AT I O N

5.8 Customs duty planning

Duty planning

Deals with import duty and excise duty. The amount of duty on imports will have a significant
effect on cost of goods finally exported to say nothing of competitiveness and profitability of the
business. Excise duty adds to cost of a locally manufactured good ultimately affecting price and
profit margins.
Customs planning can give opportunities in the following areas:
•• Duty Remission
•• Customs valuation
•• Duty Suspension
•• Classification of goods
•• Duty deferral
•• Origin of goods
Duty Remission
Investors can apply to the Minister for duty waiver or exemption under special duty rates. Duty
remissions are also available under the Tax Remission for Exports Office (TREO) programme.
T E X T

Customs valuation
This involves ensuring that the best valuation method is used. It would be advisable to import from
S T U D Y

a manufacturer rather than a middleman. In practice, the value of the second transaction is used
to calculate Customs value on import. As such, if one has prior information of first transaction and
bought directly from the importer or manufacturer, it will result in duty saving. Thus applying “first
sale” principle can minimise duty by eliminating “middleman markup.”

Duty suspension
The bonded warehouse arrangement can be used to minimise Customs value. A trader in
Tanzania approaches a Kenyan trader for the first time in order to purchase sports shoes. Had
the trader imported the sports shoes under a bonded warehouse arrangement they could have
avoided unnecessary import duties and VAT on the import (enter as transit goods).

Classification of goods
The taxpayer should ensure goods are correctly classified. Incorrect classification of goods may
lead to payment of either higher or lower duty. If lower duty is paid, there are risks of paying the
difference after a post clearance inspection. If higher duties are paid, it will result in the pursuit
of the duties outstanding (Customs duty and VAT) and even fines or interest in arrears on the
duties and VAT.

Duty deferral
This planning opportunity involves importing goods, storing or further manufacturing the goods,
then exporting the goods to another country or releasing them to the Kenyan market (pay 2.5%
surcharge)

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 TAX PLANNING 137

Origin of goods
There may be varying amounts of import duty payable depending on the origin of the goods.
Some imports from certain countries enjoy a preferential import duty. As such, the importer should
be well versed with rules of origin to make use of the preferential import duty rates. One would
need to produce a valid Certificate of Origin.

5.9 Employment versus self-employment

There is a distinction between employment (receipts taxable as earnings) and self-employment

(receipts taxable as trading income). Employment involves a contract of service, whereas self
employment involves a contract for services.
Taxpayers tend to prefer self-employment, because:
•• The rules on deductions for expenses are more generous.
•• Under self-employment, the person would be subject to withholding tax which is usually
at a lower rate than the graduated scale rates.

Factors which may be of importance include:

•• The degree of control exercised over the person doing the work: The higher the degree

T E X T
of control, the more likely that the contract of service as opposed to a contract for
service where there is minimal control from the entity.
•• Whether he must accept or provide further work: If the person must accept any further
work delegated to them, and then the same is a contract of services and not a contract

S T U D Y
for services.
•• Whether he provides his own equipment: A person on self employment is expected to
have his own equipment while providing services. If most of the equipment are provided
by the employer then it can be construed to be a contract of services.
•• Whether he hires his own helpers: If he has the authority and powers to hire his own
helpers then he is in self-employment as opposed to employment.
•• What degree of financial risk he takes: The more the degree of financial independence,
the more likely that he is in a contract for services.
•• What degree of responsibility for investment and management he has: The more such
responsibilities, the more likely that it is a contract for services.
•• Whether he can work when he chooses: If so, then it could be a contract for services.
•• The wording used in any agreement between the parties: the agreement can state
categorically what it is.

Relevant cases include:

(a) Edwards v Clinch 1981
A civil engineer acted occasionally as an inspector on temporary ad hoc appointments.
Held: There was no ongoing office which could be vacated by one person and held by another
so the fees received were from self-employment not employment.

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 138 A dvanced TA X AT I O N

(b) Hall v Lorimer 1994

A vision mixer was engaged under a series of short-term contracts.
Held: The vision mixer was self-employed, not because of any one detail of the case but because
the overall picture was one of self-employment.
(c) Carmichael and Anor v National Power Plc 1999
Individuals engaged as visitor guides on a casual 'as required' basis were not employees. An
exchange of correspondence between the company and the individuals was not a contract of
employment as there was no provision as to the frequency of work and there was flexibility to
accept work or turn it down as it arose. Sickness, holiday and pension arrangements did not
apply and neither did grievance and disciplinary procedures.
A worker's status also affects national insurance. The self-employed generally pay less than
employees.

5.10 Remuneration packages

Staff costs are significant operational costs. The employer needs to reward labour in the highest
possible way at lowest cost possible while at the same time observing full compliance with the
law. Consider lumpsum payments, benefits, expenses etc.
T E X T

An employee will usually be rewarded largely by salary, but several other elements can be
included in a remuneration package. Some of them bring tax benefits to the employee only, and
some will also benefit the employer.
S T U D Y

Bonuses are treated like salary, except that if a bonus is accrued in the employer's accounts
but is paid more than nine months after the end of the period of account, its deductibility for tax
purposes will be delayed.
The general position for benefits is that they are subject to income tax. The cost of providing
benefits is generally deductible in computing trading profit for the employer
However, there are a large number of tax free benefits and there is a great deal of planning that
can be done to ensure a tax efficient benefits package for directors and employees. The optimum
is to ensure that the company receives a tax deduction for the expenditure while creating tax free
benefits.
There are items which are commonly referred to as income but are not included in the above
mentioned list of taxable income. A number of such non-taxable incomes come to mind,
notably:
1. Pension or gratuities earned or granted in respect to disability
2. Monthly or lumpsum pension granted to a person who is 65 years of age or more.
3. That part of the income of the president of the republic of Kenya that is exempt e.g. a
salary duty, allowances, entertainment allowances paid or payable to him from public
funds
4. Allowances to the Speaker, Deputy Speaker and Members of Parliament payable to
them under the National Assembly remuneration

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 TAX PLANNING 139

5. Interest up to Kshs 100,000 per individual on housing bonds, account with Housing
Finance (formerly Housing Finance Corporation of Kenya - HFCK), Savings and Loans
of Kenya Ltd, East Africa Building Society, Home Loans and Savings. (With effect
from June 1987, interest up to Kshs 300,000 is qualifying while the excess is non
qualifying.)
6. Cost of passage to and from Kenya of a non-citizen employee borne by the employer.
7. Employer’s contribution to pension funds or provident funds.
8. Benefits, advantages/facilities of an aggregate value of less than Kshs 36,000 p.a. in
respect of employment or services rendered.(W.e.f.1.1.2006, non cash benefits are
taxed if their aggregate value is more than Kshs 36,000 p.a or Kshs 3,000 p.m.)
9. The first Kshs 150,000 per month for persons with disabilities exempt from taxation. (
w.e.f. 12.June 2009).
10. Expenditure on amenities by the physically disabled tax allowable up to a maximum of
Kshs 50,000 per month. (w.e.f. 12. June 2009)
Illustration
Mr Jared Masai, a human resource manager is currently out of employment. However, he has
received two offers of employment which require him to report on duty on 1st July.. One of the job
offer is from Mapato Ltd. The company owns a large scale farm in Kitale on which it grows maize
and rares dairy cows. The other offer is from Watalii Tourist Hotel located in Nanyuki. Mr. Masai
has approached you as a tax expert, to advise him on which of the two job offers to accept. He
has provided you with the following additional information.

T E X T
JOB OFFER A: MAPATO LTD

S T U D Y
Terms of employment
1. A basic salary of Kshs 140,000 per month
2. Free housing for him and his family within the farm , with free water and electricity. The
water is from a borehole sunk in the farm. The electricity is also generated within the
farm.
3. Free supply of farm produce subject to a maximum of Kshs 600,00 per month.
4. Reimbursement of medical expenses incurred on self and family subject to a maximum
of Kshs 1,500,000 per annum. The reimbursement policy applies only to senior
managers.
5. Payment of his children’s school fees amounting to Kshs 180,000 per month by the
employer. The employer would bear the tax on this benefit
6. His annual membersip fee to the local golf club amounting to Kshs 50,000 would be
paid for by the employer
7. He would be required to register as a member of the Institute of Human Resources
Managers and pay the initial registration fee of sh. 10,000. The employer would pay the
annual subscription fee of Kshs 18,000.

JOB OFFER B: WATALII TOURIST HOTEL

1. Terms of Employment
2. A basic salary of Kshs 180,000 per month.
Free housing and meals but only for self.
3. Monthly entertainment allowance of Kshs 15,000
4. Payment by the employer of his medical expenses subject to a maximum of Kshs
800,000 per annum. The medical scheme covers all hotel employees.

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 140 A dvanced TA X AT I O N

5. Payment by employer of his life assurance premiums amounting to Kshs 60,000 per
annum.
6. Reimbursement by the employer of annual subscription for the Journal of Human
Resources Managers amounting to Kshs 2,500 per annum.
7. A one-week fully paid holiday package worth Kshs 150,000 for his wife and children to
visit him and reside at the hotel once per year. The package will also include visits by
the family to neighbouring tourist attractions.

Mr. Masai has further provided the following information:

•• His average annual medical expenses are as follows.
Kshs
Self 150,000
Wife and children 300,000
Total average medical expenses 450000

•• His consumption of the farm produce under job Offer A would average to about Kshs.
300,000 per annum.
Required
Evaluate the two job offers and advise Mr. Masai on which offer to accept based on expected net
T E X T

annual income. Your evaluation should include both taxable and non taxable benefits.

Attempted solution
S T U D Y

JOB OFFER A
Mapato Ltd
Expected net annual income statement
(Taxable/ non-taxable benefits)
Sh. Sh.
Employment income
Basic salary (140,000 x 12) 1,680,000

Benefits
Medical benefits (Reimbursement) 450,000
Consumption of farm produce 300,000
School fees 180,000
Annual membership – golf club 50,000
Registration (Institute of Human Resource 10,000
Managers)
Annual subscription fees 18,000
Electricity 10,800
Water 2,400
Housing benefit
Higher of 10% x 2,701,200 270,120
Actual payment ________
Annual taxable income 2,971,320

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 TAX PLANNING 141

JOB OFFER B: Watalii Tourist Hotel

KSh. Sh.
Employment income
Basic salary (180,000 x 12) 2,160,000

Allowances
Entertainment allowance (15,000 x 12) 180,000

Benefits
Life assurance premiums 60,000
Reimbursement of annual subscriptions 2,500
Holiday package 150,000 392,500
2,552,500
Housing benefit
Higher of 15% x 3,002,500 450,375 450,375
Actual payment - _______
Annual taxable income 3,002,875

Computation of tax
liability JOB OFFER A JOB OFFER B

T E X T
SHS SHS

Taxable profit 2,971,320 3,002,875

Tax thereon

S T U D Y
121,968 121,968 10% 12,197 12,197
236,880 114,912 15% 17,237 17,237

351,792 114,912 20% 22,982 22,982

466,704 114,912 25% 28,728 28,728

Excess over 2,504,616 30% 751,385 760,851

Gross Tax Liability 832,529 841,995

Less Personal Relief (13,944) (13,944)

Net Tax Liability 818,585 828,051

Income after tax 2,152,735 2,174,824

Advise:
Job offer B has higher annual income after tax hence accept it.

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 142 A dvanced TA X AT I O N

b) (i) Responsibility of employers for the collection of PAYE due from retirees receiving
monthly pension income.
Pensions or retirement annuities (periodic payments) up to KShs 180,000 p.a received by a
resident individual are tax exempt so long as the scheme or fund is registered. As such the
employer will deduct tax on monthly withdrawals in excess of Kshs 180,000. However, if the
employee is above 65 years of age then the whole withdrawal from a pension fund is tax
exempt.
NB. Lumpsum withdrawals from a pension or retirement scheme of up to K.shs 480,000 p.a
received by a resident individual are tax exempt so long as the scheme or fund is registered.

5.11 Identifying opportunities to alleviate, mitigate or defer the impact

of direct or indirect taxation

The student should be able to identify opportunities to alleviate, mitigate or defer the impact of
direct or indirect taxation. Questions on this area will be practical and the student will be expected
to apply the content learnt in taxation in general.

5.12 Corporate structure and dividend flows

T E X T

The topic focuses on chargeable income, deductible expenses, capital allowances, available tax
incentives, treatment of tax losses, dividend policy, transfer pricing, etc.
S T U D Y

Forms of decision problem

1. Whether to lease an industrial building or construct one.
2. Whether to invest in office buildings or rent.
3. Whether to operate a partnership or a limited company
4. Determining expenditure tax deductible or non-tax deductible.
1. Capital structure and taxation
By capital structure of a company, we mean the long-term financing normally made up of ordinary
share capital., preference share capital, reserves (revenue and capital) and debt finance (long
term, medium and short term loans and debentures).
Capital structure explains the relationship (proportion) between the various sources of finance.
Optimum capital structure is the most ideal capital structure to be maintained and any changes
to it must affect amounts and not proportions. Optimum capital structure is achieved where,
among other considerations, the cost of finance is lowest. The capital structure has great impact
on cost of finance because some finances are cheaper to use than others. Taxation discriminates
between equity and debt capital. Debt finance is cheaper since interest on debt is tax allowable
expense and cost is less by the amount of such tax interest. Dividends on equity is not tax
deductible.

Illustration
Company ABC Ltd. is to pay interest on debt capital of 15% where corporation tax rate of 30%

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 TAX PLANNING 143

Required
Compute the true/effective cost of debt capital.
Solution
Effective cost of debt = 15% less (30% of 15%)
= 15% - 4.5%
= 10.5%
The following details relate to two companies for year ending 31/12/2005:
Company ABC Ltd. XYZ Ltd
Number of shares 1 0 % 50,000 each Kshs. 5 50,000 each Shs. 5
Preference shares
25,000 each Kshs 10% debentures Shs. 125,000
Gross income Kshs. 250,000
Gross income

Required
a) Earnings per ordinary share for each company.
b) Corporate tax rate and cost of debt.
Solution
a) Earnings per ordinary share

T E X T
ABC Ltd. XYZ Ltd.
K Kshs ‘000 K Kshs ‘000

S T U D Y
Gross income 250,000 Gross income 250,000
Less loan interest Nil ­ Less loan interest (12,500)
Before tax 250,000 Before tax 237,500
Corporation tax @30% (75,000) Corporation tax @30% (71,250)
Income after tax 175,000 Income after tax 166,250
Less Pref- dividend @ (12,500) Pref. Dividend Nil ­
Amount available to Amount available to
ordinary shareholders 162,500 ordinary shareholders 166,250

Earnings per share 3.25 Earnings per share 3.325

75000 71250
Effective tax rate � 100 = 30% Effective tax rate � 100 = 28.5%
250000 250000

b) Effective cost of debt (XYZ Ltd.)

Effective cost of debt = 10% less (30% x 10%)
= 10% - 3%
= 7%
Note in the case of XYZ Ltd. tax savings = (75,000 – 71,250) = Sh.3, 750

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 144 A dvanced TA X AT I O N

2. Income taxes and project appraisal

XYZ Company Ltd, a manufacturing company in industrial area, Nairobi requires 2,500 units a
year of a component over a period of 3 years. There are three possible plans of action to be
considered namely:

Plan A:
To buy the component from a supplier who quotes Kshs 10 per component.

Plan B
To manufacture the component themselves. Equipment needed would cost Kshs 20,000 initially.
Incremental costs are estimated at Kshs 5 per component. The equipment would be expected to
have a sale value of Kshs 8,000 after two years; repair costs during the period of use are forecast
at Kshs 200, Kshs 500 and Kshs 800 for each of the three years respectively.

Plan C:
To manufacture the component using hired equipment which would be maintained by the owner
without additional charge. The rent of the equipment would be Kshs 5,000 per annum payable
annually in advance.
The company uses a discount rate of 5% per half year. A wear and tear deduction of 12½%
would be available on purchased equipment.
T E X T

Required
Which alternative maximises tax cash inflow? (Take corporation tax rate to be 30%).
S T U D Y

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 TAX PLANNING 145

Solution
Option
Plan A ranking
Incremental cost analysis Kshs KShs Kshs Kshs

Component cost 25,000 25,000 25,000

Tax shield on the component cost
( cost x 30%) 7,500.0 7,500.0 7,500.0
Discounted figures 7,500.0 7,143 6,803 21,445.6 3
17,500.0 17,500.0 17,500.0
Tax effect 17,500.0 16,667 15,873 50,039.7

Plan B

Initial cost (20,000)

W&T 2,500 2,813 -
Depn (3,000) (3,000) (3,000)
Repairs 200 500 800
12,500 12,500 12,500

T E X T
12,200 12,813 10,300
8,540 8,969 7,210
Release on disposal -8000
28,540 8,969 (790)

S T U D Y
Tax effect 28,540 8,541.67 (717) 36,365 2

Plan C
Hire charges 5000 5000 5000
1500 1500 1500
3500 3500 3500
Discount rate 5% 5% 5%

Tax effect 3500 3,333 3,175 10,008 1

The option that maximises tax cash inflows is Option 3.

Illustration
The directors of Tycom Limited have identified Kenya as one of its most probable overseas
investment locations. One issue nevertheless arise and the directors would wish to obtain tax
advice before making a decision. These issues are:
a) They have two options:
-- Option one: To build a factory from scratch at the following costs:
Factory building Kshs 10,000,000
New machinery fixed Kshs 30,000,000
Executive office furniture Kshs 2,000,000
Three-phase power supply (paid to Kenya Power) Kshs 4,000,000

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 146 A dvanced TA X AT I O N

-- Option two: To lease a factory, fully built and ready for use. The lease will be for 10
years. The lease charges will be based on Kshs 46,000,000 on an 18 per cent per
annum cost of capital.
(Present value of annuity 18%, 10yrs = 4.4941
Solution
Tycom Ltd (assume Yr.2007)
Option 1
Investment deduction (first year of use of assets) Kshs ‘000’
ID @ 100% Residue for IBD or WTA
Kshs ‘000’ Kshs ‘000’
Factory building 10,000 10,000 -
New machinery fixed 30,000 30,000 -
Power supply 4,000 4,000 -
44,000 44,000

WTA Kshs ‘000’

T E X T

Class IV @ 12½%
Furniture 2,000
2,000
S T U D Y

WTA (Yr. 1) (250)

1,750

Summary of capital allowances Yr. 1

Kshs ‘000’
ID 44,000
WTA 250
Tax allowable capital allowance (1 year only) 44,250

Option 2
Leasing the factory would mean lease hire payments of:
46,000 46,000 Kshs.10, 235,640 tax allowable expense against income
Shs'000' =

PVF18,10years 4.491 before taxation per annum.

In 10 years lease, hire payment would be Kshs102, 356, 400 but allowable against profits.
Therefore acquiring the assets from 1st year allowance would be better.

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 TAX PLANNING 147

5.13 Form of business ownership

There are many tax implications involved in deciding the form of business:
•• Company or Business
•• Branch or subsidiary

Opening a company or a partnership

•• The following are the major tax considerations to take into account in deciding whether
to operate a partnership or a limited company.
•• A partnership is not considered as a separate taxable entity as a company, therefore,
the taxable income of a partnership is allocated among the partners according to the
profit/loss sharing ratio. A company is considered to be a separate taxable entity and as
such it will bear its taxes.
•• The partners in a partnership are taxed at the graduated scale rates which are lower than
the corporate tax rates. The taxable income or loss of a limited company is taxable on
the company at a flat rate of 30% for resident and 37.5 % for non-resident companies.
•• Partner’s salaries are not tax deductible while director’s salaries in a limited company
are tax deductible.
•• The losses made under a partnership are carried forward by the partners individually

T E X T
but not the firm while losses in a limited company are carried forward by the company.
•• The company will be required to pay withholding tax when it is declaring dividends to
its shareholders while a partnership does not declare dividends. The partners may
withdraw and any such withdrawal will be taxed on the individual partner.

S T U D Y
•• Companies have compensating tax while partnerships are not subject to the same.
•• Currently partnership can pay turnover tax at 3% on gross income if the company
has turnover of between Kshs500,000 and Kshs5 million within one year. However,
companies are not subject to turnover tax.

Opening a branch or subsidiary

The following considerations should be made in case of a branch or a subsidiary:

Branch Subsidiary
Residency Non resident for tax purposes Resident for tax purposes
Tax rate 37.5% 30%
Deductibility of Expenses of interest, royalties and Expenses incurred wholly and
expenses management or professional fees exclusively in generation of
paid to head office in India are not income are allowable except for
allowable expenses in deriving taxable those specifically disallowable.
income.
Expenditure incurred by the branch
outside Kenya is only allowable/
deductible to the extent the
Commissioner of Domestic Taxes
(CDT) may consider

Withholding tax rates No WHT tax applies WHT tax will apply to payments
to both residents and non
residents

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 148 A dvanced TA X AT I O N

The implications of debt or equity as modes of raising additional capital is as follows:

Corporate form of ownership enjoys legal personality and income is subject to corporate income
tax rates. Sole proprietorship/partnerships are not separate entities from those forming it for tax
purposes.
For a corporation, reasonable salaries paid to officers/directors who are also shareholders are
tax deductible. For sole proprietorships/partnerships no deduction is allowed for owner’s salaries
or for interest expense on invested ownership capital.
Corporate profits are subject to double taxation: first corporation tax and secondly dividends
withholding tax on recipients.
Other considerations:
•• Ease of transfer of ownership
•• Tax brackets are high or low for owners
•• Expected life of business.
Illustration:
2.1.1 Mr. Kamau has two offers for employment in two engineering firms. The details of the
two offers are as follows:

Firm A Firm B
T E X T

Sh. Sh.
Basic pay per month
65,000 61,000
Benefits:

S T U D Y

Housing (market rate) p.m

20,000 30,000
Car 2000 cc (cost)
600,000 600,000

Pension scheme, which is registered by commissioner of income, and both employer and
employee contribute 5% of the basic salary for pension scheme.

Required
What offer would you recommend to Mr. Kamau? Explain reasons for your recommendation.

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 TAX PLANNING 149

Solution:

Firm A B
Basic salary 65000pm x 12 780,000 61,000 x 12 732,000
Car benefit: Higher of
(i) 24% of Sh. 600,000 = 144,000 144,000 144,000
(ii) Benefit on 2000cc = 86,400 ______ ______
924,000 876,000
Housing benefit: higher of
(i) Mkt value 240,000 360,000
(ii) 15% x 924,000 138,600 240,000 15% x 876,000 = 131,400 360,000
Pensionable pay 1,164,000 1,236,000
Less pension contribution
By employee: lower of
(i) Set limit 240,000 240,000
(ii) 30% x 1,164,000 349,200 30% x 1,236,000 =
370,800
(iii) 5% x 780,000 39,000 (39,000) 5% x 732,000 = 36,600 (36,600)
Net taxable income 1,125,000 1,199,400

T E X T
Tax liabilities

Firm A on Kshs 1,125,000

S T U D Y
First Kshs. 466,704 = (121,968 x 10%) + (114,912 x 60%) = 81,144
Surplus Kshs (1,125,000 – 466,704) @ 30% = 197,488.8
278,632.8
Less: personal relief 13,944.0
Net tax liabilities 264,688.8

Firm B on Kshs 1,199,400

First Kshs 466,704 = (121,968 x 10%) + (114,912 x 60%) = 81,144
Surplus Kshs (1,199,400 – 466,704) @ 30% = 219,808.8
300,952.8
Less personal relief (13,944.0)
Net tax liability 287,008.8
Recommendation: Accept Job offer A where net tax liability is lower and net take home amount
is higher

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 150 A dvanced TA X AT I O N

5.14 Anti-avoidance provisions S.23

Under S.23, the Commissioner of Income Tax is empowered to reject certain business transactions
when he is of the opinion that the main purpose or one of the main purposes for effecting a
transaction is evasion or reduction of tax liability. He can direct for necessary adjustment on
taxable income and issue an assessment accordingly. If the taxpayer disputes the adjustment
and the resulting assessment, the taxpayer can appeal to the Tribunal e.g.
•• A director buying a car from the company at a throw away price. He would be taxed
on the difference between the low price he pays for the car and the market price for the
car.
•• A child paid very high salary for minor duties. The salary helps to spread tax payable but
the parent controls the child’s income. The Commissioner of Income Tax would disallow
the salary and tax it.
Tax Avoidance: Principles emerging from case law
Section 23 of the Kenya Income Tax Act empowers the Commissioner to order the adjustment of
transactions which in his opinion are effected with the main aim of avoiding or reducing liability
to tax.
Such a direction can only be challenged by appealing to the Income Tax Tribunal. This decision
of the Tribunal is final and there is no right to further appeal.
T E X T

However, the Commissioner rarely, if ever, does use such powers. Consequently, there is no
such litigation in respect of tax avoidance schemes in Kenyan courts.
However, the following principles have emerged from UK Case Law and which may well be
S T U D Y

applied in Kenya:

1. The “Duke of Westminster” Principle.

Lord Tomlin stated: “every man is entitled, if he can, to order his affairs so that the tax
attaching ... is less than it would otherwise be.
2. The “Ramsay” Principle: This was established in a Capital Gains Tax Case in relation
to composite transactions.
At the time, the most prevalent scheme to avoid tax (especially Capital Gains Tax) was to
enter into a series of transactions, which would facilitate the following:
(a) Conceal the sale of property subject to Capital Gains Tax (CGT)
(b) The exchange of shares for shares, which would not have CGT implications.

