Taxation it deals with the means government use to raise revenue, Lecture notes of Business Taxation and Tax Management

Download Taxation it deals with the means government use to raise revenue and more Lecture notes Business Taxation and Tax Management in PDF only on Docsity! P.O. Box 342-01000 Thika Email: Info@mku.ac.ke Web: www.mku.ac.ke COURSE CODE: BAF3204 COURSE TITLE: PRINCIPLES OF TAXATION Purpose: To introduce the learner to taxation it’s rational and methods tax liability determination for various incomes and tax administration. Course Objectives A learner who passes this subject Should be able to; Describe the rational the government charges taxes Explain principles of good tax system Compute taxable income, tax liabilities for various incomes Compute various capitals allowances Course Content Introduction to taxation; traditional and contemporary views, tax Shifting cannons of a good tax system Taxation of individuals; employment income, profits and gains from trade, profession, investment income Taxation of partnerships Taxation of companies, taxable income and capital allowances Tax administration; returns and assessment, objections and penalties Computation of value added tax Teaching/Learning Methodologies: Lecturers and tutorials; group discussion; demonstration; individual assignment; Case studies Instructional Materials and Equipment: Projector; test books; design catalogues; computer laboratory design software; simulators Recommended Text Books: Jones, (2006), Outlines & Highlights for Principles of Taxation PubliShsing, Academic Internet PubliShsers Text Books for further Reading: Ahmed R. (2005), Principles of Taxation, EA PubliShsers Ltd. Other support materials: Various applicable manuals and journals; variety of electronic infromation resources as prescribed by the lecturer Taxation is the part of public finance that deals with the earns by which the government raises revenue from the public by imposing taxes which revenue is used by the government to provide goods and services to the public or its citizens (to carry out government functions) taxation may be referred to as the revenue raising activity of the government. Public Finance is the department of economic theory that deals with public expenditure a revenue. Economics deals with resource allocation and seeks to answer three questions of whom to produce, how to produce and for whom to produce. We will start by exploring the government expenditure, which is characterised by the expected activities of a government. We will then look at the taxation as source of revenue to finances the government expenditure. GOVERNMENT ACTIVITIES A government is expected to carry out some activities as part of its service to the public. These activities are generally of universal application, but where applicable, a Kenyan example is given. These activities are: 1. To maintain internal security and external defence and carry out general administration in n this respect, it will incur expenditure relating to: The cost of police and judiciary for maintenance of law and order. The cost of the armed forces such as the army, navy and air force for defence against external aggression. Cost of provincial administration and general administration of law and order. 2. To provide infrastructure and communication such as: Cost of constructing roads, railways, airports and harbours Cost of constructing electricity and telephone networks, television and radio systems etc. 3. To provide basic social services such as the cost of: Medical services and medicine in hospitals Education in schools, colleges and universities Water supply and sewerage Sports and cultural activities Entertainment and infromation on radio and television 4. To participate in the production and marketing of commercial goods and services: Cost of Establishing public enterprises such as parastatals. Combining with private business though purchase of Shares in commercial enterprises. There is pressure all over the world for government to divest or privatise business enterprises. The Kenya government in the 1991 budget announced its plans to divest in 139 business enterprises. Providing froms of easy loans not obtainable in financial institutions, and providing cheap business premises such as the Kenya Industrial Estates, Export Processing Zones etc. Guaranteeing markets though protection from competition and preferential purchases. 5. Influencing and guiding the level and direction of economic activities though various regulations: Monetary policy (relating to interest and money supply); Fiscal policy (deliberate manipulation of government income and expenditure so as to achieve desired economic and social goals). 6. Redistributing income and wealth though taxation and public spending: Taxing the rich and those able to afford tax. Cost of providing basic needs to the poor such as free education, medical care and housing. Cost of relief o famine and poverty which may arise from unemployment, sickness, old age, crop failure, drought, floods, earthquakes etc. To perfrom the above functions effectively and adequately, the government needs funds. Taxation is an important source of government income. The income of the government from taxes and other sources is known as public revenue. Public revenue is all the amounts which are received by the government from different sources. The main sources of public revenue are as follows: TAXES Taxes are the most important source of public revenue. Any tax can be defined as an involuntary payment by a tax payer without involving a direct repayment of goods and services (as a “quid pro quo”) in return. In other words, there are no direct goods or services provided by the government like any other citizen without any preference or discrimination. THE FOLLOWING FEATURES ARE COMMON IN ANY TAX SYSTEM: TAXING AUTHORITY This is the authority with the power to impose tax e.g. the central government or a local authority. The taxes are received as public revenue. The taxing authority has power to enforce payment of tax. The central government imposes tax through the Kenya Revenue Authority (KRA). TAX PAYER The person or entity that pays the tax e.g. individuals, companies, business and other organizations. The amount of tax is compulsory and there is puniShsment for failure to pay. TAX The amount paid to the taxing authority as direct cash payment or paid indirectly though purchased of goods or services. The tax is not paid for any specific service rendered by the tax authority to the tax payer. The tax paid becomes revenue and is used to provide public goods and services to all citizens. In addition to the above common features of tax, the definitions of tax by some tax experts as listed below are important: a. A compulsory contribution to a public authority, irrespective of the exact amount of service rendered to the tax payer in return. b. A compulsory contribution from a person to the government to defray the expenses incurred in the common interest of all. c. A compulsory contribution of wealth by a person or body of persons for the service of the public. There is a portion of the produce of the land and labour of country that is placed at the disposal of the government for the common good of all. The raising of revenue is not the only purpose for which taxes are levied. The taxes are levied for various purposes as follows: a. Raising Revenue The main purpose of imposing taxes is to raise government income or revenue. Taxes are the major sources of government revenue. The government needs such revenue to maintain the peace and security in a country, to increase social welfare, to complete development projects like roads, schools, hospitals, power stations, etc. b. Economic Stability Taxes are also imposed to maintain economic stability in a country. In theory, during inflation, the government imposes more taxes in order to discourage the unnecessary expenditure of the individuals. On the other hand, during deflation, the taxes are reduced in order to encourage individuals to spend more money on goods and services. The increase and decrease in taxes helps to check the big fluctuations in the prices of goods and services and thus maintain the economic stability. c. Protection Policy Where a government has a policy of protecting some industries or commodities produced in a country, taxes may be imposed to implement such a policy. Heavy taxes are therefore imposed on commodities imported from other counties which compete with local commodities thus making them expensive. The confers are therefore encouraged to buy the locally produced and low priced goods and services. d. Social Welfare Some commodities such as wines, spirits, beer, cigarettes, etc. are harmful to human health. To discourage wide consumption of these harmful commodities, taxes are posed to make the commodities more expensive and therefore out of reach of as many people as possible. e. Fair Distribution of Income 2. Certainty In any country, some people will be rich and others will be poor due to limited opportunities and numerous hindrances to becoming wealthy. Taxes can be imposed which aim to achieve equality in the distribution of national income. The rich are taxed at a higher rate and the amounts obtained are spent on increasing the welfare of the poor. That way, the taxes help to achieve a fair distribution of income in a country. f. Allocation of resources Taxes can be used to achieve reasonable allocation of resources in a country for optimum utilization of those resources. The amounts collected from taxes are used to subsidise or finance more productive projects ignored by private investors. The government may also remove taxes on some industries or impose low rates of taxes to encourage allocation of resources in that direction. Increase in Employment Funds collected from taxes can be used on public works programmes like roads, drainage, and other public buildings. If manual labour is used to complete these programmes, more employment opportunities are created. PRINCIPLES OF AN OPTIMAL TAX SYSTEM These are the principles of an optimal tax system, what are known as Canons of taxation, some of which were laid down b Adam Smith. 