Compensating tax

This is a form of income tax that is rarely talked about. Many Taxation students go through their courses having heard about compensating tax only in passing. Many Taxation teachers give it only a marginal mention while teaching. As a consequence, not many Taxation graduates know about compensating tax. Even in professional practice, not many are concerned with the tax. Part of the reason many teachers superficially teach about the tax is that a large number of them lack a proper understanding of it. However, what generally accounts for the limited attention given to this tax is the fact that the Kenya Revenue Authority (KRA) is not keen on enforcing it. It is lost to many that the tax is payable at a punitively high rate and is capable of negating the value of, inter alia, exemptions from income tax and tax incentives such as capital allowances. This is explained in greater detail below.

Compensating tax is payable pursuant to section 7A of the Income Tax Act. Only resident companies are liable to pay the tax. It arises where a company distributes dividends from income on which income tax has not been paid at the corporate tax rate.

The Dividend Tax Account

It is calculated using an account known as a Dividend Tax Account. The account is debited with:

1. Income tax paid by the company. This does not include withholding tax on qualifying dividends (which is final tax) paid by the company.  
2. A fraction of dividends received by the company from another company. The fraction is determined as follows: Amount received x 30/70.  

The account is credited with a fraction of the amount of dividends paid, determined by multiplying the amount paid by 30/70. Compensating tax is payable if the account has a credit balance, i.e., the credits exceeds the debits. The amount of tax payable is the balancing figure. If the account has a debit balance, the balance is carried down to the next year of income.

Say a company, A Co. Ltd., makes a pre-tax trading profit of sh. 600m in the year 2016. It also sells shares in companies listed in the Nairobi Securities Exchange and makes a profit of sh. 200m. The company resolves to distribute all the year’s profits as dividends. What compensating tax, if any, is payable?

The company’s corporation tax for the year is sh. 180m (30% of 600m). No tax is payable on the gain on sale of the listed shares. The total profits distributed are sh. 620m (420m + 200m).

Compensating tax

Tax paid           180m     Dividend x3/7  265.71m
C. tax (bal fig)  85.71m
                           265.71m                         265.71m

The amount of compensating tax is 42.8% of the untaxed gain. This is much higher than the corporate tax to which the rest of the income is subject. If a company pays tax only out of taxed gains, the balance of the Dividend Tax Account is zero; the corporate tax paid equals the dividend fraction.

Any transaction that increases accounting profits over tax profits can give rise to compensating tax liability. Notably, liability arises only if the amount distributed in form of dividends is higher than the tax profit. Capital allowances cause accounting profits to be higher than taxable profits if the rates of capital allowances for a year of income are higher than the depreciation rates for the same period.

Take the case of a new company, B Co. Ltd., which incurs capital expenditure of sh. 1.5b in purchase of new manufacturing machinery which qualifies for investment deduction at the rate of 100% of the expenditure. The company makes a profit of sh. 600m before deduction of capital allowances/depreciation. Its policy is to depreciate machinery at rate of 15% on a reducing balance basis.

The pre-tax accounting profit is sh. 375m (i.e. sh. 600m – 15% of sh. 1.5b). However, the company has a taxation loss of sh. 900m (sh. 600m – sh. 1,500m). Thus no tax is payable. All the accounting profit is available for distribution. If the company decides to distribute the accounting profit in dividends, sh. 160.71m compensating tax will be payable.

Interestingly, even where gains are taxable at a rate lower than the corporation tax rate compensating tax is still payable. However, the rate is lower than that applicable where income is not taxed at all. Capital gains tax was reintroduced in 2015. The rate applicable is 5% and this tax is final tax. With the tax rate at 5%, the compensating tax rate is 35.7%. The effective tax rate is 40.7% (35.7 + 5%), two percentage points below the rate in cases the gain is not subjected to any tax at all.

