Kenya is in the process of reviewing its income tax regime through the enactment of the Income Tax Bill, 2018 (ITB), which will lead to the repeal of the Income Tax Act, Chapter 470, Laws of Kenya (ITA). The ITB was released by the National Treasury in mid-2018 to the public for their comments. The ITB aims to simplify compliance, widen the tax base and align Kenyan tax legislation with international best practices. The ITB is currently undergoing public participation as part of the legislative process before being introduced to the National Assembly for debate and enactment. It is expected that the ITB will be enacted in the course of 2020.
Additionally, the Finance Act, 2019 was enacted in November 2019, which has effected several changes to the tax regime in Kenya.
To this effect, the changes brought by the Finance Act, 2019 and the proposed changes of the ITB have been referred to in this chapter (where relevant).
Businesses generally adopt corporate forms for the purposes of carrying on business in Kenya. The most prevalent forms of business organisations in Kenya are companies limited by shares (either private or public) established under the Companies Act, 2015 (the Companies Act); branches of foreign companies in Kenya registered under the Companies Act, 2015; and limited liability partnerships (LLPs) established under the Limited Liability Partnership Act, 2011. Companies limited by shares and LLPs are separate and distinct legal persons, while foreign branches are not separate legal persons under Kenyan law, but adopt the legal personality of their foreign head offices.
The key difference between LLPs and companies limited by shares is that for tax purposes, LLPs are regarded as being “tax transparent”, with the income of the LLP being taxed in the hands of the LLP partners. Companies limited by shares are taxed on their income, distinct from their shareholders who receive dividend distributions from the company’s after-tax profits. Companies limited by shares are the most prevalent form of business vehicle and as such the law and practice around corporate governance, dispute resolution and liquidation is well developed. LLPs as a business vehicle are fairly recent (introduced in 2011, when the enabling legislation was enacted).
The most commonly used transparent entities are partnerships (both incorporated and unincorporated), which are generally treated as transparent for tax purposes in Kenya. Before 2012, it was only possible to establish an unincorporated partnership in Kenya and these types of entities were mainly used by professional service firms, such as audit firms and law firms. In 2012, Kenya introduced LLPs, which are corporate vehicles with a separate legal personality from their partners. While LLPs are now becoming increasingly popular, they remain relatively new and are currently primarily used in the real estate market for tax planning reasons, on account of the ease of debt funding and profit extraction. However, more professional service firms are converting to LLPs due to the fact that they have a legal personality separate from that of their partners. Thus, as it stands, the business sector and investment groups mainly use a limited liability company as their investment vehicle.
Having said this, it is also becoming common to find a foreign company, such as a Mauritius global business company, being used as an investment vehicle for investments made in Kenya; this is particularly common for private equity and hedge funds with investments in Kenya.
A company is tax resident in Kenya if:
Under the ITB, the above definition of a resident company has been retained save for the fact that the Cabinet Secretary for National Treasury and Planning will no longer have powers to declare a company to be tax resident in Kenya.
For tax-transparent entities such as LLPs, the LLP itself will be regarded as being tax resident in Kenya. The residence of an LLP's partners (in whose hands LLP income is taxed) will depend on whether they are individuals or corporate partners. Foreign corporate partners would be regarded as non-resident unless they meet any one of the tests above, particularly the “management and control” test. Foreign corporate partners of a Kenyan LLP would also need to consider whether, by virtue of their Kenyan activities, they have created a permanent establishment (PE) in Kenya. A PE is created when the foreign corporate partner has either a “fixed place of business” in Kenya or a “dependent agent” who has and habitually exercises authority in Kenya to enter into contracts on behalf of the foreign corporate partner. A PE of a foreign corporate partner would be taxable at a rate of 37.5% of the non-resident person’s business income attributable to the Kenyan PE.
Residency for individual partners is determined by two factors:
The current corporate tax rate applicable to corporations resident in Kenya is 30% on the adjusted net profits, while a non-resident company with a PE in Kenya is taxed at the rate of 37.5% on the business income of the non-resident person attributable to the Kenyan PE.
However, the ITB proposes to reduce the corporate tax rate for non-resident companies with a PE in Kenya from 37.5% to 30%. The ITB also seeks to introduce a tax of 10% on repatriated income applicable on a non-resident person who carried on business in Kenya through a PE, based on a prescribed formula as a factor of increase in net assets. The ITB also proposes to introduce a new tax rate of 35% for companies that have taxable income in excess of USD5 million.
Taxable profits are based on adjusted accounting profits. Therefore, a company’s taxable profits comprise the excess of a company’s net accounting profit having added back non-deductible expenses and having deducted allowable expenses and allowances. Generally, expenses such as capital expenditure, restricted loan interest due to thin capitalisation, personal expenses, unrealised foreign exchange losses and depreciation would be disallowed for tax purposes. On the other hand, capital allowances ranging from 12.5% to 37.5% would be allowed against taxable income for equipment used in the production of income.
There are preferential tax rates available for newly listed companies on the Nairobi Securities Exchange, pursuant to which the tax rates range from 20% to 27% for a period ranging from three to five years. The preferential rates depend on the percentage of listed shares made available to the public through the Nairobi Securities Exchange, as follows:
The ITB proposes to replace the preferential tax rates available for newly listed companies on the Nairobi Securities Exchange with a fixed tax rate for a period of time. The ITB also proposes to maintain preferential tax rates for companies listing at least 40% of their issued share capital, in which case such companies will be taxed at the corporate tax rate of 25% for the first five years as opposed to the current rate of 20%.
For businesses owned by individuals directly or through transparent entities, the individuals’ income is taxed on graduated individual tax brackets that range from 10% to 30%. These rates apply on income earned by tax-resident individuals. With effect from 1 January 2018, monthly income in excess of USD470 earned by an individual is subject to tax at the highest bracket on the graduated scale (ie, 30%) (the marginal tax rate for individuals). For non-resident individuals, the withholding tax regime would apply on passive income streams such as interest (15%), management and professional fees (20%), royalties (20%) and dividends (10%), subject to lower tax rates available under double taxation agreements (DTAs).
While the ITB proposed to introduce a new bracket of 35% income tax for individuals who earn monthly income in excess of USD7,500, it has been subsequently announced by the Cabinet Secretary for the National Treasury that the highest tax bracket of 30% (for monthly income in excess of USD470) will be retained.
Presumptive tax applies at a rate of 15% of the amount payable for a business permit or trade licence issued by a county government (state level), and applies as final tax to resident individuals whose annual business turnover does not exceed KES5 million. Presumptive tax does not apply to incorporated companies or income derived from management/professional fees or rental business.
The Finance Act, 2019 also clarified the application of turnover tax, which applies at a rate of 15% of the amount payable for a business permit or trading licence issued by a county government. The tax is payable at the time of paying for a business permit or trading licence and does not apply to incorporated companies or income derived from management/professional fees or rental business or any income that is subject to a final withholding tax under the ITA.
Profits are taxed on an accrual basis for each tax year. Taxable profits are based on the adjusted accounting profit, which is calculated by adding back non-deductible expenses to the accounting profit and deducting allowable expenses and allowances. Generally, expenses such as capital expenditure, restricted loan interest due to thin capitalisation, personal/non-business expenses, unrealised foreign exchange losses and depreciation are disallowed for tax purposes. On the other hand, capital allowances ranging from 12.5% to 33.3% are allowed against taxable income for equipment used in the production of income. There are also investment deductions that may be available as a deduction against taxable income, and that are discussed below.