1. Simplicity A tax system Should be simple enough to enable a tax paper to understand it and be able to compute his/her tax liability. A complex and difficult to understand tax system may produce a low yield as it may discourage the tax payer’s willingness to declare income. It may also create administrative difficulties leading to inefficiency. The most simple tax system is where there is a single tax. However, this may not be equitable as some people will not pay tax. The tax Should be fromulated so that tax payers are certain of how much they have to pay and when. The tax Should not be arbitrary. The government Should have reasonable certainty about the attainment of the objective (s) of that tax, the yield and the extent to which it can be evaded. There Should be readily available infromation if tax payers need it. Certainty is essential in tax planning. This involves appraising different business or investment opportunities on the h basis of the possible tax implication. It is also important in designing remuneration packages. Employers seek to offer the most tax efficient remuneration packages which would not be possible if uncertainty exists. 3. Convenience The method and frequency of payment Should be convenient to the tax payer e.g. PAYE. This may discourage tax evasion. For example, it may be difficult for many tax payers to make a lump sum payment of tax at the year-end. For such taxes, the evasion ration if quite high. 4. Economic/Administrative Efficiency A good tax system Should be capable of being administered efficiently. The system Should produce the highest possible yield at the lowest possible cost both to the tax authorities and the tax payer. The tax system Should ensure that the greatest possible proportion of taxes collected accrue to the government as revenue. 5. Taxable Capacity This refers to the maximum tax which may be collected from a tax payer without producing undesirable effects on him. A good tax system ensures that people pay taxes to the extent they can afford it. There are two aspects of taxable capacity. a) Absolute taxable capacity b) Relative taxable capacity Absolute taxable capacity is measured in relation to the general economic condition and individual position e.g. the region, or industry to which the tax payer belongs. In an individual, having regard to his circumstances and the prevailing economic conditions pays more tax that he Should, his taxable capacity would have been exceeded in the absolute sense. 2. Indirect Taxes This is concerned with the equitable distribution of taxes according to the stated taxable capacity of an individual or to some criterion of ability to pay. This is in keeping with one of the principal aims of taxation, namely the distribution and stabilization objectives. The difficulty in the application of this theory is in determining the criterion of the ability to pay. Three propositions have been advanced; income, wealth and expenditure. Should individuals be taxed according to their income, wealth or expenditure? A wealth-based tax may be useful in the redistribution of income and wealth but may not provide sufficient revenue by itself. An expenditure tax ensures that both income and wealth are taxed, when they are spent. Most tax regimes would, therefore, be partly income-based and partly expenditure based. THE COST OF SERVICE PRINCIPLE This is the cost to he authority of the services rendered to individual tax payers. Tax is a payment for which there is no “quid pro quo” between the tax authority and the tax payer; the tax payer does not necessarily have to receive goods and services equivalent to the tax paid. For this reason, the principle cannot be applied in relation to services rendered out of the proceeds of taxes e.g. police, judiciary and defence. Rather, it may be applied for such services as postal, electricity, or water supply where the price of these services are fixed according to this principle, i.e. the price paid for postal service s is the cost incurred in providing the service. It can therefore be stated that this principle may have limited application areas. CLASSIFICATION OF TAXES There are five major classifications of taxes. These are: 1. Direct Taxes A direct tax is one whole impact and incidences are on the same person. The impact of a tax is its money burden. A tax has impact on the person on whom it is legally imposed. The incidence of a tax is on the person who ultimately pays the tax whether or not it was legally imposed on him. Therefore a direct tax is one which is paid (incidence) by the person on whom it is legally imposed (impact). Examples are Pay As You Earn, corporation tax among others. Indirect tax is not held to be indirect merely because it is collected from one person and paid by another. For example, tax on employment income, Pay As You Earn (PAYE) which is collected from the employees and paid by the employer. Taxes are also classified according to how the marginal rates of tax vary with the level of income as explained herein below. 3. Progressive Taxes A tax is progressive when the marginal rate of tax rises with income. A good example of a progressive tax in Kenya is the income tax on individuals. Individual income tax rates for Kenya in 2009 Monthly taxable pay (Shillings) Rates of tax % in each Shsilling Annual taxable pay (Shillings) Rates of tax% in each Shsilling 1-10164 10% 1-121968 10% 10165-19740 15% 121969-236880 15% 19741-29316 20% 236881-351792 20% 29317-38892 25% 351793-466704 25% Excess over 38892 30% Excess over 466704 30% Personal Relief (Shs. 1,162 per annum) Personal Relief (Shs.13,944 per annum) 4. Proportional Taxes A tax is proportional when the same rate of tax is applied to all tax payers, for example the corporation tax which currently stands at 30% for all firms. 5. Regressive Taxes A regressive tax is one where the rate of tax falls as income rises. Here, the poor are called upon to make a greater sacrifice than the rich. Advantages of Direct Taxes as opposed to indirect taxes 6. Digressive Tax These are taxes that call upon the higher income earners to contribute less than their due contribution compared to the lower income earners. i.e. (a) the burden is relatively less since the tax is mildly progressive-the rate of progression is not sufficiently steep. Or (b) There is progression up to a certain point beyond which the rate becomes proportional. Taxes can be classified on the basis of the object of taxation i.e. the tax base. For example: Income tax – tax based on income Turnover tax – tax based on income from business Sales tax – tax based on expenditure Wealth tax – tax based on wealth Progressive taxes are favoured for their redistribution of income. Progressive taxes take a larger proportion of an individual’s gross income, the larger his/her income is. In a free market economy, the allocation of goods and services is achieved via the price mechanism, (according to demand which is aced by purchasing power). The price mechanism fails because production of goods and services is not raised to the socially desirable level. Individuals would not be able to satisfy even their basic wants if they do not have the ability to purchase those goods. For example, no entrepreneur will set up private schools or hospitals in remote poverty stricken areas because of lack of demand. The government intervenes to correct the market imperfection by taxing heavily the relatively affluent via a progressive income tax system, in order to fund the provision of essential goods and services at subsidized rates or at zero prices to all. However, a steeply progressive tax system may discourage enterprise. This will be examined later under the effects of taxation. 