This interdependent series of transactions would normally be “circular and self cancelling”.
The Ramsay doctrine provides that whether a series of transactions is genuine or artificial
would be dependent on the end result. Transactions which have no commercial purpose
are treated as a fiscal nullity. The preordained series of transactions are disregarded if they
have no business purpose other than achieving the preordained end.
The same principle was extended in CIR vs BURMAH OIL CO. LTD.
3. Francis vs Dawson
Facts of the Case
George Dawson and family owned two private companies which they wanted to sell. If they
were sold in UK at a gain, it would be subject to Capital Gains Tax.

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 TAX PLANNING 151

Dawson wanted to sell to W Ltd a UK company. He was advised to sell by an exchange of

shares for shares with an offshore company, G Ltd.
G Ltd then sold its shares in the two companies to W Ltd. The scheme succeeded on the
grounds that the end result led to “enduring legal consequences” and therefore the individual
transactions had a business purpose and not artificial as in the Ramsay Case.

5.15 Transfer of real properties

Income from ‘sale of land and buildings’ in Kenya is non-taxable income. It used to be tax on
gains of sale of property e.g. land and buildings but was suspended with effect from 14.6.1985.
(a) A taxpayer (or a partnership) with Kenya rental income is treated as running a business,
his Kenya property business'. All the rents and expenses for all properties are pooled,
to give a single profit or loss. Profits and losses are computed in the same way as
trading profits are computed for tax purposes, on an accrual basis.
(b) Expenses will often include rent payable where a landlord is himself renting the land
which he in turn lets to others.

This is income earned by a person for rights granted to others to occupy his property. Rent
income is made up of key money or goodwill, normal rent and premium.

T E X T
Taxation of rental income depends on whether one is a resident individual or a non resident.

Non residents
They are taxed at a flat rate of 30% on gross rent income and this is the final tax.

S T U D Y
No expenses are allowed against gross rent income.

Residents
For residents, rental income will be brought to tax at the graduated scale rates for individuals and
at the corporation tax rate for companies. However the following points are relevant in arriving at
the net taxable rental income:
Some of the tax planning measures include:
•• Claim the expenses allowable on the rental income.
•• If you obtain a mortgage to acquire rental houses, the entire interest will be allowable
against the rental income for that year of income. As such the mortgage option is
recommended.
•• Compute capital allowances and claim the same accordingly on the capital expenditure
incurred in the rental premises.
•• With the introduction of VAT on commercial rental property, it is important to charge VAT
on any such properties and issue a valid tax invoice.

5.16 Pricing policy

The firm or entity should have a tax efficient pricing policy. A tax efficient pricing policy should be
informed by all considerations including the prices of commodities and the taxes payable for the
commodities. Further, the taxpayer should consider the risk of transfer pricing.

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 152 A dvanced TA X AT I O N

Transfer pricing

The introduction of transfer pricing documentation requirements in Kenya in June 2006 has
contributed to increased tax audits by the tax authorities in regard to the same.
Transfer pricing is important when structuring transactions. Due, in part, to their often complex
nature and specific characteristics, the transfer pricing aspects of intercompany financing activities
have had a relatively low profile so far. However, in view of the tax administration’s increasing
interest in this subject and the pre-eminently ‘affiliated’ nature of shareholder financing, this
subject cannot be avoided in an M&A transaction.

Documentation requirements
Transfer pricing involves transactions among associated entities at arm’s length conditions, the
“arm’s length principle”. The fact of not meeting such transfer pricing documentation requirements
might result in severe penalties in said countries. In addition, discussions about transfer pricing
might lead to substantial taxation adjustments for both the present and past years which could
lead to double taxation. In addition to specific, local transfer pricing rules, many countries also
apply the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations
for consistent application of the arm’s length principle at an international level.

Intercompany financing transactions and Mergers & Acquisitions ( M &A)

T E X T

If shareholder loans are granted or other financing transactions are made during an M&A
transaction or even within the target group, the applied conditions should be at arm’s length and
sufficiently substantiated. Examples are the substantiation of the (often high) interest charged
by the investor on shareholder financing; the spread in a back-to-back situation; charging or
S T U D Y

not charging a fee if a group company stands as guarantor for another group company within
the scope of an overdraft facility; the allocation of the advantage in case of cash pooling; or the
situation in which external bank financing within the group is on lent at a ‘blended’ rate to all
group companies, without involving the stand-alone creditworthiness of the various companies
in the analyses. In principle, a substantiation should be available for each transaction, based on
its specific characteristics and taking into account the position of the parties involved.

Loan pricing policy

As said, the arm’s length nature of each loan should be substantiated based on the arm’s
length principle, transfer pricing legislation and local documentation requirements. Depending
on the scale and the complexity of the intercompany loans, this may constitute a considerable
administrative burden. In practice, therefore, substantial loans and high-interest loans in particular
have only been documented so far.
In order to ensure that the documentation requirements are nevertheless somewhat met and
that interest on intercompany loans is determined in a consistent manner, a loan pricing policy
can be drafted within the scope of (post-deal) structuring. In such loan pricing policy, the credit
rating of the group companies and the currency and term of the loans must be taken into account.
Based on this, and on a database with external comparables, a matrix of credit spreads can be
prepared, to be used to determine the interest and spread on intercompany loans.

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 TAX PLANNING 153

5.17 Uses of tax incentives

The taxpayer can make use of the various tax incentives as a form of tax planning. Some of the
tax incentives include:

Capital allowances

The capital allowances available in Kenya are Farm works, Industrial Building, Investment and
Wear and Tear allowances. These allowances are deductions from taxable income based on a
percentage of the qualifying cost of investment. They tend to lower the effective price of acquiring
capital since the initial cost is recovered.

Export Processing Zone incentives

Enterprises operating in the Export Processing Zones (EPZ enterprises) have got a number of
incentives. These incentives were provided on the enactment of the Export Processing Zone
Authority Act “EPZA Act” in 1990 which established the EPZ Authority (EPZA) as a” one-stop”
centre for facilitating export-oriented investment and administering a number of incentives. The
incentives offered by the Authority cover trade as well as income taxes.

T E X T
The EPZA is also an executing agency since it manages the government-owned free zone parks.
Most of the parks are, however, owned by private firms. The number of industrial parks that were
administered by the Authority rose from 7 to 16 between 1993 and 1998. Similarly, the number of
EPZ firms increased from 13 to 22 within the same period.

S T U D Y
Enterprises operating within EPZ have the following benefits:
•• There is a 10- year tax holiday. This is an exemption from corporation tax for the first
10 years of trading.
•• There is a lower corporation tax rate of 25% for the subsequent years after the 10- year
tax holiday.
•• There is an exemption from withholding tax on dividends and other payments to non
residents during the first 10 years.
•• Investment deductions are 100% of the capital expenditure claimable in the 11th year
after commencement of production.
•• Supplies from an EPZ enterprise are zero rated for purposes of VAT
•• There is a refund of import duty on raw materials to manufacture exports.

The EPZ companies are allowed to sell up to 20% of their products to the domestic market.
However, these rules were not rigidly applied during the early years of the scheme, with the
domestic firms sometimes exceeding 50%. To prevent the EPZ benefits from giving undue
disadvantage to domestic firms, an additional 2.5% import duty is charged on EPZ sales made
to the domestic market.
Another constraint for EPZ operations in Kenya is that because EPZ firms operate outside Kenya’s
Customs territory, the preferential tariff regime they would have enjoyed in marketing to the
COMESA countries is blocked. This is considered to be a major disincentive for expansion of the
scheme since many Kenyan firms target the COMESA market. The EPZ incentives encourage
the participation of the private sector in the development of the processing zones. Up to now,
EPZA has gazetted 16 zones but only half of these zones are in operation.

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VAT Remission

The Kenyan tax regime incorporates a remission scheme, including VAT targeted at either
attracting investments or promoting exports. They include the following:
A duty / VAT remission scheme for firms that import inputs under the Manufacturing Under Bond
(MUB) and Export Promotion Programmes Office (EPPO); the Minister may also remit the tax in
the public interest under specific circumstances.
Under the original VAT law introduced in 1990 imports made by MUB are zero rated to avoid the
payment of VAT up front. The zero rating incentive has since been extended to domestic supplies
made to MUBs to encourage local firms to sell to those enterprises.
Export processing zone enterprises are exempt from registration under VAT Act because they
are not considered as local firms. They are also exempt from the payment of excise duties
as specified in the Customs and Excise Act. The main trade tax incentive schemes include
export compensation, duty drawback, manufacturing under bond (MUB), and export processing
zones.

Export compensation schemes

Duty Remission Facility

T E X T

These are a form of Export Compensation schemes. Materials imported for use in manufacturing
for export; the production of raw materials for export; or the production of duty free items for sale
domestically, are eligible for duty remission. Applications for this facility should be made to the
Tax Remission for Export Office (TREO) administered by the Ministry of Finance.
S T U D Y

Manufacture under Bond

The Manufacturing under Bond (MUB) scheme. MUB was established in 1988 to boost exports
as part of the Srtuctural Adjustments Programmes introduced earlier in 1987. It is a duty or
tariff deferral scheme under which eligible firms were licensed, placed under bond and allowed
to import capital items, spares and raw materials without payment of duty. The bonds may be
established on behalf of the firms by commercial banks or insurance companies. The amount
of the bond is predetermined for each import, with the Customs authorities, canceling when the
firms make exports, using the input on which the tax was waived.
A firm must invest up to Kshs 10 million and employ a minimum of 100 people to qualify for
MUB status. The goods produced can only be sold on the domestic market with the permission
of the Commissioner of Income Tax. When goods are sold on the domestic market, the firm
becomes liable for the equivalent import duties waived on the inputs used to manufacture the
goods. The physical controls that exist for monitoring their inputs and output are similar to those
used under the excise regimes. By 1993, there were over 70 MUBs that were operating in Kenya,
exporting mainly garments to the US market. Though the scheme continues, the number of firms
has declined drastically to about 12 when, in 1994, the US trade authorities revoked Kenya’s
export quota to that market. They cited the abuse that involved transshipment of cargo from India
through Kenya as the reason for the revocation order.

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 TAX PLANNING 155

Kenya also offers Duty and VAT remission scheme as a tax incentive. The scheme was introduced
in 1990 to provide relief for the payment of these taxes on imports on raw materials and other
inputs that physically form part of the goods exported. Unlike the MUB and EPZ schemes,
the remission mechanism does not cover taxes paid on capital inputs such as equipment and
machinery. firms that wish to use the scheme are required to apply to the EPPO of the Ministry
of Finance.

Double taxation treaties

Kenya has double tax treaties with various governments. In fact, Kenya has signed double tax
treaties with United Kingdom, Germany, Canada, India, Norway and Zambia. The agreements
are aimed at eliminating double taxation of income earned by the residents of the respective
countries. The treaty rates are as shown below:
Dividends Interest Royalty, management
and
professional fees
Resident in % % %

Canada 15 15 15
Denmark 20 (a) 20 20
Germany 15 (a) 15 15

T E X T
India 15 15 (d) 20
Norway 15 (a) 20 20
Sweden 15 15 20
U.K 15 (a) 15
(b) 15

S T U D Y
Zambia (c) 0 15 20

(a) Interest paid by the government and the Central Bank of Kenya is tax-exempt.
(b) The rate is 12.5% for management and professional fees.
(c) No Kenya tax is due if the dividend is subject to tax in Zambia.
(d) The rate is 17.5% for management and professional fees.

Where the treaty rate is higher than the non-treaty rate, the lower rate applies.

Turnover tax
This is a tax on consumer expenditure introduced in the 2006 Finance Act. It was introduced as a
measure to improve compliance of small tax payers. It also acts as a tax incentive for the medium
size businesses with a turnover of less than Kshs 5 million. The imposition of the turnover tax is
contained in section 12 (c) of the Income Tax Act. It applies to any person whose gross sales is
more than Kshs 500,000 per annum and does not exceed or is not expected to exceed Kshs 5
million per annum
The applicable rate as per the 2006 Finance Bill was 3% of gross sales per annum and it was to
be a final tax. However, the 2006 Finance Act was not clear on the rate which is applicable and
also had deleted the charging section. This made it difficult for it to be imposed by 1 January
2007.
The situation was clarified in the 2007 Finance Bill and the rate was clarified as the resident rate
for any year of income. Following this amendment, the turnover tax is expected to be effective
with effect from 1 January 2008.

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5.18 Disposal of business operations and restructuring of activities

The various tax planning opportunities in the disposal of business operations and restructuring
activities are as follows:

•• Application to transfer assets of a going concern without charging VAT

Under paragraph 21 of the 6th Schedule to the VAT Act, where any person disposes of
a registered business as a going concern to another registered person, both registered
persons can apply to the Commissioner to transfer the taxable goods without charging VAT.
For the application to be granted, both registered persons must within 30 days furnish the
Commissioner with the following information:
• Details of the transaction,
• Details of the arrangements made for payment of tax due on supplies already
made
• Description of the transaction
• Quantities and value of stocks of taxable goods on hand at the date of disposal,
• Details of arrangements made for transferring the responsibility for keeping and
producing books and records relating to the business before disposal;

Unless the Commissioner has reason to believe that there would be undue risk to the
T E X T

revenue, and notifies the registered persons accordingly within 14 days of receipt of the
notification, the stocks of taxable goods on hand may be transferred without payment of the
tax otherwise due and payable; and
Further, notwithstanding that the business is being disposed of by the registered person as
S T U D Y

a going concern, that registered person shall remain registered and be responsible for all
matters under the VAT Act in relation to the business prior to its disposal, up to the time of its
disposal, until such time as the requirements of this Act have been properly complied with.
•• Transfer of assets at the WDV
Under paragraph 13(3) of the 2nd Schedule to the Income Tax Act, in the case of a transfer
where one of the parties (body of person) exercises control over the other, the body of
persons can apply to transfer assets at the written down value if the sale would have given
rise to a balancing charge. In this case, no election will be made in cases where either the
buyer or the seller is at the time of the sale a non resident person.
•• Stamp duty incentives
▪▪ Section 95 of the Stamp Duty Act
Section 95 provides some exemptions on stamp duty and a reduction on stamp duty on
increase of capital. In order for a company to qualify for the tax incentive, the following
conditions must be met:
• There must be a new company to be incorporated in Kenya or an increase of
share capital of an existing company. In our interpretation, the company must be
incorporated under the laws of Kenya.
• That the absorbing company is either registered or increases its capital with a view
to acquiring more than 90% of the share capital of the target company.
• The consideration of the transfer consists of more than 90% of the shares issued
in the transferee company.

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 TAX PLANNING 157

Section 96 exempts from tax instruments in respect to which it is shown to the satisfaction of the
collector.
(a) That the effect thereof is to convey or transfer a beneficial interest in property from one
company with limited liability (hereinafter called the transferor) to another such company
(hereinafter called the transferee); and
(b) That either—
(i) One of such companies is beneficial owner of not less than ninety per centum of the
issued share capital of the other company; or
(ii) Not less than ninety per centum of the issued share capital of each of the companies is
in the beneficial ownership of a third company with limited liability;
(c) That the instrument was not executed in pursuance of or in connection with an arrangement
where under—
(i) The consideration for the conveyance or transfer was to be provided directly or indirectly
by a person other than a company which at the time of the execution of the instrument
was associated with either the transferor or the transferee; or
(ii) The beneficial interest in the property was previously conveyed or transferred directly
or indirectly by such a person.

5.19 Chapter Summary

T E X T
•• Adequate tax planning requires a deeper understanding of the tax legislation and a
sound knowledge of case law in taxation principles.

S T U D Y
•• Tax planning for the case of an organisation may involve the following areas remuneration,
duty, VAT or corporation tax.
•• Planning is meant to achieve compliance with tax laws, ease tax administration and
advantageous financial position.

5.20 Quiz

Question one

Identify some of the opportunities for Customs planning.

Question two

Discuss the tax planning opportunities with regard to employee taxes.

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 158 A dvanced TA X AT I O N

Question three

Discuss some of the tax planning opportunities for individuals.

Question four

Discuss some of the tax planning opportunities with regard to Disposal of business
operations and restructuring of activities

Question five

With the aid of case law, discuss the anti avoidance provisions as provided under Section 23 of
the Income Tax Act.
T E X T
S T U D Y

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 TAX PLANNING 159

5.21 Quiz answers

Question one

Customs planning can give opportunities in the following areas:

1. Duty remission:Investors can apply to the Minister for duty waiver or exemption under
special duty rates. Duty remissions are also available under the Tax Remission for
Exports Office (TREO) programme.
2. Customs valuation: This involves ensuring that the best valuation method is used. It
would be advisable to import from a manufacturer rather than a middleman. In practice,
the value of the second transaction is used to calculate customs value on import. As
such, if one has prior information of first transaction and bought directly from the importer
or manufacturer, it would result in duty saving. Thus applying “first sale” principle can
minimise duty by eliminating “middleman” markup.
3. Duty suspension: The bonded warehouse arrangement can be used to minimise
Customs value. A trader in Tanzania approaches a Kenyan trader for the first time in

T E X T
order to purchase sports shoes. Had the trader imported the sports shoes under a
bonded warehouse arrangement they could have avoided unnecessary import duties
and VAT on the import (enter as transit goods).
4. Classification of goods:The taxpayer should ensure goods are correctly classified.

S T U D Y
Incorrect classification of goods may lead to payment of either higher or lower duty.
If lower duty is paid, there are risks of paying the difference after a post clearance
inspection. If higher duties are paid, it will result in the pursuit of the duties outstanding
(customs duty and VAT) and even fines or interest in arrears on the duties and VAT.
5. Duty deferral: This planning opportunity involves importing goods, storing or further
manufacturing the goods, then exporting the goods to another country or releasing
them to Kenyan market (pay 2.5% surcharge).
6. Origin of goods: There may be varying amounts of import duty payable depending
on the origin of the goods. Some imports from certain countries enjoying a preferential
import duty. As such, the importer should be well-versed with rules of origin to make
use of the preferential import duty rates. One would need to produce a valid Certificate
of Origin.

Question two

Staff costs are significant operational costs. The employer needs to reward labour in the highest
possible way at lowest cost possible while at the same time observing full compliance with the
law. Consider lumpsum payments, benefits, expenses etc.
An employee will usually be rewarded largely by salary, but several other elements can be
included in a remuneration package. Some of them bring tax benefits to the employee only,
some will benefit the employer.

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 160 A dvanced TA X AT I O N

Bonuses are treated like salary, except that if a bonus is accrued in the employer's accounts
but is paid more than nine months after the end of the period of account, its deductibility for tax
purposes will be delayed.
The general position for benefits is that they are subject to income tax. The cost of providing
benefits is generally deductible in computing trading profit for the employer.
However, there are a large number of tax free benefits and there is a great deal of planning that
can be done to ensure a tax efficient benefits package for directors and employees. The optimum
is to ensure that the company receives a tax deduction for the expenditure while creating tax.
There are items which are commonly referred to as income but are not included in the above
mentioned list of taxable income. A number of such non-taxable incomes come to mind such as:
1. Pension or gratuities earned or granted in respect to disability.
2. Monthly or lumpsum pension granted to a person who is 65 years of age or more.
3. That part of the income of the president of the republic of Kenya that is exempt e.g. a
salary duty, allowances, entertainment allowances paid or payable to him from public
funds.
4. Allowances to the Speaker, Deputy Speaker and MP payable to them under the National
Assembly remuneration.
5. Interest up to Kshs 100,000 per individual on housing bonds, account with Housing
Finance ( formerly Housing Finance Corporation of Kenya, HFCK), Savings and Loans
of Kenya Ltd, East Africa Building Society, Home Loans and Savings. (With effect
T E X T

from June 1987, interest up to Kshs 300,000 is qualifying while the excess is non
qualifying.)
6. Cost of passage to and from Kenya of a non-citizen employee borne by the employer.
7. Employer’s contribution to pension funds or provident funds
S T U D Y

8. Benefits, advantages/facilities of an aggregate value of less than Kshs 36,000 p.a. in

respect of employment or services tendered. (W.e.f.1.1.2006, non-cash benefits are
taxed if their aggregate value is more than Kshs 36,000 p.a or Kshs 3,000 p.m.)
9. The first Kshs 150,000 per month for persons with disabilities exempt from taxation. (
w.e.f. 12.June 2009).
10. Expenditure on amenities by the physically disabled tax allowable up to a maximum of
Kshs 50,000 per month. ( w.e.f. 12. June 2009)

Question three

Tax planning is the arrangement of the affairs of a taxpayer in such a way as to minimise tax
liability at lowest cost without contravening any tax law or regulations. It is determination, in
advance, of the tax effect of proposed business actions.
Tax planning requires:
▪▪ A deeper understanding of the tax legislation; and
▪▪ A sound knowledge of case law in taxation.
Tax consultancy is therefore basically tax planning involving offering tax advice to clients in
various situations. Tax revenue departments have to ensure the following through proper tax
planning: -
▪▪ Taxpayers comply fully with tax laws and regulations; and
▪▪ Revenue collection is maximised.

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 TAX PLANNING 161

A careful study of decided cases is important in:

i) Highlighting tax planning schemes;
ii) Provision of judicial interpretation of the legislation;
iii) The judgement in a particular case will show strengths and weaknesses of a particular
scheme.
Aims of tax planning
1. To achieve compliance with tax laws since non-compliance is costly as it will result in
penalties and interest charges.
2. To ease administration as in working out arrangements, methods of accounting, records
to be kept, reports to be prepared etc.
3. To achieve the most advantageous financial position out of a business transaction to be
measured in terms of direct tax savings from planning and financial benefits by way of
cash flow effects.
Tax planning for individuals
The tax planning measures of an individual would depend on whether they are employed or
unemployed. The following tax planning measures are allowable for employees.

Owner-occupier Relief
According to Section 15 (3) (b) of the Income Tax Act, interest paid by a person on amount borrowed

T E X T
from specified financial institution (includes a bank, insurance company or building society) for
the purchase of or improvement of premises that he occupies for residential purpose shall be
deductible against total taxable income of the person. The maximum allowable interest is Kshs
150,000 per annum (Kshs 12,500 per month).

S T U D Y
An employer should ensure that mortgage interest paid by the employees is allowed for deduction
in the payroll of all eligible employees.

Insurance relief
An employer should notify employees who have taken individual life assurance covers or education
policies with a maturity of 10 years (with effect from 1 January 2003) and maybe paying out of
payroll premiums on the same that they are eligible to claim insurance relief and effect the same
through the payroll. The deductible amount paid is subject to a maximum of Kshs 60,000 per
annum (Kshs 5,000 per month).

Non-cash benefits
Increasing the non-taxable benefits may reduce tax on employees especially where such benefits
are allowable for corporation tax purposes. Examples of benefits that the company could consider
introducing or expanding include the following:-

Medical services
This entails the reimbursement to staff of medical expenses incurred for self and dependants
or access to designated hospital facilities where the company holds an account. There is no
maximum limit of the same under the law.
Staff development and training
Training costs directly paid to a training institution for an employee in relation to the
employees’ responsibilities at the work place and for the benefit of the company’s business
are allowable for corporate and PAYE purposes.

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 162 A dvanced TA X AT I O N

Mileage Reimbursement for use of personal car on the company business

This benefit is tax efficient in comparison to the car benefit and provision of staff transport
which are taxable on the employees.
Meals for low income employees
Meals provided to low income employees on employer’s premises are a non taxable benefit
on the employees. A low income employee is defined as one earning not more than Kshs.
29, 316 per month, i.e. employees at income tax bracket of 20% and below. (Effective date:
13 June 2008)
School fees
Generally, where the employer pays school fees for the employee’s child, dependant or
relative, such payment becomes a taxable benefit on the employee if not already taxed on
the employer. However, educational fees for dependants of low income employees paid or
foregone by an educational institutional employer are not taxable on either the employer or
the employee.

Question four

The various tax planning opportunities in the disposal of business operations and restructuring
activities are as follows:
T E X T

•• Application to transfer assets of a going concern without charging VAT

Under paragraph 21 of the 6th Schedule to the Income Tax Act, where any person disposes of a
S T U D Y

registered business as a going concern to another registered person, both registered persons
can apply to the Commissioner to transfer the taxable goods without charging VAT. For the
application to be granted, both registered persons must within 30 days furnish the Commissioner
with the following information:
•• Details of the transaction;
•• Details of the arrangements made for payment of tax due on supplies already made;
•• Description of the transaction;
•• Quantities and value of stocks of taxable goods on hand at the date of disposal;
•• Details of arrangements made for transferring the responsibility for keeping and
producing books and records relating to the business before disposal;
Unless the Commissioner has reason to believe that there would be undue risk to the revenue,
and notifies the registered persons accordingly within 14 days of receipt of the notification, the
stocks of taxable goods on hand may be transferred without payment of the tax otherwise due
and payable; and, further, notwithstanding that the business is being disposed of by the registered
person as a going concern that registered person shall remain registered and be responsible for
all matters under the VAT Act in relation to the business prior to its disposal, up to the time of its
disposal, until such time as the requirements of this Act have been properly complied with.

•• Transfer of assets at the WDV

Under paragraph 13(3) of the Income Tax Act, in the case of a transfer where one of the parties
(body of person) exercises control over the other, the body of persons can apply to transfer
assets at the written down value if the sale would have given rise to a balancing charge. In this
case, no election will be made in cases where either the buyer or the seller is at the time of the
sale a non resident person.

