Tax concerns in mining and trading bitcoins

By gatuyu tj

This article was first published in the Business Daily

Naysayers have been waiting for the bitcoin bubble to burst. Instead, bitcoin, a decentralised cryptocurrency, has over the years grown value and gained fame. Policy makers and central banks are grappling to offer clarity on the place of bitcoins in the financial system.

bitcoin

However, little attention has been paid to tax consequences in mining and trading in bitcoins.

Lack of taxation guidance and enforcement will lead to non-taxation of cryptocurrencies, eventually distorting competition, and causing noncompliance by the taxpayers and revenue loss by the country.

The Kenya Revenue Authority (KRA) is yet to issue any guidance. The assumption is that taxpayers who mine and trade in bitcoins in the country are subject to the general taxation rules.

Trading in bitcoins involves transferring them from computer to computer through a system of cryptographic hashes and keeping them secure through public-private key cryptography.

Users store their coins in a “wallet,” this being software installed on their computer or a web-based account. Mining bitcoins involves generating new coins by computers called “bitcoin miners” through solving complicated algorithms.

Before investigating the tax implications, there is need to clarify whether, in the Kenyan setting, bitcoin may be regarded as money or commodity. In economic sense, money must serve as a medium of exchange, unit of account and measurement, and store of value.

Even though bitcoin may act as a medium of exchange, it can barely serve as store of value due to its volatility. It can barely be a unit of account as the value must first be translated into a traditional currency. In the legal sense, money must have legal tender status, issued and managed by a central bank, and physical characteristics as either coins or banknotes.

Bitcoin does not fulfil the criteria of money in both economic and legal sense. It can therefore be viewed as an asset or commodity, even for purposes of taxation. In view of the bitcoin business model, the main tax consequences would be the income taxes and the value added tax (VAT).

Income tax is imposed on persons who have earned taxable income for a relevant tax period. It is charged from, among others, gains or profits from business and from gains resulting from transfer of property.

In regard to transacting in bitcoins, the question is whether such is a business activity giving rise to business income, hence income tax, or it is a transfer of property that would merely give rise to gains subject to capital gains tax (CGT).

Whether dealing in bitcoins results in a business income or capital gain will be determined by the ‘badges of trade” tests. When a person stores Bitcoins for a long period waiting for their appreciation before disposing of them may only be subject to CGT on accrued gain.

On other hand, traders whose business involves speculating in bitcoins through buying and selling may be deemed to be engaging in a business activity, subjecting them to normal income tax.

The Kenyan Income Tax Act does not recognise virtual assets such as bitcoins. In such a case, an aggrieved taxpayer not intending to pay tax on gains emanating from bitcoins could move to the tax tribunal to challenge such taxation, on the established ground that tax should be levied on established statutory rules rather than on intendment.

This therefore originates a case for law reform. There is need to clearly define virtual assets in the Income Tax Act. Further, due to volatility of bitcoins, it is important to designate income resulting from trading in them as a specific source of income.

This will ensure risk-taking currency speculators do not incur huge losses and offset such losses from their general incomes, depriving the country of revenues.

Other issues that would benefit from statutory clarity are virtue income characterisation, allowable deductions resulting from mining activities, valuation and income computation, and records to be kept.

The other taxation issue results from the sale of goods and services for bitcoins. Having established Bitcoin as a commodity rather than money, such sale will therefore constitute a barter trade.

For purposes of taxation, in transactions where consideration does not involve monetary amounts, the determination of value of the exchanged objects is the market value, this being the amount an asset could be exchanged between knowledgeable individuals at arm’s length.

Trading in bitcoins may also have VAT consequences. In this case, supplies of bitcoins may constitute taxable supplies. However, since bitcoin does not have the status of a legal tender, the exemption available for financial services could be dis-applied. It may therefore be treated as supply of electronic services, which attracts VAT at a normal rate.

Elsewhere, in the United Kingdom, Her Majesty’s Revenue and Customs (HMRC) issued a brief in 2014 on taxation of Bitcoins, clarifying that such income is subject to the general rules of income tax and capital gains tax. For VAT purposes, the HMRC brief outlined that mining is outside the VAT scope.

Further, exchanges of Bitcoins into traditional currencies are VAT-exempt. Supplies of goods and services for bitcoins are subject to general VAT rules. If the KRA were to issue such a brief, there is a likelihood it would adopt the position taken by HMRC.