In the first scenario, assume that the shares sold were held in an unlisted company. The gain is then subject to a tax rate of 5%. The income tax paid increases to sh. 190m. The company has sh. 610m available for distribution. If the company distributes the whole amount, it will pay sh. 71.42m compensating tax.

Administration

Compensating tax is payable on or before the end of the 6th month after the end of the company’s year of income. Companies are also required to prepare a return of assessment of compensating tax and submit it to the Commissioner by the same date. A person is liable to pay additional tax equal to 5% of the compensating tax for every month during which the return remains unfiled. A penalty of 20% is immediately payable for failure to pay compensating tax when it is due. Interest is also payable on compensating tax remaining unpaid after the due date. These sanctions are applicable in addition to criminal sanctions applicable under the Income Tax Act.

Critique

Distribution of dividends is what may trigger compensating tax liability. The wisdom of exempting gains from corporation tax only to subject them to a higher rate of tax than the corporation tax rate has been questioned. The same question arises with respect to the generous rates applicable to capital allowances. The net effect of compensating tax is that for resident companies, what appears to be an incentive can be a prohibitive disincentive.

It appears that compensating tax is intended to act as a disincentive for distribution of untaxed gains or tax incentives. The present taxation regime favours reinvestment of gains arising from incentives to give rise to gains taxable at the corporation tax rate. Notably, the tax is not payable by non-resident companies with a permanent establishment in Kenya, which like resident companies are liable to corporation tax.

End.

Deductible Business Expenditure

Not all expenditure incurred by a business is allowed against the income of the business. According to S. 15(1) of the Income Tax Act, all expenditure incurred wholly and exclusively in the production of income should be deducted from that income. Therefore, the test of whether or not an expense is permitted is the purpose for which it is incurred – it must be wholly and exclusively for the production of taxable profits. Some expenses are expressly permitted and others excluded. As a general rule, capital expenditure is not allowed.

It is not always easy to tell whether or not certain expenses are incurred wholly and exclusively in the production of income. If expenses are incurred in unsuccessfully suing for recovery of monies allegedly owed, can it be argued that those expenses were incurred in the production of income yet no income is received by the business? What of money embezzled by a cahier or a director?

There is a rich body of case law from the Commonwealth dealing with these questions and others. Though the laws of the countries referred to might be different today, they were decided at a time when the statutes of those countries did not expressly permit the expenses discussed here but contained general guidelines just like section 15 of the Income Tax Act of Kenya today. The cases dealt with the interpretation of provisions which though slightly different in wording have the same meaning as our section 15.

Let us look at some troublesome expenses:

Fines and penalties for breach of the law

What is the position on fines and penalties suffered for breaches of the law in the course of conducting business? Fines and penalties imposed for breach of the law are disallowable. Such fines and penalties are intended to punish the person on whom they are imposed and to allow them would be to allow the burden of his wrongdoing with the rest of the society. The severity of a penalty or fine would also be reduced. This was the decision of the House of Lords in the English case of McKnight v. Sheppard (1999) 71 TC 419. It stated:

“But the reason (for fines being disallowed) in my opinion is much more specific and relates to the particular character of a fine or penalty. Its purpose is to punish the taxpayer and a court may easily conclude that the legislative policy would be diluted if the taxpayer were allowed to share the burden with the rest of the community by a deduction for the purposes of tax… By parity of reasoning, I think that the Special Commissioner and the judge were quite right in not allowing the fines to be deducted.”

Expenses on legal actions generally

Legal expenses incurred in actions filed by a person to remedy breach of a business contract or to defend an action for alleged breach of a business contract are allowed irrespective of the outcome of the action. It does not matter that the action or defence is successful or not so long as the expense was incurred for the purpose of the business. The House of Lords in the previously mentioned case of McKnight v. Sheppard stated as follows:

“Can there be a distinction between the costs of a successful and an unsuccessful defence? It might be argued that, as a matter of policy, the unsuccessful defendant should have to bear his legal costs personally in the same way as the penalty itself. But I think there would be great difficulties about giving effect to such a rule. It might not be easy to tell which costs had been expended successfully and which unsuccessfully... More important, it is fundamental that everyone, guilty or not guilty, should be entitled to defend themselves.”