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 TAX PLANNING 163

•• Stamp duty incentives

▪▪ Section 95 of the Stamp Duty Act
Section 95 provides some exemptions on stamp duty and a reduction on stamp duty on
increase of capital. In order for a company to qualify for the tax incentive, the following
conditions must be met:
• There must be a new company to be incorporated in Kenya or an increase of
share capital of an existing company. In our interpretation, the company must be
incorporated under the laws of Kenya.
• That the absorbing company is either registered or increases its capital with a view
to acquiring more than 90% of the share capital of the target company.
• The consideration of the transfer consists of more than 90% of the shares issued
in the transferee company.
Section 96 exempts from tax instruments in respect to which it is shown to the satisfaction
of the Collector.
(a) that the effect thereof is to convey or transfer a beneficial interest in property from
one company with limited liability (hereinafter called the transferor) to another such
company (hereinafter called the transferee); and
(b) that either—
(i) One of such companies is beneficial owner of not less than ninety per centum of
the issued share capital of the other company; or
(ii) Not less than ninety per centum of the issued share capital of each of the companies

T E X T
is in the beneficial ownership of a third company with limited liability;
(c) that the instrument was not executed in pursuance of or in connection with an
arrangement where under—
• The consideration for the conveyance or transfer was to be provided directly or

S T U D Y
indirectly by a person other than a company which at the time of the execution of
the instrument was associated with either the transferor or the transferee; or
• The beneficial interest in the property was previously conveyed or transferred
directly or indirectly by such a person.

▪▪ Section 96 of the Stamp duty Act

Section 96 exempts from tax instruments in respect to which it is shown to the satisfaction
of the Collector.
(a) That the effect thereof is to convey or transfer a beneficial interest in property from
one company with limited liability (hereinafter called the transferor) to another such
company (hereinafter called the transferee); and
(b) That either—
(i) One of such companies is beneficial owner of not less than ninety per centum of
the issued share capital of the other company; or
(ii) Not less than ninety per centum of the issued share capital of each of the companies
is in the beneficial ownership of a third company with limited liability;
(c) that the instrument was not executed in pursuance of or in connection with an
arrangement where under—
• The consideration for the conveyance or transfer was to be provided directly or
indirectly by a person other than a company which at the time of the execution of
the instrument was associated with either the transferor or the transferee; or
• The beneficial interest in the property was previously conveyed or transferred
directly or indirectly by such a person.

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 164 A dvanced TA X AT I O N

Question five

Anti-avoidance provisions S.23

Under S.23, the Commissioner of Income Tax is empowered to reject certain business transactions
when he is of the opinion that the main purpose or one of the main purposes for effecting a
transaction is evasion or reduction of tax liability. He can direct for necessary adjustment on
taxable income and issue an assessment accordingly. If the taxpayer disputes the adjustment
and the resulting assessment, the taxpayer can appeal to the Tribunal e.g.
•• A director buying a car from the company at a throw away price. He would be taxed
on the difference between the low price he pays for the car and the market price for the
car.
•• A child paid very high salary for minor duties. The salary helps to spread tax payable but
the parent controls the child’s income. The Commissioner of Income Tax would disallow
the salary and tax it.
Tax Avoidance: Principles emerging from case law
Section 23 of the Kenya Income Tax Act empowers the Commissioner to order the adjustment of
transactions which in his opinion are effected with the main aim of avoiding or reducing liability
to tax.
Such a direction can only be challenged by appealing to the Income Tax Tribunal. This decision
T E X T

of the Tribunal is final and there is no right to further appeal.

However, the Commissioner rarely, if ever, does use such powers. Consequently, there is no
such litigation in respect of tax avoidance schemes in Kenyan courts.
S T U D Y

However, the following principles have emerged from UK Case Law and which may well be
applied in Kenya:
1. The “Duke of Westminster” Principle.
Lord Tomlin stated: “every man is entitled, if he can, to order his affairs so that the tax
attaching ... is less than it would otherwise be.
2. The “Ramsay” Principle: This was established in a Capital Gains Tax Case in relation
to composite transactions.

At the time, the most prevalent scheme to avoid tax (especially Capital Gains Tax) was to enter
into a series of transactions, which would facilitate the following:
a. Conceal the sale of property subject to Capital Gains Tax (CGT)
b. The exchange of shares for shares, which would not have CGT implications.

This interdependent series of transactions would normally be “circular and self cancelling”.
The Ramsay doctrine provides that whether a series of transactions is genuine or artificial would
be dependent on the end result. Transactions which have no commercial purpose are treated as
a fiscal nullity. The preordained series of transactions are disregarded if they have no business
purpose other than achieving the preordained end.
The same principle was extended in CIR vs BURMAH OIL CO. LTD.

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 TAX PLANNING 165

5.21 Past paper analysis

The following is a list of questions covering the topic that were tested in previous examsThe
questions are listed in this format: Month/year e.g. 6/01 represents June or May 2001.
6/00 Q.5 (a) 12/05 Q.5 (a), 06/06 Q.5 (a), 06/08 Q.2, 12/08 Q.5 (a),
Taxation 1- 12/08,

5.22 Revision questions

Question one

a) i) Define the term ‘tax planning’ (2 marks)

T E X T
ii) Briefly explain two instances in which a business may apply the concept of tax planning
(4 marks)
(Dec 2005 Q 5)

S T U D Y
Question two

Discuss the concept of corporate tax planning

Question three

a) Explain the main tax incentives provided to newly listed companies in your country.
(4 marks)
b) Under what circumstances are imported goods considered to have been dumped in your
country? (6 marks)
c) Write brief notes on the following:
i) Tax-free employment benefits (6 marks)
ii) Set off of import duty (4 marks)
(Total: 20 marks)

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 166 A dvanced TA X AT I O N

Question four

“In my judgement, not every payment made to an employee is necessarily made to him as a
profit arising from his employment. Indeed, in my judgement, the authorities show that to be a
profit arising from employment the payment must be in reference to the services the employee
renders by virtue of his office, and it must be something in the nature of a reward for services
past, present or future”. Justice Upjohn in Hochstrasser v – Mayes (1960) 38 TC 673.

Required:
In the light of the above judgement and the relevant provisions of Income Tax Act (Cap 470) of
the laws of Kenya, explain the tax benefits arising out of the use of the following in the design of
an “Executive Remuneration Package”.
Expense reimbursement. (4 marks)
Benefits in kind (4 marks)
Pension entitlement (4 marks)
Bonus Schemes (4 marks)
Share Purchase arrangements for employees. (4 marks)
T E X T

Question five

a) “Multinational corporations may adopt certain pricing structures for their Kenyan subsidiaries
S T U D Y

that shift profits out of Kenya to countries where profits are taxed less and thus divert part of
Kenya’s revenue abroad”. (Deloitte and Touche: 2006 East Africa Budget Insight).
Required:
With reference to the statement above and section 18(3) of the Income Tax Act (Cap.470):
i) Outline the characteristics of transactions that may constitute transfer pricing.
(4 marks)
ii) Identify four methods of determining an appropriate transfer price as provided in the
Organisation for Economic Co-operation and Development (OECD) model.
(4 marks)

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 TAX PLANNING 167

T E X T
S T U D Y

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 168 A dvanced TA X AT I O N
T E X T
S T U D Y

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 TAX SYSTEMS AND POLICIES 169

CHAPTER SIX
ONE

T E TX ET X T
S T U D Y T E X T
S T SU TDUYD Y

TAX SYSTEMS AND

POLICIES

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 170 A dvanced TA X AT I O N
T E X T
S T U D Y

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 TAX SYSTEMS AND POLICIES 171

CHAPTER SIX
TAX SYSTEMS AND POLICIES

6.0 Tax systems and policies

6.1 Introduction

In the previous chapter we covered tax planning. In this chapter we will lay emphasis on developing
tax systems and policies. Tax systems are the frames on which a country’s revenue collection is
built. The chapter will assist the student understand the various types of tax systems and be able
to recommend a viable tax system based on International best practices.
In the next chapter we shall look at professional ethics in taxation.

6.2 Objectives

T E X T
After this chapter the students should have understood the following concepts:
•• Types of tax systems
•• Role of taxation in economic development

S T U D Y
•• Design of a tax policy
•• Criteria for evaluation of a tax system
•• Tax reforms and modernisation of tax systems

6.3 Exam Context

This is a new topic introduced with the review of the syllabus. Questions in this topic are likely to
be theoretical and could test a candidates’ understanding of tax systems, reforms, modernisation
of the tax systems and design of a tax policy.

6.4 Industrial Context

This topic will enable economic experts understand the various tax systems and be in a position
to advise accordingly. It will also help students understand the role of taxation in economic
development.

6.5 Key definitions

Tax system: This is an organised way in which the government collects tax from its citizens.
It involves the various approaches, structures and policies adopted over time and relating to
taxation and revenue generation.

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 172 A dvanced TA X AT I O N

Tax policy: is the government's approach to taxation, both from the practical and normative
side of the equation. Policymakers debate the nature of the tax structure they plan to implement
(i.e., how progressive or regressive) and how it might affect individuals and businesses (i.e., tax
incidence).
Tax reforms: These are changes or amendments of the tax system with the general objective of
revenue adequacy, economic efficiency, equity and fairness and simplicity.
Tax Modernisation: These are reforms implemented to ensure that tax systems are kept
abreast with technological advances. This improves tax collection and ensures efficiency in the
tax system.

6.6 Types of tax systems

Generally, there are two major types of tax systems.

•• Single or unified tax system
•• Multiple tax system.

Unified tax system

A unified tax system has only one form of tax. For example, in some countries, turnover tax is the
T E X T

only tax upon income of a person. A unified tax is a fixed tax that is paid for a given period of time,
usually one year, to guarantee business entity of all legal protection for the period.
It caters for tax liabilities that a business entity is required to pay in order to acquire the legal
S T U D Y

protection for a specified period of time usually one year. The regime is usually graduated into
tax schedules defined on the basis of either profitability or employment levels of business entities
such that the higher the level of employment or profitability, the higher the amount of unified tax
payable.

Multiple tax system

It comprises a variety of taxes that are applicable at the same time on the income of a person.
In Kenya, for example, we have a multiple tax system since there are many taxes applicable
including personal tax, corporation tax, withholding tax, compensating tax, turnover tax, Value
Added Tax, Customs and Excise tax ..
A multiple tax system may be preferred to a single tax system for the following reasons:
i) Sufficient revenue
A government implementing a multiple tax system is able to collect sufficient revenue
due to a wide tax base
ii) Desire to regulate externalities
A country implementing a multiple tax system will be in a position to regulate externalities
whenever they arise e.g. a country may impose heavy import duty to protect local
industries
iii) Minimise incidences of tax evasion
Since a multiple tax system has a wide tax base it is able to minimise tax evasion by
bringing every taxable person into the tax blanket

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 TAX SYSTEMS AND POLICIES 173

6.7 Role of taxation in economic development

The role of taxation and fiscal policy in the development strategy of a country has to
be viewed in the background of the functions a taxation system performs. The main
functions of taxation in relation to economic are as follows.

a. Economic stability
Taxes are imposed to maintain economic stability in the country. During inflation, the government
imposes more taxes in order to discourage the unnecessary expenditure of the individuals.
During deflation, taxes are reduced in order to enable the individuals to spend more money. In
this way, the increase or decrease of tax helps to check the big fluctuations in the prices and
maintain economic stability.

b. Raise revenue
The revenue is required to pay for the goods and services which the government provides. These
goods are of two types – public and merit goods. Public goods, such as defense and police are
consumed collectively and no one can be prevented from enjoying them if he wishes to do so.
These goods have to be provided by governments. Merit goods, such as education and medical
care, could be, and often are, provided privately but not necessarily in the amounts considered
socially desirable and hence governments may subsidise their production. This may be done for

T E X T
a variety of reasons but mainly because the market may not reflect the real costs and benefits of
the production of a good. Thus, the public may be subsidised because the market does not take
account of all the costs and benefits of the public transport system.

S T U D Y
c. Pay interest on national debt
Taxes are also levied by the government to pay interest on national debt.

d. Fair redistribution of income

A major function of taxation is to bring about some redistribution of income. First, tax revenue
provides the lower income groups with benefits in cash and kind. Second, the higher income
groups, through a system of progressive taxation, pay a higher proportion of their income in tax
than the less well-off members of the society.

e. Protection policy
Taxes are also imposed to give protection to those commodities which are produced in the
country. The government thus imposes heavy taxes on the import of such commodities from the
other countries. In the view of these taxes, the individuals are induced to buy local products.

h. Social welfare
The government imposes taxes on the production of those commodities which are harmful to
human health e.g. excise duty on wines, cigarettes among others.

i. Optimum allocation of resources

Taxes are also imposed to allocate resources of the country for their optimum use The amounts
collected by the government from taxes are spent on more productive projects. It means the
resources are allocated to achieve the maximum possible output in the given circumstances.

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 174 A dvanced TA X AT I O N

6.8 Design of a tax policy

Tax policy challenges facing developing countries

Taxation is the only practical means of raising the revenue to finance government spending on
the goods and services that the citizens of a country demand. Setting up an efficient and fair tax
system is not easy, particularly for developing countries that want to become integrated in the
international economy. The ideal tax system in developing countries like Kenya, should raise
essential revenue without excessive government borrowing, and should do so without discouraging
economic activity and without deviating too much from tax systems in other countries.
Developing countries face formidable challenges when they attempt to establish efficient tax
systems:
i. Most workers in developing countries are typically employed in agriculture or in small,
informal enterprises. As they are seldom paid a regular, fixed wage, their earnings
fluctuate, and many are paid in cash, "off the books." The base for an income tax is
therefore hard to calculate. Nor do workers in these countries typically spend their
earnings in large stores that keep accurate records of sales and inventories. As a result,
modern means of raising revenue, such as income taxes and consumer taxes, play a
diminished role in these economies, and the possibility that the government will achieve
T E X T

high tax levels is virtually excluded.

ii. It is difficult to create an efficient tax administration without a well-educated and
well-trained staff, when money is lacking to pay good wages to tax officials and to
S T U D Y

computerise the operation (or even to provide efficient telephone and mail services),
and when taxpayers have limited ability to keep accounts. As a result, governments
often take the path of least resistance, developing tax systems that allow them to exploit
whatever options are available rather than establishing rational, modern, and efficient
tax systems.
iii. Informal structure and financial limitations of the economy in many developing countries
and hinder the statistical and tax offices from generating reliable statistics. This lack of
data prevents policymakers from assessing the potential impact of major changes to
the tax system. As a result, marginal changes are often preferred over major structural
changes, even when the latter are clearly preferable. This perpetuates inefficient tax
structures.
iv. Income tends to be unevenly distributed within developing countries. Although raising
high tax revenues in this situation ideally calls for the rich to be taxed more heavily
than the poor, the economic and political power of rich taxpayers often allows them to
prevent fiscal reforms that would increase their tax burdens. This explains in part why
many developing countries have not fully exploited personal income and property taxes
and why their tax systems rarely achieve satisfactory progressivity (in other words,
where the rich pay proportionately more taxes).

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 TAX SYSTEMS AND POLICIES 175

v. Developing countries attempting to become fully integrated in the world economy will
probably need a higher tax level if they are to pursue a government role closer to that
of industrial countries, which, on average, enjoy twice the tax revenue. Developing
countries will need to reduce sharply their reliance on foreign trade taxes, without at
the same time creating economic disincentives, especially in raising more revenue from
personal income tax. To meet these challenges, policymakers in these countries will have
to get their policy priorities right and have the political will to implement the necessary
reforms. Tax administrations must be strengthened to accompany the needed policy
changes.
vi. As trade barriers come down and capital becomes more mobile, the formulation of
sound tax policy poses significant challenges for developing countries. The need
to replace foreign trade taxes with domestic taxes will be accompanied by growing
concerns about profit diversion by foreign investors, which weak provisions against tax
abuse in the tax laws as well as inadequate technical training of tax auditors in many
developing countries are currently unable to deter. A concerted effort to eliminate these
deficiencies is therefore of the utmost urgency.
vii. Tax competition is another policy challenge in a world of liberalised capital movement.
The effectiveness of tax incentives— in the absence of other necessary fundamentals
— is highly questionable. A tax system that is riddled with such incentives will inevitably
provide fertile grounds for rent-seeking activities. To allow their emerging markets to
take proper root, developing countries would be well advised to refrain from reliance on

T E X T
poorly targeted tax incentives as the main vehicle for investment promotion.
viii. Finally, personal income taxes have been contributing very little to total tax revenue
in many developing countries. Apart from structural, policy, and administrative
considerations, the ease with which income received by individuals can be invested

S T U D Y
abroad significantly contributes to this outcome. Taxing this income is therefore a
daunting challenge for developing countries. This has been particularly problematic in
several Latin American countries that have largely stopped taxing financial income to
encourage financial capital to remain in the country.

6.9 Criteria for the evaluation of a tax system

Principles of an optimal tax system

The principles of an optimal tax system, what are known as Canons of taxation, some of which
were laid down by Adam Smith include:

1. Simplicity
A tax system should be simple enough to enable a taxpayer to understand it and be able to
compute his/her tax liability. A complex and difficult to understand tax system may produce a
low yield as it may discourage the taxpayer's willingness to declare income. It may also create
administrative difficulties leading to inefficiency. The simplest tax system is one with only a single
tax. However, this may not be equitable as some people will not pay tax.

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 176 A dvanced TA X AT I O N

2. Certainty
The tax should be formulated so that taxpayers are certain of how much they have to pay and
when. The tax should not be arbitrary. The government should have reasonable certainty about
the attainment of the objective(s) of that tax, the yield and the extent to which it can be evaded.
There should be readily available information if taxpayers need it.
Certainty is essential in tax planning. This involves appraising different business or investment
opportunities on the basis of the possible tax implications. It is also important in designing
remuneration packages. Employers seek to offer the most tax efficient remuneration packages
which would not be possible if uncertainty exists.

3. Convenience
The method and frequency of payment should be convenient to the taxpayer e.g. PAYE. This may
discourage tax evasion. For example, it may be difficult for many taxpayers to make a lumpsum
payment of tax at the year-end. For such taxes, the evasion ratio is quite high.

4. Economic/administrative efficiency
A good tax system should be capable of being administered efficiently. The system should
produce the highest possible yield at the lowest possible cost both to the tax authorities and the
taxpayer.
The tax system should ensure that the greatest possible proportion of taxes collected accrue to
T E X T

the government as revenue.

5. Taxable capacity
S T U D Y

This refers to the maximum tax which may be collected from a taxpayer without producing
undesirable effects on him. A good tax system ensures that people pay taxes to the extent they
can afford it. There are two aspects of taxable capacity.
a) Absolute taxable capacity
b) Relative taxable capacity

Absolute taxable capacity is measured in relation to the general economic conditions and
individual position e.g. the region, or industry to which the taxpayer belongs.
If an individual, having regard to his circumstances and the prevailing economic conditions
pays more tax than he should, his taxable capacity would have been exceeded in the absolute
sense.
Relative taxable capacity is measured by comparing the absolute taxable capacities of different
individuals or communities.

6. Neutrality
Neutrality is the measure of the extent to which a tax avoids distorting the workings of the market
mechanism. It should produce the minimum substitution effects. The allocation of goods and
services in a free market economy is achieved through the price mechanism. A neutral tax system
should not affect the taxpayer's choice of goods or services to be consumed.

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 TAX SYSTEMS AND POLICIES 177

7. Productivity
A tax should be productive in the sense that it should bring in large revenue which should be
adequate for the government. This does not mean overtaxing by the government. A single tax
which brings in large revenues is better than many taxes that bring in little revenue. For example
Value Added Tax was introduced since it would provide more revenue than Sales Tax.

8. Elasticity or buoyancy
By elasticity we mean that the government should be capable of varying (increasing or reducing)
rates of taxation in step with the circumstances in the economy, e.g. if the government requires
additional revenue, it should be able to increase the rates of taxation. Excise duty, for instance,
is imposed on a number of commodities locally manufactured and their rates can be increased in
order to raise more revenue. However, care must be taken not to charge increased rate of excise
duty from year to year because they might exert inflational pressures on the economy.

9. Flexibility
It means that there should be no rigidity in taxation i.e. the tax system can be changed to meet
the revenue requirement of the state; both the rate and structure of taxes should be capable
of change or being changed to reflect the state’s requirements. Such that certain old taxes
are discouraged while new ones are introduced. The entire tax structure should be capable of
change.

T E X T
10. Diversity
It means that there should be variety or diversity in taxation. That the tax base should be wide
enough so as to raise adequate revenue and also the tax burden is evenly distributed among the

S T U D Y
taxpayers. A single tax or a few taxes may not meet revenue requirements of the state. There
should be both direct and indirect taxes.

11. Equity
A good tax system should be based on the ability to pay. Equity is about how the burden of
taxation is distributed. The tax system should be arranged so as to result in the minimum possible
sacrifice. Through progressive taxation, those with high incomes pay a large amount of tax as
well as a regular proportion of their income as tax.
Equity means people in similar circumstances should be given similar treatment (horizontal
equity) and dissimilar treatment for people in dissimilar circumstances (vertical equity).
There are three alternative principles that may be applied in the equitable distribution of the tax
burden.
a. The benefit principle
b. The ability to pay principle
c. The cost of service principle

6.10 Tax reforms and modernisation of tax systems

The Kenya Revenue Authority was established in 1995 as a semi-autonomous government

agency responsible for revenue administration. The overall objective was to provide operational
autonomy in revenue administration and enable its evolution into a modern, flexible and integrated
revenue collection agency.

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 178 A dvanced TA X AT I O N

Since the inception of KRA, revenue collection has continued to grow while professionalism in
revenue administration has been enhanced. However, a number of processes remain manual
and KRA is yet to operate as a fully integrated organisation. Thus the KRA Second Corporate
Plan while acknowledging these challenges recommended appropriate strategies to address
the same. This actuated the Revenue Administration Reform and Modernisation Programme
(RARMP) which commenced in 2004/05 with the objective of transforming KRA into a modern,
fully integrated and client-focused organisation.
The RARMP process has adopted project management and business analysis techniques in
accordance with international best practice with the creation of the Programme Management
and Business Analysis Office (PMBO) under the Office of the Commissioner General. This has
led to the development of an institutionalised administrative framework for the RARMP making it
easier to track progress in the reform initiatives and enhance project ownership and acceptance
to change from both internal and external stakeholders. 
The RARMP has now entered its Second Phase which will run until 2008/09 and will see the
reforms entrenched at the operational levels to achieve operational efficiencies and enhance
service delivery. This will be achieved through the implementation of the following seven key
projects:
1. Customs Reforms & Modernisation Project
2. Domestic Taxes Reform & Modernisation Project
3. Road Transport Reform & Modernisation Project
T E X T

4. Investigation & Enforcement Reform & Modernisation Project

5. KRA Infrastructure Development Project
6. KRA Business Automation Project
7. Human Resource Revitalisation Project
S T U D Y

Achievements:
Many positive developments in revenue administration were achieved during the implementation
of the First Phase of the Revenue Administration Reform and Modernisation Programme.
Overall,
•• Revenue collection has increased by 1% of the Gross Domestic Product from Kshs
202 billion in 2002/03 to Kshs 297 billion in the 2005/06 financial year.
•• Income Tax, Value Added Tax and Domestic Excise were merged to form Domestic
Taxes Department (DTD) while the mandate and taxpayer population of LTO was clearly
defined with LTO being elevated to department status.
•• The Simba system was implemented to facilitate self-assessment and Post Clearance
Audit (PCA) function was strengthened.
•• Support Service Department was created to consolidate support functions and enhance
taxpayer services while the Office of Regional Heads was formed to bring services and
decision making closer to taxpayers.
•• The KRA Information Communication & Technology (ICT) strategy was developed to
act as the blue print for all future automation programmes.
•• Employee development programmes were undertaken and staff terms of service
improved.
Challenges:
Despite the achievements enumerated above, significant challenges still remain. These
include:
•• Lack of sufficient funding.

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 TAX SYSTEMS AND POLICIES 179

•• Implementation hiccups in Simba 2005 towards the attainment of a complete self

assessment regime while faster progress is needed in the implementation of an
Integrated Tax Management System.
•• Stakeholders’ resistance to reform initiatives.
•• Need for sustained efforts in fighting corruption and tax fraud.
•• Timeliness of legislative changes.
•• Human resource issues like remuneration, skills and integrity.
The above challenges are recognised and adequately addressed in the Third Corporate Plan
whose theme is ‘Develop a dedicated professional team embracing modern processes and
technologies to deliver customer focused services that enhance compliance and revenue
collection’.

Key perfomance indicators

Below are the Key Performance Indicators on the basis of which we not only will KRA evaluate
itself but invite its stakeholders to evaluate it on the performance of the reform programme
•• Improve tax compliance by 5% per annum (assuming an overall compliance level of
60%).
•• Enhance revenue collection by an additional Kshs 15 billion per annum on account of
improved compliance
•• Maintain cost of collection at below 2% of printed estimates.

T E X T
•• Improved quality of service to stakeholders.
•• Improved public perception of KRA.
•• Competitive terms and conditions of service for employees.