While there is no patent box regime in Kenya, there is an important provision in the ITA that allows for expenditure of a capital or revenue nature incurred in scientific research for the purposes of business carried on to be fully deducted in a year of income. This is unlike other types of capital expenditure that are not deductible in full against income but are instead capitalised and receive capital allowances according to the applicable rates.
It is, however, important to note that the ITA provides that the following expenditure falls within the meaning of “scientific research”:
In addition, the following technology-related capital allowances are available:
The ITB proposes to amend the above rates by introducing the following technology-related investment allowances:
The ITA provides various specific tax incentives that are particularly geared towards investment. They include Investment Deduction (ID), currently pegged at 100% on buildings and machinery used for manufacturing purposes; and ID at 150% on the construction of a building, or purchase and installation of machinery valued at KES200 million at least and undertaken outside the city of Nairobi or the municipalities of Mombasa or Kisumu. Industrial Building Allowances (IBA) range between 10% and 25% for industrial and hotel buildings and educational and training buildings; Mining Deductions Allowance (MDA) is at a rate of 40% in the first year and 10% for the remaining six years on a straight-line basis; and Farm Works Deductions (FWD) are at the rate of 20% on a straight-line basis for five years of income.
In the real estate sector, developers who construct 100 residential units annually enjoy a 15% corporate tax, subject to the approval of the Cabinet Secretary for housing. Any company implementing a project under the affordable housing scheme would not be subject to thin capitalisation restrictions that limit deductibility of interest where a foreign controlled company exceeds the 3:1 debt-to-equity ratio. Further, for local motor vehicle assemblers, a 15% corporate tax rate applies for the first five years from commencement of operations, provided that such 15% corporate tax rate can be extended for a further five years if the company achieves a local content equivalent to 50% of the ex-factory value of the motor vehicles.
However, the ITB proposes to amend the above tax incentives by introducing the following investment allowance provisions:
Companies in the Export Processing Zones (EPZs) enjoy a ten-year corporate tax holiday and a 25% tax rate on profits thereafter (except for commercial activities). EPZ companies also enjoy a ten-year withholding tax holiday, as well as exemption from payment of import duty, stamp duty and VAT.
Effective 1 January 2016, a concessionary rate of 10% corporate tax is applicable for companies under the Special Economic Zones (SEZs) regime for the first ten years of operation and a 15% rate is applicable for the subsequent ten years, and 30% thereafter with these entities enjoying exemption from all other taxes and levies.
The ITB, however, proposes that companies in EPZs shall be taxed at 10% for the first ten years from date of first operation and thereafter 15% for another ten years, after which they shall be taxed at the resident corporate tax rate of 30% to ensure consistency between the corporate tax rates for EPZs and SEZs.
The Finance Act, 2019 exempts from income tax any interest income accruing from all listed bonds, notes or other similar securities used to raise funds for infrastructure, projects and assets defined under Green Bonds Standards and Guidelines, and other social services. This is provided that such bonds, notes or securities have a maturity of at least three years.
A Green Bond, as provided by the Standards and Guidelines, refers to a fixed income instrument, either unlisted or listed on a securities exchange, approved by the Capital Market Authority, whose proceeds are used to finance or refinance new or existing projects that generate climate or other environmental benefits that conform to green guidelines and standards.
With effect from 1 January 2016, tax losses are deductible in the year in which they are incurred and can be carried forward for the subsequent nine years. If the losses are not exhausted within those nine years, an application can be made to the Commissioner to extend the period for claiming the tax losses beyond this period of ten years. The Cabinet Secretary for the National Treasury has authority to extend the tax loss utilisation period indefinitely. The ITB proposes to retain the ten-year tax loss utilisation period but upon expiry of the period, the Cabinet Secretary can only extend the tax utilisation period by a maximum of two years.
For companies in the mining, oil and gas industries, any losses incurred in a year of income can be carried forward indefinitely. These companies are also allowed to carry back tax losses for a period of three years, from the year of income in which the loss arose and operations ceased. The licensee or contractor is, however, required to apply to the Commissioner to allow the tax loss carry-back. The ITB, however, proposes to limit the period of carrying losses forward for companies in the mining, oil and gas industries to 14 years.
Kenya has thin capitalisation rules that restrict the deductibility of interest of a resident company in the following circumstances:
A company is considered to be “controlled” by a non-resident person where the non-resident person holds 25% or more of the issued share capital in the company. “Debt” is deemed to comprise all types of financial indebtedness, while “equity” is deemed to comprise all classes of share capital (including redeemable preference shares). Where the debt-to-equity ratio exceeds 3:1, such a company is said to be thinly capitalised and the interest on the loan that exceeds the ratio will be non-deductible for tax purposes. Additionally, where a company is thinly capitalised, the foreign exchange losses (whether realised or unrealised) in respect of loans are deferred and hence not tax deductible until the Kenyan entity ceases to be thinly capitalised.
Thin capitalisation rules do not, however, affect financial institutions licensed under the Banking Act. Additionally, for contractors and licensees in mining and petroleum operations, the debt-to-equity ratio for thin capitalisation purposes is 2:1.
The Finance Act, 2019 excludes companies implementing a project under an affordable housing scheme from the thin capitalisation rules upon recommendation by the Cabinet Secretary responsible for housing.
The ITB proposes to change the definition of “control” to restrict it further, and the ratio is proposed to be reduced to 2:1.
The ITB has also proposed to lower the thin capitalisation ratio from 3:1 to 2:1 but limit the definition of “debt” for purposes of determining the debt-to-equity ratio to loans from a non-resident person. The reduction in the ratio will lead to a higher interest expense restriction and result in a higher taxable income for companies that exceed the debt-to-equity ratio.
Each company in a group is taxed in its own right and its losses are accounted for separately without affecting the taxation of the other companies in the group. Further, tax losses are not transferable within groups.
Where significant tax losses exist in one group company and not another, transfers of business from one group company to another have been considered with a view to utilising the tax losses in one company by another member of the group. However, this is in practice a complicated process and therefore rarely undertaken.
Capital Gains Tax (CGT) was reintroduced in Kenya with effect from 1 January 2015 after being suspended in 1985. CGT is chargeable on the whole gain that accrues to a resident/non-resident corporation/individual on the transfer of property situated in Kenya, at a rate of 5% of the gain. This gain for CGT purposes is the excess of the transfer value of the property over the property’s adjusted cost. The property that is subject to CGT of a company includes goods, choses in action, land and property of every description, whether movable (save for business assets that have enjoyed wear and tear allowance) 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.
CGT is only applicable where the property is situated in Kenya, thus the sale of shares in an offshore holding company that owns shares in a Kenyan company (an indirect transfer) does not trigger CGT in Kenya. With effect from 1 January 2016, there is no CGT arising on the sale of securities listed on a securities exchange in Kenya.
There are a number of transactions that are exempt from payment of CGT, primarily: vesting property in a liquidator through a court order; issuance of a company’s shares or debentures; and transfer of assets between family members and to a family-owned company. A CGT exemption is available in the case of a corporate reorganisation but it is not automatic; it can only be granted by the Cabinet Secretary for the National Treasury, at his or her discretion, having been satisfied that it is in the public interest for him or her to do so.