The House of Lords also established that the nature of the action is not relevant. In other words legal expenses will be allowed not only in civil actions but also where a business is being defended in a criminal action. The case actually concerned a criminal action. The House of Lords decided that the legal expenses incurred in the defence were expended wholly and exclusively in the production of income.

The Canadian Exchequer Court in Reader's Digest Association (Canada) Ltd. v. MNR (1966) 66DTC5416 also allowed the deduction of legal expenses incurred by a taxpayer in unsuccessfully resisting imposition of excise tax on his income. The court reasoned that the expenses were incurred to protect future income.

In civil cases, damages are also allowed where a person defends an action unsuccessfully. The amounts allowed also include those paid to settle a civil suit. However, if the damages imposed are punitive damages they are not allowed, Golder v. Great Boulder Proprietary Gold Mines Ltd (1952) 33TC75.

Costs of appeal against a tax assessment
It has been established that legal and accountancy expenses incurred in an appeal against a tax assessment are not allowed because they cannot be said to have been incurred wholly and exclusively in the production of income. The authority on this position is the case of Allen v. Farquharson & Bros Co (1932) 17TC59. In the case, the company sought to be allowed to deduct legal expenses incurred in connection with an appeal against an assessment. The High Court in finding that the legal costs were not allowable stated that it is not enough that the expense arise out of, or be connected with the trade. It must be incurred for the purpose of earning the profits of the business. Justice Finlay reasoned that this was an application of profits after they were earned rather than an expense to earn those profits. 

Expenses in preparation of accounts

Book keeping is a necessary part of business. There is no doubt that book keeping expenses are expenses incurred wholly and exclusively in the production of income. So these are allowed. Accounting statements are also prepared for various business reasons including raising loans, monitoring etc. and therefore expenses on them can be said to be prepared in the production of income. Can the same be said of expenses in preparation of tax accounts? Following the court’s reasoning in Allen v. Farquharson, it cannot be said that expenses re incurred in the production of income for two reasons; first, by the time they are incurred profits have already been earned and secondly, preparation of these accounts does not lead to an inflow of income.

However, tax authorities including the Kenya Revenue Authority allow expenses incurred in preparation of tax accounts. This practice was approved by in the English case of Smith’s Potato Ltd v. Bolland (Inspector of Taxes) (1948) 30TC267. The House of Lords first noted that just like expenses in an appeal against a tax assessment, expenses in preparation of accounts for tax purposes are not incurred to earn income. It then stated that these expenses should be allowed because the necessity to prepare these accounts is an obligation imposed by law. Without such an obligation the expense would not be incurred. The House of Lords had the following to say:

“If there were no obligation to ascertain and pay either of these taxes, there would be no necessity for making up accounts on Income Tax principles, it would suffice to make up the ordinary commercial accounts. The computation of accounts for tax purposes is therefore not directly associated with the carrying on of the business. It is an obligation imposed upon the Company for another and extraneous purpose, that is, for the purpose of ascertaining the tax to be paid out of profits. It is not, at any rate directly, undertaken for trade purposes but to satisfy the Revenue authorities.
It is true that as a matter of convenience the cost of making up accounts for the Inland Revenue is allowed by the authorities as a deduction from profits, as is the cost of making up the strictly business accounts of the trade, but this is not a matter of principle but of expediency.”

The House of Lords was of the opinion that it is in the interest of the revenue authority that tax accounts are prepared accurately. Though it stated that strictly in law there was no principle under which the expenses were allowed, it concluded that the advantages of allowing the costs outweigh the disadvantages.