3. A tax n a commodity which is Shsifted forward to the consumers ahs the effect of raising its prices. This may force the consumers t partake less of that commodity. The reduced consumption is the indirect real burden of the tax. 4. In the illustration above, the dealer would pay the tax to the government even before the commodity is sold and the tax recovered from the consumers. Some time will elapse, occasioning an opportunity cost to the dealer equivalent to the interest he could have earned on the money paid to the tax authorities. This constitutes the indirect money burden of the tax. Other examples of indirect money burden of tax would include tax consultancy fees, and the cost of remitting tax. TAX INCIDENCE The incidence of a tax is the direct money burden of the tax. It deals with who ultimately pays the tax. From the illustration given above the incidence of the tax collected from the dealer is: 1. Wholly on the consumer if, as a direct result of the tax, the price of the commodity rises by at least the full amount of the tax: 2. Wholly on the dealer if the price does not rise at all; 3. Partly on the dealer if the price rises by an amount less than the full amount of the tax. IMPORTANCE OF TAX INCIDENCE There are numerous objectives of taxation. An efficacious tax system must be designed having regard to the possible incidence of the taxation. For example, if a tax is imposed in cigarette sales in order to discourage smoking and hence cut expenditure on health, it must be ascertained whether the smokers will be affected “adversely” by the tax. The importance of tax incidence can be summarized as follows: It ensures that there is an equitable distribution of the tax burden according to who pays the tax. The government needs to know who ultimately bears the money burden of any tax which Shows the final resting point of any tax. It helps identify reactions and repercussions of any tax. Incidence of a tax is its direct money burden equal to the total tax collection going to the treasury. Effects of a tax refer to its real burden both direct and indirect e.g. sacrifice of economic welfare or reduced consumption of a commodity. Incidence of a tax leads to the effect of the tax. It is the incidence of a tax that may be Shsifted. TAXABLE CAPACITY Taxable capacity This is the measure of an individual’s ability to pay tax. There are two aspects fo taxable capacity. These are: Absolute taxable capacity This is the maximum amount of tax that can be collected from an individual or community without causing a diminiShsing effect in economic welfare. If adverse effects result from the operation of a given tax system, it can be held that the taxable capacity has been exceeded in an absolute sense. Relative taxable capacity It refers to the distribution of the tax burden between two or more persons, communities or countries according to certain criterion of ability to pay. If one person contributes more than his due proportion of tax, it may be held that his taxable capacity has been exceeded in the relative sense. Taxable capacity depends on the ability to pay tax and also on the ability of the government to collect the tax. Ability to pay mainly depends on the per capital income in excess of the subsistent requirements. The ability of the government to collect taxes depends on the administrative efficiency and effectiveness. FACTORS AFFECTING TAXABLE CAPACITY Number of inhabitants or population size The larger the number of inhabitant or population size, the greater the taxable capacity of the country. This is the case at least in the absolute sense. If incomes or wealth is relatively low and more equally distributed then taxable capacity will be correspondingly reduced and vice versa. METHOD OF TAXATION A good tax system with wide base with various tax types will yield more tax revenues. Purpose of Taxation If the purpose of tax is to promote the welfare of the people they will be more willing to pay the tax. If the tax is for fighting famine, drought, disease and the results are evident then tax payers are more willing to contribute towards such popular causes but if the public funds are raised to maintain expensive emoluments for civil servants then the taxable capacity will Shsrink. Psychology of tax payers It depends on tax payer’s attitude towards their government. A popular government can stimulate the spirit of the people and prepare them for great sacrifice. Stability of income Where incomes are uncertain then the scope for further taxation is limited. Inflation It lowers the purchasing power of persons and this would limit the ability to sacrifice for common good. BUDGETARY OBJECTIVES A budget is statement which consists of the revenue and expenditure estimates of the government for one particular year. The budget is an important instrument that every government uses to define the direction of its national policy, the cost implications of government programmers, and the possible sources of revenues during a fiscal year. Budgetary objectives include: Price stability. Capital accumulation. Raising government revenue for provision of government services Equitable distribution of income and wealth Collection and allocation of scarce resources to priority sectors Provision of public goods and services by government; and FISCAL POLICY REFROMS AND THEIR IMPACT ON GOVERNMENT REVENUE EXPENDITURE AND ECONOMIC ACTIVITES. Fiscal policy Fiscal policies are measures arrived at achieving desirable economic objectives by the government. Fiscal policy is made up of: public debt, public expenditure and public revenue as the major instruments. The major source of public revenue is tax hence taxation policy is an important part of fiscal policy. The objectives of fiscal policy in a developing country such as Kenya are: Achievement of desirable wealth distribution Encouragement of flow of investment into desirable areas of the society Attract foreign and local investments e.g. though tax incentives. Promote import substitution Achievement of desirable level of development Promote accountability in public finance and recourses i.e. good governance of public institutions Increasing the level of employment A budget is a statement which consists of the revenue and expenditure estimates of the government for one particular year. Where government estimate expenditure is greater than the revenue, a deficit budget arises. If estimate revenue is greater than the expenditure the budget is referred to as a surplus budget. A budget is prepared on an annual basis, presented by the Minister of Finance before Parliament for approval. A budget may be of two kinds: Revenue budget Capital budget. Revenue budget relates to normal income and expenditure items while capital budget relates to development projects. The main sources of revenue for the revenue budget include:- Income and corporation tax Customs and excise duties Income from state properties Fines The main expenditure heads for the revenue budget include: Administration Defense Education Health Tax collection Capital budget Sources of income for the capital budget are: Loans and grants obtained by the government from other sources Planned expenditure made up of government contribution to foreign financed projects. Budgetary policy This is the sum total of all measures designed to achieve clearly designed budgetary objectives with a view to regulate the economy. Budget as an instrument of planning A budget is an instrument of development planning. In a planned economy, a budget is a plan of national resources and output capacity. It is the overall regulator of all the determinants of the economic growth. A budget can encourage for discourage private expenditure. Government budget can be sued to increase the rate of capital accumulation and economic growth. Budget ensures sound finance in light of the ever increasing responsibility of the requirements or spending. Note: the government uses both fiscal and monetary instruments in order to achieve budgetary objectives. Budgetary polices may be separately designed to answer particular needs of uses fiscal and monetary instruments to achieve this. Budget Surplus and Deficit Where the government operates a budget surplus, by increasing taxation, all other factors constant, there will be a decrease in private bank balances. With no excess reserves in banks, there will be a decline in the total money supply and hence interest rates will rise. Decreased bank balances will reduce bank credit and the resultant high interest rte reduces private borrowing and investment a deflationary effect on aggregate economic activity results. Where the government operates a budget deficit, then such deficit has to be financed through: Short term strategies for financing budget deficit Running down cash reserves Use of open market operations e.g. sale of government bonds or securities, assets, property. Borrowing both locally and abroad. This approach will expand the money supply and drive interest rates down. It will induce an expansionary influence on the level of economic activity. Long term strategies in reducing budget deficit include: To increase borrowing both internally and externally so as to increase revenue. The problem with the strategy is that there is the cost of servicing the loan as well as final repayment of the loans which can be a burden to the state. Reduce the deficit by cutting down on the expenditures such as debt repayment, defense and public administration. Increasing taxes bearing in mind the taxable capacity. Indirect taxes would be more favourable. Role of the Parliament in the budgetary process Budget proposals are presented to Parliament by the Finance Minister on the second Thursday of every year. The proposals are debated upon by the members of Parliament. Each Ministry will seek authority from parliament to get funds from the consolidated Question One EXERCISES Briefly explain the principle or canons of taxation Question Two Define a direct tax and explain some of its benefits (10 marks) (10 Marks) Question Three Explain the Benefit Theory (5 Marks) Question Four Distinguish between regressive and digressive taxes (5 marks) (Total: 30 marks) Question one PROBLEMS (a) Distinction between a single and multiple tax system (4 Marks) (b) Explain the reasons why a country might prefer a multiple tax system over a single tax system. (8 Marks) Question Two (a) Name and briefly explain the principles of a good tax system (Total: 16 Marks) Question three (a) (i) Define the term “fiscal policy) (2 Marks) (ii) State six objectives of fiscal policies with specific reference tot he needs of developing countries. (6 Marks) Question four (a) Distinguish between forward and backward Shifting of a tax (2 Marks) (b) Briefly explain the extent to which the following taxes can be Shifted (i) Income Tax (2 Marks) (ii) Customs duty (2 Marks) (c) Outline four advantages of progressive