Still, it will be challenging to enforce tax on trading in Bitcoins. The reality is transactions take place anonymously and usually in a multijurisdictional setting. There is no paper trail from which to conduct a tax audit.Although the entire history of Bitcoin transactions is publicly available, it is extremely difficult to trace the earnings accumulated in a particular wallet back to a particular taxpayer.

It is unlikely that tax authorities would know about the income, unless the taxpayer volunteers it.

Why derivative actions against companies are becoming so popular in Kenya

images

By gatuyu tj

Once upon a time, this being before August 2015, there was rule, based on common law. It was the rule in Foss v Harbottle. It affirmed, that a company is a separate legal personality, distinct from its shareholders.

Thus, a shareholder could not bring an action on behalf of the company, however aggrieved. It was the company, and the company alone, that could sue on a wrong suffered by it. But there were exceptions to the rule, which a potential derivative claimant had to satisfy.

In 2015, there came the Companies Act. The Act found the rule in Foss v Harbottle to be unhelpful, and scrapped it. It means that a shareholder dissatisfied with the running of the company, can sue the directors of the company, on behalf of the company. We call this a derivative action.

By way of a definition therefore, a derivative action is a mechanism which allows shareholders to litigate on behalf of the company. Often, this is against an insider (whether a director, majority shareholder or other officer), whose action has allegedly injured the company.

Since the enactment of the Kenyan Companies Act, the overarching question has been. What are the parameters upon which the action could be founded and explored? It was not clear.

It was not clear until recently, when the High Court in Ghelani Metals Limited & 3 others v Elesh Ghelani Natwarlal & another, clarified the issue. Facts of the case. Directors of Ghelani Metals allotted and issued shares of the company and changed a company secretary without knowledge of its members and following required procedure. The plaintiff filed a case on behalf of the company, citing a wrong done. He alleged the erring director was committing fraud against the company.

In the judgement, the court first, settled the procedural aspect of pursuing a derivative action. It affirmed that derivative action is pursued as a two stage process. In the first stage, the Court would first consider whether the action pleaded disclosed the existence of a case, on the face of it. Frivolous claims, will be denied judicial approval, and struck out.

In the second stage, the Court will then go into depth. It will consider statutory provisions and factors which would ordinarily guide judicial discretion in the realm of derivative action.

Therefore, the court said, derivative actions can be commenced only in respect of a causes of action arising from an actual or proposed act or omission involving negligencedefaultbreach of dutybreach of trust by a director of the company.

In this, the court will consider three factors. One, the seriousness of the alleged wrong. This will be determined by conducting a cost-benefit analysis of the intended action. A derivative claimant would need to know.The intended litigation should not disrupt the company’s business. The cost of the intended litigation should not be burdensome to the company. Issues of reputational damage, will also be considered.

Two, the derivative suit ought to be allowed if it was in the best interests of the company. Three, other alternative remedies must have been explored and considered. This should be a last result option.

With this judicial clarification, the days ahead, are the days of derivative claimants.

Why Jirongo’s Bankruptcy Tricks Will Backfire

Jirongo
Jirongo. Photo Source: Unknown 

Not long time ago, a debtor, to defeat his creditors, would cause to be adjudged bankrupt. Or like the son of Moi, a famous citizen, file bankruptcy to avoid paying maintenance for an estranged wife.

In those days, one would be adjudged bankrupt for committing, what was called, an act of bankruptcy. There were eight acts of bankruptcy, including failure to pay debts and fraudulent preferences.

Potential bankrupts had found a trick. Before jumping into a cesspool that is bankruptcy, they would conceal his properties. The concealment would be by way putting the properties into shadow companies, bogus trusts or transferring their titles to hideous relatives.

They would leave little traceable properties, from which creditors would use to satisfy their debts, in outlined statutory priority.  It was the morally bankrupt lawyers and accountants who engineered and arranged these crooked tricks. They thought, they were very clever. Not any more.

No sooner than the bankrupt was discharged from bankruptcy than they would retrieve concealed properties, go on to live happily thereafter, creditors demands vanquished.

Cyrus Jirongo, a politician of shady history, has been adjudged bankrupt. Probably, he is playing those tricks yore. Little does he know, the cheese has moved. Such era is long gone. Who moved the cheese? The errant era went with the passage of the new insolvency law, that year 2015.