The Public Procurement and Asset Disposal Bill, 2014

Introduction

The Public Procurement and Asset Disposal Bill, 2014 proposes important changes to the existing public procurement legal regime. Some of the changes appear directed at compliance with the new constitutional order. Others are intended to improve public procurement generally. It has many provisions intended to professionalize public procurement. The main changes are as discussed below:

Definition of public entities

The definition of public entities under the bill includes the following new bodies:[1]

      Constituencies

      Independent Offices established under the Constitution

      Cities and urban areas created under the Urban Areas and Cities Act

      Kenya’s diplomatic missions

      Public entity pension funds

      Bodies which are not necessarily state corporations under the State Corporations Act but in which the national or a county government has controlling interest

      Bodies using public assets under contract undertaking (including public private partnerships)

      Companies owned by public entities

Notably, the Bill proposes to exclude cooperative societies from the definition. Recently, there was a dispute between Githunguri Cooperative Society and National Treasury.[2]

Objectives

The Bill prioritizes the objective of maximising economy, efficiency and value for money,[3] though it still contains the objectives enumerated in the Public Procurement and Disposal Act (PPDA). The objectives sometimes conflict and judges need a guide on which objectives to give more weight. The prioritization creates a hierarchy, though not a satisfactory one, which can guide judges.

The bill also includes other objectives that are not contained in the PPDA including:

·         Promoting professionalism in procurement

·         Providing sanction against tenderers who are not tax compliant

·         Providing sanctions against tenderers and contractors who have committed serious violations of employment laws

·         Creating an enabling environment for small medium and micro enterprises without foregoing quality and high standards

Government to government procurement

Kenyans must remember government officials defending the award procedure of Kenya’s biggest procurement contract, the Standard Gauge Railway contract, by saying that the contract was outside the scope of PPDA because it was a government to government agreement.[4] The argument was fallacious because contract was illegal rather than legal and outside the scope of the Act since the PPDA does not recognize such arrangements.

Section 7 of the Bill provides for government to government procurement between the Government of Kenya and a foreign government on the basis of a bilateral or multilateral agreement. The term government to government procurement is to be interpreted to refer to the procurement of goods, works or services between the Government of Kenya and a foreign government through a negotiated loan or grant.

Section 7 also provides for the possibility of the foreign government identifying the supplier but requires that the foreign government must use a competitive process. The concurrence of the Government of Kenya is also necessary before the tender can be awarded.

Policy formulation

Section 9 provides that the National Treasury shall be the central organ responsible for formulating public procurement and disposal policy. This is a departure from the present position where the Public Procurement Oversight Authority (PPOA) is responsible for initiating public procurement policy.[5] The National Treasury is also proposed to have many other responsibilities which include:

a)      Maintaining linkages between public procurement and other financial management aspects;

b)      Managing  and  administering  the  scheme  of  service  of the  procurement  and  supply  chain  management services cadre for the National Government;

c)      Developing  and  promoting  electronic  procurement strategies  and  policies  in  both  the  national  and county  governments  including  state  corporations and other government agencies;

d)      Carrying out review of procurement and supply chain management system to assist procuring entities;

e)      Promoting  policy  on  professionalism  in  the  supply chain  management  functions  with  key stakeholders;

f)       Steering consultations with stakeholders of the public procurement and asset disposal system;

g)      Developing  and  reviewing  policy  on  procurement  of common  user  items  in  the  public  sector  both  at national and county government levels;

h)      Development of a curriculum, management and coordination of professional examinations for supply chain management cadres;

i)        Issuing guidelines  to  public  entities  with  respect  to procurement  matters  and  monitor  their implementation and compliance.