taxes (4 Marks) (CPA ADAPTED) CHAPTER TWO TAXATION OF INCOME OF PERSONS OBJECTIVES Establish the tax liability of different individuals, partnerships and body corporate To be able determine a resident and a non resident for taxation purposes Establish the different incomes to be taxed and the non taxable incomes Explain the treatment of different incomes in the computation of tax Evaluate the taxation of married women in Kenya. INTRODUCTION In the previous chapter we were introduced the general taxation framework in Kenya. In this chapter, we identify the various incomes to be taxed. We also see how to collect together all of an individual’s income in a personal tax computation, and then work out the tax on that income. In addition, we Shall study how to compute tax of partnerships and body corporate. Further, we will look at the expenses that are allowable and not allowable against income of a taxable person. In the next chapter we will look at the taxation of specific sources of income of a taxable person. DEFINITION OF KEY TERMS Residence- The term residence is a concept used to determine the tax treatment of a person. It applies both to individuals and companies as discussed herein below. Taxable income- this is income of a person that is subject to tax under the taxation Acts. It includes employment income, business income, income arising from rights granted for use of property among others. INDUSTRY CONTEXT This chapter will assist the accountant be able to compute tax on salaries (PAYE) and also on their other incomes. Further, it will help the firm or company’s management ascertain their respective tax liability. This will help the accountant in ensuring compliance with the tax law. Lumumba was a resident in 2007 as the average days for the three years is more than 122 days. Wabwire was not a resident in 2007 as the average days for the three years at 122 is not more than 122 days. Note: Kenya includes the air space which is a distance up in the sky considered to be part of Kenya. It also includes the Territorial waters which are a distance into the sea considered to be part of Kenya. b) Resident in relation to a body of persons means that: (i) The body is a company incorporated under the laws of Kenya; or (ii) The management and control of the affairs of the body was exercised in Kenya in the year of income under consideration; or iii) Te body has been declared, by the Minister for Finance by a notice in the Gazette, to be resident in Kenya for any year of income. c. Non-Resident: Means any person (individual or body of persons) not covered by the above conditions for resident. Note: Residents have some tax advantages over non-residents which relate to tax reliefs rates of tax, and expenses allowable against some income. (Income) Accrued in or Derived From Kenya The income which is taxable is income arising from or earned in Kenya Under certain conditions, some business and some employment income derived from outside Kenya is taxable in Kenya. SOURCES OF TAXABLE INCOMES Some items of income are subject to tax and others are not. The Act has listed the income upon which tax is charged. The income which is taxed s income in respect of: a) Gains or profits from business b) Gains or profits from employment or service rendered; c) Gains or profit from rights granted to other persons for use or occupation of property e.g. rent; d) Dividend and interest; e) Pension, charge or annuity, and withdrawals from registered pension and provident funds; f) An amount deemed to be income of a person under the Act or rules made under the Act; Any person (individual or legal person) who receives all or some of the above income in a given year of income is taxed on the income. Each item of taxable income will be examined in detail to see the various components that make up the particular item of income. NON TAXABLE INCOMES/EXEMPT INCOME There are items which are commonly referred to as income but are not included in the above mentioned list of taxable income. A number of such non-taxable incomes come to mind such as: 1. Dowry 2. Gifts-(however, tip arising from employment are taxable) 3. Harambee collections 4. Inheritance 5. Charity sweepstake winnings 6. Premium bonds winnings 7. Income or interest on post office savings bank account 8. profit on selling isolated assets 9. Honoraria 10. Pension or gratuities earned or granted in respect to disability 11. The income of a registered pension fund or trust 12. Monthly or lump sum pension granted to a person who is 65 years of age or more 13. That part of the income of the president of the republic of Kenya that is exempt e.g. a salary duty, allowances, entertainment allowances paid or payable to him from public funds. 14. Allowances to the speaker, deputy speaker and MP payable to them under the National Assembly remuneration 15. Interest up to Shs. 100,000 per individual on housing bonds, account with Housing Finance Corporation of Kenya (HFCK), saving and loans of Kenya Ltd, East Africa Building Society, Home Loans and Savings. (With effect from June 1987, The Kenya Post Office Savings Bank, the Cotton Board of Kenya. 3. Charitable organizations as defined by the Act. 4. The income other than income from investment of an amateur sporting association. 5. Profits or gains of an agricultural society accrued in or derived from Kenya from any exhibition or Show held for the purposes of the society, which are applied, solely to those purposes, and the interest on investments of that society. 6. The income of any local authorities 7. Interest on any tax reserve certificates issued by the Kenya Government 8. The income of any registered pension scheme. 9. The income of any registered provident fund. 10. The income of any registered trust scheme. 11. The income from the investment of an annuity fund defined in Sec. 19 of the Income Tax Act, of Insurance Company. 12. Pensions or gratuities granted in respect of wounds or disabilities. 13. Interest on a savings account held with the Kenya Post Office Savings Bank 14. Interest paid on loans granted by the Local Government Loans Authority. 15. The income of a registered individual retirement fund. 16. The income of a registered individual retirement fund. 17. The income of a registered home ownership savings plan 18. Allowances to the Speaker, Deputy Speaker and Members of the Parliament payable under the National Assembly Remuneration Act. 19. Interest up to a maximum of Shs. 300,000 per individual earned on housing bonds with: Housing Finance Corporation of Kenya (HFCK) Savings and Loan Kenya Limited East African Building Society Home Loans and Savings Any interest in excess of Shs. 300,000 is subject to 10% withholding tax. This means that after the withholding tax at 10% the interest will not be subject to any tax. TAX RATES: RELIEF AND WITHHOLDING TAXES Rates of tax RATES OF TAX After determining the taxable income, also referred to as assessable or chargeable income/loss f a person, the person is taxed. a) Loss is carried forward on the basis of specified sources until the person makes profit to off-set the loss. The loss from one specified source can only be off-set against future income from the same specified source. b) Income is taxed at the prescribed rates of taxation. There are Corporation rates of tax applicable to companies (legal persons) and there are individual rates of tax applicable to individuals (natural persons). Corporation Rates of Tax The corporation rates of tax apply to legal persons such as companies, trusts, clubs, estates, co- operatives, associations etc. 1) Corporation rates of tax from years 2000 to date are 30% for resident corporations. 2) From year 2000 to date, a non-resident company with a permanent Establishment in Kenya is taxed at 37 ½ %. Listed companies Companies newly listed on any securities exchange approved under the Capital Markets Act enjoy favourable corporation tax rates as follows: If the company lists at least 20% of its issued Share capital listed, the corporation tax rate applicable will be 27% of the period of three years commencing immediately after the year of income following the date of such listing.” If the company lists at least 30% of its issued Share capital listed, the corporation tax rate applicable will be 25% for the period of five years commencing immediately after the year of income following the date of listing.” WITHHOLDING TAX A resident person is required to withhold tax on various payments, under section 35 of the income Tax Act. Withholding tax is applicable on payments to both residents and non-residents. Such payments include dividends, interest, royalties, management and professional fees and agency, consultancy and contractual fees. The importance of deducting withholding tax is that it makes tax collection easily and it also ensures that some incomes do not escape taxation. The withholding tax Should be viewed as incomes do not escape taxation. The withholding tax Should be viewed as income tax paid in advance. A person making payments of incomes subject to withholding tax is legally required to deduct the withholding tax or the tax at source at appropriate rates before effecting the payment and: a) Remit the tax so deducted t the Domestic Taxes Department; b) Pay the payee the amount net of tax; and c) Issue the payee with a certificate of the withholding tax or tax paid at source e.g. interest certificate or a divide voucher. For any given year of income, the payee is assessed on gross income and is given credit for the tax paid at source except in cases where the withholding tax is the final tax. The