An individual will only be adjudged bankrupt on two scenarios. By their own filing of bankruptcy petition, when unable to pay their debts as they fall due. Or by failure to pay statutory demand of debt or levy of execution from creditors, within 21 days.

Once adjudged bankrupt, all properties will vest on the bankruptcy trustee. The official receiver, this being an office in the Attorney General’s office, is the bankruptcy trustee in the first instance. Later, creditors may appoint an insolvency practitioner to carry on.

To those who use bankruptcy to defeat creditors, woe. The catch comes by way of a claw back period, of two years. Properties that have been fraudulently transferred, sold at an undervalue, preference in payment to creditors, within two years, will have such transactions voidable.

The same note applies for a company. However, a company is not necessarily liquidated for being insolvent. Insolvency is a fact, where liabilities exceed assets. Liquidation is only the last step, of technically interring the company. But there are others ways, call them alternatives, on which an insolvent company may be saved.

Even so for individuals. Even when insolvent, one will not be adjudged bankrupt, if they are able to enter into scheme of arrangement with creditors. Such a scheme must be registered by the court.

The Insolvency Act that applies, Kenya copy and pasted it from England, without building consensus, without interrogating. It would look, Corruption has permeated even in law making. Consultants are hired to generate bills after kickbacks and they deliver tosh.

It is why you will find there is already an amendment Bill to amend this insolvency Act, despite it being less than two years old. The amendment bill is a shameful read. You will come across clauses like-

“Paragraph x is amended by deleting the word United Kingdom immediately after the word (.) and substituting thereof with word Kenya”.  Even proper copy and pasting was a problem. Rotten republic.

It means. Defeating creditors demand. Any property you will have transferred to your relatives, trusts, used to capitalize companies, will be deemed to be either a preference, or fraudulent transfer. Such transfer will be voidable and will be reversed and vested to the bankruptcy trustee.

As a bankrupt, try concealing your properties, you will be risking penalties and jail terms. Before, penalties were a pat on the bank. Now such penalties are a stab on the belly. But you are will be entitled to keep your tools of trade. If Jirongo has orchestrated his bankruptcy, the future is gloomy.

Oh, Shakhalaga Jirongo, your life has become Shaghalabagala!

Muscles of Central Banking: Analysing Tools of Monetary Policy in Kenya

By gatuyu t.j

Introduction

Central banks wear many caps. They formulate, and implement, monetary policies of their countries. They ensure stability in general level of prices. It is their mandate, to foster a stable, market-based, financial system. They will often be called by their governments’ to support efforts of actualising economic growth and employment creation.

cbk Logo
Central Bank of Kenya Logo

In executing these diverse mandates, more as masters of the monetary policy, central banks have on their backs, strapped, a quiver of instruments.

Whereas central banks in the west have over the years significantly improvised and innovated on these tools, their counterparts in Africa have remained conservative. Like others, the Central Bank of Kenya (CBK) is the custodian of the country’s monetary policy.

Headaches of Inflation

One of the unenviable roles of central bank is to cure inflation, and in rare circumstances, deflation, in the economy. Inflation ought to be tamed to be within allowable margins. The allowable margin in Kenya is on a target prescribed by National Treasury in annual budget statement. Currently, the prescribed inflation target is 5%. It has been so for nearly a decade. The allowable margin is plus or minus 2.5%.

Thus, CBK is supposed to ensure inflation is at 5% plus or minus 2.5% margin. In such a case, it could be 7.5% in the upper side. It slide trend up 2.5% in the lower side, and be okay, falling below which the country would be on deflation.

On this inflation fighting battle, the CBK has experienced marginal success. As per the Kenya National Bureau of Statistics, Kenyan inflation as measured through Consumer Price Index averages at 11% normally and 8% for NFNF (Non-fuel non-food).

Why then, has keeping inflation tamed become such a fuss? You will note. It will be noted. Low and stable inflation, liquidity in the market, ensures higher levels of domestic savings. It facilitates private investment. This results into improved economic growth, where people are able to have higher real incomes, and employment opportunities increased.

There is another flipside. A government that fails to tame inflation may cook its geese. Meet President Nicholas Maduro, of Venezuela. He has been unable to tame the hyperinflation in his country. On this account we are able to predict meme mene tekel has been inscribed on his wall.  His days are numbered. But he may survive. Mugabe, a despot who created a hyperinflationary economy in Zimbabwe, has survived.