The Director General of PPOA

The Bill provides for the appointment of a Director General (DG) by the Public Procurement Oversight Advisory Board with the approval of the Cabinet Secretary for National Treasury.[6] PPDA provides for the appointment to be appointed by the Advisory Board with the approval of Parliament.[7] A university degree in law is now recognized as qualifying one to be a Director General while a degree in engineering no longer qualifies. The Act requires a person to have the following qualifications in addition to a degree in procurement, supply chain management, law, commerce, business administration, economics, or a related field of study, to be qualified for appointment:  

a)      a post-graduate  degree  in  a  related  field  of study from a recognised university in Kenya;

b)      a professional  qualification  in  supply  chain management  from  a  reputable  organisation recognised in Kenya;

c)      a full member of the Kenya Institute of Supplies Management and of good standing;

d)      at  least  ten  years’  experience  in  senior management  position  in  procurement  and  supply chain management; and

e)      meet the requirements  of  Chapter  Six  of  the Constitution.   

These requirements are more stringent than those contained in PPDA and would ensure that the Director General is an expert in procurement matters. The Bill should be amended to require the Director General to be competitively recruited. Section 15 provides for the Director General to vacate his office if he/she loses his/her membership of the Kenya Institute of Supplies Management.

The Advisory Board

The Advisory Board proposed by the Bill is to comprise of 7 persons down from the 12 under the PPDA.[8] It also required that the chairperson and vice chairperson and two members must be competitively recruited. They must have a university degree and be procurement professionals who are members of Kenya Institute of Supplies Management. The other member are the Principal Secretary of the National Treasury or his alternate, the Attorney-General or his representative and the Director-General of the PPOA. The reduction in the size of the Board and the requirement for 4 of the 7 members to be competitively recruited procurement professionals are important developments. The latter makes the Board more professional than it is today.  With regard to the former, there is no justification for the Board to be as large as it is under the PPDA.

New provisions on county government

Section 33 provides that the County Treasury shall be responsible for implementation of public procurement and asset disposal policy in a county. Specific functions include:

·         implementing public  procurement  and  asset  disposal procedures;

·         coordinating administration of procurement and asset disposal contracts;

·         developing county-specific procurement and inventory strategies  which  shall  be  consistent  with  the national  policy  on  public  procurement  and  asset disposal matters;

·         maintaining linkages  between  the  county  and  the national government;

·         coordinating  consultations  with  county  stakeholders of  the  public  procurement  and  asset  disposal system  in  liaison  with  the  National  Treasury  and the Authority;

·         advising  the  accounting  officers  of  county government  entities  on  public  procurement  and asset disposal matters.

Qualifications for contract award

Section 31 of the PPDA provides for the qualifications for the award of a contract. Section 53 of the Bill proposes four additional qualifications. They include 

·         the person  if  a  member  of  a  regulated  profession has satisfied all the professional requirements;

·         the person has fulfilled tax obligations;

·         the person  has  not  been  convicted  of  corrupt practices; and

·         the person has  not  violated  fair  employment  laws  and practices.

An accounting officer of a procuring entity is required to determine whether a person is qualified and for that purpose may seek proof of qualification. A person must be disqualified for submitting false, inaccurate or incomplete information about his or her qualifications.

Termination of procurement proceedings

Section 59 provides for the termination of proceedings only where certain conditions are applicable. Section 36 of the PPDA does not specify the basis on which a procurement entity may terminate procurement proceedings. Under section 36, a procurement entity has almost unlimited discretion on whether or not to terminate proceedings. The limit of the powers of a procurement entity was the issue at the centre of the Selex case.

Open tendering and Procurement methods (s. 89 – 91)

Section 89 of the Bill maintains the preference for open tendering provided for by section 29 of the PPDA. The Bill, however, permits an accounting officer to use alternative procurement procedure if that procedure is allowed and conditions for it to be used are satisfied. It introduces procurement procedures that are not recognized by the PPDA. These include two stage tendering, electronic reverse auction, competitive negotiation, force account and community participation.

Performance security (s. 140 – 143)

Section 140 introduces more elaborate provisions on performance security than there is in the PPDA. It provides that where required, performance security shall be submitted by a successful tenderer before signing the procurement contract. However, there is no provision in the Bill indicating when performance security may be required. It shall be between five per cent (5%) and ten per cent (10%) of the contract value. In  case  the  contract  is  not  fully  or  well  executed,

the  performance  security  shall  unconditionally  be  fully seized  by  the  procuring  entity  as  compensation  without prejudice to other penalties provided for by the Act. The performance security shall be returned to the successful tenderer within thirty (30)  days  following the  final  acceptance  by  the  accounting  officer  of  the procuring entity.