withholding tax rates are as follows: WITHHOLDING TAX RATES TAXES Payments Residents Non-Residents Notes % % Dividends 5% 10% Interest-Housing Bonds - Other sources Insurance Commission -Brokers - Others (a) (b) (c) 10% 15% 15% 15% Royalties 5% 20% Pension and retirement annuities (d) 0%-30% 5% Management and professional fees, training fees (e) 5% 20% Sporting or entertainment income 20% Real estate rent 20% Lease of equipment 30% Contractual fee (e) 3% 15% Telecommunication service fee (f) 5% Notes: (a) Quantifying interest in respect of Housing Bonds is limited to Shs 300,000 per year. (b) Withholding tax on interest received by a resident individual from the following sources is final: Banks or financial institutions licensed under the Banking Act. Building societies licensed under the Building Societies Act. Central Bank of Kenya (c) Commissions payable to non-resident agents for purposes of auctioning horticultural produce outside Kenya are exempt from withholding tax. (d) Tax deducted at source on withdrawals from provident and pension schemes in excess of the tax-free amounts made after the expiry of fifteen years or on the attainment of the age of fifty years, or upon earlier retirement on health grounds are final. (e) Withholding tax n payments to resident persons for management and professional fees applies to payments of Shs. 24,000 or more in a month to both registered and non registered business. The tax rate in respect of consultancy fees payable to citizens of the East African Community Partner States is 15%. (f) The tax is subjected to payments made to non-resident telecommunication service providers and is based on gross amounts. Note: Various reduced rates of withholding tax apply to counties with double tax relief treaties with Kenya. The incomes of the non-residents are taxed gross, that is, no expenses are allowed against the income. The withholding tax must be remitted to the Domestic taxes Department within 20 days of its being deducted. There is n further tax for the non-resident after the withholding tax is paid as far as Kenya is concerned. OTHER TAXES AT SOURCE There other taxes that are deducted at source in addition to withholding tax. These are: Employment income (PAYE) The employment income is taxed at source monthly under the Pay AS You Earn (PAYE) tax deduction system. The tax is referred to as income tax. It will apply to salaries, wages, directors’ fees, benefits, etc. paid monthly to any employee. Every employer is legally required to operate a PAYE deduction system. The main features of the PAYE system are: (i) The employers deduct PAYE tax monthly on all employment income they pay to their employees; (ii) A PAYE tax deduction card (from pg9) is maintained for each employee, Showing monthly gross pay, benefits, allowed deductions, PAYE deducted, personal relief and net pay; (iii) The details above must be given to every employee by the employer per month, i.e. the pay slip or pay advice; (iv) The PAYE deducted must be paid to the Domestic Taxes Department (banked using credit slip paying-in-book called P11) by the 9 th day of the month following the one in which PAYE was deducted; (v) The employer is required to issue a certificate of pay and tax (from p39) at the end of each calendar year or whenever an employee leaves employment; (vi) At the end of each calendar year, every employer is required to submit the PAYE end- TAXATION OF INDIVIDUALS, PARTNERSHIPS AND BODY CORPORATES. A TAXATION OF INDIVIDUALS An individual is taxed in respect of the incomes he receives. As highlighted above, there are various specified sources of income. In this section, we will highlight the taxations of individuals receiving business income and employment income. Gains or profits from any business, for whatever period of time carried on. The Income Tax Act has defined business to include any trade, profession or vocation, and every manufacture, adventure and concern in the nature of trade, but does not include employment. Trade means buying and selling for gain; Profession means professional practice such as by a doctor, lawyer, accountant etc; Vocation means a calling or career; Adventure would include smuggling and poaching; Concern would mean any commercial enterprise. Business may be carried on for a Short time or a full year. The period a business is carried is irrelevant in taxing the income (gains or profits) and so the use of the phrase “for whatever period” of time (business is) carried on. The act charges tax n gains or profits from any business. One person may carry on illegal business an another one may carry on a legal business. Both would be taxed on gains or profits from business as the Act is not concerned with the legality of the business when it comes to taxing the business income (gains or profit). The following items whenever they arise will from part of the gins or profits from business: 1) An amount of gains from ordinary business arising from buying and selling as a trade e.g. butchery, grocery, manufacture, transport etc. 2) Where business is carried on partly within and partly outside Kenya, by a resident person, the gains or profits is deemed to be derived from Kenya. A good example of this is a transporters who transports goods from Mombasa to Kigali (trading in Kenya) and then transports goods from Kigali to Kampala and to Mombasa (trading outside Kenya). 3) An amount of insurance claim received for loss of profit or for damage or compensation for loss of trading stock. 4) An amount of trade debt recovered which was previously written off. 5) An amount of balancing charge. This arises where business has ceased and the machinery in a class of wear and tear is sold for more than the written down value. For example: Wear and tear computation Class III Sh s Sale proceeds (business ceased) 35,000 Written down Value 30,000 Balancing Charge (taxable income) 5,000 This concept will be clear to you later in the course when dealing with the calculation and claim for wear and tear deduction, which at this point may be viewed as the standard depreciation for tax on machinery used for business. 6) An amount on trading receipt. This arises where business is continuing and all the machinery in a class of wear and tear is sold for more than the written down value. For example, the same figures as in 5 above can be used: Wear and tear computation Class III Shs. Sale proceeds (business continuing 35,000 Written down Value 30,000 Trading receipts (taxable income) (5,000) 7. An amount of realized foreign exchange gain. If the foreign exchange gain is not realized, it is not taxable. 2. Hire charges paid. VALUE OF TAXABLE BENEFITS PRESCRIBED BY CIT (YEAR 2009) Taxable Employment Benefits-Year 2009 RATES OF TAX (including wife’s employment, self employment and professional income rates of tax). Year of income 2008/2009 Taxable Employment Benefits-Year 2008/2009 Monthly taxable pay (Shillings) Annual taxable pay (Shillings) Rates of tax% in each Shilling 1 10,164 1 121,968 10% 10,165 19,740 121,969 236,880 15% 19,741 29,316 236,881 351,792 20% 29,317 38,892 351,793 466,704 25% Excess over 38,892 Excess over 466,704 30% Personal relief Shs. 1,162 per month (Shs 13,944 per annum) Commissioner’s prescribed benefit rates Monthly rates Annual rates Shs. Shs. (i) Electricity (Communal or from a generator 1,500 18,000 (ii) Water (Communal or from a borehole) (iii) Provision of furniture (1% of cost to employer) (iv) Telephone (Landline and mobile phones) 30% of bills. Agricultural employees: Reduced rates of benefits (i) Water 200 2,400 (ii) Electricity 900 10,800 Low interest rate employment benefit: The benefit is the difference between the interest charged by the employer and the prescribed rate of interest. Other benefits: Other benefits, for example servants, security, staff meals etc are taxable at the higher of fair market value and actual cost to employer. Note Land Rovers and vehicles of a similar nature are classified as Saloons. b) Housing Benefit – Section 5 (3) A housing benefit. Arises where an employee is housed by the employer. The employer may own the house or lease it from other parties. To determine the amount of housing benefit, the employees are classified into six groups and the values of the housing benefit will depend on this classification: (i) Ordinary Employee 15% of his gains or profits from employment (i.e. monthly cash pay plus benefits) excluding the value of these premises, minus rent charged to the employee; subject to the limit of the rent paid by the employer if that is paid under agreement made at arm’s length with a third party. (ii) Agricultural employees (Including a whole-time service director) who is required by term of employment to reside on a plantation or farm:- 10% of his gains or profits from employment- i.e. monthly cash pay plus benefits), minus amount of rent charged to the employee. This subject to employer obtaining prior approval from Domestic Taxes Department-Note also reduced rates of benefits for agricultural employees. If an employee acquires a loan from his employer at a rate of interest that is lower than the prescribed rate of interest, then the difference between the prescribed rate of interest and employer’s interest is a benefit from employment. This benefit can be brought to charge as follow: i) Low Interest Rate Benefit: This benefit arises fro the difference between the prescribed rate and the interest rate charged by the employer for loans provided by the employer on or before 11 th June 1998. This benefit is taxable on the employee. Example: Loan provided KShs. 500,000 Employer’s