You will now decipher. Central banks do not seek to control inflation and keep tap on monetary policy as matter of aesthetics. At stake, includes stability of the government.

Just like other African countries, CBK monetary tools are retrieved from the book of the conservative. The main instruments, being approximately six of them, are as described.

  1. Open Market Operations (OMO)

Open Market Operations are the bedrock of monetary policy instruments. They are CBK actions for regulating money supply and credit conditions. OMO involves stabilising of short term interest through sale and purchase of eligible securities.

When a Central Bank buys securities in the open market, it increases reserves available to commercial banks, for it pumps money to them. This makes it possible for banks to expand their loans. Money supply to the economy is increased. OMO tools that the CBK applies include various variations of Repurchase agreements and Term Auction deposits. What are these?

a) Repurchase Agreements (Repos)

They include vertical Repos, reverse Repos and horizontal Repos.

Vertical Repos is where the CBK sells, through auction, of eligible securities to commercial banks. CBK is compelled to take such action when there the supply of money is high and there is need to reduce liquidity by taking out excess money. Such sale ensures CBK has reduced commercial banks deposits held at the CBK. Repos have fixed tenors. They range between 3 and 7 working days.

There may be instances when money supply in the economy is low. Liquidity needs to be improved. In such a case, CBK applies the Reverse Repo. This is where the CBK purchases securities from commercial banks. In such purchase it supplies them with money. The current tenors for Reverse Repos are either 7, 14, 21, and 28 days.

Lastly, there is the Horizontal Repos. This is not a typical monetary policy instrument. It is more of a mode of improving liquidity distribution between commercial banks under the supervision of the CBK. Commercial banks agree to lend to each other on short term basis on negotiated tenors and yields. They generally use government securities as collateral.

A bank in short of deposit required to be kept overnight at the CBK will borrow from others with excess deposits, mostly on an overnight basis. The CBK monitors, but rarely intervenes, in the overnight interbank borrowing. However, where there is tightness or slackness in horizontal repo, CBK will intervene through other tools at disposal.

b. Term Auction Deposit.

We have seen that Repos are short term instruments. There are times, when securities held by the CBK for Repo purposes are exhausted. Further, certain market conditions may compel the CBK to offer long tenor options of more than a week or up to one month. Instead of vertical repos, the CBK will seek to acquire deposits of commercial banks. These are the term auction deposit. At maturity, they revert to respective commercial banks.

  1. Central Bank Rate (CBR)

Central Bank Rate is the most visible and the key monetary policy instrument. It is the base for all monetary policy operations. The Monetary Policy Committee (MPC), a specialised arm of the CBK, is tasked with setting and reviewing the CBR. The MPC reviews the CBR at least every two months.

Movements in the CBR, both in direction and magnitude, signal the monetary policy stance. We will illustrate.

When CBK is injecting or withdrawing liquidity through reverse and vertical Repos, the CBR, is the interest rate applicable in buying or auctioning bids. Only on Term Auction Deposits, where we have exceptions, for in practice, we have seen CBK offer rates higher than the CBR on term auction deposits.

The CBR is the base rate for commercial banks’ lending interest rates and deposit rates banks should offer on interest earning accounts. This edict was introduced by the Banking (Amendment) Act, 2016, which came in force on September 14, 2016. The amendment set commercial bank interest rate on lending to customers at CBR+4%.

Before the Banking Amendment Act, banks’ lending interest rate was pegged on Kenya Banks’ Reference Rate (KBRR) + k. Banks were left with the onus of allocating constant K, according to their estimation of credit worthiness rating of the borrowers. Mired in greed and walloped by myopia, banks abused the discretion by skyrocketing interest rates in chase of supernormal profits. The formula was statutorily discontinued.

But then, the history of Kenya’s CBR is mixed. Once upon a time, that being the year 1992 or thereabouts, CBR was as the high of almost 76%. The economy was on the verge of collapse after Goldenberg looting. CBR will again run amok during the tenor of Njuguna Nd’ungu as the CBK chief.  It was set at the high of 18%. At the date of this article, CBR is at 10%, where it has stabilised for months.

A reduction of the CBR signals easing of monetary policy. It shows a desire for market interest rates to move downwards. Lower interest rates encourage economic activity. It stirs growth. When interest rates declines, it promotes credit creation.