The Finance Act, 2019 introduces an exemption of the transfers of property in internal corporate restructuring from CGT. Restructuring transactions include incorporation, recapitalisation, acquisition, amalgamation, separation and dissolution. The exemption will cover transactions where the transfer of property is as a result of:
Further, under the provisions of some DTAs, the sale of shares in a Kenyan company (or other property subject to CGT) by a shareholder in the counterpart foreign country would not be taxable in Kenya, but would be taxable in the country where the foreign shareholder is based. This legal position may have the effect of exempting the share sale from CGT.
The ITB proposes to increase the rate of CGT from 5% to 20% but in turn introduce an indexation allowance based on the Consumer Price Indices published by the Kenya National Bureau of Statistics. It is anticipated that the indexation system will cushion sellers from paying CGT on inflationary increases in prices. However, it has been subsequently announced by the Cabinet Secretary for the National Treasury that the 5% CGT rate will be retained. Further, the ITB proposes to grant CGT exemption for internal business reorganisations that are necessitated by a legal or regulatory requirement or compulsory acquisition by the government. This position has already been enacted through the amendments made in the Finance Act, 2019.
Value Added Tax
Value added tax (VAT) is a consumption tax charged on the supply of taxable goods or services made in Kenya and on the importation of taxable goods or services into Kenya from outside Kenya. The rate for VAT is 0% (such as exports) or 16% (the standard rate), with 8% VAT applying on petroleum products. All traders who have a turnover of taxable supplies of at least KES5 million per annum are required by law to register for VAT and charge, collect and remit VAT on their taxable supplies, with an allowance to recover VAT paid on their purchases (input VAT).
Only registered traders are required to charge VAT, although there is an allowance for voluntary registration where the KES5 million threshold has not been met. The supply or importation of goods or services that are designated as exempt are not subject to VAT and, as such, their sale does not constitute a taxable supply for VAT registration purposes. Zero-rated VAT is applicable to goods and services exported from Kenya, goods and services supplied to EPZs and SEZs, and the supply of coffee and tea for export to coffee and tea auction centres. All zero-rated supplies are considered as “taxable supplies”. For imported services, the Kenyan importer is required to account for “reverse charge VAT” only to the extent that such importer makes exempt supplies; as such, an importer of services who makes only taxable supplies would not be required to account for “reverse charge VAT”. The Finance Act, 2019 now requires any person (including VAT un-registered persons) who imports services from a non-resident person to account for reverse charge VAT.
Any non-resident person who qualifies for VAT registration but does not have a fixed place of business in Kenya is required to appoint a resident person as his or her tax representative for VAT compliance purposes. Should such non-resident person not do this, the Commissioner has the authority to appoint a tax representative for such non-resident person and apply a penalty of KES200,000 or imprisonment, upon conviction, for a term not exceeding two years.
Withholding VAT is a mechanism by which an appointed withholding VAT agent deducts and remits withholding VAT on every purchase they make from a VAT registered person. Prior to 7 November 2019, the withholding VAT rate was 6% but this was reduced to 2% under the amendments made by the Finance Act, 2019 and provided that withholding VAT shall not apply to zero-rated supplies. This provision follows an amendment in the VAT Act, 2013 in July 2019 under the Statute Law (Miscellaneous Amendments) Act, 2019 that allowed for a refund of VAT arising from withholding VAT.
Stamp duty is charged according to the value of the transaction or the nominal rates on certain financial instruments and transactions. Stamp duty of 1% is payable on the transfer of shares and registration of share capital. However, no stamp duty is charged on the transfer of shares in companies listed on the Nairobi Securities Exchange.
A stamp duty of 4% of the value of the land is payable on the transfer of the land in towns/urban areas, and 2% of the value of the land is payable on the transfer of land in rural areas. Land purchased for the expansion and development of schools is exempt from stamp duty, provided the land does not revert to any other use after such a purchase.
Stamp duty also applies at varying rates on registration of debentures and mortgages, on leases and on stamping of various registrable instruments.
Other relevant taxes applicable on goods imported into Kenya are import duty, excise duty, catering levy, import declaration fee (3.5% of customs value) and railway development levy (2% of customs value), subject to specific exemptions. Import duty is charged on the importation of goods depending on their nature and value. Import duty ranges from the rate of 0% on raw materials, 10% on semi-finished goods and 25% on fully finished goods, in accordance with the East African Community Common External Tariff. Certain imported and locally manufactured goods also attract excise duty at varying rates based on either ad valorem (value) or quantity of the excisable goods or services.
Notable taxes that incorporated businesses are subject to have been discussed above.
Most closely held local businesses operate in corporate form as private limited liability companies. As indicated above, although legislation on LLPs was introduced in 2012, limited liability companies remain the predominant investment vehicle.
The highest Pay As You Earn (PAYE)/employee tax rate is 30%, which is applicable to employment income above KES564,709, and is largely comparable to the resident corporate tax rate of 30%. There are, as such, no rules to prevent individual professionals from earning income at corporate rates.
If, in the opinion of the Commissioner, dividends have not been paid out to shareholders that ought to have been paid out within a period of 12 months after a company’s accounting year-end, the Commissioner may deem such dividends as having been distributed and charge withholding tax thereon.
The ITB proposes to give the Commissioner power to direct that an amount not less than 60% of the accounting profits shall be deemed as having been distributed as dividends.
Any distribution, whether in cash or kind, made before or during winding-up by a company to its shareholders with respect to their equity interest in the company is regarded as dividends for purposes of taxation. Further, the Finance Act, 2018 amended the ITA to expand the definition of dividends to include the following transactions:
In addition to the expanded definition under the Finance Act, 2018, the ITB provides that the following shall also be considered dividends:
The above transactions will therefore be deemed to be a distribution of dividends and thus subject to withholding tax.
For dividends paid to Kenyan residents or to citizens of the East African Community, the rate of withholding tax on dividends is 5%. A rate of 10% is applicable to non-residents. Where a dividend is paid to a resident company that holds directly or indirectly more than 12.5% of the shares of the underlying company, there shall be no withholding tax. This 12.5% exemption does not apply to individual shareholders. The ITB proposes to increase the shareholding threshold for corporate shareholders from 12.5% to 25%.
CGT is applicable at the rate of 5% on the excess of transfer value over adjusted cost on the gains from the sale of unlisted securities. See 2.7 Capital Gains Taxation for more information.
A company may be liable to a tax known as compensating tax at a rate of up to 42.86%, if it makes a distribution from previously untaxed earnings or income taxed at a rate lower than the applicable corporate tax rate of 30%. In essence, every company resident in Kenya is required to establish and maintain a dividend tax account that matches dividends paid out by the company against incomes that have been subjected to income tax.
Where a company has earned exempt income or income that is subject to a tax rate lower than the corporation tax rate of 30%, and such income is distributed to shareholders by way of dividends, the dividend tax account requires a payment of compensating tax to reduce the balance to zero.
Where a company is liable for compensating tax, it is required to make payment of compensating tax by the end of the sixth month following a company’s financial year-end.
The Finance Act, 2018 repealed the compensating tax provisions and replaces it with a new tax on untaxed distributions. Thus, with effect from 1 January 2019, where a company distributes dividends from untaxed profits, the company will be charged tax in the year of income in which the dividends are distributed at the resident corporate tax rate (30% in the case of resident companies) on the dividends distributed. The Finance Act, 2018 also does not expressly require companies to maintain a dividend tax account.