Loan Interest Rate 2% Prescribed Rate 10% Low Interest Benefit =(10%-2%) x 500,000 = Shs. 40,000 p.a i) Fringe Benefit This benefit arise from the difference between the Market Interest rate and the employer’s interest rate for loans provided after 11 th June 1998 or loans provided on or before 11 th June 1998 whose terms and conditions have changed after 11 th June 1998. Such a benefit is taxable on the employer at the corporation Tax Rate. The tax on Fringe Benefits is known as Fringe Benefit Tax Example Loans amount Shs. 800,000 Interest Rate charged by Employer 2% Market Interest rate for the month 12% Fringe Benefit (12% - 2% = Shs. 80,000 p.a Fringe Benefit Tax =80,000 x 30% = Shs. 24,000 p.a or Shs. 2,000 p.m Mr. Mwangi Determination of the assessable amount of compensation Shs. Rate of earning p.a. 300,000 Compensation 700,000 Compensation is spread as follows: Year 2007 300,000 Year 2008 300,000 Year 2009 100,000 Assessable or taxable amount 700,000 Suppose the amount of compensation was 1,500,000 Mr. Mwangi Determination of the assessable amount of compensation Shs. Rate of earning p.a. 300,000 Compensation 1,500,000 Compensation is spread as follows: Year 2007 300,000 Year 2008 300,000 Year 2009 300,000 Year 2010 300,000 Year 2011 300,000 1,500,000 (c) Unspecified term and no provision for terminal payment. Where the contract is for unspecified term and does not provide for terminal payment, the compensation is to be spread forward in equal amounts for three years. Illustration Mr. Ole Sakuda had a contract for unspecified term that had no provision for payment of compensation upon termination of employment. The contract is terminated on 31 st Dec 2006 and Shs. 1.5 m i l l i o n is c o m p e n s a t i o n . Immediately b e f o r e t e r m i n a t i o n , t h e e m p l o y e e ’ s r a t e o f remuneration was Shs. 48,000 p.a. Required Establish the amount of the compensation that will be assessed to tax Showing clearly the year to which it relates (the spread). Contract is for unspecified term and provides for compensation. Mr. Ole Sakuda Determination of the assessable amount of compensation. Shs. Rate of earning p.a. 480,000 Compensation 1,500,000 Compensation is spread as follows: Year 2007 500,000 Year 2008 500,000 Year 2009 500,000 Assessable or taxable amount 1,500,000 Tax free remuneration There are certain instances where an employer wiShses to pay his employee salaries negotiated set of tax. In such cases, the employer bears the burden on behalf of those employees. The tax to be paid by the employer on behalf of the employee becomes benefit chargeable to tax on the employer. Employee Share option plans (ESOPS) The granting of bonus Share for better performance by the firm is a benefit in kind received for employment services rendered thus a taxable benefit. Where Shares are given free, the taxable benefit is based on the prevailing market price per Share (MPS). When Shares are issued at a price lower than the market price per Share, the taxable benefit will be (MPS – issue price) X number of Shares issued. Limiting of benefits Where a benefit is enjoyed for a period of less than a year, the taxable value of the benefit is proportionately reduced to the period enjoyed. For example, if an employee was provided with furniture for t hree months in 2005, he would be taxed on one quarter of the benefit as follows: assuming the price of the furniture was Shs. 800,000. Taxable benefit=12% x 800,000 x 3/12=24,000 Benefits excluded from Employment Income. (Tax free employment benefits): 1. Expenditure on passage for expatriates only This is expenditure on travelling between Kenya and any other place outside Kenya borne by the employer for the expatriate employee and family. Conditions for qualifying for passage: (i) The employee must not be a citizen of Kenya. (ii) The e m p l o ye e m u s t b e r e c r u i t e d o r engaged f r o m outside Kenya. However, a n expatriate employee does not loose the free passage by changing jobs in Kenya. (iii) The employee must be in Kenya solely for the purpose of serving the employer. The expatriate may fail to qualify for passage if he engages in commercial activities in addition to employment. (iv) The employer obtains tickets or reimburses the expatriate or employee the passage cost. vii) Monthly pension granted to a person who is 65 years of age or more viii) The first Shs. 2000 paid to an employer per day as an allowance while on official duty Shall be deemed to be a reimbursement and therefore not taxable. ix) Non-cash benefits up to a maximum of Kshs. 36,000 per year. Gains or profits from rights granted to any other person for use or occupation of property. This is consideration received for the use or occupation of property and includes:- Royalty for copyrights, patents, trademarks etc. Rent which is the tenant’s periodic payment for the use of land, building or part of the building etc. Rent premium or key money being inducement to lease out a property Income in Respect of Dividend and Interest 1. Dividend: Dividend is the amount of profit of a company which it pays to its Share-holders in proportion to their Share holding in any particular year. It is income in the hands of the recipients. The following are deemed to be payments of dividend to those receiving: a. In a voluntary winding up of a company, amount distributed as profits whether earned before or during winding up, whether pain in cash or otherwise. b. Issue of debentures or redeemable preference Shares for no payment. The dividend is taken to be greater of nominal or redeemable value e.g. Nominal value Shs. 100 Redeemable value Shs. 110 Taxable dividend is Shs. 110, (the greater of the two) c. Payment for debentures or redeemable preference Shares for less than 95% of the nominal value and redeemable value whichever is greater e.g. payment of Shs. 70 in (b) above. 95/100x Shs. 110=Shs. 104.5. The payment of Shs. 70 is less than 95% of Shs. 110 which is Shs. 104.5. The difference Shs. 40 is taxable dividend income i.e. Shs. 110-Shs.70=Shs.40. The following dividends received by a resident company are not taxed on the company; The dividend received by a company which owns or controls 12 ½ % or more of the voting power (Shares) of the paying company. Note: (i) Foreign dividends not earned in Kenya are not taxable. (ii) Dividends are subject to withholding tax (tax at source) at 5% which is deducted by the person paying and remitted to the Domestic Taxes Department. This constitutes the final tax i.e. no further tax is chargeable for Kenya residents. Dividends are treated as income of the year in which they are received. w.e.f. 13.06.2008, Dividends received by financial institutions is subject to withholding tax. 2. Interest This means interest payable in any manner in respect of any loan, deposit, debt, claim, or other rights or obligations, e.g. loans by banks and financial institutions, deposits to banks and financial institutions etc. Interest is assessed on a cash basis, which means that it is taxed when received not when earned if not paid. Interest income exempted from taxation: a) Interest from Post Office Savings Bank Account. The Post Office Savings Bank does not accept deposits of more than Shs 500,000. The interest from Fixed Deposit with the Post Office Savings Bank is exempted from taxation. b) Part exemption: The interest of up to Shs. 300,000 from housing development bonds called “qualifying interest” is partly exempted from taxation, i.e. the first Shs. 300,000 of interest on housing bonds is subject to 10% withholding tax as final tax. The “qualifying interest” here means interest received by an individual which does not exceed Shs. 300,000 in any year of income in respect of housing development bonds held by threat individual with a financial institution licensed under the Banking Act or a Building Society registered under the Building Societies Act and which has been approved to issue housing development bonds. The housing development bonds are issued by a financial institution on payment of money and the money earns interest. The money raised through issue of housing development bonds is supposed to help in housing development. The qualifying interest is taxed at a “qualifying interest rate of tax” which is the resident withholding tax of 15%. Income In Respect Of Pension, Charge Or Annuity, And With Effect From 1 st January 1991, Any Withdrawals Or Payments From Registered Pension Fund Or Registered Provident Fund. A pension fund is created by contributions from employer, or from employees, or both. An employee receives pension from this fund when he/Shse retires because of old age or for any other reason. Normally, the retiring employee is paid a lump sum on retirement, and thereafter, a stated amount per month for life or for a stated period. A provident fund is also created by contributions from employee or from employer o r both. An employee, on leaving employment is paid a lump sum from the fund depending on the contributions made to the fund. (i) Pension is received for past service and after retirement. (ii) Pension annuity of up to Shs. 900,000 p.a. is exempted from taxation, where it is received by resident individuals. They are exempted from taxation as follows: First Shs. 480,000 Any amount received in excess of exempt amount is taxed as follows above Shs. 480, 000 tax exempt. 