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Recent developments affecting Double Taxation Treaties and Withholding Tax – October 2014

Recent developments affecting Double Taxation Treaties and Withholding Tax – October 2014

The Finance Act, 2014 (Finance Act) was brought into force on 14th September 2014.  The Finance Bill, as originally presented to Parliament, underwent a series of last minute amendments which will see the re-introduction of capital gains tax (CGT) in Kenya with effect from 1st January 2015.  The provisions in the Income Tax Act (ITA) dealing with the taxation of capital gains had previously been suspended since 1985.

The Finance Act also makes changes in relation to the application of double taxation agreements concluded between Kenya and other countries.  These provisions will, in some cases, have a significant effect on payments to non-residents which are subject to withholding tax.

Capital Gains Tax

Charge of Capital Gains Tax

Income which is chargeable to tax is the whole gain which accrues to a company or an individual on the transfer of property situated in Kenya.  For this purpose “property” means:

  • in relation to a company – money, goods, choses in action, land and every description of property (movable / immovable) and also obligations, easements, interest and profit whether present or future but does not include a road vehicle
  • in relation to an individual – land and marketable securities including investment shares (shares listed on the Nairobi Securities Exchange).

A transfer occurs where the property is sold, exchanged, conveyed or otherwise disposed (including by way of gift) whether or not for consideration. A transfer also occurs on the occasion of loss / destruction of the property.

Rate

CGT is charged at the rate of 5% as a final tax.

There is an anomaly in relation to investment shares sold by individuals where the historic rate of 7.5% in the Eighth Schedule of the ITA appears to have been overlooked.  We are of the view that the 5% rate will apply.

Computation of Capital Gain

The chargeable gain is determined by the following formula:

Chargeable Gain = Transfer Value – Adjusted Cost

Where:

  • Transfer value is, essentially, the amount or value of the consideration received by the seller less the incidental costs of sale.  If the amount cannot be ascertained, it will be the market value as determined by the Commissioner for Income Tax.
  • Adjusted cost is the total cost of acquisition including expenditure wholly and exclusively incurred for the purpose of enhancing or preserving the property value after acquisition and incidental costs of acquiring the property.

Exemptions

Certain transactions are exempt from CGT. These include:

  • the transfer of a private residence occupied by an individual continuously for a period of 3 years prior to the transfer is exempt from CGT;
  • land transferred by an individual where the transfer value is not more than KES 30,000;
  • transfer by an individual of certain agricultural property (essentially agricultural property situated outside an urban area) of less than 100 acres;
  • transfer of property, in exchange for other property, pursuant to a transaction involving the incorporation or restructuring of one or more companies found by the Minister to be in the public interest.

Also, certain transactions do not constitute a transfer for the purposes of CGT including:

  • transfer of property for the purpose of securing a debt or returning property used as security;
  • issuance of a company of its own shares or debentures;
  • vesting of property in a personal representative of a deceased person by operation of law;
  • transfer by a trustee of property to a beneficiary;
  • transfer of an asset between spouses or former spouses as part of a divorce settlement or separation agreement.

Anomalies

The provisions dealing with the reintroduction of CGT do not appear to have been very carefully considered.  Consequently, there are a number of anomalies and surprising changes.

  • As mentioned above, the old rate of 7.5% in relation to investment shares sold by individuals appears to have been overlooked.
  • There is no indexation by reference to the date of acquisition.  Part III of the Eighth Schedule which had a reduction formula for acquisitions prior to 1975 has been deleted.  In effect, tax payers will be taxed on inflation as the CGT provisions in the ITA do not distinguish between gains arising as a result of capital appreciation in the value of property from gains due to inflation.
  • The Finance Act repeals the provisions which dealt with the deduction of withholding tax on transfers which are subject to CGT.  It is not clear how the Government proposes to enforce collection of CGT, particularly in relation to sales by non-residents.  Residents will, presumably, be expected to include CGT in their self-assessment annual tax returns.
  • The withholding tax provisions in the Eighth Schedule imposing an obligation on stockbrokers to deduct CGT from sales of investment shares remain in place.

We understand that the Kenya Revenue Authority (KRA) and the National Treasury are considering how CGT is to be implemented effectively.  It is quite possible that we will see further changes to the law in the short term.