However, the amendment caused great uncertainty as it was not clear whether exempt dividends received by holding companies and gains that had been subject to capital gains tax could be distributed without triggering the new compensating tax. The Kenya Revenue Authority (KRA) thereafter issued a public notice setting out income not subject to tax under Section 7A. The Finance Act, 2019 amends Section 7A to exclude application of the section on compensating tax to income that is already exempt from tax under the ITA. This move clarifies the tax impact of making distributions to company shareholders.
Dividends received from a publicly traded company are taxable on the same basis as those received from a private company, ie, 5% for a resident and 10% for a non-resident, as a first and final tax.
Gains on sale of shares of publicly traded corporations are subject to CGT on the same basis as shares of private companies, except where the shares of the corporation are listed and traded on a licensed securities exchange in Kenya. Publicly traded shares on over-the-counter (OTC) markets do not receive this exemption from CGT.
In addition, shares in a Kenyan company are considered property situated in Kenya and are therefore subject to stamp duty at the rate of 1% on the higher of the consideration and the market value of the shares as certified by the company’s auditor. The transferee in such a case would be responsible for payment of stamp duty.
Royalties are subject to withholding tax at a rate of 5% when paid to resident persons and 20% when paid to non-resident persons, on the gross royalty payment made.
Interest when paid to both resident and non-resident persons is liable to withholding tax at 15% on the gross interest paid, with the exception of interest from housing bonds to resident persons, which is subject to withholding tax at the rate of 10% on the gross interest paid. Interest on loans from a foreign source invested in the energy or water sector or in roads, ports, railways or aerodromes is exempt from withholding tax.
Dividends when paid to residents and citizens of the East African Community Partner States are subject to withholding tax at a rate of 5%, while a rate of 10% is applicable to dividends paid to non-residents.
Where a DTA exists between Kenya and a foreign country, lower withholding tax rates for royalties, interest and dividends may apply, if the recipient of such passive income qualifies under the limitation of benefits provisions.
Increasingly, equity investments into Kenya are made through a Mauritius vehicle. Mauritius as a destination is primarily a consideration owing to the wide DTA Mauritius has on the African continent. In March 2019, the High Court of Kenya declared the Kenya-Mauritius DTA invalid. The decision did not result in any adverse implications for Kenyan companies with structures in Mauritius and the withholding tax rates set out in the ITA would continue to apply to payments being made by Kenyan subsidiaries to their Mauritian holding companies. In October 2019, a protocol was signed amending a Kenya-Mauritius DTA that was signed in April 2015, with Legal Notice 173 of 2019 initiating the legislative process that brings the Kenya-Mauritius DTA to force in Kenya.
Kenya has DTAs (which are in force) with a number of countries, including the United Kingdom, Germany, Sweden, France, India, Zambia, Canada, Denmark, Norway, Iran, South Korea, Qatar, the United Arab Emirates (UAE) and South Africa. Kenya has also signed DTAs with the following countries, but these are not yet in force: Seychelles, Mauritius, Italy, Kuwait, China, East African Community Member States, Portugal, Singapore and the Netherlands.
Treaty benefits are not available to non-treaty country residents.
The Finance Act, 2014 introduced a restriction on the applicability of DTAs that Kenya has concluded with other countries that took effect on 1 January 2015. Under the new restriction (limitation of benefits clause), for a foreign entity to be entitled to the benefits arising from a DTA at least 50% of its underlying ownership should be held by persons who are tax resident in the relevant foreign jurisdiction or the entity should be listed on the stock exchange of the relevant foreign jurisdiction. In effect, benefits under a tax treaty concluded between Kenya and another contracting state shall not be available to a resident person of the other contracting state if 50% or more of the underlying ownership of that person is held by an individual or individuals who are not residents of that other contracting state. "Underlying ownership" is defined as an interest in the person held directly, or indirectly through an interposed person or persons, by an individual or by a person not ultimately owned by the individuals.
The ITB proposes to introduce further restrictions on the applicability of tax treaties that Kenya has concluded with other countries. Under the ITB, a foreign entity shall only be entitled to the benefits arising from a DTA if the entity is a company listed on the stock exchange of the contracting state. Where the foreign entity is not listed on the stock exchange of the contracting state, the foreign entity shall only be entitled to the benefits arising from a DTA where at least 50% of the underlying ownership of the company is held by individuals who are residents of the other contracting state in addition to the following requirements:
The Commissioner can conduct an audit and make adjustments in the taxable profit of a company and demand corporate tax where applicable. Particularly, the Commissioner can adjust the profits accruing to a resident company from a course of business conducted with related non-resident persons to reflect such profits as would have accrued if the course of business had been conducted by independent persons dealing at arm’s length. In effect the Commissioner can adjust prices in cross-border transactions involving related parties to reflect an arm’s-length price. The onus is on the person who avers the existence of an arm’s-length price in respect of related-party transactions to demonstrate it. Therefore, a detailed transfer pricing policy with respect to all related-party transactions should be developed.
A detailed transfer pricing policy is important because the KRA regularly requests transfer pricing documentation from local corporations with cross-border related-party transactions with the intention of risk-profiling them for the purpose of conducting transfer pricing audits. In particular, inbound management services and payments relating to the use of intellectual property (such as trade marks), marketing and advertising services are ordinarily queried by the KRA.
Transfer pricing applies to transactions between a head office and its subsidiaries and branches as well as between such individual subsidiaries and branches. The ITA considers branches as separate and distinct entities from their head offices for transfer pricing purposes. Under the ITA there are no specific transfer pricing penalties; however, as stated above, the Commissioner can adjust the taxable profit of a company and demand tax where applicable following an audit. The ITB proposes to introduce a penalty of 2% of the value of the transaction where a company fails to provide transfer pricing documentation. The ITB further provides that the imposition of the penalty does not prevent the Commissioner from assessing and recovering any taxes due.
Additionally, the ITB proposes to extend transfer pricing to transactions between resident companies and non-resident companies (including unrelated entities) situated in preferential tax regimes (defined as regimes that have tax rates of less than 16%, do not have effective exchange of information arrangements, do not allow access to banking information or lack transparency on the details of its application, including details of: corporate structure, ownership of the legal entities located in the country, beneficial owners of income or capital, or financial disclosure).
Under the current ITA, transfer pricing rules apply only to transactions between related parties. The ITB, however, expands the application of transfer pricing rules to include transactions between parties that are not related, where one of the parties operates in a preferential tax regime or beneficial tax regime.
A beneficial tax regime is defined as a regime anchored in any legislation or regulation that provides a preferential rate of taxation to any income, including reduction in the tax rate or tax base. This would include businesses operating in an SEZ or an EPZ.
Limited risk distribution arrangements are common in Kenya, especially in the alcoholic beverages and fast-moving consumer goods sectors. Although limited risk distribution arrangements are usually scrutinised carefully by the KRA, such arrangements will only be challenged where the operations on the ground do not align with the basic principles on which the model is based.
The Kenyan transfer pricing rules are broadly modelled on the principles set out in the OECD Guidelines. Further, Kenyan courts have used the OECD Guidelines and commentary to form jurisprudence where the domestic tax law does not set out equivalent provisions.
The Commissioner is authorised to make transfer pricing adjustments in instances where there has been transfer mispricing. Should these adjustments result in an increase in a tax deductible expense, then the full value of this increase can be claimed by the company as a set-off against its taxable income. Further, the payment of any income tax penalty or interest on tax arrears would be regarded as a non-deductible expense and therefore be subject to tax at the appropriate corporate tax rate.