S T U D Y
•• Reduction in corruption/bribery index.
•• Number of KRA functions fully integrated.
•• Number of IT business solutions successfully implemented.
•• Quality and timeliness of production of statistics.
Customs Services Department Reform and Modernisation Project (CRM)
This project aims to transform Customs into a modern Customs administration by 2008/09 in
accordance with internationally accepted conventional standards and best practice as outlined in
WTO agreements and the WCO Revised Kyoto Convention on Simplification and Harmonisation
of Customs Procedures. This will be done through:
•• Implementation of a fully function-based Customs structure and reengineering of
Customs procedures from physically controlled checks to risk based and post release
controls through strengthening of Post Clearance Audit.
•• Taking the lead in implementing an inter-agency review of border processing and
clearance time to enhance service delivery at the borders.
•• Taking the lead at the regional level Customs in addressing deficiencies in the East
African Management Act to streamline the import/export process.
•• Enhancement of the Simba 2005 system functionality in critical areas of manifest
acquittal, management reporting and risk based selection.
•• Enhancement of staff competencies in critical areas such as risk-based approaches to
cargo management and the adoption of post release verification and audit.

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 180 A dvanced TA X AT I O N

Domestic Taxes Department Reform and Modernisation Project

This project seeks to create a Domestic Taxes Department that is structured along the key tax
administration functions of taxpayer education and services, returns and payments processing,
audit, enforced collection and tax operations policy. This will be achieved through:
•• Implementation of an Integrated Tax Management System (ITMS) that integrates both
income tax and value added tax operations and takes a single view of the taxpayer.
•• Enhance service delivery by achieving complete taxpayer segmentation through
building capacity in the Large Taxpayer Office and developing specific programmes
targeting the Middle and Small taxpayers.
Road Transport Department Reform and Modernisation Project
Considerable progress has been made in automating RTD processes. This project aims at
automating all remaining manual processes and simplifying administrative procedures through
record keeping and file tracking features that support front office operations. The project also
aims to achieve full connectivity of the RTD with all other KRA departments in order to ensure
seamless flow of information. Indeed this is already being achieved through the interconnection
between Simba 2005 system and the RTD system KOVIS.

Investigation & Enforcements Reform and Modernisation Project

The project seeks to create a modern Business Intelligence unit that will analyse data to assess
the risks inherent in transaction and ownership relationships which constitute the basis for
T E X T

evasion schemes. The project also seeks to strengthen the prosecution unit and implement a
KRA-wide enforcement strategy to discourage tax malpractices by imposing maximum penalties
and publicise recurrent evaders to deter future tax evasion.
S T U D Y

Infrastructure Development Reform and Modernisation Project

This project aims at ensuring that projects in the reform programme are given adequate support
through timely acquisition and provision of needed utilities, upgrading of KRA infrastructure and
enhancement of asset and security management systems. It also seeks to boost the capacity
of KRA to respond to the various needs of stakeholders through the implementation of modern
KRA-wide taxpayer education, integrity and accountability programmes

KRA Business Automation Project

This project seeks to develop and implement an enterprise-wide IT strategy for KRA which
promotes integration of domestic tax administration and the exchange of information between
DTD, Customs and RTD. The project will enable a ‘single view of the taxpayer’ across all KRA
functions, ensure efficient and effective revenue collection and attain operational excellence. The
project will undertake to provide seamless sharing of information across KRA and interconnectivity
with external systems of stakeholders to enable integrated e-processing of tax returns and
efficient enforcement.

Human Resources Revitalisation Project

This project seeks to upgrade and diversify the skill base at KRA to international best practice
standards with emphasis being placed on competency based management, recruitment and
retention policy, establishment review and clearly defined career path progression.
For any reform programme to be successful, it needs to be hinged on a strong administrative
structure that creates ownership and enhances ownership. KRA has put in place an elaborate
governance structure for the RARMP.

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 TAX SYSTEMS AND POLICIES 181

6.11 Chapter Summary

♦♦ A tax system is an organised way in which the government collects tax from its citizens.
It involves the various approaches, structures and policies adopted over time and
relating to taxation and revenue generation.
♦♦ Tax policy: is the government's approach to taxation, both from the practical and
normative side of the equation. Policymakers debate the nature of the tax structure
they plan to implement (i.e., how progressive or regressive) and how they might affect
individuals and businesses (i.e., tax incidence).
♦♦ There are two types of tax systems:
• Unified Tax system
• Multiple tax system
♦♦ Role of taxation in economic development
a. Raising revenue
b. Economic stability
c. Protection policy
d. Social welfare
e. Fair distribution of income

T E X T
f. Allocation of resources
g. Increase in employment
♦♦ Principles of an optimal tax system
a. Simplicity

S T U D Y
b. Certainty
c. Convenience
d. Economic/administrative efficiency
e. Taxable capacity
f. Neutrality
g. Productivity
h. Elasticity or buoyancy
i. Flexibility
j. Diversity
k. Equity

6.12 Quiz

Question One

a. What is a tax system?

b. What is a tax policy?
c. What are tax reforms?

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 182 A dvanced TA X AT I O N

Question Two

List and explain the role of taxation in economic development.

Question Three

List and explain the principles of an optimal tax system

Question Four

Discuss the challenges faced by tax authorities like the KRA in the process of modernising tax
collection and administration procedures
T E X T
S T U D Y

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 TAX SYSTEMS AND POLICIES 183

6.13 Answers to QuIZ

Question One

Tax system: A tax system is an organised way in which the government collects tax from its
citizens. It involves the various approaches, structures and policies adopted over timeand relating
to taxation and revenue generation.
Tax policy: is the government's approach to taxation, both from the practical and normative
side of the equation. Policymakers debate the nature of the tax structure they plan to implement
(i.e., how progressive or regressive) and how they might affect individuals and businesses (i.e.,
tax incidence).
Tax reforms: These are changes or amendments of the tax system with the general objective of
revenue adequacy, economic efficiency, equity and fairness and simplicity

Question Two

T E X T
a. Raising revenue
b. Economic stability

S T U D Y
c. Protection policy
d. Social welfare
e. Fair distribution of income
f. Allocation of resources
g. Increase in employment

Question Three

The principles of an optimal tax system, what are known as Canons of taxation, some of which
were laid down by Adam Smith include:
Simplicity
A tax system should be simple enough to enable a taxpayer to understand it and be able to
compute his/her tax liability. A complex and difficult to understand tax system may produce a
low yield as it may discourage the taxpayer's willingness to declare income. It may also create
administrative difficulties leading to inefficiency. The simplest tax system is one with only a single
tax. However, this may not be equitable as some people will not pay tax.
Certainty
The tax should be formulated so that taxpayers are certain of how much they have to pay and
when. The tax should not be arbitrary. The government should have reasonable certainty about
the attainment of the objective(s) of that tax, the yield and the extent to which it can be evaded.
There should be readily available information if taxpayers need it.

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 184 A dvanced TA X AT I O N

Certainty is essential in tax planning. This involves appraising different business or investment
opportunities on the basis of the possible tax implications. It is also important in designing
remuneration packages. Employers seek to offer the most tax efficient remuneration packages
which would not be possible if uncertainty exists.
Convenience
The method and frequency of payment should be convenient to the taxpayer e.g. PAYE. This may
discourage tax evasion. For example, it may be difficult for many taxpayers to make a lumpsum
payment of tax at the year-end. For such taxes, the evasion ratio is quite high.
Economic/administrative efficiency
A good tax system should be capable of being administered efficiently. The system should
produce the highest possible yield at the lowest possible cost both to the tax authorities and the
taxpayer.
The tax system should ensure that the greatest possible proportion of taxes collected accrue to
the government as revenue.
Taxable capacity
This refers to the maximum tax which may be collected from a taxpayer without producing
undesirable effects on him. A good tax system ensures that people pay taxes to the extent they
can afford it. There are two aspects of taxable capacity.
T E X T

•• Absolute taxable capacity

•• Relative taxable capacity
S T U D Y

Absolute taxable capacity is measured in relation to the general economic conditions and
individual position e.g. the region, or industry to which the taxpayer belongs.
If an individual, having regard to his circumstances and the prevailing economic conditions
pays more tax than he should, his taxable capacity would have been exceeded in the absolute
sense.
Relative taxable capacity is measured by comparing the absolute taxable capacities of different
individuals or communities.
Neutrality
Neutrality is the measure of the extent to which a tax avoids distorting the workings of the market
mechanism. It should produce the minimum substitution effects. The allocation of goods and
services in a free market economy is achieved through the price mechanism. A neutral tax system
should not affect the taxpayer's choice of goods or services to be consumed.

Productivity
A tax should be productive in the sense that it should bring in large revenue which should be
adequate for the government. This does not mean overtaxing by the government. A single tax
which brings in large revenues is better than many taxes that bring in little revenue. For example
Value Added Tax was introduced since it would provide more revenue than Sales Tax.

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 TAX SYSTEMS AND POLICIES 185

Elasticity or buoyancy
By elasticity we mean that the government should be capable of varying (increasing or reducing)
rates of taxation in step with the circumstances in the economy, e.g. if the government requires
additional revenue, it should be able to increase the rates of taxation. Excise duty, for instance,
is imposed on a number of commodities locally manufactured and their rates can be increased in
order to raise more revenue. However, care must be taken not to charge increased rate of excise
duty from year to year because they might exert inflational pressures on the economy.

Flexibility
It means that there should be no rigidity in taxation i.e. the tax system can be changed to meet
the revenue requirement of the state; both the rate and structure of taxes should be capable
of change or being changed to reflect the state’s requirements. Such that certain old taxes
are discouraged while new ones are introduced. The entire tax structure should be capable of
change.

Diversity
It means that there should be variety or diversity in taxation. That the tax base should be wide
enough so as to raise adequate revenue and also the tax burden is evenly distributed among the
taxpayers. A single tax or a few taxes may not meet revenue requirements of the state. There
should be both direct and indirect taxes.

T E X T
Equity
A good tax system should be based on the ability to pay. Equity is about how the burden of
taxation is distributed. The tax system should be arranged so as to result in the minimum possible

S T U D Y
sacrifice. Through progressive taxation, those with high incomes pay a large amount of tax as
well as a regular proportion of their income as tax.

Question Four

•• Challenges faced by tax authorities in the process of modernising tax collection and
administration procedures
•• Technological limitations: The fact that many of the taxpayers do not have access to
Internet nor able to use new may hamper the tax authority’s attempts to modernise the
KRA administrative systems, for example, the electronic filing system
•• Complicated tax regime: Many taxpayers do not understand the tax system. They find
the taxes available in Kenya very complicated. This makes them not be able to comply
as required.
•• Financial constraints: Some of the systems involve substantial financial outlay.
•• Inadequate support from other government agencies.
•• Scope of the reforms: Some of the reforms have a very wide scope and as such they
may take a longer period before their impact is felt.
•• Political interference: Some of the proposed tax reforms have been affected by politics
of the day e.g the proposed taxation of Members of Parliament among others.
•• Evolving tax avoidance strategies: Some taxpayers have adopted well calculated and
complicated mechanisms of tax evasion. This has made the revenue authority ensure
that they under go continuous training to be on top of their game.
•• Lack of enough assessors (personnel) to ensure compliance: The revenue authority
does not have enough personnel to enforce the taxation laws and collect taxes.

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 186 A dvanced TA X AT I O N

•• Non tax paying culture: The payment of some taxes is dependent on the culture of the
taxpayers. For example, the payment of turnover tax will depend on the integrity of the
taxpayers to disclose the sales as required by law. If the taxpayers do not develop a
good tax paying culture, the attempts by the revenue authority to ensure high revenue
collection may not succeed.
•• Cumbersome dispute resolution mechanisms: It has been argued that the dispute
resolution mechanism available under the Kenyan tax laws has flaws which need to be
redressed.

6.14 Past Paper Analysis

The following isa list of questions in which the topic was tested in past exams. The questions are
listed in this format: Month/year e.g. 6/01 represents June or May 2001.
12/07 Q.4(b),

6.15 Revision Questions

T E X T

Question One
S T U D Y

a. Distinguish between single and multiple tax system

b. Explain four reasons why a country may prefer a multiple tax system over a single tax
system
(June 2008 Q. 1)

Question Two

Discuss why taxation policies of developing countries should be different from those of developed
countries.
(June 2008 Q. 5)

Question Three

a. Highlight the benefits of an effective tax policy to a developing country

(June 2006 Q.4(b))
b. As part of institutional reforms, of tax systems, governments usually establish advisory units
within tax departments such as Tax Policy Units (TPUs). What role do such TPU’s play in
Kenya.
(May 2002 Q.1(d))

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 TAX SYSTEMS AND POLICIES 187

Question Four

Revenue production of a tax system is measured through as buoyancy and elasticity.

(a) Distinguish buoyancy from elasticity of a tax. (4 marks)
(b) State and explain two methods that can be used to estimate tax elasticities. (6 marks)
(c) Explain the elasticity of taxes with reference to:
(i) Value Added Tax (VAT) (2 marks)
(ii) Income tax (2 marks)
(iii) Customs and excise duty. (2 marks)
(May 2002 Q. 1)

Question Five

List and briefly explain the various types of taxes that can comprise a multiple tax system in
Kenya. (10 marks)

T E X T
S T U D Y

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 188 A dvanced TA X AT I O N
T E X T
S T U D Y

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 PROFESSIONAL ETHICS IN TAXATION 189

CHAPTER SEVEN
ONE

T E TX ET X T
S T U D Y T E X T
S T SU TDUYD Y

PROFESSIONAL
ETHICS IN TAXATION

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T E X T
S T U D Y

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 PROFESSIONAL ETHICS IN TAXATION 191

CHAPTER SEVEN
PROFESSIONAL ETHICS IN TAXATION

7.1 Introduction

In the previous chapter we covered tax systems and policies in Kenya. In this topic we shall
lay emphasis on professional ethics in taxation. Tax systems are the background of a country’s
revenue collection basis. The chapter will assist the student understand the various types of tax
systems and be able to recommend a viable tax system based on International best practices. In
the next chapter we shall study professional ethics in taxation.

7.2 Objectives

The objective of this topic is to equip the student with ethical principles that will assist them
in their work place. The chapter discusses the form of tax practice and matters relating to the
accountant’s obligations to their clients and how to handle client work. The chapter discusses the

T E X T
various ethical regulations by the applicable accountancy bodies that go a long way in assisting
the accountants at work. After this chapter the students should have understood the following
concepts:
•• Form of tax practice and matters relating thereto Obligations to clients

S T U D Y
•• Confidentiality
•• Matters relating to new clients
•• Handling of client work
•• Charging for services
•• Matters giving rise to conflict of interest
•• Disclosures in tax returns, computations and correspondence with the Revenue
Authority
•• Dealing with the Revenue Authority
•• Moral and social issues in taxation

7.3 Exam Context

This is a new topic introduced during the review of the syllabus. Questions in this topic are likely to
be both theoretical and practical in nature. The examiner could test on candidates’ understanding
of the practical ethical issues at the work place as a tax consultant.

7.4 Industrial Context

This chapter will enable accountants and tax consultants acquire skills on how to manage their
tax practices, how to manage client work and charging for services. Further, they will understand
the ethical issues affecting their businesses and how to deal with the ever aggressive revenue

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 192 A dvanced TA X AT I O N

authority. There is an increasing focus in the industry on adherence to the professional ethical
standards hence the need for the importance of this topic.

7.5 Key Definitions

Ethics- Ethics may be defined as the science of the moral rectitude of human acts in accordance
with the first principles of natural reason. It is the moral standards by which people judge
behaviour.
Integrity- Is defined as:
•• the quality or state of being complete; unbroken condition; wholeness; entirety
•• the quality or state of being unimpaired; perfect condition; soundness
•• the quality or state of being of sound moral principle; uprightness, honesty, and
sincerity

7.6 Regulation

The Institute of Certified Public Accountants (ICPAK), like any other professional body, requires
its members to observe the highest professional standards in all aspects of their work. This
chapter discusses how these standards can be maintained, with particular reference to taxation.
T E X T

Members are also required to comply with statutory and regulatory requirements imposed by the
government.
ICPAK publishes a Code of Ethics and Conduct covering the standards and ethical requirements
S T U D Y

which they expect. It details the fundamental principles and sets out a framework for applying
those principles. Members must apply this framework to particular situations to identify instances
where compliance with the ethical standards may be compromised so that safeguards may be
put in place to avoid threats, or to reduce them to below the minimum level that can be regarded
as acceptable.
Normally a member's responsibility will be to a client, or to an employer, but there may be
instances where a member may need to act in the public interest.

7.7 Fundamental principles of Ethics

The fundamental principles that govern the ethical issues should be well observed by ICPAK
members as well as students. These include:

Integrity:
Requires all members to be straightforward and honest in professional and business relationships.
A member should not be associated with information if he believes that the information contains
a materially false or misleading statement, statements or information furnished recklessly, or
omits or obscures information required to be included where such omission or obscurity would
be misleading.

Objectivity:
Imposes an obligation on members not to compromise their professional or business judgement

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 PROFESSIONAL ETHICS IN TAXATION 193

because of bias, conflict of interest or the undue influence of others. Relationships that bias or
unduly influence the professional judgment of the member should be avoided.

Professional competence and due care:

Requires members to maintain professional knowledge and skill at the level required to ensure
that clients or employers receive competent professional service based on current developments
in practice, legislation and techniques; and act diligently in accordance with applicable technical
and professional standards when providing professional services
Any limitations relating to the service being provided must be made clear to clients and other
users to ensure that misinterpretation of facts or opinions does not take place.

Confidentiality
It imposes an obligation on members to refrain from:
7.7.1 Disclosing outside the firm confidential information acquired as a result of professional
and business relationships without proper and specific authority or unless there is a
legal or professional right or duty to disclose; and
7.7.23 Using confidential information acquired as a result of professional and business
relationships to their personal advantage or the advantage of third parties
A member should consider the need to maintain confidentiality of information within the firm. A
member should also maintain confidentiality of information disclosed by a prospective client or

T E X T
employer
The need to maintain confidentiality continues even after the end of relationships between a
member and a client or employer. When a member changes employment or acquires a new

S T U D Y
client, the member is entitled to use prior experience, but not confidential information obtained
from the previous relationship

Professional behaviour
Imposes an obligation on a member to comply with relevant laws and regulations and avoid any
action that may bring discredit to the profession.
This includes actions which a reasonable and informed third party, having knowledge of all
relevant information, would conclude negatively affects the good reputation of the profession.
Members should be honest and truthful and should not
i. Make exaggerated claims for the services they are able to offer, the qualifications they
possess, or experience they have gained
ii. Make disparaging references or unsubstantiated comparisons to the work of others.

7.7 Form of tax practice and matters relating thereto

In Kenya, to form a tax practice, one has to have the requisite qualifications. It can be a company
or a partnership. In most cases, firms that offer tax services also offer audit services under a
partnership.
Once the firm has been set up, the firm will hire qualified personnel and proceed with business.
The firm will take up clients in a professional way.

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7.8 Obligations to clients

It is advisable that the tax practice enters into a written contract with clients that provide specific
duties and rights under the contract. Some of the obligations that tax practices have to clients
include:
•• Agents for all tax matters
•• Agent for tax compliance matters
•• Agent for corporate tax matters
The firm should ensure that it meets its part of the bargain to avoid misunderstanding and
unnecessary litigation.

7.9 Confidentiality

Confidentiality as a principle does not only affect the members in provision of tax services. It also
affects the tax officers. The Income Tax Act provides that:
An officer and any other person in carrying out the provisions of this Act shall regard and deal with
all documents and information relating to the income of a person and all confidential instructions
in respect of the administration of the Income Tax Department which may come into possession
T E X T

or to his knowledge in the course of his duties as secret.

In the light of this statement, any tax officer or member of ICPAK should not disclose any
information regarding income of a person unless:
S T U D Y

•• The recipient is an officer or person so employed in the course of his duties, or to

a person authorised in that behalf by the Minister in relation to a person resident in
Kenya, or to a court or person for the purposes of this Act;
•• The recipient is in the service of the government, in the revenue and statistical
department and the information will be used solely for revenue or statistical purposes
(official purposes). The recipient should also have made a declaration of secrecy in
relation to information coming to his knowledge in the course of his official duties;
•• The recipient is an officer under the Higher Education Loans Board and he requires
the name and address of any person granted education loan where such information is
required for the performance of the Board’s official duties in recovery of the education
loans.

7.10 Matters relating to new clients

7.10.1 Acceptance of new clients

Members invited to act as tax advisers by clients must contact the existing tax advisers to
ascertain if there are any matters they should be aware of when deciding whether to accept the
appointment.
Before accepting a new client, members should consider whether acceptance of the client or the
particular engagement would create any threats to compliance with the fundamental principles.

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 PROFESSIONAL ETHICS IN TAXATION 195

Potential threats to integrity or professional behaviour may be created from, for example,
questionable issues associated with the client, or a threat to professional competence and due
care may be created if the engagement team does not possess the necessary skills to carry out
the engagement.
Where it is not possible to implement safeguards to reduce the threats to an acceptable level,
members should decline to enter into the relationship.

Changes in Professional Appointment

It is required that members who are asked to replace another accountant to ascertain whether
there are any professional or other reasons for not accepting the engagement. This may require
direct communication with the existing accountant to establish the facts and circumstances
behind the proposed change so that members can decide whether it is appropriate to accept the
engagement.
The main purpose of communication is to enable members to ensure that there has been no action
by the client which would on ethical grounds, prevent members from accepting the appointment
and that, after considering all the facts, the client is someone for whom members would wish to
act. Thus, members must always communicate with the existing accountant on being asked to
accept appointment for any recurring work.
The extent to which a client's affairs may be discussed with a prospective accountant will depend

T E X T
on the nature of the engagement and on whether the client's permission has been obtained. If
the client refuses permission, the existing accountant should inform the prospective accountant,
who should then inform the client that he is unable to accept the appointment.

S T U D Y
If the existing accountant fails to communicate with the prospective accountant despite the client's
permission, the prospective accountant will need to make other enquiries to ensure there are no
reasons not to accept the appointment. This could be through communications with third parties,
such as banks.
Where the member is the existing accountant then, subject to obtaining the client's permission,
he should disclose all information requested without delay.

7.11 Handling of client work

Clients’ work should be handled with care. This is to ensure quality in output and delivery of the
assignment.

7.12 Charging for services

The firm should have a policy for charging its clients. The fee would be dependent on time taken,
on the output or deliverables, on a contingency basis or any other basis. The fee charged should
be fair and uniform for its clients. ICPAK does not regulate its fees.

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Matters giving rise to conflict of interest

One should take reasonable steps to identify circumstances that could pose a conflict of interest.
These may give rise to threats to compliance with the fundamental principles. A conflict may arise
between the firm and the client or between two conflicting clients being managed by the same
firm. For example if the firm acts for its directors in their personal capacity.
A member may evaluate the threats by considering whether he has any business interests or
relationships with the client or a third party that could give rise to threats. When the evaluation
reveals some conflict of interest, some safeguard measures should be looked into.
The safeguards ordinarily include the member in public practice:
(a) Notifying the client of the firm's business interest or activities that may represent a
conflict of interest
(b) Notifying all known relevant parties that the member is acting for two or more parties in
respect of a matter where their respective interests are in conflict
(c) Notifying the client that the member does not act exclusively for any one client in the
provision of proposed services

The member should obtain the consent of the relevant parties to act in ways to avoid conflict of
interest.
T E X T

Where a member has requested consent from a client to act for another party (which may or may
not be an existing client) and that consent has been refused, then he must not continue to act for
one of the parties in the matter giving rise to the conflict of interest.
The following additional safeguards should also be considered:
S T U D Y

(a) The use of separate engagement teams

(b) Procedures to prevent access to information (e.g. strict physical separation of such
teams, confidential and secure data filing)
(c) Clear guidelines for members of the engagement team on issues of security and
confidentiality
(d) The use of confidentiality agreements signed by employees and partners of the firm
(e) Regular review of the application of safeguards by a senior individual not involved with
relevant client engagements.

Where a conflict of interest poses a threat to one or more of the fundamental principles that
cannot be eliminated or reduced to an acceptable level through the application of safeguards,
the member should conclude that it is not appropriate to accept a specific engagement or that
resignation from one or more conflicting engagements is required.

7.13 Disclosures in tax returns, computations and correspondence

with the Revenue Authority

When a taxpayer or a tax practice is completing returns or making a declaration for any goods
or remittance of revenue collected on behalf of the departments, she or he has an obligation to
ensure that the return and declarations represent full and true disclosure of the transactions for
the period covered. KRA may cross-check the information you provide.

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 PROFESSIONAL ETHICS IN TAXATION 197

The law provides for penalty for an incorrect return and/or prosecution in case of gross negligence
or fraud.
Taxpayers have an obligation to disclose and produce all relevant information, records and
documents required by KRA officials when carrying out their lawful duties. It is an offence to
refuse to give or to withhold information, records or documents. Penalties for this offence have
been prescribed under the various revenue Acts.

7.14 Dealing with the Revenue Authority

The work of a tax practice involves frequent correspondence with the Kenya Revenue Authority
officials. These may include requests to carry out audits or demand taxes from your clients. It is
important that you fully co-operate with the KRA.
You have an obligation to accord KRA officials co-operation, due respect and freedom to carry out
their lawful duties. You should not intimidate, abuse, threaten or influence them in any manner,
whether financial or otherwise.

7.15 Moral and social issues in taxation

T E X T
During the conduct of the tax practice many moral and ethical issues will arise, for example;
•• Should I advise my client to evade tax?
•• Should I overcharge my client?

