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?

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[1] See http://www.standardmedia.co.ke/sports/article/2000102995/athletics-fury-greets-kra-order; http://www.bbc.com/news/world-africa-25860645;

The Diffusion Theory of Incidence of Taxation

The theory

According to this theory, any tax is shifted automatically in the economic system ad infinitum such that every person in the economy bears the burden of the tax. In the end the amount of tax borne by an individual in the system is so small that it is practically burden- less. 

The theory is a fallacy. It is based on the false assumption that there are successive infinitive transactions. It assumes that a person who purchases any product on which tax has been imposed will use the product as an input in production. When he sells his finished products he transfers a small portion of the tax to each of the purchasers. Such purchasers use the product in production of other products and there process of transfer is repeated until the tax being transferred is so little that its burden cannot be felt by the person on whom it finally rests. This is far from the practical reality. Sometimes products on which tax has been imposed are bought directly by the final consumer from the person on whom the tax is initially imposed. A person might buy beer from a brewer for his own consumption. Such a person cannot pass the tax burden to anyone; he bears the whole of it.

Even where there are a series of transfers the final consumer may end up carrying the whole burden of the tax as originally imposed. Consider a brewer in Kenya on whose beer excise duty is imposed. The excise duty is imposed on the ex-factory price. The brewer factors the excise duty in the selling price. A bar operator who purchases the beer from the factory will temporarily bear the burden of the excise duty before transferring it to his customers. A customer who buys the beer from the bar is not in a position to transfer the tax to anyone. He therefore bears the whole burden of the excise duty.

At times products may be used to manufacture other products successively but the process is never infinitive. Even when we consider a case where there are several transfers the tax borne by the final consumer is not so little as to be burden-less. Consider a manufacturer who is using an item that is the product of six manufacturing processes since the original product was manufactured. At this point the tax being passed should be very little and he should pass an even lesser amount to his customers. Does such a manufacturer pass only a little tax to each consumer? The answer is no, why? 

The reason is, a product will require several inputs to produce it and since taxes are imposed on a wide range of products, all the tax components of each input will make the tax component of the product significant. For instance a manufacturer of VATable goods in Kenya will factor in his selling price the tax on electricity, audit services, legal services, purchase of equipment etc. In addition to the tax charged on the raw materials used in the manufacture of his products. Therefore though the tax passed to this manufacturer by suppliers of each raw material may be small, the tax he will factor on the selling price of his products will be not be small because he will include the tax charged for each raw material and the tax on the services mentioned above.

 
If the diffusion theory holds true, tax the government would never have to worry about the incidence of indirect taxes. It would just impose taxes knowing that the burden on each person in the society will not be felt because of how insignificant the tax will be. 

This theory is, in my opinion, useless in tax policy, law and practice.