A local branch of a non-local corporation is treated as a taxable presence of the non-resident person whereas a local subsidiary of a non-local corporation is treated as a resident person for tax purposes.
The corporate tax rate applicable to a local branch is 37.5% of its adjusted annual taxable income. A branch’s taxable income comprises gross income earned in or derived from Kenya after deducting expenses wholly and exclusively incurred in the production of income. In ascertaining a branch’s taxable income, the local branch’s gains or profits realised from a business carried on in Kenya are ascertained with no deductions allowed in respect of expenditure incurred outside Kenya by the non-local corporation head office, other than such expenditure in respect of which the Commissioner determines that adequate consideration has been given in Kenya. The Commissioner may, however, determine such executive and general administrative expenses are just and reasonable in his or her sole discretion as being allowable expenses for tax purposes.
Under the ITA, repatriated profits of a branch are not subject to any further taxes. The ITB, however, proposes to tax at the rate of 10% any notional repatriated income, earned for the year of income. The ITB also proposes to reduce the corporate tax rate for a branch from 37.5% to 30%. Thus, effectively, the corporate tax rate for a branch and subsidiary under the ITB will be the same (30%).
On the other hand, a local subsidiary is treated as a resident corporation for tax purposes. The tax rate applicable to subsidiaries is 30% of its annual taxable income. However, for a subsidiary with a non-resident shareholder, a further 10% withholding tax is applied on dividends. As such, the effective tax rate for a subsidiary is 37%. Therefore, the tax difference between a subsidiary and a branch is not significant, particularly where it is intended that profits are distributed to non-resident shareholders on an annual basis.
CGT is chargeable on the gain accruing on the transfer of property situated in Kenya. However, the Finance Act, 2015 exempted sale of shares in a listed company from CGT, effective as of 1 January 2016. Thus CGT will be applicable where non-residents sell stock in local corporations since the shares are located in Kenya.
Gains accruing from the disposal of shares of a non-local holding company (ie, an indirect disposal) will not be subject to CGT in Kenya, based on current law, as this would not constitute property situated in Kenya.
Some DTAs signed by Kenya exclude CGT on the sale of shares by a resident of a counterpart contracting state when such person sells shares in a company resident in Kenya. Such a benefit would, however, only accrue where the non-resident seller has fulfilled the limitation of benefits test under the ITA; ie, 50% underlying ownership of the non-resident seller owned by tax residents of the foreign counterpart state.
Section 54(B) of the ITA imposes an obligation to notify the Commissioner if there is a 10% or more change in the shareholding of a person carrying on business, but imposes no tax obligation on account of an indirect holding change.
A separate taxation regime applies for petroleum companies engaged in the oil and gas industry. Paragraph 14 of the Ninth Schedule to the ITA extends this obligation to cases where there is a 10% or more change in the underlying ownership of a company operating in the mining, oil and gas sector. Underlying ownership is defined as an interest in the person held directly or indirectly through an interposed person or persons, by an individual or by a person not ultimately owned by the individuals. The net gain from the indirect disposal of shares in petroleum companies is subject to tax in a manner similar to taxation of assignment of rights, as below:
The income of foreign-owned local affiliates is taxed at the resident corporate tax rate of 30%, with no tax distinction being made on account of their foreign shareholding. However, transfer pricing considerations require that all transactions between related parties are at arm’s length, failing which, the Commissioner can make an adjustment to cater for the application of any price that is not an arm’s-length price.
As outlined in 5.2 Taxing Differences, the local branch’s gains or profits realised from a business carried on in Kenya are ascertained with no deductions allowed in respect of expenditure incurred outside Kenya by the non-local corporation head office, other than such expenditure in respect of which the Commissioner determines that adequate consideration has been given in Kenya. The Commissioner may, however, determine such executive and general administrative expenses are just and reasonable in his or her sole discretion as being allowable expenses for tax purposes.
There are thin capitalisation rules (3:1 debt-to-equity ratio) applicable in Kenya pursuant to the provisions of the ITA that are relevant where the foreign lender is a shareholder in the Kenyan entity. For more, see 2.5 Imposed Limits on Deduction of Interest.
Where a non-resident shareholder has extended a loan to a resident company on an interest-free basis, the resident company is required to calculate a deemed-interest charge based on the prevailing Treasury Bill rates and the withholding tax of 15% remitted to the KRA. To avoid the requirement to account for withholding tax, a notional interest may be charged on the loan, on which withholding tax at 15% would be accounted for (although such interest would need to be at arm’s length in accordance with transfer pricing requirements). Lastly, as deemed interest is notional in nature, it would not be considered a tax-deductible expense when calculating the company’s taxable profit.
Business income earned by local corporations is not tax exempt. Section 4(a) of the ITA provides that where a business is carried on or exercised partly within and partly outside Kenya by a resident person (such as a local corporation), the whole of the gains or profits from that business shall be deemed to have been accrued in or to have been derived from Kenya. Such income will be taxed similarly to income derived in Kenya. Therefore, foreign income would be taxable at 30% as business income generated by a resident company.
The same is maintained under the ITB.
The ITA provides that all expenses incurred wholly and exclusively in the generation of business income are deductible in calculating the taxable profit of a local corporation.
In Kenya, foreign dividend income is exempt from tax. Any expenses that are directly attributable to such exempt income are non-deductible for tax purposes in Kenya.
The use of a local corporation’s intangibles by foreign related parties such as non-local subsidiaries needs to comply with transfer pricing requirements that the price paid for royalties needs to be at arm’s length. From a VAT perspective, the use of local intangibles by foreign related parties is considered an exported service for VAT purposes and therefore a zero-rated supply.
CFC-type rules do not apply in Kenya for both non-local subsidiaries and branches of local corporations. Section 4(a) of the ITA, however, provides that where a business is carried on or exercised partly within and partly outside Kenya by a resident person, the whole of the gains or profits from that business shall be deemed to have been accrued in or to have been derived from Kenya. Such income will be taxed similarly to income derived in Kenya, at a resident corporate tax rate of 30%.
Presently, there is no explicit provision that determines the substance of a non-local affiliate company. The current position is that since a non-local company could be resident in Kenya if managed or controlled from Kenya, there is a risk that a non-local affiliate may be deemed to be resident in Kenya if its directors and shareholders are all located in Kenya. It is, however, the case that the ITA does not state what the position would be if the non-local affiliate company lacks substance but is not managed or controlled from Kenya.
Having said this, where a DTA exists, the ITA restricts a foreign company in a treaty country from accessing DTA benefits in Kenya where at least 50% of underlying ownership is not held by citizens of the treaty country.
Capital gain on sale of shares in a non-local affiliate is not taxable in Kenya but may be subject to tax in the foreign country where the non-local affiliate is resident.
The ITA provides that where the Commissioner is of the opinion that the main purpose, or one of the main purposes, for which a transaction was effected was the avoidance or reduction of liability to tax for a year of income, or that the main benefit that might have been expected to accrue from the transaction in the three years immediately following the completion thereof was the avoidance or reduction of liability to tax, he or she may, if he or she determines it to be just and reasonable, direct that such adjustments shall be made as respects liability to tax as he or she considers appropriate to counteract the avoidance or reduction of liability to tax that could otherwise be effected by the transaction.