S T U D Y
•• Should I collude with the revenue authority officials to defraud my client?
•• Should I engage in s to get favours from the KRA on behalf of my clients?
•• To the government; is it ethical for the government to collect revenue without using the
resources for development?
The tax practitioner should exhibit high standards of moral, ethical and social uprightness in the
discharge of his or her duties.

7.16 Chapter Summary

•• Principles governing ethical issues in taxation include: integrity, objectivity, professional

competence and due care, confidentiality, professional behaviour.
•• Members asked to take up new clients should consider communicating with existing
accountants so as to learn of any pending issues regarding tax and other relevant matters.
•• Conflict of interest is also an ethical issue. An accountant should evaluate whether his
appointment gives rise to any threats of conflict of interest. If it does, he should take necessary
measures to minimise the threats.

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7.17 Quiz

Question One

You have acted for Mr. X. but have discovered a serious tax irregularity which Mr. X has refused
to correct and you have advised Mr. X that you can no longer act for him. You receive a letter from
another ICPAK member advising you that he has been asked to act for Mr. X. Mr. X has forbidden
you from divulging any information to him. What should you do?

Question Two

You have acted for Maria Rosella Ltd for several years, and also for the three director shareholders,
Maria, Rose and Ella. During this year, Maria has a disagreement with Rose and Ella over the
direction of the company.
What should you do?
T E X T
S T U D Y

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 PROFESSIONAL ETHICS IN TAXATION 199

7.18 Answers to the Quiz

Question One

You should advise the new accountant that Mr. X has not given you permission to divulge any
information. The new accountant should then refuse to act for Mr. X.

Question Two

When you commenced acting for both the company and Maria, Rose and Ella, you should have
advised each that you were acting for the others, and asked their permission to act. Providing
there were no areas where the interests of the clients conflicted, there is no reason why you
should not have acted for all the clients, although it may be advisable to have ensured that, for
example, a different tax manager was responsible for each client.
However, now that there has been a disagreement between Maria and the other clients the situation

T E X T
has changed and there is a conflict of interest. It is most likely that it would be inappropriate to
continue to act for all the clients, and you will need to cease to act, either for Maria, or for Rose,
Ella and the company.

S T U D Y
7.19 Revision Questions

Question one

Can a member act for both a husband and wife?

Question two

What should you do if you suspect that a client may have taken a bribe from a customer?

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T E X T
S T U D Y

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 EMERGING TRENDS IN TAXATION 201

CHAPTER EIGHT
ONE

T E TX ET X T
S T U D Y T E X T
S T SU TDUYD Y

EMERGING TRENDS IN
TAXATION

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T E X T
S T U D Y

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 EMERGING TRENDS IN TAXATION 203

CHAPTER EIGHT
EMERGING TRENDS IN TAXATION

8.1 Objectives

At the end of this chapter, the student should be able to:

appreciate the emerging trends in the Kenyan taxation system
understand the various changes that have taken place in the Kenyan taxation system

8.2 Introduction

In the previous chapter, we dealt with professional ethics in taxation. In this chapter, we look at
emerging trends in the Kenyan taxation system. We will also look at various changes that have
taken place in the current budget that warrant to be mentioned. These changes may have been
pointed out in earlier chapters.

T E X T
8.3 Exam Context

S T U D Y
This area is new and has not been tested before. However, the students are expected to keep
abreast with changes in the taxation system. They can do this by ensuring that they know the
current year’s budget and be able to interpret various changes in the budget.

8.4 Industrial Context

Every year, the Finance Minister presents a budget as part of executing his obligation. The budget
normally includes some changes in taxation and allowances that are important in businesses.
The finance manager, tax consultant and owners of small businesses should be aware of these
changes to avoid applicable penalties.

8.5 Information, Communication and Technology

ETR: The first attempt by the Kenya Revenue Authority to incorporate technology in tax
administration is the introduction of the Electronic Tax Register (ETR). The main role of an ETR
is to improve VAT compliance and administration. Every person chargeable to VAT is supposed
to install an ETR machine and issue an ETR generated tax invoice.

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 204 A dvanced TA X AT I O N

KRA Website: The Kenya Revenue Authority has now gone electronic. The authority’s website
has many portals for access by the common citizen. For example, the authority gives employers
an option of filing returns online when the employees do not exceed 10,000. Taxpayers can
also download various forms that are needed to enable them to pay tax. Citizens can also apply
online for PIN numbers; file VAT returns, register for turnover tax among others.
Simba system: The Simba System is a Customs automated system that the Kenya Revenue
Authority introduced in an attempt to modernise customs operations. It enhances efficiency and tax
collection in the Customs and Excise department. Under the Simba System, Customs authorities
require one to be registered as a clearing agent in order to lodge documents electronically. The
system was introduced in 2005.

8.6 Taxes:

•• Personal taxes of the physically challenged persons: The minimum taxable income
for the physically challenged persons introduced and pegged at Kshs 150,000 per month.
Expenditure on healthcare services and facilities for physically challenged allowable
deduction up to Kshs. 50,000 per month.
•• Reduction of tax burden on senior citizens: The Minister of Finance reduced the tax
burden on senior citizens by increasing the exemption gap of monthly pension income from
Kshs. 15,000 to Kshs. 25,000 of monthly, i.e. the first Kshs 25,000 of monthly pension
T E X T

income is exempted from tax, from Kshs. 15,000 that was previously exempted.
•• For lumpsum withdrawals, the first Kshs. 600,000, up from Kshs. 480,000 withdrawals from
a registered pension or individual retirement fund is exempted from tax.
•• VAT: To fasten the withholding VAT claiming process, withholding agents are required to
S T U D Y

issue withholding VAT certificate at the point of payment. Previously, the agent was obligated
to furnish the supplier with “acknowledgement of the payment.”
•• Turnover Tax: Turnover tax of 3% has been introduced. It targets businesses with an
annual turnover of between Kshs. 500,000 and Kshs. 5,000,000. These include individuals
and partnerships. Turnover tax returns shall be submitted quarterly using a pay-in slip.
The regulations also say that the payments shall be made by the 20th day of the month
immediately following the end of the tax quarter.

8.7 Allowances:

•• Capital expenditure incurred in acquisition of an indefeasible right to use a fibre optic cable
by a telecommunication operator granted deduction of 5% per annum.
•• Allowance is granted at 25% per annum on cost of commercial buildings.
•• Telecommunication equipment has been granted specific allowance at 20% per annum on
cost.
•• Qualifying cost of machinery and buildings on investment deduction has been capped to
Kshs. 200 million. i.e. for buildings or machinery to qualify for investment deduction, their
cost must be Kshs. 200 million or more.
•• An investment deduction has been introduced on filming equipment. It has been granted at
100%.
•• A special incentive has been introduced for investment in the satellite towns adjoining
Nairobi, Mombasa or Kisumu at 150%. This is to decongest the three cities. It is also an
incentive to encourage regional growth.
•• Expenditure on computer software is allowable at 5% per annum.

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 EMERGING TRENDS IN TAXATION 205

8.8 Taxpayer Education

The Kenya Revenue Authority (KRA), in its quest to modernise the Kenyan tax system, is holding
seminars to sensitise the taxpayers on the importance of paying tax. The Kenya Revenue
Authority also creates awareness to the taxpayers on their rights and obligations, regarding tax
issues. The seminars are being held on a monthly basis.

8.9 Chapter Summary

•• The Kenya Revenue Authority is embracing information technology in its bid to improve tax
collection and to increase operational efficiency. Some of the ideas introduced include use
of an ETR, online filing of returns, the Simba system among others.
•• The 2009 Finance Bill introduced many changes in regard to capital allowances.

8.10 Quiz

T E X T
Question one

S T U D Y
Discuss the role of information technology development in taxation.

Question two

Discuss Turnover Tax as an emerging tax in the Kenyan tax system.

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 206 A dvanced TA X AT I O N

8.11 Quiz Answers

Question one

•• The first attempt by the Kenya Revenue Authority to incorporate information technology in
tax administration is the introduction of the Electronic Tax Register (ETR). The main role of
an ETR is to improve VAT compliance and administration. Every person chargeable to VAT
is supposed to install an ETR machine and issue an ETR generated tax invoice.
•• KRA Website: The Kenya Revenue Authority has gone electronic. The authority’s website has
many portals for access by the common citizen. For example, the authority gives employers
an option of filing returns online when the employees do not exceed 10,000. Taxpayers can
also download various forms that are needed to enable them to pay tax. Citizens can also
apply online for PIN numbers; file VAT returns, register for turnover taxamong others.
•• Simba System: The Simba System is a Customs automated system that the Kenya
Revenue Authority introduced in an attempt to modernise customs operations. It
enhances efficiency and tax collection in the Customs and Excise department.
T E X T

•• Under the Simba System, Customs authorities require one to be registered as a clearing
agent in order to lodge documents electronically. The system was introduced in 2005

Question two
S T U D Y

Turnover tax of 3% has been introduced. It targets businesses with an annual turnover of between
Kshs. 500,000 and Kshs. 5,000,000. These include individuals, partnerships, limited companies
and other legal persons. Turnover tax returns shall be submitted quarterly using a pay-in slip. The
regulations also say that the payments shall be made by the 20th day of the month immediately
following the end of the tax quarter.

8.12 Revision Questions

Question ONE

What are the factors that contribute to failure by revenue authority to achieve its tax targets
Dec 2008 Q 4

Question two

Discuss the objectives of the Customs Union.

Dec 2008 Q 2

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 EMERGING TRENDS IN TAXATION 207

Question three

Discuss the significance of the East African Community Customs Management Act
(2004) in the Kenyan context.

T E X T
S T U D Y

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 208 A dvanced TA X AT I O N

SELECTED CASES IN
TAXATION
Key to cases

LUMPSUMS
Beak v. Robson £7,000 not to compete with his company if he NOT TAXABLE.
ever left them
Duff v. Barlow £4,000 paid for relinquishing right to future NOT TAXABLE.
remuneration
Davis v. Harrison Professional footballers benefit TAXABLE.
Dale v. de £1,000 compensation for early termination of TAXABLE.
Soissons post: it in the contract
Henry v. Foster company’s articles provided for lump sum when TAXABLE.
a director ceased to hold office. Foster resigned
and got it.
T E X T

Hunter v. Dewhurst Dewhurst, about to retire agreed to remain on a NOT TAXABLE.

lower salary and also waived his right to the Lump
sum. He then received £10,000.
Hose v. Warwick £30,000 paid to relinquish old terms and a NOT
S T U D Y

personal connection on accepting managing TAXABLE.

directorship
Pudd v. Collins Secretary got £1,000 negotiating the sale of a TAXABLE.
branch.
Prendergast v £45,000 to stay on but with less time and smaller TAXABLE.
Cameron salary.
Radcliffe v Holt £2,000 gift voted by the shareholders because TAXABLE.
profit high
Reed v. Seymour Professional cricketer-benefit match. NOT TAXABLE.
Wales & Tilley £4,000 paid to (a) release company from a (a) NOT (b) -
pension obligation and (b)Tilley to continue at a TAXABLE.
reduced salary
Weston v. Hearn Voluntary payment after 25 years faithful service TAXABLE.
Cowan v. Seymour Shareholders voted a sum to the liquidator who NOT TAXABLE.
was formerly unpaid secretary.
BENEFITS

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 EMERGING TRENDS IN TAXATION 209

Parker v. Chapman Remuneration paid in the form of shares. TAXABLE.

Hartland v. Diggines Employer paid the tax on Hartland’s salary. TAXABLE.

Richardson v Lyon Employer paid the annual insurance premium. TAXABLE.

Ede v. Wilson Shares sold to manager at par market value higher. TAXABLE.
Weight v. Salmon Shares allotted to Managing Director at par market TAXABLE
value higher.
Nicoll v. Austin Coy Paid upkeep of managing director’s residence. TAXABLE.
Smyth v. Stretton Sum placed on credit under a provident scheme. TAXABLE.

EXPENSES
Friedson v. Glyn Faversham curate up Edmonton curacy. NOT TAXABLE.
Tom Removal expenses

Ricketts v House to office London barrister and N.A.

Colquhoum Recorder of Portsmouth.
Eagles v. Levy Court costs of suit to recover NA Airline pilot (a) cost
remuneration due to Managing Director of the Car upkeep for
of Ardath Ltd “house to airport” running
(b) cost of telephone. (a)

T E X T
+ (b)- N.A.
Nolder v. Walter (c) Excess hotel etc expenses as ( c ) – ALLOWABLE.
subsistence allowance not enough.
Dingley v. McNulty Director of a Benefit fund received one N.A.

S T U D Y
guinea per meeting,
Blackwell v. Mills Lab research student must attend N.A.
certain classes. Travelling and
textbooks.
Short v. Mclgorm Fee paid to an employment agency for NA.
getting a job.
Simpson v. Tate Country Managing Director’s N.A.
subscription to medical societies
membership not obligatory.

BEAK v. ROBSON
Robson entered into an agreement with his company to continue as director and manager for
five years at a fixed salary plus bonuses. By the last two clauses he covenanted for £7,000 not
to compete with the company if he left it.
Lawrence: The £7,000 comes not from having or exercising an office but from absence from
employment after the cessation of the office.
Lord Greene MR: Robson is selling to the company the benefit of a covenant which only come
into effect when the service is concluded. The £7,000 is not paid for performing the service in
respect of which he is chargeable under schedule E.

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COWAN v. SEYMOUR
Cowan acted as unpaid secretary of a company, and later as liquidator. After liquidation, there
remained a sum on hand which the shareholders (NB: Not the employer) voted unanimously to
the secretary and chairman. The resolution stated “... the late secretary be asked to accept a
moiety of such balance...” M.R. (It is)... more in the nature of a testimonial to him for what he had
done in the past whilst in office, which had then terminated.

Younger L.J: ... this was not a profit by reason of the office...but was really a gift by persons in
the position of beneficiaries who had appreciated and it may be, had benefited by, the personal
exertions of the holder of the office while he held it.
Held: That the sum voted by the shareholder did not accrue to him by reason of an officer or
employment of profit and was not chargeable.

DUFF v. BARLOW
Barlow was a director of a company manufacturing metal goods. A subsidiary company was
formed which supplied the parent with tinplate at cost. The responsibility for the venture fell
largely on Barlow, who was to be remunerated with a percentage of profits. These were much
larger than expected, so it was agreed that Barlow would receive, £500 remuneration for his
T E X T

services, the agreement to be cancelled and £4,000 compensation paid for the loss of his right to
future remuneration. He continued to be the Managing Director of the parent company.
Lawrence J: The question whether the sum was paid as compensation for loss of Barlow’s office
which, being a source of income was a capital asset or was a payment for future services in that
S T U D Y

office. As the agreement was determined there could rest upon him thereafter, no obligation to
perform his services and such services could not be any part of the consideration for payment
of that sum.
Held: That the sum was compensation for giving up a right to remuneration.

DAVIS v. HARRISON
Harrison was a professional with Everton F.C. The club agreed to pay £650 benefit if he was still
employed in 1925 i.e. the season following 10 completed seasons. In 1923, he was transferred,
but the football association agreed to Everton’s application to pay £650 accrued benefit.
Rowlatt J: The benefit seems to be ... simply a payment. It is not the result of direct subscription
by the public and indirect support to the fund by the public attending a match the gate money of
which goes to the professional (it is) ... simply a payment not only in view of his services but for
his services.
Held: That the payment was remuneration for services rendered.

DALE v. de SOISSONS
de Soissons was assistant to the MD of ballahers Ltd. His service contract was for, £3,000 salary
p.a. for 3 years. It provided however for the company to terminate it, if it wished after one year
on payment of “compensation for loss of office” of £10,000. This actually happened.
Raxburgh J: He got exactly what he was entitled to get under his contract of employment.

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 EMERGING TRENDS IN TAXATION 2 11

Sir R Evershed MR: The remuneration for the services took the form of ... (salary) ... plus a
further sum which he was contractually entitled to ...
Held: That the £10,000 was a compensation for losses of office. It was assessable.

HENRY v. FOSTER
Foster was a Company director. There was no contract of service but an article of the Company
provided that a lumpsum be paid to any director who ceased to hold office after at least five years
service. The so-called “compensation for loss of office” equalled the last 5 years salary. Foster
resigned and got the lumpsum.
Howarth MR: In substance ... this payment ... was made for services rendered. If related to
services rendered, it comes back to being a sum which is a profit...arising from the office.
Held: The payment constituted a profit of the office of director.

HUNTER & DEWHURST

Hunter was on the same terms in the same company. He wanted to retire but agreed to stay on at
a reduced salary and waiving his rights under the article. He received £10,000 as compensation
in lieu of the rights he waived.
Lord Atkin: The £10,000 was not paid for past remuneration for the condition of it to become
payable never was performed. It was not paid for future remuneration for that was expressed

T E X T
to be £250 p.a. It seems to me that a sum of money paid to obtain a release from a contingent
liability under a contract of employment, cannot be said to be received “under” the contract... and
is not received “from” the contract...
Held: In the circumstances of the case (House of Lords 3-2) the sum was not income assessable

S T U D Y
to tax.

HOSE v. MARWICK
Hose was an insurance broker who had built up an expensive personal connection. His company
received the benefit of this connection - though it remained his property - and his remuneration
was fixed partly by reference to it under an oral service agreement. He became the managing
director of the company. The terms included:
(a) That he sell his personal connection to the company.
(b) He surrender his old rights to remuneration.
(c) Not to engage in business on his own account.
(d) Not to compete when he finally left the company.
He received a lumpsum of £30,000.
Artkinson J: The £30,000 (was) a payment for giving up something. He gave up working on
and developing his personal connection and he gave up that connection to the company. The
£30,000 has nothing to do with his remuneration as managing director. I can see no conceivable
reason for not giving effect to what everybody must have known was the plain intention of the
parties.
Held: That the £30,000 was not remuneration for services rendered or to be rendered, but
compensation for the relinquishment by the appellant of his rights under his previous agreement
for service and his personal connection.

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MUDD v. COLLINS
Mudd was the paid secretary of a company. He negotiated the sale of a branch for which he
was given £1,000. He argued unsuccessfully that the negotiation was outside his duties and that
payment was a voluntary gift.
Row Catt: If an officer is willing to do something outside the duties of office... and his employer
gives him something in that respect, that is a profit, it becomes a profit of his office which is
enlarged a little so as to receive it.
Held: That the sum paid is chargeable to tax.

PRENDERGAST v. CAMERON
Cameron, a director, intimated that he wished to resign. The company wanted to continue using
his services. He agreed to carry on, but to devote less time to the business at a reduced salary,
on payment of £45,000.
Caldecote L.C: I can see no difference between a promise not to resign and a promise to
continue to serve the company.
Maugham: The sum was paid to induce him to continue to serve the company.
Raner: In consideration of the payment, the appellant agreed to continue to serve as a
director.
T E X T

Held: That the sum is assessable as a profit from the office of director.

RADCLIFFE v. HOLT
Holt was a company director. Because the years’ profits greatly exceeded that of the past years,
S T U D Y

they voted “a gift of £2,000 tax free... to the directors” in addition to their ordinary remuneration.
Held: That the payment was remuneration arising from Holt’s office and was assessable.

REED v. SEYMOUR
A cricket club, in the exercise of their absolute discretion, granted a benefit match to Seymour.
The proceeds together with certain public subscriptions were invested in the names of the
trustees of the club and the income therefore paid to Seymour. Subsequently, the investments
were released and paid over to Seymour.
Sargant L: We have to consider whether this (sum) comes to Seymour merely as a member
of the Kent County Eleven, or ...by way of a personal gift in recognition of the brilliance of his
performance in the past.
Viscount Care L.C: The terms of his employment did not entitle him to a benefit, though they
provide that if a benefit were granted, the club should have a voice in the application of the
proceeds, a benefit...is to express the gratitude of his employers and of the cricket loving public
for what he has already done, and their appreciation of his personal qualities. Just as those
(public) subscriptions which are the spontaneous gift of members of the public are plainly not
income or taxable as such, so the gate moneys taken at the benefit match which may be taken
as the contribution of the club to the subscription list are in the same category.
Held: That the proceeds of the benefit match was a personal gift and not assessable.

WALES v. TILLEY
A company agreed to pay Tilley £6,000 p.a. salary and when he ceased to be a managing director,

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 EMERGING TRENDS IN TAXATION 213

a pension of £4,000 p.a. for 10 years after cessation. A new agreement cancelled the obligation
to pay the pension, and reduced the salary to £2,000 p.a. for a consideration of £40,000.
Viscount Simon L.C: The £40,000 is paid in part as the price of compounding the pension, and
in part in consideration of the reduction of the salary. The ordinary way or remunerating ... a
person employed is to make payment to him periodically but I cannot think that such payment...
escape the quality of income ...because an arrangement is made to reduce for the future the
annual payments, while paying a lumpsum...to represent the difference. Whatever part of the
£40,000 is the equivalent of a drop in salary... of £4,000 p.a. is within the charge on profits from
the office of director.
Lord Porter: (The balance)...is a sum paid for the release of an obligation to provide a pension.
If so, it is admittedly not subject to tax.
Held: The portion paid in compromise of reduction if salary was assessable. (Prendegast v
Cameron followed); the portion representing capitalisation of pension was not assessable (Hunter
v Dewhurst followed).

WESTON v. HEARN
On completion of 25 years service, Weston was given £250, which he contended was a voluntary
payment of a voluntary nature.
McNaughton: (This sum) ...was a gratuity by way of a bonus after 25 years service.

T E X T
Held: That the sum was remuneration for services rendered.

PARKER v. CHARMAN
Parker was a director of a company on a salary and commission basis. His commission was

S T U D Y
credited to his account. In 1920 a dividend was proposed, together with an announcement of a
new share issue. Later, the price of the company’s trading commodity (sugar) fell from $125 to
£15 per ton. The company was reluctant to pay the dividend. They also realised that the share
issue would not be taken up. To support the credit of the company, Parker utilised his dividend
and his commission towards purchasing a large portion of the new issue.
Rowcatt: A company pays its debts in shares, (it is) ...applying the money which it owes its
creditor by the consent of the creditor in buying the company.
Lord Hanworth MR: This commission was a sum which Mr. Parker received and subsequently
appropriated to the benefit of the company.
Held: That the appellant was assessable on the full amount of remuneration credited to him.

HARTLAND v. DIGGINES
The company paid the tax charged on standard salary, though it entered into no agreement
verbal or written to do so.
Pollock MR: The salary paid to Hartland is not all he has received. He has received moneys
worth to the extent of the sum which has been paid in respect of that salary to the revenue.
Samtton L.J:Because the appellant is an employer of the company the company pays his tax
and that is clearly an employment relating to his office as accountant in the company.
Held: Tax liability, paid by the employer is assessable.

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RICHARDSON v. LYON
By agreement the company agreed to pay the annual premium on a policy on the life of the
employee.
Held: That the payments are part of the emoluments of his office.

EDE v. WILSON
Wilson was employed in a managerial capacity in a subsidiary company. He was given the
privilege of acquiring shares in the parent company at par value. He gave a verbal undertaking
that he would not sell such shares without the permission of the directors of the parent company
as long as he remained in the employment of the subsidiary.
Woottesley: He has received an advantage...that can be turned into money (the shares could
be sold).
Held: That Wilson was assessable on the privilege.

WEIGHT v. SALMON
Salmon was a managing director of a company and was entitled to a fixed salary under a service
agreement. By resolution, his “eminent and special services” were rewarded by giving him the
right to take up shares at par value. The market price was considerably higher.
Finlay J: The privilege was granted to a person exercising an office of profit and in respect of his
T E X T

successful exercise of that office of profit he has got a thing which...by ...selling can be turned
into money. It is a privilege, which in itself is not indeed, money, but moneys worth.
Held: that the privilege represented money’s worth and was assessable.
S T U D Y

NICOLSS v. AUSTIN
Austin who was a life governing director of a company entered into an agreement which provided,
interalia, that the company should bear the cost of upkeep of his residence. Austin had previously
intimated that due to the cost of upkeep, he might have to vacate his residence. The company
wished him to continue to reside there for the convenience and prestige of the business.
Finlay J: These sums... were moneys worth and therefore income of the respondent.
Held: That the sums paid are assessable as profit of his office as managing director.

SMYTH v. STRETTON
Stretton’s terms of service were altered. His salary was increased but the increase was placed
to his credit under the provident scheme. Of the sum due, no part was payable until Stratton left
his employment, and the moiety was contingent on length of service and good conduct.
Bhannel J: A sum receivable by way of salary or wages is not the less taxable because ...the
person who receives it has not got the full right to apply it just as he likes. (it is) ...a sum which
really has been added to the salary.
Held: That the sum is assessable.

CALVERT v. WAINWRIGHT
Wainwright was employed by a taxi hire company at a definite wage. The bargain made no
reference to tips.

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 EMERGING TRENDS IN TAXATION 215

Atkinson J: Tips received by a man as a reward for services rendered ...are assessable to tax.
Personal gifts, gifts to a man on personal grounds, irrespectively of and without regard to the
question of whether services have been rendered or not, are not assessable.
Held: That the tips having been given in ordinary way as remunerating for service rendered are
assessable.

COOPER v. BLAKISTON
An appeal was made by the Bishop and supported by the church wardens stating that it was the
privilege and the duty of the laity to augment the poor stipends of the clergy by personal freewill
gifts which an offer would be collected on Easter Sunday.
Lord Chancellor: Where a sum of money is given to an incumbent substantially in respect of
his services as an incumbent, it accrues to him by reason of his office. There was a continuity of
annual payments from any special occasion or purpose.
Lord Ashbourne: The whole machinery was, ecclesiastical-bishop, church wardens, church
collections-and I am able to see room for doubt that they are made for the vicar because he was
the vicar and became.part of the profits which accrued to him by reason of his office.
Held: That the Easter offerings were assessable.