1 st Shs. 400,000 @ 10% Next Shs. 400,000 @ 15% Next Shs. 400,000 @ 20% Next Shs. 400,000 @ 25% Excess of Shs. 1,600,000 @ 30% iv)Pension received by anon-resident is not exempted for taxation and is in fact subject to withholding tax of 5% of Gross Income. No portion of the income is exempted. Income In Respect Of Any Amount Deemed To Be the Income of A Person Under The Income Tax or Rules Made Under the Income Tax Act. i. All the income from business carried on partly outside and partly inside Kenya is deemed to be income derived from Kenya, and is taxed in Kenya. ii. For a resident individual, income from employment or service rendered inside or outside Kenya is deemed to be income derived from Kenya, and is taxed in Kenya. Income / (Loss) Any Pay As You Earn (PAYE) tax deducted from employment in the above cases was refunded. Where tax deducted at source was high, tax refunds were also high. The concept of specified (separate) sources of income was introduced in 1979 as an anti- avoidance measure, some taxpayers had set up loss-making businesses which cleared taxable income from other sources and thus ended up not paying any tax. With effect from 1.1.79 the income of a person is computed on the basis of specified sources of income or loss from each source separately determined. a) The loss from a specified source can only be off-set against future income from the same source. b) The income from specified sources are added together and taxed as the total income of a person. SPECIFIED SOURCES OF INCOME ARE 1. The right granted to other persons for use or occupation of property e.g. rent and royalty. 2. Employment remuneration, e.g. salary, wages benefits etc. 3. Professional income from practicing, professional e.g. lawyer, doctor, engineer etc. A loss from professional practice can be offset against employment income. Professionals rarely make losses. 4. Employment and any self-employed professional vocation. 5. Farming including agricultural, pastoral, horticultural, forestry, fiShsing and similar farming activities. 6. Business e.g. Shop, hotel, butchery etc and any other source of income chargeable to tax as gains or profits but not included in (1) to (3) above. 7. Dividend and interest with effect from 1.1.87 8. Unspecified sources. These are sources of income that do not fit into any of the above e.g. pension, annuity or charge and withdrawals or payments from registered pension and provident funds. It is important to note that loss brought forward as at 31.12.78, called deficit of total income, can be offset against all income from specified sources. TAXATION OF PARTNERSHIP PROFITS The definition of a taxable person in the Act does not include a partnership. The income/loss of a partnership is assessed and taxed on the partners. The gains or profits of a partner from a partnership are the aggregate of: a) Remuneration payable to him /her. b) Interest on capital receivable, less interest on capital (drawings) payable by the partner to the partnership. c) His/ her Share of adjusted partnership profits. Shs Shs Partnership salary XX Interest on capital receivable XX XX Interest on capital payable (X) XX Share of profits / (Loss) X XX The profits of a partnership that are apportioned to each partner are calculated after. i) Deducting remuneration payable. ii) Deducting interest on capital payable to partners. iii) Adding interest on capital (drawings) payable by partners to the partnership. Where the adjustment of partnership profit results in a loss, the gain or profit from the partnership of a partner is the excess of remuneration and interest received, less interest payable, over loss. X enterprises adjusted Business Income Shs Shs Loss as per account (200,000) Add back: Depreciation 100,000 Salaries A 400,000 B 300,000 C 200,000 Interest on Capital A 100,000 C 100,000 Commission B 200,000 1,400,000 1,200,000 Distribution of Adjusted Profit to Partners A B C Total Salaries 400,000 300,000 200,000 900,000 Interest on capital 100,000 _ 100,000 200,000 Commission - 200,000 - 200,000 Share of Loss: (40,000) (40,000) (20,000) (100,000) 460,000 460,000 280,000 1,200,000 Partners’ Taxable Income from Partnership. A 460,000 B 460,000 C 280,000 1,200,000 Taxation of Companies Resident body corporates are taxed at the corporation tax rate of 30% while nonresident companies are taxed at 37.5%. All body corporates incorporated in Kenya are expected to pay installments tax before the end of the accounting year. Therefore, the amount of tax payable Shall be determined at the beginning of each year. This is based on the higher of: The budgeted profits of the year or 110% of the last year’s tax liability. Once determined, the installment tax is payable as follows. 1st Installment 25% of tax due by 20th day of the 4th month during the year of income 2nd Installment 25% of tax due by 20th day of the 6th month during the year of income 3rd Installment 25% of tax due by 20th day of the 9th month during the year of income 4th Installment 25% of tax due by 20th day of the 12th month during the year of income Final Tax (Tax balance) Actual tax payable minus total installment tax paid on the last day of the fourth month after the end of the year of income. However for firms in agriculture sector, installment tax is payable as: 1st Installment 75% of tax due by 20th day of the 9th month during the year of income 2nd Installment 25% of tax due by 20th day of the 12th month during the year of income Final Tax (Tax balance) Actual tax payable minus total installment tax paid on the last day of the fourth month after the end of the year of income. TAXATION OF ENTERPRISES OR COMPANIES IN THE EXPORT PROCESSING ZONE (EPZ) An E.P.Z is an area within a country which is free of duty or government red tape. The main objectives of Establishing E.P.Zs are: 1. To create employment; 2. To attract foreign investment; 3. Export promotion – as a means to boosting foreign exchange earnings; 4. Technological transfer. Enterprises operating within EPZ have the following benefits: 1. A ten year tax holiday -This is an exemption from corporation tax for the first ten years of trading. 2. A lower corporation tax rate of 25% for the subsequent 10 years after the ten years tax holiday. 3. An exemption from all Withholding tax on dividends and other payments to non residents during the first 10 years. 4. Investment deductions are 100% of the capital expenditure claimable in the 11th year after commencement of production. 5. Zero rated for purposes of VAT 6. There is a refund of import duty on raw materials to manufacture exports. Note: EPZ enterprises must submit annually returns of income and supporting accounts to the commissioner of income tax. Emoluments paid to employees and resident directors of EPZ enterprises must subject to PAYE deductions as required by law even during the period the enterprise is exempt from tax. income: i) The amount of general provisions for bad debts e.g. a provision of 5% on all debts. ii) The amount of any bad debt on sale of capital item and on other non-trade activities like friendly loans. Arising from the above, the following should be noted: a) If a trade debt was previously written off and is recovered, it is taxable income for the year in which it is recovered. b) A debt previously not allowed as a write off is not taxed when recovered. c) Allowed provisions no longer required or no longer necessary are taxed in the year they are no longer required e.g. if a specific doubtful debt is provided for in full in a given year and one half of the debt is paid in the following year, then 50% of the provision would not be required and the amount would be taxed by adding it to the trading income. b) Any capital expenditure for the prevention of soil erosion in a farm land. The capital expenditure Should be incurred by the owner or occupier of the farm land. For example, on construction of dams, terraces, wind breaks etc. c) Any capital expenditure on clearing agricultural land or on clearing and planting Permanent or semi-permanent crops. The common examples of permanent crops are cashew nuts, citrus, coconuts, coffee, passion-fruit, paw-paw, pineapples, pyrethrum, sisal, sugar-cane, tea, apples, pears, peaches, plums, bananas, roses, pine, cypress, Eucalyptus etc. d) The pre-trading expenses, that is, expenditure incurred before the commencement business which would be allowable if the business was operating. The pre-trading expenses are allowable when business commences. Two examples of pre-trading expenses are: i) In case of a new hotel-the cost of recruiting and training of staff before the hotel opens for business. ii) In case of new coffee or tea farmer-of cultivation, fertilizer, and other farm expenses for two to three years before picking commences. This does not include expenditure related to the formation of the business. a) The legal costs and stamp duty for registration of a lease of business premises. The lease period must not be in excess of or capable of extension beyond 99 years. b) The expenditure on structural alterations to enable premises to be let e.g. subdivision of open rooms in a house which is necessary to maintain existing rent. The expenses relating to extension or replacement of premises are not part of structural alterations and are therefore not allowed against rent income. If there is a rent increase as a result of the structural alterations, the expenditure is disallowed against rent income. c) The diminution or decrease in value of implements, utensils or similar articles e.g. loose tools in workshop or factory; crockery, cutlery, kitchen utensils in hotels or restaurants; jembes, pangas etc. in a farm. These are not machinery or plant for which wear and tear deduction is given as will be seen later in the Study text. In practice, the Domestic Tax Department accepts taxpayer’s