The Tax Procedures Act, 2015 also penalises any tax avoidance schemes by a taxpayer. Tax avoidance is defined under the Tax Procedures Act, 2015 as any transaction or scheme designed to avoid liability to pay tax under any tax law. The Tax Procedures Act, 2015 provides that where the Commissioner has applied a tax avoidance provision in assessing a taxpayer, the taxpayer shall be liable to a tax avoidance penalty equal to double the amount of tax that would have been avoided but for the application of the tax avoidance provision. The Commissioner does not have authority to remit/waive a tax avoidance penalty as is the case with other penalties levied under different tax laws.
There are no regular routine tax audits in Kenya. However, the practice by the KRA is for audits to be done on a three to five-year period as this corresponds to the audit limitation period of five years. In particular, the Large Taxpayers Office of the KRA (which audits companies with turnover of approximately USD10 million and above) usually audits all taxpayers under its ambit every three years.
Tax audits were common in the past, with the KRA making physical visits to a taxpayer’s premises to ascertain the taxpayer’s level of tax compliance. Section 58 of the Tax Procedures Act, 2015 gives an authorised officer of the KRA the power to enquire into the affairs of a person under any tax law, and full and free access to all lands, buildings and places to inspect all goods, equipment, devices and records, whether in the custody of a public officer or a body corporate or any other person, and make extracts from or copies of those records. However, since 2015, the KRA has adopted a more data-driven approach with the onset of the KRA’s online portal, iTax. iTax allows taxpayers to update their tax registration details, file tax returns, register all tax payments and make status enquiries in real time. The KRA routinely requests transfer pricing documentation from all taxpayers with cross-border related-party transactions with the intention of risk-profiling them for the purpose of conducting transfer pricing audits. In this regard, all multinationals are potential targets for transfer pricing/permanent establishment audits. In addition, the KRA has in the recent past focused on the audit of VAT refund claims made by Kenyan VAT registered persons making exports of services, and raised tax assessments on IT and software companies providing cross-border services.
Kenya has implemented the following BEPS recommended changes.
Limitation of Benefits
Kenya has a limitation of benefits provision in the ITA. The ITA provides that a foreign entity will only be entitled to the benefits arising from a DTA if at least 50% of its underlying ownership is held by persons who are tax resident in the relevant foreign jurisdiction or if the foreign entity is listed on the stock exchange of the relevant foreign jurisdiction. The Income Tax Bill, 2018 proposes to introduce further restrictions on the applicability of tax treaties that Kenya has concluded with other countries. Under the ITB, a foreign entity will only be entitled to the benefits arising from a DTA if the entity is a company listed on the stock exchange of the contracting state. Where the foreign entity is not listed on the stock exchange of the contracting state, the foreign entity shall only be entitled to the benefits arising from a DTA where at least 50% of the underlying ownership of the company is held by individuals who are residents of the other contracting state and:
In effect the company in the other contracting country cannot be a holding company, an administration company or a financing company.
Transfer Pricing Changes
The ITB contains the following provisions that are BEPS recommended changes:
Inclusion Treaty Anti-abuse Rules in Renegotiated Treaties and Newly Signed Treaties
The recent DTAs that Kenya has signed, such as the renegotiated Kenya-India DTA (which is in force), contain provisions proposed under Action 6 of BEPS, such as the following.
Expanding the Definition of Permanent Establishment to Counter Artificial Avoidance of PE Status
The ITB proposes to expand the definition of a PE to align it with BEPS recommended changes of preventing artificial avoidance of PE status. The proposed definition under the ITB includes a warehouse, sales outlet, farm, plantation or other place where agricultural, forestry or related activities are carried on; and an installation or structure used in the exploration of natural resources, where that installation or structure continues for a period of not less than 183 days. Service companies, including consultancy firms, will be deemed to have created a PE through employees or other personnel engaged, where the furnishing of services continues within Kenya for a period in aggregate exceeding 91 days in any 12-month period.
Amendments of the Kenya-India DTA in Relation to Definition of Permanent Establishment under BEPS Action 6 on Preventing Artificial Avoidance of PE Status
The BEPS recommendation on activities of a fixed place of business that do not create a PE provides that preparatory or auxiliary activities of a fixed place of business will not be considered to create a PE of a foreign entity. Previously the requirement only applied to certain activities of a fixed place of business but now all the activities of the fixed place of business need to be of a preparatory or auxiliary character in order not to be considered to have created a PE for a business with a fixed place of business.
In recent years, the KRA has become more aggressive in ensuring that BEPS measures are implemented to protect the tax revenue base. For example, the government, through the Kenya Revenue Authority, routinely requests transfer pricing documentation from all taxpayers with cross-border related-party transactions with the intention of risk-profiling them for the purpose of conducting transfer pricing audits. There has also been increased government expenditure to the KRA in training staff on BEPS practices and how to counter them.
The Finance Act, 2019 has introduced tax on income accruing through a digital marketplace. Action 1 of the BEPS Action Plan calls for work to address the tax challenges of the digital economy. In this regard, the Finance Act, 2019 requires that the Cabinet Secretary should come up with regulations to provide for the mechanism and implementation of digital tax.
In line with the initiatives of the Financial Action Task Force on Money Laundering (FATF), the Statute Law (Miscellaneous Amendments) Act No 12 of 2019 clarified that every company incorporated or registered in Kenya will now be required to keep two separate registers: (i) a register of members and (ii) a register of beneficial owners. The two registers are required to be lodged with the Registrar of Companies upon any change in legal or beneficial ownership of a company’s shares.
Kenya signed the Yaoundé Declaration, which establishes a framework on transparency with regard to tax-related information. Additionally, the ITB proposes to introduce a provision on filing of a country-by-country report in line with the BEPS proposals for transparency and country-by-country reporting.
The KRA has also focused on transactions relating to intangible property and management fees and unsurprisingly, as part of the BEPS Action Plan, the OECD has issued comprehensive papers on intangibles (such as royalties) and management fees that would guide tax administrators on the audit approach to take when reviewing these transactions.
In Kenya, international tax does not have a high public profile as tax issues are left to the tax practitioners and government, with members of the general public being mostly interested with local tax and its implication on their livelihoods.
One of the main objectives for Kenya, being a developing country, is to attract potential investors into the Kenyan market. For this purpose, Kenya has tried to make its tax regime competitive through incentives and tax exemptions such as EPZ and SEZ, and investment deductions. The competitive object of Kenya’s tax regime may, however, be difficult to balance in the wake of the BEPS objectives. Implementation of the BEPS Action Plan by Kenya may make Kenya’s tax obligations quite onerous and therefore less attractive as a place to set up for tax planning purposes. This may also pose a disadvantage to Kenya as it will not be as competitive as the non-OECD nations.
Kenya has numerous tax incentives, including Special Economic Zones, Export Processing Zones and investment deduction allowances. Despite evidence to indicate that tax incentives do not necessary play a key role in influencing the majority of investment decisions by foreign investors, Kenya continues to add to the tax incentives on offer with each budget cycle. The Kenyan tax statutes give the Cabinet Secretary in charge of the National Treasury discretionary powers to exempt any income or class of income from tax. In 2018, the Cabinet Secretary of Treasury and Planning introduced guidelines for the management of tax incentives and the granting of exemptions so as to streamline the process, reduce abuse and improve transparency and accountability. In the authors' view, the granting of tax incentives ought to conform to strict and transparent assessments to ensure that Kenya does not lose out on tax due to tax incentives offered to large businesses.