HERBERT v. McQUADE

T E X T
Herbert was a person of a large parish, on a stipend of under £200 p.a. The Queen Victoria
Clergy Sustentation Fund made grants to him to augment his income.
M.R.: (This sum) ...comes to him only because he is the incumbent for the time being of
inadequately provided for parish.

S T U D Y
Held: That the sums paid were assessable.

Re: STRONG
Strong received (a) Xmas £100 as a gift from his congregation. There was no obligation to make
or repeat the gift. Marshall (Lord of the Exchequer) it is a voluntary contribution ...made to the
appellant payment (is) either a (Sch E) emolument ...or ...a gain
Held: That the sum was assessable.

TURNER v. CUXSON
A curate received a grant from a religious society, receivable annually on certain conditions, at
discretion. The grant is in recognition of faithful service as a clergyman but not the employer.
Colefidge (C.J.): The payment comes to him at the mere will of a charitable society which at its
own pleasure, pays him. The payment is made not for services in the parish, not by the persons
whom he serves, and not in respect of the particular services which he renders.
Held: That the sum is not assessable.

TRIVEDI v. C.I.T.
Trivedi, a Chartered Accountant, sold on commission a sisal estate for a client. A single and
solitary transaction - he had never sold property before, which is usually the business of an
estate agent.

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 216 A dvanced TA X AT I O N

Bacon J of a:...the word ‘business’-and especially when regarded in juxtaposition with the
expression “for whatever period of time ...carried on...” plainly covers a transaction such as the
appellants procurement of the sale of an industrial concern...
Held: That the commission received was gains or profits from a business associate.

FRIEDSON v. GLYTOM
Glyn Tom was a curate at Faversham. He left there to take up a curacy at Edmonton. He
claimed the expenses of removal.
Samkey J: There is all the difference in the world between an expense which you have to incur in
order to go to a place in order to take up your duties and an expense incurred in the performance
of your duties.
Held: That the deduction is not an allowable deduction.

RICKETTS v. COLQUHOUN
Ricketts was a barrister living and practising in London. He also held the office of Recorder
of Portsmouth. He claimed as a deduction from his emoluments as Recorder the travelling
expenses to Portsmouth and the hotel expenses whilst there.
Viscount Cave LC: (The expenses) ... are incurred not because the appellant holds the office of
Recorder, but because, living and practising away from Portsmouth, he must travel to that place
T E X T

before he can begin to perform his duties. They (the expenses) are incurred, partly before he
enters upon (the duties) and partly after he has fulfilled them.
Held: The expenses are not an allowable deduction.
S T U D Y

EAGLES v. LEVY
Levy had been chairman and managing director of a company. He started a high court action
for the recovery of the balance of remuneration which he claimed was due to him. On the
second day of the hearing, the action was settled without a court order. Counsel for the company
stated in court that “the sum is a comprehensive sum; there are no costs on either side in the
matter”. Levy claimed his expenses over £6,000 in making the action as a deduction from the
emoluments recovered.
Finlay J: This £45,000 p.a. did not, to any extent represent costs but on the contrary, was a sum
from which costs were excluded (following Ricketts v. Colquhoum) ...this was not a sum which
can be deductible.
Held: That the costs of the action were not necessarily incurred in the performance of his
duties.

NOLDER v. WALTERS
Walter was an airline pilot. He claimed as a deduction expenditure in respect of
a) The cost of upkeep of a car to convey him from his home to the aerodrome.
b) The cost of telephone.
c) The expense, over the subsistence allowance granted him when away from home to
duty.

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 EMERGING TRENDS IN TAXATION 217

Rowlatt J: In getting there, he is not doing the duties or doing the work of the office. (The
telephone) ...is a mere question of communicating with him with a view to him coming to the
office to do his duties, which begin when he gets there. He would be entitled to charge something
for the extra expense he is put to by having to spend...all of the day and often the night, away
from home, because that is part of his duty.
Held: (a) and (b) not allowable, (c) allowable.

DINGLEY v. McNULTY
Dingley was a director of a Benevolent Fund. He received one guinea per meeting and attended
74 meetings. An allowance of 25% was made for expenses and the rest assessed. Dingley
contended that the entire 74 guineas was an allowance for sums expended wholly exclusively
and necessarily in the performance of his duties. He provided the evidence of expenditure.
Held: That the sum paid was assessable as remuneration and that in the absence of detailed
evidence, the allowance made for expenses was adequate.

BLACKWELL v. MILLS
Mills was a student assistant in a research lab. As a condition of his employment, he was
required to attend classes to study for a Bsc. He was allowed time off without deduction of pay.
He claimed the cost of travelling to and from Chelsea Polytechnic and the cost of text books.
MacNaughton J: It seems to me impossible to say that when he was listening to the lecturer

T E X T
...he was performing the duties of a student assistant. The expenses permitted to be deducted
must be expenses incurred in the performance of the duties of the office.
Held: that the expenses claimed are not an allowable deduction.

S T U D Y
SHORT v. McILGORM
Short obtained employment through an employment agency to whom he paid a fee. He claimed
the fee was an expense incurred in performing the duties of the office.
Wrottesley J: ...the money expended in order to get the job was in no sense money spent in the
performance of the duties attached to the job.
Held: That the deductions claimed are not allowable.

SIMPSON v. TATE
Tate was a bounty Medical Officer. He belonged to certain professional societies, membership of
which was not a condition of his employment. He claimed the subscription as a deduction from
earnings.
Rowlatt J: He is qualifying himself so that he may continue to hold his office, just as he did qualify
himself before he got the office to enable him to perform it.
Held: That the deductions claimed are not allowable.

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 218 A dvanced TA X AT I O N
T E X T
S T U D Y

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 REVISION AID 219

CHAPTER NINE
ONE

T E TX ET X T
S T U D Y T E X T
S T SU TDUYD Y

REVISION AID

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 220 A dvanced TA X AT I O N
T E X T
S T U D Y

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 REVISION AID 221

CHAPTER NINE
REVISION AID

KASNEB SYLLABUS FOR ADVANCED TAXATION

SECTION 6

PAPER NO. 16 ADVANCED TAXATION

GENERAL OBJECTIVE

T E X T
To equip the candidate with advanced knowledge of current taxation practices as well
as the ability to solve practical taxation problems using relevant legislation

S T U D Y
SPECIFIC OBJECTIVES

1. A candidate who passes this paper should be able to:

2. Compute the tax liability of leasing entities, co-operative societies, trade associations,
trust bodies and other specialised entities
3. Explain the procedure for conducting a tax investigation
4. Explain the tax implications of cross border business activities
5. Identify the broad components of tax planning
6. Analyse various tax systems and policies
7. Identify ethical issues in the practice of taxation

CONTENT

Advanced aspects of the taxation of business income

•• Partnerships
•• Limited companies
•• Application of relevant case law

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 222 A dvanced TA X AT I O N

Taxation of specialised activities

•• Leasing entities
•• Co-operative societies
•• Trade associations and clubs
•• Charitable institutions
•• Trust bodies, settlements and estates under administration
•• Petroleum, banking, insurance, sea and air transport undertakings
•• Unit trusts
•• Property developers and contractors
•• Application of relevant case law

Tax investigation

•• Tax evasion, tax avoidance and fraud

•• Events which may trigger an investigation
•• Back duty and in-depth examinations
•• Methods of computing omitted and understated income
•• VAT refunds, false claims and accountant's certificate
•• Capital statements and ascertainment of income omitted or understated
•• Customs and excise investigations
T E X T

•• Negotiation for settlement

•• Tax audit
•• Application of relevant case law
S T U D Y

Taxation of cross border activities

•• Distinction between trading in and trading with a country

•• Double taxation agreements; theory, design and application
•• Regional perspective with reference to the East African Community (EAC) and the
Common Market for Eastern and Southern Africa (COMESA)
•• Most favoured nation status
•• Withholding tax provisions
•• Transfer pricing
•• Application of relevant case law

Tax Planning

•• Tax planning for individuals and companies

•• Employment versus self-employment
•• Identifying opportunities to alleviate, mitigate or defer the impact of direct or indirect
taxation
•• Remuneration packages
•• Corporate structure and dividend flows
•• Anti-avoidance provisions
•• Transfer of real properties
•• Pricing policy
•• Uses of tax incentives
•• Disposal of business operations and restructuring of activities

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 REVISION AID 223

Tax systems and policies

•• Types of tax systems

•• Role of taxation in economic development
•• Design of a tax policy
•• Criteria for evaluation of a tax system
•• Tax reforms and modernization of tax systems

Professional ethics in taxation

•• Form of tax practice and matters relating thereto

•• Obligations to clients
•• Confidentiality
•• Matters relating to new clients
•• Handling of client work
•• Charging for services
•• Matters giving rise to conflict of interest
•• Disclosures in tax returns, computations and correspondence with the Revenue
Authority
•• Dealing with the Revenue Authority
•• Moral and social issues in taxation

T E X T
Emerging trends in taxation

S T U D Y

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 224 A dvanced TA X AT I O N

Tax Rates

Individual rates

VALUE OF TAXABLE BENEFITS PRESCRIBED BY CIT (YEAR 2009)

Taxable Employment Benefits - Year 2009
RATES OF TAX (Including wife’s employment, self employment and professional income rates
of tax).
Year of income 2009
Taxable Employment Benefits - Year 2008/2009
Monthly taxable pay(shillings) Annual taxable pay (shillings) Rates of tax % in
each shilling
1 - 10,164 1 - 121,968 10%
10,165 - 19,740 121,969 - 236,880 15%
T E X T

19,741 - 29,316 236,881 - 351,792 20%

29,317 - 38,892 351,793 - 466,704 25%
Excess over - 38,892 Excess over - 466,704 30%
S T U D Y

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 REVISION AID 225

Personal relief Shs. 1,162 per month (Shs. 13,944 per annum)

Prescribed benefit rates of motor vehicles provided

by employer

Monthly A n n u a l
rates rates
(Sh.)
(Sh.)
Capital allowances: (i) Saloon, Hatch Backs
and Estates
Wear and tear allowances Upto - 1200 cc 3,600 43,200
Class I 37.5% 1201 - 1500 cc 4,200 50,400
Class II 30% 1501 - 1750 cc 5,800 69,600
Class III 25% 1751 - 2000 cc 7,200 86,400
Class IV 12.5% 2001 - 3000 cc 8,600 103,200
Industrial building allowance: Over - 3000 cc 14,400 172,800
   Industrial buildings 2.5% (ii) Pick-ups, Panel Van
(Unconverted)
   Hotels
2006 4.0%

T E X T
2007 to date 10%
Farm works Upto 1750 cc 3,600 43,200
allowance
2006 33%

S T U D Y
2007 to date 50%
Investment deduction allowance: Over 1750 cc 4,200 50,400
   2003          - 70% (iii) Land Rovers/ 7,200 86,400
Cruisers
   2004          - 100% OR 2% of the initial capital cost of the vehicle for
each month, whichever is higher.
   2006 to date 100%
Shipping investment deduction 40%
Mining allowance:
Year 1 40%
Year 2 – 7 10%

Commissioner’s prescribed benefit rates

Services Monthly rates              Annual rates
                                                                                                Sh.                               Sh.
(i)       Electricity (Communal or from a generator) 1,500 18,000
(ii)       Water (Communal or from a borehole) 500 6,000
(iii)      Provision of furniture (1% of cost to employer)
           If hired, the cost of hire should be brought to charge
(iv)      Telephone (Landline and mobile phones) 30% of bills

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 226 A dvanced TA X AT I O N

Agricultural employees: Reduced rates of benefits

(i) Water 200 2,400
(ii) Electricity 900 10,800

Low interest rate employment benefit:

The benefit is the difference between the interest charged by the employer and the prescribed
rate of interest.
Other benefits:
Other benefits, for example servants, security, staff meals etc are taxable at the higher of fair
market value and actual cost to employer.
T E X T
S T U D Y

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 REVISION AID 227

T E X T
S T U D Y

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 228 A dvanced TA X AT I O N
T E X T
S T U D Y

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 229

CHAPTER ONE

T E TX ET X T
S T U D Y T E X T
S T SU TDUYD Y

SUGGESTED
SOULTIONS

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 230 A dvanced TA X AT I O N
T E X T
S T U D Y

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 231

MODEL ANSWERS TO
REVISION/
EXAM QUESTIONS
Chapter One

Question One

a. The following considerations should be made in case of a branch or a subsidiary:

Branch Subsidiary
Residency Non resident for tax purposes Resident for tax purposes
Tax rate 37.5% 30%
Deductibility of Expenses of interest, royalties Expenses incurred wholly and
expenses and management or professional exclusively in generation of income

T E X T
fees paid to head office are not are allowable except for those
allowable expenses in deriving specifically disallowable.
taxable income.
Expenditure incurred by the

S T U D Y
branch outside Kenya is only
allowable/deductible to the extent
the Commissioner of Domestic
Taxes (CDT) may consider

W i t h h o l d i n g No WHT tax applies WHT tax will apply to payments to

tax rates both residents and non residents

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 232 A dvanced TA X AT I O N

b.
Mazuri Ltd
Adjusted taxable income for year ended 31/12/07
Kshs. Kshs Kshs
Reported accounting Net Profits 6,306
Add back disallowable expenses – preparing 150
M.O.A
- Fees for land purchase 60
- Bank loans 20
Bad debts – Loan to director 200
- General bad debts 120
Advertising – Neon sign 100
Travelling expenses private = 20% x 180 36
Goodwill amortisation 25
Donations to trade association 40
Cost of goods withdrawn 600
Depreciation 150 1,501
Less allowable/deductible items
Capital allowances 200
T E X T

Sales to directors 720

400
Overstated closing stock = 2400 - 2400
1.20
S T U D Y

Gain on sale of equipments 120

Interest on savings account 40
Refund of import duty 80 (1,569)
6,238

•• Assumed foreign exchange gain realised hence taxable

•• Golden handshake is for services rendered in the past, present or could have rendered
in future hence allowable

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 233

ii) Tax payable – 6,238,000 x 30% = 1,871,100

Question Two

(a) Christine Atieno and Rose Njeri Partnership

Taxable profit (loss)
For the year ended 31.12.2007
Kshs. Kshs
Income
Professional fees 8,200,000

Allowable deductions/expenses
Business mileage allowance Atieno
360,000
Njeri
300,000
Mobile airtime official Atieno
36,000
Njeri
36,000
Staff
24,000
Office tea and snacks

T E X T
60,000
Advertisement commission 200,000
Salaries to staff 436,000
Contribution to staff retirement benefit 120,000

S T U D Y
plan
Contribution to medical scheme staff 150,000
Red cross society of Kenya 60,000
Tax consultancy fees 35,000
Subscriptions to law society of Kenya 40,000
Training fee staff 80,000
Motor vehicle insurance 30,000
Office expenses 100,000
Capital allowance (Note 1)
Class II 51,600
III 625,000
IV 44,000 (2,787,600)
Taxable profit 5,412,400

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 234 A dvanced TA X AT I O N

Note 1: Wear and Tear Allowance Schedule

Class I Class II Class III Class IV
(37.5%) (30%) (25%) (12.5%)
WDV b/f
Additions
Motor vehicle 2,500,000
Furniture and fittings 280,000
Computer and printers 120,000
Telephone and fax 40,000
Reference books 16,000
Kitchen utensils 3,000
Television set 12,000
Fans 6,000
Carpets 22,000
Safe ________ ________ __________ 25,000
- 172,000 2,500,000 352,000
WTA (51,600) (625,000) (44,000)
WDV c/f 120,400 1,875,000 308,000

Allocation/ division of the partnership profit/loss to partners

T E X T

ATIENO ROSE TOTAL

Kshs Kshs Kshs
Partner's salaries 600,000 400,000 1,000,000
S T U D Y

Contribution to pension fund 108,000 72,000 180,000

Contribution to medical scheme 168,000 112,000 280,000
Premium on insurance polices 84,000 126,000 210,000
Golf club membership 30,000 20,000 50,000
Interest on capital 100,000 150,000 250,000
Training; partner’s children’s
fees 56,000 84,000 140,000
Share of Profit (3:2) 2,430,240 1,620,160 4,050,400
     
3,576,240 2,584,160 6,160,400

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 235

(c)

Computation of tax payable by each partner

For the year ended 31 December 2007
ATIENO ROSE
Kshs Kshs
Taxable profit 3,576,240 2,584,160
Less: pension contribution (108,000) (72,000)
3,468,240 2,512,160

Tax thereon
121,968 121,968 10% 12,197 12,197
236,880 114,912 15% 17,237 17,237
351,792 114,912 20% 22,982 22,982
466,704 114,912 25% 28,728 28,728
Excess over 30% 900,461 613,637
Gross Tax Liability 981,605 694,781
Personal
Less Relief (13,944) (13,944)
Insurance

T E X T
relief (18,900) (12,600)
Net Tax Liability 948,761 668,237

S T U D Y

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 236 A dvanced TA X AT I O N

Question Three

Starlit Company Ltd.

2005 Computation of Investment deduction
part a (i)
Investment Deduction Allowance

Item Qualifying cost Workings ID @70% Residue

IB 17,988,166 W1a 12,591,716 5,396,449.70

Processing
machinery 26,000,000 W1b 18,200,000 7,800,000.00
   
30,791,716 13,196,449.70
ID for 2003=Kshs 43,988,165.65
Working 1a
To determine the cost of IB as at 1 Jan
2003
T E X T

Item Cost IBD @2.5% WDV

2003 Industrial Building 17,988,166 449,704 17,538,462
2004 Industrial Building 17,538,462 438,462 17,100,000
 
S T U D Y

888,166
Working 1b
Wear and Tear allowance
Class 4
Cost @12.5% WDV
2003 Processing machinery 26,000,000 3,250,000 22,750,000
2004 22,750,000 2,843,750 19,906,250
 
Part a(ii) 6,093,750

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 237

(b) 2005 Computation of adjusted profit (loss)

Starlit Company Limited
Computation of Adjusted Taxable profit/loss
For 2005 year of income
Kshs'000 Kshs'000
Net profit before tax per the accounts 4,500
Add
Add back disallowable expenses
Depreciation 7500
Conveyance fees on purchase of land 2,000
Understated sales(100/90x2100)-21000 233 9,733
14,233
Less
Capital allowances Notes (2,696)
Adjusted Taxable Profit 11,537

Notes

•• Flotation costs and stamp duty costs on issue of debentures is allowable by virtue
of Section 15(s) as expenditure incurred in relation to issue of shares to the general
public.

T E X T
•• Foreign exchange losses have been assumed to be realised. Further the company
is not thinly capitalised and as such, the exchange losses will not be deferred as per
Section 4A of the Income Tax Act.

S T U D Y
•• The sales to the parent company at 10% below the normal selling price has a transfer
pricing exposure. The sales figure has been adjusted accordingly

NB: (3) Wear and tear allowances

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 238 A dvanced TA X AT I O N

Wear and Tear Allowance schedule

2003 Class 1 Class 2 Class 3 Class 4 Total

37.50% 30% 25% 12.50%
Computers 900,000 900,000
Processing machinery 7,800,000 7,800,000
Office partitions 400,000 400,000
Lorries 4,500,000 4,500,000
Delivery Van 3,600,000 3,600,000
Pick ups 2,500,000 2,500,000
Furniture & fittings 600,000 600,000
Office equipment 800,000 800,000
         
WDV as at 1.1.2003 4,500,000 900,000 6,100,000 9,600,000 21,100,000
WTA (1,687,500) (270,000) (1,525,000) (1,200,000) (4,682,500)
WDV as at 1.1.2004 2,812,500 630,000 4,575,000 8,400,000 16,417,500
WTA (1,054,688) (189,000) (1,143,750) (1,050,000) (3,437,438)
WDV as at 1.1.2005 1,757,813 441,000 3,431,250 7,350,000 12,980,063
WTA (659,180) (132,300) (857,813) (918,750) (2,568,042)
T E X T

        0
WDV as at 31 Dec 2005 1,098,633 308,700 2,573,438 6,431,250 10,412,020
S T U D Y

Wear and Tear allowance- Kshs 2,568,042

Question Four

a. Provisions of the Income Tax Act (cap 470) relating to shortfall tax on non-distribution of
dividends
Where the commissioner is of the opinion that a company has not distributed to its shareholders
as dividends within a reasonable period, not exceeding twelve months, after the end of its
accounting period that part of its income for that period which could be so distributed without
prejudice to the requirements of the company’s business, he may direct that, that part of the
income of the company shall be treated for the purposes of this Act as having been distributed as
a dividend to the shareholders in accordance with their respective interests and shall be deemed
to have been paid on a date twelve months after the end of that accounting period – Section
24(1).

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 239

For example if the adjusted income for tax for Jitahidi Company Ltd for year of income 2005 was
Kshs.20 million and dividend declared was Kshs.2 million then the shortfall distribution would be
arrived at as follows:
JITAHIDI COMPANY LTD
DIVIDEND DISTRIBUTION SHORTFALL
Kshs ‘000
Adjusted income for tax 20,000
Corporation tax @ 30% (6,000)
Profit after tax 14,000
Allowable retention @ 60% (8,400)
Distributable as dividend 5,600
Less actual distribution (2,000)
Shortfall distribution of dividends 3,600

The commissioner can direct Jitahidi Company Ltd to distribute the Kshs 3.6 million dividend
shortfall to the shareholders and deduct withholding tax thereof accordingly.
Note that a company is allowed to retain 60% of its after tax profits and to distribute 40% as
dividend from which the commissioner receives a withholding tax. Note also that a company may
be allowed to retain more than 60% of after tax profits where it proves the following:-

T E X T
Company’s liquidity position is poor;
Company has entered into heavy capital and development commitments requiring payments of
huge sums;

S T U D Y
That the directors do not owe any monies to the company; and
That the shareholders have paid up their Share Capital

b.
SHORTFALL CALCULATION
Types of income Operating Investment Rental Total
income inc. income
Kshs. Kshs. Kshs. Kshs.
NET INCOME 12,000,000 550,000 1,600,000 14,250,000
Less corporation tax @ (3,600,000) (195,000) (480,000) (4,275,000)
30%
Income after tax 8,400,000 355,000 1,120,000 9,975,000

Less allowable retention (5,040,000) - 5,040,000

60%
3,360,000 355,000 1,120,000 4,835,000

Less dividend distributed (1,300,000)

SHORTFALL 3,535,000

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 240 A dvanced TA X AT I O N

Question Five

a. “Compensating tax” as per section 7A of the Income 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 paid.

b.
ABC LTD
COMPENSATING TAX PAYABLE FOR YEAR TO 31 DECEMBER 2007
DIVIDEND TAX ACCOUNT
Kshs Kshs ‘000
‘000
Import duty refunds 400 Dividend received (.3/.7 x 3,000) 1,285.714
Dividend paid (.3/.7 x 8,800) 3,771.429 Tax paid NIL
______- Compensating tax 2,885.715
4,171.429 4,171.429

Note
T E X T

Tax for year 2007 has not yet been paid by year end. Neither is there a tax payment relating to
year 2006 tax liability.
S T U D Y

c) Four areas which may constitute a customs area are:

•• Airport
•• Seaport
•• Customs bonded warehouse
•• Internal Inland Container depot etc

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 241

d)
D. MKASANA
TOTAL TAXABLE INCOME FOR THE YEAR TO 31 DECEMBER 2006

Tax at source
Kshs ‘000’ Kshs ‘000’
Employment
Basic pay (250,000 x 12) 3,000 (50,000 x 12) 600
Medical bill (Director 1,300
other than whole time
service
Share issue (80 – 50) 30
1,000
Free lunch & tea 96

Rental income: Kshs ‘000

Net rental income 724

T E X T
reported
Add back:
Purchase of furniture & 100

S T U D Y
fittings
Painting before letting 96
920
Less WTA on furniture (12.5) 907.5
(12½% x 100)

Business income: Kshs ‘000

Sales 8,000
Less: Pesticides (180)
Forex losses (64)
Other farm expenses (1,200)
Farmworks (240 x 33 (80) 6,476
1/3%) (sheds)
11,809.5

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 242 A dvanced TA X AT I O N

Notes
Structural alterations to premises has been allowed since no rent increase resulted therefrom.
Deposit for water connection is part of overall water expenses hence allowable.
Legal fees on collection of rent in arrears is normal revenue expense in a continuous process of
rent collection hence allowable.

Chapter Two

Question one - Lease hire arrangements

A lease is classified as a finance lease if it transfers substantially all the risks and rewards
incident to ownership. All other leases are classified as operating leases. Classification is made
at the inception of the lease.
Any income derived from leasing activities is taxable at the corporate tax rate for companies
while individuals are taxed at the graduated scale rates.

Corporation tax on lease hire arrangements

T E X T

Whereas the leasing rules have defined the operating and finance leases, there is no distinction
between the two categories of leasing for corporate tax purposes. However, this distinction exists
for Value Added Tax (VAT) purposes.
S T U D Y

Lease rentals are allowable expenses for corporate tax purposes. if the Commissioner is satisfied
that:
a. The sole consideration for the payment is the use of or the right to use the asset; and
b. The entire payment is income in the hands of the recipient.