This does not apply to tenders related to consultant services, works and supplies where their estimated value  does  not  exceed  a threshold established by the procurement Regulations.

Advance payment

Section 144 of the Bill  requires that no works,  goods  or  services  contract  shall  be paid  for  before  they  are  executed  or  delivered  and accepted by the accounting officer of a procuring entity or an officer authorized by him / her in writing except where so  specified  in  the  tender  documents  and  contract agreement. There is no similar provision in the PPDA.

Implementation team

Section 149 provides for the appointment of a contract implementation team for every complex  and  specialized procurement  contract. The team shall include members from the procurement function,  and  the  requisitioner, the  relevant  technical department and a consultant where applicable and shall be appointed by the  accounting  officer  of  the procuring  entity. If well implemented, the idea of an implementation team is a great one. It will ensure effective delivery by contractors.

For  the  purpose  of  managing  complex  and specialized  procurement  contracts  the  contract implementation team is responsible for—

a.      monitoring  the  performance  of  the  contractor,  to ensure  that  all  delivery  or  performance  obligations are met or appropriate action taken by the procuring entity in the event of obligations not being met;

b.      ensuring  that  the  contractor  submits  all  required documentation  as  specified  in  the  tendering documents, the contract and as required by law;

c.       ensuring  that  the  procuring  entity  meets  all  its payment  and  other  obligations  on  time  and  in accordance with the contract.

d.      ensuring that there is right quality and within the time frame, where required;

e.      reviewing  any  contract  variation  requests  and  make recommendations to the respective tender awarding authority  for  considerations.  Such  reviews  for variation  shall  be  clearly  justified  by  the  technical department  in  writing  backed  by  supporting evidence  and  submitted  to  the  head  of  the procurement function for processing;

f.        managing  handover  or  acceptance  procedures  as prescribed;

g.      making  recommendations  for  contract  termination, where appropriate;

h.      ensuring that the contract is complete, prior to closing the contract file including all handover procedures, transfers  of  title  if  need  be  and  that  the  final retention payment has been made;

i.        ensuring  that  all  contract  administration  records  are complete, up to date, filed and archived as required;

j.        ensuring that the contractor act in accordance with the provisions of the contract; and

k.       ensuring discharge  of  performance  guarantee  where required.

Conclusion

The above changes are the most significant proposed by the Bill. There are many minor other changes also. The discussion here has only focussed on the main changes. The proposed changes are progressive and can lead not only to greater value for money but also to improved service delivery by the government. There are provisions that also need to be re-examined and they should be re-examined before the Bill is passed.

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[1] Kenya, Public Procurement and Asset Disposal Bill, 2014 s 2.

[2] ‘Dairy Farmers Oppose New Procurement Rules’ <http://mobile.nation.co.ke/business/Dairy-farmers-oppose-new-procurement-rules/-/1950106/2757050/-/format/xhtml/-/pd51yh/-/index.html> accessed 30 July 2015.

[3] Kenya Public Procurement and Asset Disposal Bill, 2014 (n 1) s 3.

[4] ‘Railway Deal Exempt from Procurement Law, Court Told’ <http://www.businessdailyafrica.com/Railway-deal-exempt-from-procurement-law/-/539546/2092370/-/tldorkz/-/index.html> accessed 30 July 2015.

[5] Public Procurement and Disposal Act, Cap 412C s 23.

[6] Kenya Public Procurement and Asset Disposal Bill, 2014 (n 1) s 12.

[7] Public Procurement and Disposal Act, Cap 412C (n 5).

[8] Kenya Public Procurement and Asset Disposal Bill, 2014 (n 1) s 24.