Transactions before 31st December 2014

Obviously, sellers who are negotiating transactions which may become subject to CGT will want to close these transactions before the commencement date of 1st January 2015.

Under the ITA, a chargeable gain is realised when there is a transfer or property.  In most cases, this will take place when the “property is sold, exchanged, conveyed or otherwise disposed of in any manner”.  The point in time when this occurs is not always easily determined.  Under similar provisions in other jurisdictions, the point of sale is often the time when an unconditional sale agreement has been concluded, regardless of the date of formal transfer.  However, knowing the KRA and the Kenyan Courts, we suspect that they are more likely to adopt the date of transfer.

In some cases, it may be necessary to consider inventive ways of closing the transactions before the end of the year.  One possible method would be to provide for deferred payment or payment by instalments with the transfer being made subject to security in favour of the seller for the balance of the purchase price e.g. by a charge back of the property being sold.  It is worth noting that the ITA specifically provides that a gain or loss realised by a person on the transfer of property is realised at the time of the transfer, whether or not the consideration is payable by instalments.

Recent Developments affecting Double Taxation Treaties and Withholding Tax

Double Taxation Treaties

Under the ITA, arrangements for the relief of double taxation entered into between Kenya and the government of another country (commonly known as double taxation treaties or agreements (DTA)) of which notice has been given by the Cabinet Secretary (formerly the Minister) take precedence over the provisions of the ITA and other domestic laws.  Currently, Kenya has concluded 11 DTAs with other countries.

In some cases, DTAs provide for non-resident withholding tax rates which are lower than the general rate.  One example is the reduced rate of 12.5% (as opposed to the general rate of 20%) which applies to management and professional fees paid to persons in the United Kingdom.

DTAs may also restrict the types of payment on which withholding tax can be charged.  Kenya has adopted a very wide definition of management and professional charges which goes beyond international norms.  In particular, it encompasses agency fees such as commissions.  Under the DTA with the United Kingdom and some other countries, the KRA cannot claim withholding tax for commissions earned by United Kingdom residents for sales of Kenyan produce (e.g. tea).

The situation can become even more complex where a country DTA or other similar agreement contains a “most favoured nation” provision which requires Kenya to accord to that nation the benefit of any concession made for any other country.   For example, under the Kenya-Mauritius DTA which comes into effect in  on 1st January 2015, there is reduced rate of 5% on dividends (as opposed to the general rate of 10%).  Presumably, residents of countries such as France (which has a most favoured nation DTA with Kenya) will, in future, be able to take advantage of this reduced rate.

Finance Act Changes

The Finance Act introduces an important qualification to the ability to utilise double taxation reliefs.  With effect from 1st January 2015, the benefit of an exemption or reduction in the rate of Kenyan tax is only be available to a resident of the counterparty contracting state if 50% or more of the underlying ownership of that person is held by an individual(s) who is resident in that other contracting state or if the resident of the other contracting state is listed on a stock exchange in that country.

The Cabinet Secretary in his budget speech indicated that the intention of the amendment is to prevent the abuse of DTAs by companies structuring their businesses to take advantage of favourable tax treatment in certain jurisdictions – a practice commonly referred to as  ‘treaty shopping’.

There is a possibility that the change may be challenged on constitutional grounds.  In particular, under the 2010 Constitution, treaties now form part of our domestic law.  This begs the question whether it is possible for an Act of Parliament to amend unilaterally a bilateral treaty such as a DTA.

One country which is most likely to be aggrieved in this regard is Mauritius where few of the holding companies established as holding companies there will be able to take advantage of the new DTA if the qualification applies.

KRA and enforcement of withholding tax

We also draw your attention to the fact that the KRA has been increasingly vigilant in its audit of transactions which may be subject to withholding tax particularly in relation to management and professional fees.  Some of these claims may seem quite surprising.  For instance, we have seen claims for withholding tax on bank charges for an overseas bank account.  Given the very broad definition of management and professional fees, this claim by the KRA is probably sustainable except in cases where there is a specific restriction under a DTA.

Presented by Oliver Fowler and Gachini Macharia of Kenyan LEX African member, Kaplan & Stratton.

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