However, lease-hire payments in respect of a non-commercial vehicle are not deductible

Related costs such as maintenance are allowable expenses for tax purposes.
The lessee is entitled to claim VAT on expenses incurred on the leased asset.
The lessor enjoys wear and tear allowance deductions as long as the equipment was utilized
wholly and exclusively for generation of taxable income
The lessor enjoys investment allowance and which is deducted from his profits in the same tax
year in which the investment is made. The deduction is made at a rate of 100% of the cost of
investing in machinery and buildings provided these are used for the purpose of manufacturing.

Withholding tax of lease hire arrangements

The lessee should withhold tax at a rate of 3% on any payment made to the lessor in relation to
payment of lease rentals. In case the lessor is a non-resident, tax is withheld at a rate of 15%.
Effective 1 July 2003, lease rental payment in relation to aircrafts is exempted from withholding
taxes

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 243

Taxation of lease rentals

Finance Lease: Eventual ownership of the leased asset passes to lessee upon payment of 75%
of cost.
Operating Lease: Ownership remains with lessor throughout the entire lease agreement.
Leasing is included in the definition of supply as “The letting of taxable goods on hire, leasing
or other transfers”, which supply is taxable. It is worth noting that it is only leasing of taxable
goods.
Leasing is considered as a service, and lease instalments, being payments for this service, are
subject to VAT. If equipment that is the subject of a lease is either exempted from VAT or attracts
zero VAT, then the lease payments are similarly exempted from VAT.
Leasing of land, residential buildings, and non-residential buildings are exempted from VAT. This
exemption does not apply with respect to car park services, conference or exhibition services.

Question two

(a) `(i) Taxation of petroleum companies and their sub-contractors. ( Ninth Schedule Income
Tax Act)
- Favourable rates of tax on management or professional fees and interest paid to

T E X T
non-residents by such companies.
- Generous terms with regard to allowable deductions for tax purposes.
- Non-resident contractors will be deemed to have made a taxable profit of 15%
of the sum paid to them by a petroleum company (exclusive of certain defined

S T U D Y
expenses, and the tax on this is deducted when payment is made.
- The firms are taxed at 30% corporate tax rate.

(ii) Enterprises situated in export processing zones (EPZs)

- For the first 10 years, from the date of commencement of business:
(a) Payments to the EPZ will be subject to withholding tax at non-resident rate
(b) Payment by the EPZ to non-resident persons will be exempt from tax
(c) The EPZ will be exempt from corporate tax.
- For the period of 10 years commencing immediately after its initial 10-year
commencing immediately after its initial 10-year period the EPZ will be subject to
corporation tax at the rate of 25%.
- Thereafter 20 year, CT is 30%.
- Employees and directors of EPZ if resident are liable to tax and deduction of PAYE
in the normal way.
Exports are zero rated for V.A.T purposes.
- Investment allowance is granted at 100% on cost of qualifying building and
machinery and is claimed on the 11th year after commencement.

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 244 A dvanced TA X AT I O N

Question three

a) LINDA INSURANCE COMPANY LTD

i) TAXABLE INCOME OR LOSS FOR YEAR OF INCOME 2006

Nature of business: General Life 

Kshs Kshs Kshs Kshs ‘000
‘000 ‘000’ ‘000 Kshs ‘000
Premiums received 15,450
Commission and management fees - 13,600
Premiums returned and interest (770) (-)
charged on returns
Net premiums received 14,680 13,600
Add: Re-insurance Commission 1,360 3,450
Income from subrogation rights 1,250 1,800
Recoveries from re-insurance 150 180
Income from insurance business 17,440 19,030
Less allowable expenses:
Premiums paid to re-insurance 4,680 12,000
Agency expenses 1,350 1,960
Management expense (1,934 – 456) 1,478 2,456
T E X T

Travel 1,800 2,400

Advertising 364 820
General expenses (8,490 – 2,060) 6,430 (4,640 – 1,580)
3,060
S T U D Y

Bad debts (Specific) 368 240

Interest paid out of
Annuity paid on surrender of policies - 23,670
Wear & Tear allowances 397.5 323.5
GENERAL LIFE
Claims paid 7,600 6,900
Less outstanding at beginning (5,640) (3,460)
Add outstanding at end 6,200 2,880
Reserves at year end 1,760 5,370
Less at beginning (3,240) (23,547.5) (4,340) (54,279.5)
Profit for insurance business (6,107.5) 51,650.5
Rent income (13,780 – 3,780) 10,000 (16,400 -
5,200) 11,200
3,892.5 62,850.5

Kshs
‘000
Total income for the year (3,892.5 + 66,743
62,850.5)

ii) Tax payable @ 30% = (66,743,000 x .3) = Kshs.20,022,900

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 245

Question four

Taxation of charitable trusts

Income of a charitable trust is exempted from tax if:
•• It is public in character
•• It is established for relief of distress or poverty to the public.
•• It is established to advance religion or education.
•• Its total income is used or spent on charitable purposes.

If a charitable trust runs a business then profits thereof are not taxed if proceeds are used for
purposes 2 and 3 above.

Taxation of amateur sporting associations

The income other than income from investment of an amateur sporting association is not
taxable.
The conditions for the associations income to be exempted from tax include:
- Its sole or main objective is to foster or control outdoor sporting activities;
- Its members consist of amateurs and non professionals;

T E X T
- Its memorandum of association and articles state that should any member turn
professional he shall be discontinued from membership.
(3 marks)

S T U D Y
Question five

(a) (i) Ukulima Sacco

Taxable Income for the year 2007
Sh.
Rental Income (100% of 2,252,500) 2,252,500
Dividend Income (50% of 424,000) 212,000
Interest Income (50% of 747,300) 373,650
Taxable income 2,838,150

Tax payable
30% of 2,838,150 = Sh. 851,445

(ii) Information not used

Interest from loans to members – This is not taxable
Expenses – These are ignored since income is assessed gross.
(b) Basic principles of taxing co-operatives
•• Taxed on incomes from independent activities e.g rent
•• The basic notion underlying the new code of taxation is that a co-operative society
is a body corporate having its own existence, separate from that of its members. A

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 246 A dvanced TA X AT I O N

co-operative society is, therefore, deemed to have its own income, regardless of the
consideration that some of that income may be derived from transactions with its own
members. The current law sanctions the deduction from the income of the co-operative
society appropriations to profit made by it from its members. ( only 50% of interest is
taxed)
•• Corporate rate = 30%
•• Tax on gross investment income
•• A different basis of taxation has been laid down for credit and savings societies. These
societies will be liable to tax generally on only their gross investment income that is on
interest and dividends derived from normal investment of surpluses.
•• Expenses not from incomes deducted.

Interest income deducted from members loans not taxable.

T E X T
S T U D Y

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 247

Chapter Three

Question one

(a)
Saambaya & Associates
Certified Public Accountants
P.O. Box X2222
Nairobi

December 5th, 2007

Client
P O Box 59857
Nairobi

Dear Sir,

T E X T
Re: Back Duty Investigation

The following write-up is in response to queries raised by you with respect to the above subject
matter.

S T U D Y
(i) The obligation to declare all incomes for tax purposes rests with the person liable to pay tax
(taxpayer) whether or not he has been specifically told to do so by the Income Tax Department.
Yours is a case of under declaration of income for a number of years and the following information
may have been received by the assessor regarding your affairs:
Reference was made to your PIN (personal Identification Number) records and this may have
revealed discontinued disclosure of incomes from certain sources;
You may have consistently done business promotions through the public media regarding a
business line but have consistently not declared any income from such source;
You did register a business at the Registrar General’s office but have not made return of such
income.
You may have been in receipt of farming income from a farming organization and such information
has landed in the assessors hands through informers.
(ii) The Income Tax department may take into consideration the following circumstances of your
case in accepting a payment of less than the full amount due:
The assistance (co-operation) you give to the revenue officials in arriving at the income under-
declared;
The degree of deliberation in carrying out the fraud or omission/motive for false declarations.
Whether or not payment of additional tax arrived at in the back duty investigation will cripple your
business financial position.
Defaulters circumstances during period of omissions such as age and health and whether or not
a voluntary declaration had been made by the tax payer.

Yours faithfully,

Michael Odutu
Partner

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 248 A dvanced TA X AT I O N

(b) Sophia (client)

(i) Capital Statements

Year of income 2004 2005 2006 2007

Kshs Kshs Kshs Kshs
’000’ ’000’ ’000’ ’000’
Net assets: 16.3 33.02 44.585
Beginning 5.5 33.02 44.585 57.272
End year 16.3 16.72 11.565 12.687
10.8 5.2 6.24 9.8
Add: Personal 3.14 0.12 0.525 2.42
drawings
0.105 2.00 12 -
Tax & National
___- (7) (7) (7)
Insurance
7.555 17.04 23.33 17.907
Cash gifts
Deduct: Legacy
T E X T

(ii) Factors the assessor will take into account in negotiating penalties and interest charges
•• Gross or willful negligence on the part of the tax payer or his accountant;
S T U D Y

•• Fraud on part of taxpayer

•• Number of years involved (year of non/under declaration)
•• Level of co-operation from the taxpayer under investigation
•• Whether or not a quasi voluntary declaration was made by the taxpayer.
•• Motive of non-declaration of income
•• Whether such payment of additional tax plus penalties and interest charges will affect
adversely the taxpayers financial position.

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 249

Question two

b) i)
Mr. DICKSON MAELFU
TAXABLE INCOME FOR EACH OF THE FOUR YEARS TO 31 DECEMBER
2004, 2005, 2006 AND 2007
YEAR 2004 2005 2006 2007
Kshs Kshs Kshs Kshs ‘000
‘000’ ‘000 ‘000
ASSETS
Factory building 48,000 48,000 52,000 54,000
Plant & Machinery 28,000 36,000 36,000 38,000
Commercial Vehicles 12,000 12,000 15,000 18,000
Stock in trade 4,200 8,000 9,000 7,000
Trade debtors 3,540 2,640 2,530 2,980
Private residence 13,600 13,600 13,600 13,600
Bank balance 5,400 3,600 3,760 4,670
Total Assets 114,740 123,840 131,890 138,250

T E X T
LIABILITIES
Trade Creditors 8,640 9,420 8,360 7,890
Bank loan 10,000 9,870 7,640 9,840

S T U D Y
Loan from Uncle 700 600 870 640
Mortgage loan 3,780 3,780 3,780 3,780
(23,120) (23,670) (20,650) (22,150)
Net worth 91,620 100,170 111,240 116,100
Less: Net Assets at beginning of Year (65,440) (96,720) (106,950) (117,070)
Increase in Networth 26,180 3,450 4,290 (970)
Increase in Networth b/d 26,180 3,450 4,290 (970)
Adjustments
Inheritance from relative - (400) - -
Living expenses 70 120 90 150
Interest on mortgages (150) (150) (150) (150)
Estimate taxable income 26,100 3,020 4,230 (970)

iii) Four areas for further clarification from Mr. Maelfu

Bank loan – The purpose for the bank loan whether for business or private purposes
and what is the interest rate to determine its allowability.
Loan from uncle – Was the loan used in business or private purposes and what is the
interest rate if any. This would determine whether it is a business loan and deductibility
of the interest thereof.
Fixed Assets - Whether or not any capital allowances had been claimed and the written
down valuers for the respective capital alloances tables.

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 250 A dvanced TA X AT I O N

Other sources of income - Whether or not he was in receipt of any other incomes such
as dividends, interest, rent, consultancy fees and others which should be included in
taxable income.

Question three

(a) Alternative 1
Sh. Sh.
Net Loss as per accounts (1,879,500)
Add: understated sales 2,000,000
Overstated cost of sales 1,000,000
Overstated printing and stationery 10,000
Net discount as per accounts 10,000
1,140,500
20,000
Less: office rent understated 1,120,500
Add: correct discount net 26,200
T E X T

Adjusted accounting profit 1,146,700

Add back: depreciation 30,000
S T U D Y

Provision for bad debts 175,000

Interest on capital 265,000 470,000
1,616,700
Less: tax allowances 32,000
Specific Bad debts provision 215,000 (247,000)
1,369,700
From the workings:
i. Sales are understated by Sh.2,000,000
ii. Cost of goods sold are overstated by Sh.1,000,000
iii. Office rent is understated by Sh.20,000
iv. Printing and stationery is overstated by Sh.10,000
v. Net discounts should be credit of Sh.26,200 (income)
vi. Opening capital is overstated by Sh.1,000,000

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 251

Alternative 2
Sh. Sh.
Gross profit (see workings) 3,510,000
Less: Allowable expenses
Salaries 1,200,000
Office rent 240,000
Advertising 97,500 
General expenses 60,000
Motor upkeep 137,500
Printing & Stationery 84,500
Travelling expenses 100,000
Bad debts (specific) 215,000
Wear and Tear 32,000
Allowance (2,069,000)
1,441,000
Add: Discount net 26,200
Taxable income 1,467,200

Workings:

T E X T
DEBTORS ACCOUNT

Balance b/d (**) 4,700,000 Cash 13,500,000

S T U D Y
Credit Sales 12,440,000 Discount 140,000
________ Balance c/d 3,500,000
17,140,000 17,140,000

CREDITORS ACCOUNT

Cash 11,200,000 Balance b/d 2,340,000

Discount 120,000 Purchases (**) 10,830,000
Balance c/d 1,850,000 ________
13,170,000 13,170,000

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 252 A dvanced TA X AT I O N

Sales:
Sh.
Opening stock 2,200,000
Purchases 10,830,000
13,030,000
Closing stock (2,500,000)
Cost of goods sold 10,530,000
1
Add: 33 % mark-up 3,510,000
3
Total sales 14,040,000
(**) – Balancing figures

Tax consequences on incorrect returns of income:

(b) In the case of the tax payers:

Additional tax of an amount twice the tax conceded, plus a maximum of Kshs.200,000 fine
and or up to 2 years imprisonment.
T E X T

Question four
S T U D Y

(a) When sales are predominantly to businesses registered for VAT. This will enable the trader
claim VAT paid on purchases.
•• When sales are zero-rated items and the trader wishes to reclaim input VAT (exports)
•• When the trader wishes to conceal the small size of business from customers.

(b) Refund
VAT refund is properly due under the following circumstances:
•• Where input tax exceeds output tax continually and it is a regular feature of the
business
•• Where goods are imported and then re-exported without being used in Kenya. VAT on
import is refundable.
•• Where newly registered persons have goods in stock which are intended for us in the
manufacture of taxable supplies.
•• Refund for credit sales which became bad debt as long as 3 years have lapsed and
supplier have taken all necessary legal actions in an attempt to recover the bad debt.
•• Where tax has been paid in error.
•• Where the registered person has incurred major capital costs in construction of building
to manufacture taxable supplies.
•• Where taxable goods have been imported into Kenya and tax has been paid in respect
of those goods and before being used, the goods are exported under customs control
•• Where in the opinion of the Minister, a refund is due in the public interest.

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 253

(c) Procedure
Fill in VAT 4 (Refund Claim Form)
If claim is for an amount of Ksh. 1M and above attach audit certificate
Lodge the claim with the VAT department
Trader must have filled a VAT 3 (return form) which must correspond to VAT 4.

(d) VAT Audit Refund Certificate

Kasuku Rolling Mills Ltd (KRM)
VAT Refund Audit Certificate for January 2007.
We have examined the attached claim for refund of VAT amounting to Ksh ( … ) made by
KRM Ltd. for the period from 1st January 2007 to 31st January 2007 to ensure compliance
with the VAT Act and regulations, and have obtained all the information and explanations
necessary for the purposes of our examination.
Our examination was designed to enable us to obtain reasonable assurance that the claim
is free from material misstatement, and included verification, on a test basis, of evidence
supporting the amount claimed. It also included an assessment of the adequacy of KRM’s
system of recording and accounting for VAT.

In our opinion the attached VAT claim gives a true and fair view of the amount claimed and

T E X T
is properly refundable under the VAT Act and regulations.

c) Implications of the error

S T U D Y
•• Input VAT was understated
•• The company did not avail the invoices in respect to some of the purchases made.
•• The company’s record keeping may not be accurate.
•• The company would be losing a lot of cash flows

Input tax can still be claimed in a subsequent month as long as its not more that 12 months old.
If it’s more than 12 months old, you apply to the Commissioner to be able to claim the same.

Question five

(a)
i. Non-remittance of PAYE which has been deducted.
ii. Fluctuating and late payment of PAYE by the employer.
iii. Irregularities detected through examination of PAYE end year returns.
iv Employers whose final accounts submitted to the department are suspect i.e. they
arouse suspicion.
v. When director’s fees and bonuses are claimed in the accounts with no corresponding
PAYE remittances.
vi. When proper books of accounts are not kept by the organisation. (8
marks)

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 254 A dvanced TA X AT I O N

(b) Circumstances that trigger off PAYE Audit

-- Salaries and wages figure per the audited accounts is higher or lower than the amounts
reflected in the PAYE returns.
-- PAYE is usually not paid on time
-- Material fluctuations over the months on PAYE payments
-- Third party information or complaints
-- Non-compliance noted/detected during a normal tax examination be it VAT or Corporate
tax examination.
-- Of late KRA is offering rewards to anybody who divulges information that leads to a tax
recovery by authorised persons only.
-- Newspaper reports
-- Court cases
-- Construction sites sign boards – This affects mainly contractors and professionals in
the construction industry.
-- Information emanating from related companies audited
-- Cessation of business on a large part of a business
-- Higher salaries awarded to middle level managers compared to those awarded to their
seniors.

Chapter Four
T E X T

Question one
S T U D Y

This is a reciprocated economic and tax “favour” granted to a member country if a trading or
economic bloc first as the receiving member has granted other members of the bloc. It generally
involves agreement on tax/tariff concessions on particular goods. The benefits are
•• It enhances international trade among member countries due to lower tariffs on imports
and exports.
•• Facilitates comparative advantage as countries specialise in production of what they
produce at lowest cost
•• Promotes free trade as member countries remove any restrictions on trade barriers on
imports/exports of member countries.
•• It accords equal commercial opportunities on import duties and freedom of investment
•• Enable member countries to enjoy trading benefits accorded to third states by member
countries

Question two

Double taxation relief:

•• A relief allowed for income tax in two different counties, one of which must be Kenya.
•• The foreign tax will be compared with the increase in the Kenyan tax liability and the
lower of the two taxes is allowed as the double taxation relief.
•• Time limit for claims is six years.
•• The double taxation agreement must be gazetted in the Kenya Gazette.
•• Encourage cross boarder investments.

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 255

Question three

a) Taxation of
i) Incapacitated person
• According to Section 46 of Cap 470 (Income Tax Act) the income of incapacitated
person shall be assessed on and tax thereon charged on that person in the name
of his trustee, guardian, curator, committee or receiver appointed by the court.
• It shall be assessed on such a name in the same manner and to the same amount
as that incapacitated person would have been assessed and charged if he were
not an incapacitated person.

ii) Non-resident persons (Section 47 of Cap 470)

• The income shall be assessed on and tax thereon charged on that person either in
is name or the name of his trustee, guardian, curator or committee or of attorney,
factor, agent, receiver or manager.
• For tax purposes a normal agent maybe deemed to be the master of a ship or the
captain of an aircraft owned by a non-resident person chargeable to tax shall does
not exclude any other agent.
• Non-resident persons are taxed at a specified withholding tax rates.
• Individuals don’t enjoy personal relief.

T E X T
b) i) Mr. Mbazo was an individual resident in Kenya for tax purposes because he was
present in Kenya for a period exceeding 183 days during year of income under
consideration although he does not have a permanent home in Kenya

S T U D Y
Mr. Mbazo taxable income for year ending 31/12/2007

Basic pay Jan – Sep (200,000 p.m x 9) 1,800,000

Oct – Dec (200 x 1.25 x 3 months) 750,000
2,550,000
Add other benefits
192,500
Rent reimbursed (35,000 p.m. x 1 x 11)
2
Air tickets (not an expatriate) 25,000
Entertainment allowance (12,000p.m x 6) 72,000
20,000
Motor vehicle insurance (80,000 x 3 )
12
Medical cover/allowance (8,000 p.m x 3) 24,000
Performance bonus 150,000
Net taxable income 3,033,500

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 256 A dvanced TA X AT I O N

Tax liability (using year 2007 rates)

1st Ksh.121,968 @10% 12,196.8
Next 114,912 @15%
Next 114,912 @20% = 114,912 x 60% = 68,947.2
Next 114,912 @25% 81,144.0
466,704
Surplus (3,033,500 – 466,704) @ 30% 770,039

Less personal relief 1162p.m x 12 (13,944.0)

P.A.Y.E. deducted (200,000.0)
Net tax liability 637,239

Question four

a) Concept of the double taxation treaties

Double taxation treaties are agreements drawn between one country such as Kenya and other
states for two main reasons:
i. To encourage technological transfers and capital transfers in commerce and industry
without overburdening investors with taxation in both countries on same income
T E X T

ii. To encourage exchanges of technical personnel without overburdening them with

taxation in both countries on same income.

In terms of the Kenyan taxation laws, Section 41 of the Income Tax Act authorises for double
S T U D Y

taxation relief to be granted while Section 42 details on the determination of such relief where
there exists, a double taxation treaty entered into by Kenya with another country.
It is worth noting, at this point, that Kenya non-residents are taxed on income derived from Kenya
only. Kenya residents, on the other hand may be liable to tax on income derived from outside
Kenya in addition to tax on income derived from Kenya. Kenya residents may suffer double
taxation as a result.
With a view to reduce the tax burden suffered by Kenya residents relating to tax already paid
in other countries, Kenya has signed double taxation treaties, with countries such as Denmark,
Italy, Switzerland, Zambia, UK, Sweden, Norway, Malawi, Uganda, Tanzania, Germany, Canada
and all COMESA countries.
The tax treaties adhere to the following principles:
•• The agreements get the approval of the parliament,
•• Are gazetted by the Minister For Finance,
•• The foreign tax shall be compared with the increase in the Kenya tax liability and the
lower of the two will be allowed as a set off tax,
•• Time limit for double taxation relief claim is 6 years.

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 257

b)
DANIEL OTWORI
DOUBLE TAXATION RELIEF DUE FOR THE YEAR TO 31 DECEMBER 2006

Income from UK in Ksh. = [140 x (£960 + £4,800)]

= 140 x 5,760
= Ksh.806,400
Tax charged in the UK in Kshs. = (£960 x 140)
= Ksh.134,000
Total income for year Ksh (806,400 + 1,765,000) = Ksh.2,571,400

Kenya Tax charged on total income

Kshs.
First Kshs = 121,968 @ 10% = 12,196.8
Next Kshs. 114,912 (1% + 20% + 25%) = 68,947.2
Balance Ksh.2,104,696 @ 30% = 631,408.8
Gross tax liability in Kenya on combined income 712,552.8

Tax on Kenya income alone

T E X T
Income from Kenya Kshs. 1,765,000
Tax thereof: Kshs
First Kshs.121,968 @ 10% = 12,196.8

S T U D Y
Next Kshs.114,912 (15% + 20% + 25%) = 68,947.2
Balance Kshs.1,298,296 @ 30% = 389,488.8
Gross tax on Kenya income alone 470,632.8

Difference between tax on combined income and tax on Kenya income alone

i.e. Kshs. (712,552.8 – 470,632.8) = Kshs.241,920

Double taxation relief shall be the lesser of increase in tax liability due to addition of foreign
income and actual tax deducted in the foreign country.
Kshs.241,920 0r Kshs.134,400
That is relief is Kshs.134,400 the tax charged in the UK.

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 258 A dvanced TA X AT I O N

c)
J. Karimi
VAT PAYABLE (OR REFUNDABLE) FOR THE MONTH OF APRIL 2007
VAT ACCOUNT MONTH OF APRIL 2007
  Kshs   Kshs ‘000
‘000
Std rate Purchases (.16 x 3184.00 Standard rate sales (.16 3200.00
19,900) x 20,000)
Photocopier (.12 x 100) 12.00 Ministry of Health 1280.00
Electricity (.16 x 16) 2.56 Debit notes (.16 x 800) 128.00
Electronic tax register (.16 x 24.00    
150)
Electronic tax register (cost 150.00    
recovery)
Legal fees (.16 x 50) 80.00    
Bad debt relief (.16 x 500) 80.00    
Returns in (.16 x 600) 96.00    
VAT payable 979.44   ____
  4608.00   4608.00
T E X T

Notes:
1. VAT relating to VAT appeals is not deductible.
S T U D Y

2. Purchase of a photocopier is not part of purchases at standard rate, however VAT

suffered is deductible.
3. Water is assumed to be for a public source hence no VAT charged.
4. Suppliers to Ministry of Health exempt from VAT.
5. Cost of Electronic tax register is deductible with prior approval from the commissioner,
provided that ETR was acquired from the Commissioner, provided that the ETR was
acquired and installed before 31.12.06

Question five

(a) Transactions that constitute transfer pricing include:

•• Sale of goods to a subsidiary or branch by the head office at a price that is not at arm’s
length i.e. prices that are not granted on sale of goods to third parties.
•• Purchase of goods to another company in which one or more of the directors are also
directors in the selling company and the goods are not sold at the open market.
•• Inflating cost of goods which are subsequently sold in a low tax location at lower prices
so as to reflect lowered profits or nil profits for tax purposes in the country of export.