The proposals for dealing with hybrid instruments from the Kenyan context are quite favourable to Kenya’s tax objectives. The proposal to seal these loopholes that may be used through hybrid mismatches will give Kenya and other countries greater powers to ensure that entities do not benefit at their expense. Kenya has already started implementing some of the proposals in some of its international treaties; for instance, the Kenya-India DTA, effective 1 January 2018, which gives contracting parties the right to use domestic legislation to prevent tax avoidance and evasion issues. This shows that Kenya is on its way to implementing the changes recommended by BEPS. However, we will have to wait and see whether all the recommendations shall be implemented.
Kenya has a territorial tax regime and thus only income that is accrued in or derived from Kenya is subject to tax in Kenya. However, where a business is carried on or exercised partly within and partly outside Kenya by a resident company, the whole of the income from that business is taxable in Kenya on a worldwide basis.
Kenya has thin capitalisation rules (Thin Cap Rules) that restrict interest deductibility. The Thin Cap Rules limit the deductibility of interest on loans for any year of income where the company is in the control of a non-resident person alone or together with four or fewer other persons and the highest amount of all loans held by the Kenyan company during the year of income exceeds three times the sum of the revenue reserves and the issued and paid-up capital of all classes of shares of the Kenyan company. Based on the above, Kenya uses the debt-to-equity ratio to limit deductibility of interest on loans and the debt-to-equity ratio in Kenya is 3:1. In effect, companies are allowed to deduct interest payments on debt of up to three times the total amount of equity of the company. Kenya uses the total debt of the Kenyan company as the basis of determining the debt-to-equity ratio. Debt is deemed to comprise all types of financial indebtedness, such as loans and bonds, while equity is deemed to comprise all classes of paid-up share capital, including redeemable preference shares.
OECD Action 5 has criticised the use of debt-to-equity ratios as a means of limiting deductibility of interest on the basis that it still allows significant flexibility in terms of the rate of interest that an entity may pay on debt and also allows entities with higher levels of equity capital to deduct more interest expense. For these reasons, the debt-to-equity ratio is not considered a best practice approach to address base erosion and profit shifting. The best practice approach under BEPS is the fixed ratio of interest to earnings with the measure of earnings being earnings before interest, taxes, depreciation and amortisation (EBITDA). The interest-to-earnings ratio limits an entity’s net interest deductions to a fixed percentage of its profits measured using EBITDA. The recommended fixed percentage is 10% to 30%. The interest-to-earnings ratio ensures an entity’s interest deductions are directly linked to its economic activity and to its taxable income, making it robust against tax planning. BEPS also recommends combining this fixed ratio rule with a group ratio rule.
The ITB has also proposed to lower the thin capitalisation ratio from 3:1 to 2:1; however, the Thin Cap Rules still apply.
The firm agrees with the general objective of the CFC proposals, which, as the authors understand, are geared to preventing profit shifting and, in turn, base erosion of taxes. However, in terms of the scope of the CFC rules, some of these appear to be far too broad to achieve and may cause inconsistency amongst nations (in particular, the potential for CFC rules to challenge "foreign-to-foreign" shifting). Given the fact that many territories adopt a territorial tax system, frequently supplemented by rules against tax avoidance and tax evasion, such an approach is likely to give rise to duplication of efforts. In a time when most countries are moving towards a more regional collaborative approach, this could lead to a situation where many territories have strict CFC rules and others have none, and even more competition between nations (especially between OECD and non-OECD nations).
Investors into Kenya in most cases incorporate a holding company in a low tax jurisdiction (such as Mauritius) to be the holding company for the Kenyan company. The investors then invest into the Kenyan company indirectly through the holding company. The investment is in the form of shares, advancing loans, offering management and professional services or getting into licensing agreements with the Kenyan subsidiary allowing it to use the foreign-held intellectual property (IP) owned by the holding company. Thereafter, the investors extract capital in the form of dividends, interest, royalties, management and professional fees paid to the holding company by the Kenyan subsidiary.
The holding company benefits from lower withholding tax rates provided for in the DTA. However, in most cases the holding company serves as an interposing company or financing company incorporated with the aim of extracting the profits from the Kenyan subsidiary and enjoying the lower withholding tax rates provided for under the DTA. However, with the limitation of benefits provisions and principal purpose of transaction test, an interposing holding company will not be able to enjoy the lower withholding tax rates under the different DTAs if it is established that the main purpose or one of the main purposes of the transaction is to enjoy the lower withholding tax rates provided for under the DTA. Additionally, based on the limitation of benefits rule, if the provisions of the ITB are passed in their current form, the entity in the other state must be engaged in active business in order to enjoy the benefits under a DTA that Kenya has signed with a foreign country. Therefore, entities operating in the following activities will not be in a position to enjoy DTA benefits: companies providing group financing, providing supervision or administration of group companies or operating as holding companies. This will therefore have a great impact on inbound and outbound investors.
Some DTAs, such as the South Africa DTA, provide that the sale of shares by a South African tax resident in a company in Kenya would not be subject to CGT in Kenya and vice versa, thus promoting inbound and outbound investments.
In addition, many DTAs do not have a clause providing for the taxation of management and professional fees earned by a non-resident in Kenya, making such income taxable as business income in the foreign country. Such provisions deny the KRA withholding tax revenue.
The ITB introduces transfer pricing rules whereby transactions between resident companies and non-resident companies (including unrelated entities) situated in preferential tax regimes (defined as regimes that have tax rates of less than 16% or that do not have effective exchange of information arrangements or do not allow access to banking information or lack transparency) are to be on an arm's-length basis.
Additionally, the gains and profits of a resident person operating in a beneficial tax regime (such as a Special Economic Zone) shall be computed, taking into account the provisions of the ITB in relation to transfer pricing rules. The effect of the ITB proposals is to increase the reach of transfer pricing rules to apply to resident and non-resident entities, including unrelated entities. In relation to taxation of profits from intellectual property (IP), the transfer pricing proposals will affect transactions between holding companies and Kenyan companies with IP licensing agreements and transactions between financing companies and Kenyan companies. The Income Tax (Transfer Pricing) Rules, 2006 (TP Rules) were enacted to provide guidelines to be applied by related enterprises in determining the arm’s-length prices of goods and services in transactions involving them. Royalties when paid out to non-residents are subject to withholding tax at the rate of 20%. However, where a DTA exists between Kenya and a foreign country, lower withholding tax rates for royalties may apply.
The ITB contains a provision on transfer pricing in transactions involving intangible property. In line with OECD recommendations on taxation of intangible property, the ITB contains a provision that determination of arm’s-length conditions for controlled transactions involving the exploitation of an intangible asset must take into account the contractual arrangements in respect of the development, enhancement, maintenance, protection and exploitation of the asset (DEMPE). This means that legal ownership alone will not necessarily generate a right to all (or indeed any) of the return that is generated by the exploitation of the intangible property. Instead, returns from intangible property will accrue to the entities that carry out the DEMPE functions and not necessarily to the legal owner. This is likely to affect multinational enterprises that have an interposing holding company in a low tax jurisdiction that has the legal ownership of its intangible property such as IP rights and a Kenyan company licensed to use the IP. In most cases the interposing holding company will enter into a licensing agreement with the Kenyan company that will allow the Kenyan company to use the IP and the Kenyan company will pay royalties to the interposing holding company. The Kenyan company ideally develops, enhances or exploits the IP and the returns made will be paid to the holding company as the legal owner of the IP rights. The royalties will be subject to withholding tax at 20% and in most cases the interposing company is in a country that has a DTA with Kenya that provides for lower withholding tax rates. However, with the TP provisions on transactions involving intangible property contained both in BEPS action points and the ITB, the interposing company will not be entitled to all the returns from the IP rights simply by virtue of being the legal owner. Instead, if the Kenyan company is the one involved in the DEMPE functions then it would be the one entitled to the returns, with the value of the licence fees to the holding company being limited, not the holding company. The holding company, despite being the legal owner, will only be entitled to the returns to the extent it is involved in the DEMPE functions. Economic return from IP will be allocated to entities that perform and control DEMPE functions.
