Tuesday, 13 October 2015

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.

Friday, 31 July 2015

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.


[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.

Friday, 19 June 2015

Double Taxation Relief under the Income Tax Act



Introduction

In January 2014, the Kenya Revenue Authority (KRA) sent demand notices to several athletes requiring them to honour their tax obligations. Some athletes reacted angrily with some threatening to change their nationality.[1] They complained that they were being taxed twice and taking home only 20% of their prize money. The first time the matter of assessment of athletes went public was in 2012. Mainstream media (mis)reported that the KRA had introduced a new tax on athletes’ earnings. This was not correct because first, the KRA has no power to impose taxes, only Parliament can do that. Secondly, the income earned by athletes has been subject to tax for as long as the Income Tax Act has been in force. 

This is the basis of taxation of such income. Income from business is taxable in Kenya. A business includes any trade, profession or vocation and every manufacture, adventure and concern in the nature of trade. Professional sporting and other forms of commercial exploitation of talent fall in the category of vocations. Therefore any income earned from professional sporting is income from business.

The correct position is that KRA never pursued athletes before 2012 just like it never pursued landlords for rental income. With pressure to meet revenue targets set by Treasury, the Authority has been making efforts to make people who were previously not complying comply. I wont debate the merits and demerits of the requirement for athletes to pay taxes, I will only interpret the law. 

Double Taxation

The term is used mainly in relation to income. Double taxation occurs when the same income is subject to tax by two jurisdictions or countries. Kenya taxes income on the basis of residence. Kenya taxes income on the basis of residence and source. All income which has its source in Kenya is taxable in Kenya irrespective of whether the person who has earned it is a resident or a non resident (s. 3(1) Income Tax Act). 

If a person is resident in Kenya he is liable to pay tax on income earned abroad in certain cases. If a resident carries on business partly in Kenya and partly outside, all the income from that business is taxable in Kenya (s. 4(a) ITA). For instance if a company resident and doing business in Kenya opens a branch in Uganda, all the income of the company including income earned by the Ugandan branch is taxable in Kenya.

The Ugandan government will also tax the income earned by the branch in its territory. The income from the branch will therefore be subject to tax by both Kenya and Uganda. This is what is not known as double taxation. Assuming that a rate of 30% applies in both countries, the company will have its income taxed at an effective rate of 60%.    

The income earned by athletes outside Kenya may, and often does, suffer double taxation i.e. taxation in the foreign country where the income is earned and in Kenya. However, the ITA provides for relief from double taxation. There are two categories of reliefs given for foreign tax:
a)      Relief for tax paid countries with which Kenya has no Double Taxation Treaty; and
b)      Relief for tax paid in countries with which Kenya has a Double Taxation Treaty.

1.      Double taxation relief in the absence of a treaty (s. 39) 

Relief is available if one proves that he has paid tax in that other country in respect of the same income. The income to which this applies is:
i)        Employment income
ii)      Income from appearances and performances to divert an audience (music events, sporting events, etc.). 

The amount of relief is the lower of:
a)      the difference between the Kenyan tax on total income and the Kenyan tax on the Kenyan income, and 
b)      the tax payable in Kenya on such income.  

There need not exist a double taxation agreement between Kenya and the country from which the income is derived for set off to be allowed under section 39. However, note that the set off is allowed for only two categories of incomes. A person must also be a citizen to benefit from the set off. 

2.      Relief under Double Taxation Treaty (Ss. 41, 42)

Section 41 empowers the Kenya Government to enter into a double taxation relief agreement with the government of any country with a view to affording relief from double taxation in relation to income tax and other taxes of similar character. The Minister is empowered to declare by notice in the Kenya Gazette that such special arrangements have been made. Among other things the agreement may provide for foreign tax paid or payable in respect of income derived by a resident person to be allowed as a credit against that income. A person need not be a citizen to be entitled to a double taxation relief in this case; one only needs to be a resident.

The amount of the relief to be allowed is the lesser of:
a)      The difference between the Kenyan tax on total income and the Kenyan tax on the income from Kenya, and
b)      The foreign tax on the income from another country.

This method of granting relief from double taxation is known as the credit method. With this method, a taxpayer pays additional tax on foreign income only if the rate of tax in the foreign country is lower than the rate of tax in Kenya. If the rate in the foreign country is equal to or less than the rate in Kenya, no additional tax will be paid in Kenya on the foreign income.

Kenya has double taxation relief agreements with among other countries: Zambia, Denmark, Norway and Sweden. If one derives income from a country which does not have a double taxation agreement with Kenya, the income will suffer double taxation unless it is income in respect of which a person can afford himself a set off under section 39.

Consider this:
Certain income earned domestically may be subjected to tax twice. For instance, the trading income of a company is subject to corporation tax at a rate of 30%. When the income is distributed to resident shareholders it is subjected to further tax at a rate of 5%.
Is this double taxation?