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 259

Chapter Five

Question one

a) i) Tax planning
♦♦ The arrangement of affairs of a taxpayer in such a way as to minimise tax liability at the
lowest cost without contradicting any tax laws and regulations. It involves determining
in advance the tax effect of any proposed business action and decision.
♦♦ It requires a deep understanding of tax legislations and decided case law of taxation.
The aims of tax planning are to:
i. Achieve the most advantageous financial position from business transactions
measured in terms of direct tax savings and improved cash inflows.
ii. Ease tax administration (internally) in terms of methods of accounting for tax,
records to be maintained and tax reports to be prepared.
iii. Achieve the highest level of compliance with the tax laws.

ii) The planning areas in business decisions may include

T E X T
• Lease or buy decisions: do we lease assets and pay lease charges (allowable) or
buy assets and enjoy capital allowances?
• Financing decisions: do we use debt capital (interest charges are allowable) or
equity capital (dividends not allowable)?

S T U D Y
• Form of business ownership: do we operate as a partnership, sole proprietorship
or a limited company?
• Trading decisions – do we produce and sell locally or export (exports are zero
rated for VAT purposes)?

Question two

Corporate Tax Planning

Tax Planning
Defined as the arrangement of affairs of tax in such a way as to minimise tax liability at the lowest
cost without contradicting any tax laws and regulations. It involves determining in advance the
tax effect of any proposed business action and decision. It requires a deep understanding of
existing tax legislation and decided case law of taxation. The aims of tax planning are to:
-- Achieve the most advantageous financial position from business transactions measured
in terms of direct tax savings and improved cash inflows
-- Ease tax administration (intensity) in terms of methods of accounting for tax, records to
be maintained and tax reports to be prepared
-- Achieve the highest level of compliance with the tax laws
The following are various ways in which corporate entities may engage in tax planning
i. Lease or buy decisions: Do we lease assets and pay lease charges (allowable) or buy
assets and enjoy capital allowances

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 260 A dvanced TA X AT I O N

ii. Financing decision: Do we use debt capital (interest charges are allowable) or equity
(dividends not allowable)
iii. Trading decisions: Do we produce and sell locally or export (exports are zero rated for
VAT purposes)

Question three

a) Tax incentives to newly listed companies:-

•• Flotation costs e.g. Legal expenses are allowable
•• Reduced corporate tax rate of 20% p.a. for the first 5 years if listed any time after
1/1/2006. Any issues at least 40% of shares to the public with effect from 1/1/2003.
The rate applies for first five years of listing.
•• A tax amnesty for past tax evasion activities.
•• A reduced corporate tax rate of 27% p.a. for the first 3 years for any company that get
listed after 1/1/2002.

b) Imported goods are deemed to have been dumped in Kenya if:-

•• Goods are sold in Kenya at a price lower than the cost of importing (cost of insurance,
freight, duties and cost of goods to the exporter)
•• The export price by the foreign exporter to Kenya is less than the fair market price in
the exporting country.
T E X T

•• If the country exporting goods to Kenya had imported such goods and either
i. The export price of the original country less than fair market price in that country
ii Export price of the country re-exporting the goods is less than fair market price in
that re-exporting country.
S T U D Y

c) i) Tax free (exempt) employment benefits

•• Fringe benefits
•• Benefits in kind not exceeding Kshs. 36,000 p.a (Kshs 3,000p.m)
•• Education fees paid by employer for employee and his dependents if such fees are
taxed on the employer.
•• Medical benefits if scheme is non-discriminative.
•• Passages/translocation costs for non-citizen expatriates.
•• Contribution by employer for employees to registered and unregistered pension and
provident funds.

Question four

(i) Expense Reimbursement

Reimbursement of personal expenses constitutes a taxable benefit. The assessed benefit will be
equivalent to the cost of the employer. Consequently, this scheme does not have any benefits
if the reimbursement is for personal expenses. The reimbursement of expenses incurred in the
course of carrying out the business of the employer does not constitute a taxable benefit. Here,
it is assumed the reimbursement is for the actual cost incurred by the employee. If the amount
reimbursed exceeds the cost to the employee, the difference will be subject to tax.

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 261

The personal expenses reimbursed will be tax deductible by the employer if the employee has
been taxed. Reimbursement of business expenses is tax deductible if the employee has been
taxed. Reimbursement of business expenses is tax deductible if the expenditure is incurred
wholly and exclusively for the purpose of the business.

(ii) Benefits in kind

Benefits in kind are taxable, unless the aggregate value does not exceed Kshs.36,000 p.a (Kshs.
3,000 pm). This amount is not significant enough to be included in an “Executive Remuneration
Package”. Other benefits not subject to tax include:
•• Medical services to full time employees;
•• Employer’s contribution to a pension or provident fund (whether registered or not);
•• Education fees of an employee’s dependents, where treated as a non-deductible
expense by the employer;
•• Passages between Kenya and any place outside Kenya for expatriates.
(iii) Pension Entitlement
Contributions by an employer to a pension or provident fund, whether registered or not are not
taxable on the employees. However, the employer is not allowed to deduct contributions to
non-registered schemes. The employees can benefit from these schemes but may not be tax
efficient because the employer will be taxed on the contributions.
The employer is tax exempt (e.g. NGO), contributions to unregistered schemes are fully taxable

T E X T
on the employees.

(iv) Bonus Schemes

S T U D Y
Bonuses constitute cash payments to employees. All cash payments received as a gain or
profit from employment are taxable in full. This item will not be tax effective to be included in a
remuneration package.

(v) Share Purchase Arrangements

(a) The granting of bonus share for better performance by the firm is a benefit in kind
received for employment services rendered thus a taxable benefit.
Where the shares are given free, the taxable benefit is based on the prevailing market
price per share (MPS). Where the shares are issued at price lower than the market
price per share, the taxable benefit shall be (MPS – issue price) number of shares
issued.
Where the difference between MPS and issue price is 5% or less of the MPS, the
benefit is not taxable. Example.

Assume 1 2
MPS Sh.100 Sh.100
Issue price to employee Sh. 96 Sh. 91
Different/discount Sh. 4 Sh. 91
% of MPS 4 x 100 = 4% 9 x 100 = 9%
100 100

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 262 A dvanced TA X AT I O N

Where the shares are redeemable, the taxable benefit shall be the higher of the difference
between:
•• Issue price and nominal value; or
•• Issue price and redemption value.

Question five

i) Characteristics of transactions that constitute transfer pricing

•• Fixing of prices based on non-market criteria resulting in saving company tax;
•• Apportioning taxable income among various jurisdictions in a way to transfer a larger
portion of overall income to low tax jurisdictions
•• Selling of goods from a division in one country to another division in yet another
country;
•• Absence of the arms length relationship.

ii) Four methods of determining appropriate transfer price provided in the Organisation for
Economic Co-operation and Development (OECD) model
a) Uncontrolled price method
This method compares the price at which a controlled transaction is conducted to the
price at which a comparable uncontrolled transaction is conducted.
T E X T

b) Cost plus method

Is a method generally used for the trade of finished goods, and is determined by adding
an appropriate mark-up to the costs incurred by the selling party in manufacturing/
purchasing the goods or services provided, with the appropriate mark-up being based
S T U D Y

on the profits of other companies comparable to the tested party.

c) Resale price method
Is similar to the cost plus method but is arrived at by working backwards from transactions
taking place at the next stage working backwards from transactions taking place at
the next stage in the supply chain and is determined by subtracting an appropriate
gross. Mark-up from the sale price to an unrelated, third party with the appropriate
gross margin being determined by examining the conditions under which the goods or
services are sold and comparing the transaction to other, third party transactions.
d) Profit split method
Is a method applied when businesses involved in the transaction are too integrated to
allow for separate evaluation and so the ultimate profit derived from the endeavour is
split based on the level of contribution of each of the participants in the project.

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 263

Chapter Six

Question One

Distinction between a single and multiple tax system

Single tax system Multiple tax system
A tax system comprising of only one tax A tax system comprising of a variety of taxes
for example hut tax during the colonial that are applicable at the same time. For
times. In addition, some countries have example, in Kenya we have a multiple tax
got turnover tax that is the only tax system since there are many taxes applicable.
which is final. These include:
Corporation tax
Withholding tax
Customs & excise
Turnover tax
Compensating tax

T E X T
etc

S T U D Y
Reasons why a country might prefer a multiple tax system over a single tax system

Sufficient revenue
A government implementing a multiple tax system is able to collect sufficient revenue due to a
wide tax base

Desire to regulate externalities

A country implementing a multiple tax system will be in a position to regulate externalities
whenever they arise e.g. a country may impose heavy import duty to protect local industries

Minimise incidences of tax evasion

Since a multiple tax system has a wide tax base it is able to minimize tax evasion by bring every
taxable person to the tax blanket

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 264 A dvanced TA X AT I O N

Questions Two

i. Most workers in developing countries are typically employed in agriculture or in small,

informal enterprises. As they are seldom paid a regular, fixed wage, their earnings
fluctuate, and many are paid in cash, "off the books." The base for an income tax is
therefore hard to calculate. Nor do workers in these countries typically spend their
earnings in large stores that keep accurate records of sales and inventories. As a result,
modern means of raising revenue, such as income taxes and consumer taxes, play a
diminished role in these economies, and the possibility that the government will achieve
high tax levels is virtually excluded.
ii. It is difficult to create an efficient tax administration without a well-educated and
well-trained staff, when money is lacking to pay good wages to tax officials and to
computerize the operation (or even to provide efficient telephone and mail services),
and when taxpayers have limited ability to keep accounts. As a result, governments
often take the path of least resistance, developing tax systems that allow them to exploit
whatever options are available rather than establishing rational, modern, and efficient
tax systems.
iii. Informal structure and financial limitations of the economy in many developing countries
and hinder the statistical and tax offices from generating reliable statistics. This lack of
data prevents policymakers from assessing the potential impact of major changes to
the tax system. As a result, marginal changes are often preferred over major structural
T E X T

changes, even when the latter are clearly preferable. This perpetuates inefficient tax
structures.
iv. Income tends to be unevenly distributed within developing countries. Although raising
high tax revenues in this situation ideally calls for the rich to be taxed more heavily
S T U D Y

than the poor, the economic and political power of rich taxpayers often allows them to
prevent fiscal reforms that would increase their tax burdens. This explains in part why
many developing countries have not fully exploited personal income and property taxes
and why their tax systems rarely achieve satisfactory progressivity (in other words,
where the rich pay proportionately more taxes).
v. Developing countries attempting to become fully integrated in the world economy will
probably need a higher tax level if they are to pursue a government role closer to that
of industrial countries, which, on average, enjoy twice the tax revenue. Developing
countries will need to reduce sharply their reliance on foreign trade taxes, without at
the same time creating economic disincentives, especially in raising more revenue from
personal income tax. To meet these challenges, policymakers in these countries will have
to get their policy priorities right and have the political will to implement the necessary
reforms. Tax administrations must be strengthened to accompany the needed policy
changes.
vi. As trade barriers come down and capital becomes more mobile, the formulation of
sound tax policy poses significant challenges for developing countries. The need
to replace foreign trade taxes with domestic taxes will be accompanied by growing
concerns about profit diversion by foreign investors, which weak provisions against tax
abuse in the tax laws as well as inadequate technical training of tax auditors in many
developing countries are currently unable to deter. A concerted effort to eliminate these
deficiencies is therefore of the utmost urgency.

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 265

vii. Tax competition is another policy challenge in a world of liberalised capital movement.
The effectiveness of tax incentives—in the absence of other necessary fundamentals—
is highly questionable. A tax system that is riddled with such incentives will inevitably
provide fertile grounds for rent-seeking activities. To allow their emerging markets to
take proper root, developing countries would be well advised to refrain from reliance on
poorly targeted tax incentives as the main vehicle for investment promotion.
viii. Finally, personal income taxes have been contributing very little to total tax revenue
in many developing countries. Apart from structural, policy, and administrative
considerations, the ease with which income received by individuals can be invested
abroad significantly contributes to this outcome. Taxing this income is therefore a
daunting challenge for developing countries. This has been particularly problematic in
several Latin American countries that have largely stopped taxing financial income to
encourage financial capital to remain in the country.

Question Three

TPU’s role is to make policies relating to Kenyan taxes specifically issues relating to:
•• Harmonisation and rationaliation of Kenya’s tax rates.
•• Widening or narrowing tax brackets
•• Narrowing or widening the tax net as all the above have implications on tax revenue

T E X T
•• Long term tax objectives.

Question Four

S T U D Y
(a) (i) Buoyancy
Buoyancy of a tax is the responsiveness of tax revenue to changes in national income
and to discretionary changes.
(ii) Elasticity of a tax is the responsiveness of the tax revenue to changes in national income
adjusted for discretionary changes.
Where discretionary changes are the changes in tax rates and rules governing the tax
system.

(b) (i) Historical time series tax data (HTSTD) attempts to eliminate discretionary tax
changes to estimate elasticity by using a single equatica model.

Log (Ti) = Log a + Log bi + log (βi) + ei

Where: T = adjusted HTSTD to discretionary tax changes

β = tax base (or GDP aggregate level)
e = disturbance term
bi = tax elasticity

(ii) Adjusted HTSTD with time trends or dummy variables as proxies for discretionary tax
measures.
Adjustments could be done using.
The proportional adjustment method
The constant rate structure method
The dummy variable approach

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 266 A dvanced TA X AT I O N

(c) (i) Value Added Tax (VAT)

This is tax elastic because a slight change in VAT rate leads to a significant fall in
revenue. This applies for taxable goods.
However, for zero-rated and exempt goods, VAT is tax inelastic.

(ii) Income Tax
Income tax is tax inelastic since the amount of tax tends to be proportional to tax rate in
case of proportional corporate taxes.
For individual taxes reduction or increase in tax rates does not significantly change tax
collectible but works to encourage or discourage tax evasion or tax avoidance.

(iii) Customs and Excise Duty

Excise taxes tend to be tax inelastic as consumers tend to reorganize their spending in
the case of excise tax.
Customs tax however is tax elastic and increase in import tax discourages imports
leading to low customs tax collected.

Question Five

Employee Taxes (PAYE)- This is tax on the income of an employee. An employer has an obligation
to deduct tax on graduated scale rates. An employee can be said to be a holder of a public office or
T E X T

other appointment for which remuneration is paid. The remuneration is the reward or pay for work or
service rendered, for example, in the case of a minister, civil servant, company directors, company
secretary, accountant, clerk, engineer, and all those commonly referred to as employees.
S T U D Y

Fringe benefit Tax- This benefit arises from the difference between the Market Interest rate and
the employer’s interest rate for loans provided after 11th June 1998 or loans provided on or before
11th June 1998 whose terms and conditions have changed after 11th June 1998. Such a benefit is
taxable on the employer at the corporation Tax Rate.
Turnover tax- This is a tax on consumer expenditure introduced in the 2006 and 2007 Finance
Acts. The imposition of the turnover tax is contained in Section 12 (c) of the Income Tax Act. TOT
came into application on the 1st of January 2008. According to Section 12C of the Income Tax Act
and the Turnover tax regulations, income from business includes gross receipts, gross earnings,
revenue, takings, yield, proceeds or other income.
Withholding Tax- A resident person is required to withhold tax on various payments, under
section 35 of the Income Tax Act. Withholding tax is applicable on payments to both residents
and non-residents. Such payments include dividends, interest, royalties, management and
professional fees and agency, consultancy and contractual fees.
Value Added Tax- VAT is tax on spending which is collected by businesses and passed on to the
government. Value Added Tax is charged on the supply of goods or services in Kenya and on the
importation of goods into Kenya. The current VAT rate is 16% and the taxable turnover is Kshs. 5
million.
Compensating tax- Compensating tax was introduced in 1993 under Section 7 A of the Income Tax
Act. It is an additional tax imposed on companies and arise 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.

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 267

Stamp Duty- Stamp duties are chargeable in respect of certain legal documents as specified
in the stamp duties Act. In order to enforce the collection of stamp duty legal instruments which
have not been duly stamped are inadmissible as evidence in any civil proceeding and may not be
registered or legally enforced as evidence of ownership.
Customs and Excise Tax-This is the duty on tax paid in goods imported through the port of
Kenya or imported and which are specified in the first schedule. Excise Duty is the tax imposed
on goods manufactured locally and specified on the 5th schedule
Corporation Tax- is tax on a company at the corporation tax rate of 30% for resident companies
while 37.5% for non resident companies.

Chapter Seven

Question one

It depends on whether there are any relationships between the two that could give rise to a conflict of interest.
For example they may be business partners, or one may employ the other. Even so, it may be sufficient to
ensure that each is aware that you act for both, provided you keep the position under review.

T E X T
In other cases the conflict of interest might be such that you should not; for example if they are in the course
of a divorce.

S T U D Y
Question two

This is likely to be a criminal offence and you should report your suspicions to the police.

Chapter Eight

Question one

•• Tax avoidance measures implemented by tax payers

•• Good set targets but bad measures to meet the targets
•• Technological limitations- The fact that many of the taxpayers have no access to nor
understand technology, hampers the tax authority’s attempts to achieve its target.
•• Complicated Tax regime- Many tax payable do not understand the tax system. They
find the taxes available in Kenya very complicated. This makes them not be able to
comply as required.
•• Evolving tax avoidance strategies- Some tax payers have adopted well calculated and
complicated mechanisms of tax evasion. This has made the revenue authority ensure
that they undergo continuous training to be on top of their game.
•• Lack of enough assessors (personnel) to ensure compliance- The revenue authority
does not have enough personnel to be able to enforce the taxation laws and such

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 268 A dvanced TA X AT I O N

collect taxes.
•• Non-tax paying culture- The payment of some taxes is dependent on the culture of the
tax payers. For example, the payment of turnover tax will depend on the integrity of the
tax payers to disclose the sales as required by law. If the tax payers do not develop a
good tax paying culture, the attempts by the revenue authority to ensure high revenue
collection may not succeed.

Question two

•• Objectives of the Customs Union:

•• To raise revenue for the government
•• To protect local industries from multinational or foreign based industries by imposing
high customs duty to discourage consumption of imports
•• Prevention of dumping of goods into the Kenyan market
•• Discourage production of harmful goods e.g. beer and cigarettes

Question three

East African Community Customs Management Act (2004)

T E X T

This is an Act that came into force in 2005 following the revival of the East Africa Community
Customs Union. Customs control is therefore under the East Africa Customs Union and excise
duty will be under the control of respective partner states. Under the Union, goods traded within
the partner sates will be zero rated except for certain specified items from Tanzania and Uganda
S T U D Y

albeit for transition period only.

Goods are classified under the Harmonised System Convention (HSC) that forms the basis for
tariff classification of goods traded in the international market as listed in Annex 1 to the Protocol
on the Establishment of the East African Community Customs Union.

Customs duty rates

Duties are charged at varying rates as published by the Council of Ministers under the Common
External Tariff. The bases of charge of duties are ad valorem (on price value of the good so
declared) and specific units (on quantity, weight, number or measurement). The Customs duty
rates range from 0 to 25%. Reduced customs duty rates are applicable on some imports from
countries in the COMESA region, while “Sensitive” imports attract duty above 25% as prescribed
by the Council of Ministers.
With effect from 1 January 2005, the East African Community Partner States (Kenya, Uganda
and Tanzania) agreed to charge import duties as follows:
(a) Common External Tariff (CET) on goods coming into the EAC from third party states. The
applicable three-band Common External Tariff rates are as follows:

Category Rate (%)

Raw materials 0
Intermediate goods 10

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 SUGGESTED SOLUTIONS TO EXAM QUESTIONS 269

Finished goods 25
However, sugar, wheat and milk and a few other products are categorized as “sensitive” and
attract surcharges above the 25% maximum, while all goods entered for home use from Export
Processing Zone (EPZ) enterprises attract additional duty as follows:
•• 2½% of the value of sales, or
•• 5% of specific rate specified in the Annex I to the EAC Customs Union Protocol: Common
External Tariff.
The Partner States agreed on a transitional provision to eliminate the internal tariffs under the
principle of asymmetry: that with effect from 1 January 2006 the Kenyan exports to Uganda and
Tanzania would attract duty at reducing rates as follows:

Year Uganda Tanzania

Duty rate (%) Duty rate (%)*

1 10 25
2 8 20
3 6 15
4 4 10
5 2 5
6 0 0

T E X T
* Maximum rates for the year.

S T U D Y

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 270 A dvanced TA X AT I O N
T E X T
S T U D Y

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 271

CHAPTER ONE
GLOSSARY

T E TX ET X T
S T U D Y T E X T
S T SU TDUYD Y

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 272 A dvanced TA X AT I O N
T E X T
S T U D Y

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 GLOSSARY 273

GLOSSARY
Business - Business includes any trade, profession or vocation, and every manufacture, adventure
and concern in the nature of trade, but does not include employment.
Deductions Allowed - For expenditure to be deductible it must be wholly and exclusively incurred
in the production of income.
Farmer - Farmer means a person who carries on pastoral, agricultural or other similar operations
The setting test - This test distinguishes plant as part of the apparatus with which the trade is
carried on from assets forming part of the setting in which a trade is carried on.
The functional test - A structure will be regarded as plant if it fulfills the function of plant in the
trader's operations.
Trading receipt and trading loss - Where a business is a going concern and the entire class of
assets qualifying for WTA is disposed of at a value greater than the written down value the gains
or profits arising therefrom are called trading receipt which is taxable business income; in case
of a loss, it’s a trading loss
Balancing charge and balancing deduction - In case a firm is being liquidated trading receipt
is called balancing charge which is a taxable income while the trading loss is called balancing

T E X T
deduction which is an allowable expense.
Off shore taxation (Tax havens) - Refers to the principle of harmonising Company law, Trust
law, Banking and Tax regulations with a view to attract investors. The measures put into place
have to be tax effective as compared to those established in the average countries in the world.

S T U D Y
Back-duty - Back-duty refers to collection of all kinds of tax in arrears which arise due to Under
declaration of income (incomplete and incorrect returns), Non-declaration of income, Taxpayer
claims expenses, allowances, reliefs he is not entitled to
Tax evasion - The reduction of tax liabilities by illegal means such as concealing information or
supplying false information.
Tax avoidance - The reduction of tax liabilities by legal, although possibly artificial means.
Group Registration - Where a group of companies is owned or substantially controlled by
another person it may apply to the Commissioner to be treated as one person.
Zero-rated Supplies - Where a supply is not charged to taxation and the supply will in all other
respects be treated as a taxable supply.
Partial Exemption - This arises where only part of the taxable person’s supplies are taxable.
Customs Duty - This is the duty on tax paid in goods imported through the port of Kenya or
imported and which are specified in the first schedule.
Excise Duty - This is the tax imposed on goods manufactured locally and specified on the 5th
schedule.
Custom warehouse - This is a place approved in CCE for deposits.
Duty- Defined to include Customs duty, excise duty, levy, cess, imposition, tax, surtax imposed
on goods by CCE.

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 274 A dvanced TA X AT I O N

Subsidy - This comes in form of direct or indirect deduction on production or output by way
of grants or loans and tax relief relating to the goods themselves or the material used to make
goods
Bonded security - A bond is a commitment to honour certain terms and conditions and fulfill
obligations relating to an agreement. The failure to honour the commitment leads to consequences,
which include forfeiting of an asset that may have been given out as a security.
Direct exporters - Manufacturers who import raw materials, manufacture, then export the
finished product.
Indirect exporters - A manufacture/producer who imports goods for use in the production of
goods for supply to another manufacturer for use in the production of goods for export.
T E X T
S T U D Y

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 GLOSSARY 275

T E X T
S T U D Y

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 276 A dvanced TA X AT I O N
T E X T
S T U D Y

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 277

CHAPTER ONE
INDEX

T E TX ET X T
S T U D Y T E X T
S T SU TDUYD Y

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 278 A dvanced TA X AT I O N
T E X T
S T U D Y

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 INDEX 279

INDEX
A

Assessment .................................................................................................... 6, 85, 150, 164

Back duty .......................................................................................................................... 273

Balancing charge .............................................................................................................. 273
Balancing deduction . ........................................................................................................ 273
Bankruptcy .............................................................................................................................v
Business ............................................................................................................... 88, 91, 273

Customs Duty ................................................................................................................... 273

Custom warehouse ........................................................................................................... 273

T E X T
D

S T U D Y
Deductions Allowed . ......................................................................................................... 273

Excise Duty ....................................................................................................................... 273

Functional test . ................................................................................................................. 273

Group Registration ............................................................................................................ 273

Input tax ........................................................................................................................ 90, 95

insurance .......................................................................................................................... 122
Interest .................................................................................................... 42, 71, 72, 122, 123

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 280 A dvanced TA X AT I O N

Liquidation . ............................................................................................................................v

Most Favoured Nation Status ....................................................................................116, 122

Off shore taxation . ............................................................................................. 110, 116, 273

Partial Exemption .............................................................................................................. 273

Pension ..................................................................................................................................v
Principles of an optimal tax system, . ........................................................................ 175, 183

R
T E X T

Receivership ..........................................................................................................................v
Relief ................................................................................................................................. 274
S T U D Y

Setting test ........................................................................................................................ 273

Tax avoidance ........................................................................................................... 132, 273

Tax evasion ............................................................................................................... 132, 273
Tax planning .............................................................................................. 131, 132, 157, 160
trading loss . ...................................................................................................................... 273
Trading receipt .................................................................................................................. 273
Transfer pricing ..................................................................................................................119

Withholding ................................................................................................................. 85, 148

Withholding tax .................................................................................... 72, 118, 119, 122, 123

Zero-rated Supplies .......................................................................................................... 273

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