Kenya is in favour of the proposals for transparency and country-by-country reporting. The ITB proposes to introduce a provision on filing of a country-by-country report by ultimate parent entities that are resident in Kenya for tax purposes with the Commissioner not later than 12 months after the last day of the reporting financial year of the multinational enterprise group.
However, there are certain improvements that could be made to the OECD recommendations on transparency and country-by-country reporting to ensure the aim of Action 13 is achieved. These include the following.
Inclusion of Intercompany Interest, Royalties and other Payments in the Country-by-Country Report
The OECD country-by-country reporting template excludes intercompany interest, royalties and other payments from the country-by-country report filed by multinational enterprises (MNEs) with the tax administrators. However, IP licensing arrangements together with intercompany debt financing are generally considered amongst the most prominent channels for base erosion and profit shifting.
Inclusion of Withholding Tax Data in the Country-by-Country Report
The OECD country-by-country report excludes disclosure of withholding tax data from the final country-by-country report filed by MNEs with tax administrators. Withholding tax information could prove useful in identifying potential tax abuse such as treaty shopping.
Mandatory Reconciliation Procedure of the Data Reported in the Country-by-Country Report and the MNE’s Consolidated Financial Statements
Under the OECD proposals on transparency and country-by-country reporting, there is no requirement for mandatory reconciliation of the data reported by the MNE in the country-by-country report and the MNE’s consolidated financial statements. The reconciliation process would serve as a tool for identifying high-risk audit targets, rather than just gathering additional information at a time when the audit subject is already determined. A top-down reconciliation rule should be adopted to achieve reconciliation first between the consolidated financial statements of the group company and its local financial statements for the different countries; second, a reconciliation of the local financial statements to the locally filed tax returns; and then reconciliation to the filed country-by-country report.
Adoption of an Entity-by-Entity Approach over Country Consolidation Reporting
The OECD country-by-country proposal adopts a country consolidation reporting as opposed to an entity-by-entity approach. Use of country consolidation reporting gives MNEs an opportunity to hide key information about a specific entity amongst similar information of other country entities of the same group. To address this, an entity-by-entity approach should be adopted in the proposal for country-by-country reporting.
Making the Country-by-Country Report Available to the Public
With the aim of safeguarding the confidentiality of data provided by MNEs, country-by-country reports will only be available to the tax administrators and tax administrators are obligated to take all necessary actions in order to make sure that there is no disclosure of confidential information or any other commercially sensitive information provided in the context of transfer pricing documentation. In as much as country-by-country reporting promotes tax transparency by exposing MNEs to tax authorities, tax authorities are not the sole stakeholders that can influence the behaviour of MNEs and hold them accountable for their actions. Other stakeholders such as consumers, activist groups and the media can have an impact that matters to MNEs. This is especially because MNEs recognise reputational risks as a restriction in their tax planning arrangements and may be a dominant reason for MNEs not to engage in particular tax planning strategies. Reputational risks are a concern to MNEs as they can translate to negative consumer reactions, targeting by activist groups and decline on the stock market price, which all have an adverse effect on the company. Public disclosure of country-by-country reports is therefore important as it strengthens accountability, which translates to increased tax transparency.
The Finance Act, 2019 introduced tax on income accruing through a digital marketplace. A digital marketplace is defined to mean “a platform that enables the direct interaction between buyers and sellers of goods and services through electronic means.” Additionally, the VAT Act, 2013 provides for imposition of VAT on supplies made through a digital marketplace.
The VAT Act, 2013 defines “electronic services” as any of the following services, when provided or delivered on or through a telecommunications network:
On the other hand, “telecommunications services” is defined under the Value Added Tax Regulations, 2017 (the VAT Regulations) as “the transmission, emission, or reception of signals, writing, images, sounds, or information of any kind by wire, radio, optical, or other electromagnetic systems, and includes:
but does not include the supply of the underlying writing, images, sounds, or information.”
As such, a strict interpretation of the law would mean that since all persons importing services from a non-resident person are required to account for reverse charge VAT, this provision would apply to the importation of electronic and telecommunication services.
The ITA requires the Cabinet Secretary to enact regulations to provide for the mechanism and implementation of digital tax. However, the regulations are yet to be enacted.
While the ITA has introduced tax on income earned in a digital marketplace, it is still not clear how international companies operating on digital platforms with no physical presence in Kenya will be taxed as the tax laws in Kenya only cater for businesses that have a physical presence (either through a local entity or through a permanent establishment). Further, it is also unclear why the ITA provides for a new charging section for buyers and sellers in the digital marketplace as their income has always been subject to income tax under the ITA.
Action 1 of the BEPS Action Plan calls for the tax challenges of the digital economy to be addressed. In relation to indirect taxes, Action Plan 1 recognises new challenges related to the collection of VAT on goods and services traded online. In this regard, the Act provides that the digital marketplace shall now be subjected to VAT.
Action 1 recommends implementing the "destination principle" contained in the 2017 OECD International VAT/GST Guidelines together with the mechanisms for effective collection of VAT/GST on cross-border supplies of services and intangibles presented in those Guidelines.
Kenya applies a territorial (source-based) taxation system and therefore only income accrued or derived from Kenya is subject to tax in Kenya. Additionally, employment income and business income earned partly in Kenya and partly outside Kenya are wholly taxable in Kenya. Accordingly, the VAT Act, 2013 provides that VAT in relation to the digital marketplace shall be charged on:
Given that the Kenyan tax regime is progressively realising BEPS principles, it is likely that the regulations on digital tax will be modelled upon BEPS Action 1 on digital tax.
Many multinational enterprises use IP structuring models whereby the legal ownership, funding and user rights of intellectual property operate in such a way that the income derived from intellectual property in one location is received in another lower tax regime. IP tax planning models result in profit shifting that may lead to an erosion of the tax base. Currently, the ITA provides that the provision of services such as IP licensing between a Kenyan resident and related non-resident entity is subject to transfer pricing requirements to be at arm’s length.
The ITB proposes to further the transfer pricing regime around the use of IP by proposing that the determination of arm’s-length conditions for controlled transactions involving the exploitation of intangible property must take into account the contractual arrangements in respect of the development, enhancement, maintenance, protection and exploitation of the asset. Transfer pricing has been discussed in 4.4 Transfer Pricing Issues and the same rules are to apply to intellectual property.
Kenya has generally made positive steps towards the implementation of BEPS recommended changes, mainly under the ITB. It is expected that once the ITB is enacted into law, Kenya’s tax landscape will change significantly. The changes will not only affect Kenyan companies but also MNEs. The ITB is expected to come into force in 2020.