valuation of tools and implements and generally, most taxpayers take the life of loose tools to be about three years thus writing off their cost over the three years. d) The entrance fees or annual subscription paid to a trade association e.g. Kenya National Chamber of Commerce and Industry and Kenya Association of Manufacturers. The trade association must have elected to be treated as trading by giving notice to the Commissioner of Domestic Taxes under S.21 (2) of the Income Tax Act. Members' Clubs and trade associations are deemed to be trading but if 75% or more of j their gross receipts, other than gross investment receipts (interest, dividends, royalties, rents etc) are from members, it is deemed to be trading. It can then elect by notice to CDT to be treated as trading and entrance fee deemed income from business. e) Club subscription paid by an employer on behalf of an employee; ix) The amount of trading loss. The trading loss arises where business is continuing and all the assets in a class of wear and tear are sold for less than the written down value e.g. Wear & Tear Class Written down value 50,000 Sale of all assets (business continuing) 40.000 Trading loss-allowable against income 10, 000 The concept will be clear later in the lessons when the calculation and claim for Wear and Tear Deduction is explained. o) The amount of balancing deduction. The balancing deduction arises where business has ceased and all the assets of a class of wear and tear are sold for less than the written down value e.g. Wear & Tear Class Written down value 50,000 Sale of all assets (business has ceased) 40,000 Balancing deduction-allowable against income 10,000 The concept will be clear later in the lessons when the calculation and claim for and Tear deduction is explained. p) The amount of interest on money borrowed and used in the production of income e.g. interest on loan, overdraft, debentures etc. q) The amount of realized foreign exchange loss (capital or revenue) with effect 1.1.89. If the foreign exchange loss is not realized or incurred, it is not allowed against taxable income. r) Capital deductions under the second schedule of the Act, namely: i) The amount of wear and tear deduction (allowance) on machinery used for business. ii) The amount of industrial building deduction (allowance) on industrial buildings used for business. iii) The amount of farm works deduction (allowance) given to farmers only on construction of farm works used for farming. iv) The amount of investment deduction (allowance) given only once to an investor on some industrial buildings and machinery used for business. v) The amount of mining deduction (allowance) on capital expenditure incurred in the mining of specified minerals. The calculation and claiming of the capital deductions above which are allowed under the Second Schedule to the Income Tax Act, is explained in detail after the next topic regarding expenses and deductions not allowed against taxable income. vi) Cost of provision of meals to employees. EXPENSES OR DEDUCTIONS NOT ALLOWED AGAINST TAXABLE INCOME S.16 of the Income Tax Act lists expenses which are either generally not allowable against taxable income or are specifically stated not to be allowable against taxable income. Expenditure generally not allowed against taxable income S.16 (1) of the Income Tax Act generally disallows expenditure which is not incurred in the production of taxable income. The section reads as follows: S.16 (1)"..... For the purpose of ascertaining the total income of the person..... no deduction Shall be allowed in respect of expenditure ..... Which is not wholly and exclusively incurred by the person in the production? of income?" This is a general provision for disallowing: a) Expenses which under normal accounting practice are not allowable against income, subject to any extension made by the Income Tax Act; and b) Expenses which are not commercial expenses of a business e.g. notional rent, salary to self etc. Specific items or expenditure not allowable against income In addition to S.16 (1) generally disallowing expenditure which is not wholly and exclusively incurred in the production of taxable income, S.16 (2) disallows specific items of expenditure 'f charged against taxable income. The items of expenditure listed below must be disallowed where charged against taxable income: a) The amount of capital expenditure, loss, diminution or exhaustion of capital e.g. depreciation, amortization, write-off of all assets, loss on sale of asset etc. These are disallowed unless specifically allowed in the Income Tax Act. b) The amount of personal expenditure incurred by any individual in the maintenance of himself, his family, or for domestic purpose. With effect from 1.6.'91, the disallowed expenditure includes: i) Entertainment expenses for personal purposes; ii) Hotel, restaurant, or catering expenses except: a) On business trip: b) During training or work related conventions or conferences; and c) Meals provided to low income employees on employers’ premises iii) Vocational trips except those provided to expatriates; iv) Education fees, if not taxed on the employee(s): d) The amount of expenditure or loss recoverable under insurance contract or indemnity. e) The amount of income tax paid, or any tax on income. Other taxes may be allowed TAX COMPUTATIONS The income tax computation is a process in which an effort is made to reconcile the financial statements (accounts) with the requirements of the Income Tax Act as regards taxable/non- taxable income and expenses allowable/not allowable against income. The Income tax computation can also be looked at as a process of arriving at the taxable income/loss of a person for a year of income. The income tax computation is also a process of computing or determining the taxable income/loss of a person for a year of income. In computing or determining the taxable income/loss, you will rely heavily on your knowledge of accounting in the preparation of financial statement, and particularly the net profit/loss for the accounting period. You will also be required to have a good knowledge of taxable/non- taxable income, and deductible/non-deductible expenses. The income tax computation involves: a) Determining (computing) income or loss to be taxed. The Income is taxed and losses are carried forward for each specified source of income to the next year of income and so on until there is income to off-set it. b) Adjusting the net profit/loss per the accounts to comply with the requirements or provisions of the Income Tax Act. c) Reviewing various incomes appearing in the accounts to determine whether they are taxable or not. d) Reviewing the various expenses appearing in the accounts to determine whether allowable against income or not. We will now look at the items of income and expenditure appearing in the accounts and how some are adjusted in the income tax computation in arriving at the taxable income/loss for the year. The adjustments are necessary because: a) Non-taxable income may be included in the accounting net profit/loss or taxable income may be omitted in the accounting net profit/loss. b) Non-deductible expenses may be included in arriving at the accounting net profit/loss or deductible expenses may be omitted in arriving at the accounting net profit/loss. Income Income is either: a) taxable (chargeable, assessable) to tax, that is, it is included in the definition of taxable income as per the Income Tax Act e.g. salary, rent, business profit etc; or b) not taxable (not chargeable, not assessable) to tax, that is, it is excluded from the definition of taxable income or is exempted from being taxed as per the Income Tax Act e.g. dowry, Post Office Premium bond winnings, Charity Sweepstake winning5' Post Office Savings Bank interest (exempt), interest from the Tax Reserve Certificate (exempt) etc. Expenses An item of expenditure is either: a) Allowable or deductible (can be deducted) against income e.g. in case of a grocery Shop, salary of Shop assistant, rent of business premises, purchase of trading stock etc; or b) Not allowable or not deductible against income e.g. capital expenditure; and in case of individuals, personal expenditure such as school fees, family food, house rent, and other living expenses. Where accounts are involved and an income tax computation is to be prepared, always start with the net profit/loss per the accounts. The items of income or expenditure are then adjusted by adding to or deducting from the net profit/loss depending on how the items have affected the net profit/loss. Rules for adjusting income items in the income tax computation i) Where an amount of taxable income is omitted in the accounting net profit/loss — adds back the amount that is; add the amount to the net profit/loss to include the omitted income. ii) where an amount of income which is exempt from taxation, not taxable, or is assessable separately as a specified source, is included in arriving at the accounting net profit/ loss — deduct the amount, that is deduct the amount from the net profit/loss. Rules for adjusting expenditure items in the income tax computation: i) Where an amount of expenditure which is not allowable has been included in arriving at the accounting net profit/loss — add back the amount, that is, exclude it in arriving at the net profit/loss. ii) Where an amount of allowable or deductible expenditure has been omitted in arriving at the accounting net profit/loss — deduct the amount, that is, deduct the amount from the net profit/loss to include it in arriving at the net profit/loss.