  1. Overnight Discount Window Facilities

There is a requirement, that commercial banks must ensure certain amount of their deposits “sleeps” at the CBK, every day. A times, banks may not have sufficient deposit to ensure compliance. They could borrow from other banks in horizontal repo. What if they are unable to raise deposit through this repo?

CBK is the lender of last resort. It will come in to provide secured loans to such a commercial bank on an overnight basis. The facility is referred to as the Discount Window. This lending will be at a penal rate over the CBR. Discount window could be traced from the Bagehot’s rule. Bagehot called that in times of financial crisis in a banking institution, central banks should move quickly to “lend without limit, to solvent firms, against good collateral, at high rates.”

CBK reviews rules for access to the discount window from time to time. Banks that make use of this facility more than twice in a week are closely scrutinized and supervisory action may be taken. It is no surprise therefore; banks ordinarily prefer horizontal repos to discount window facilities.

  1. The Cash Reserves Ratio (CRR)

The CBK Prudential Guidelines require commercial banks to maintain certain cash reserves. These are maintained as deposits with the CBK at no interest. The reserves are in proportion to a commercial bank’s total deposit liabilities.

Currently, CRR is 5.25% of the total of a bank’s domestic and foreign currency deposit liabilities. CBK, recently, changed its policy. It now requires commercial banks to maintain their CRR based on a daily average level from the 15th of the previous month to the 14th of the current month. However, it should not to fall below a CRR of 3% on any day.

The banking industry is undergoing changes especially when the Basel III standards on bank regulation are adopted. Basel III is comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision.

Their aim is to strengthen the regulation, supervision and risk management of the banking sector. Their adoption will necessitate the review of CRR requirement, as CBK will move to enforce more of risk based supervisory mechanisms such as requirements for constant stress tests.

  1. Foreign Exchange Market Operations:

CBK may inject or withdraw liquidity from the banking system through foreign exchange transactions. For instance, a sale of foreign exchange to banks withdraws liquidity from the system, as the central bank takes local currency from banks.  On the other hand, a purchase of foreign exchange injects liquidity into the system.

Why would the CBK participate in the foreign exchange market?

A domineering motivation is usually the need to acquire foreign exchange to service official debts. Further, central banks need to build-up foreign exchange reserves in line with statutory requirement. The CBK, in practice, strives to maintain foreign reserves equivalent to four months’ of cover. This is as recorded and averaged for the last three preceding years.

Foreign exchange reserves in Kenya have averaged $4089.54 million between 1995 and 2017. The reserve as at the date of this article is at highest of $11,143.76 million four months of cover.  But there was a time that was in November 1995 when the reserve was at a low of $853 million. The trigger was political climate at the time that led the country being starved of donor aid.

Once in a while, you will see the CBK intervening in the exchange market to stabilize it in cases of excess volatility. As a matter of practice though, and Kenya being a market economy, the CBK does not defend any particular position in shilling trading.

To support the stability of the exchange rate, Prudential Guidelines have offered CBK various arsenals of regulating the Forex market. These are:

  1. The tenor of swaps and Kenya Shilling borrowing where offshore bank is involved is limited to a tenor of not less than one year.
  2. CBK limits the tenor of swaps between residents to not less than seven days.
  3. Requirement that reduction of the foreign exchange exposure ratio of core capital from 20% to 10%. Further, the foreign exchange limits should not exceed the 10% overall limit at any time during any day.
  4. Lastly, there is a requirement that local banks must obtain supporting documents for all transactions in the Nostro accounts of offshore banks.

Forex trading, in recent years, has moved to online platforms. The online traders have for long been unregulated. The Capital Markets Authority (CMA) has taken up the licensing and regulating role of the foreign online Forex traders.

It is not clear why the CMA had to take up this role. It is true currency swaps and options are derivatives instruments classifiable as capital market instruments. Nevertheless, currency trading is generally a money market arena, of which it ought to have been the CBK to prefect.

  1. Other CBK Monetary policy Roles

CBK has other roles which influences the monetary policy.

It licenses financial institutions. It uses this licensing and supervision tools to ensure stability and efficiency. This includes vetting potential managers for suitability, both with respect to qualifications and character, before they take up managerial positions with the banks. In fact, Prudential Guidelines have made it mandatory for vetting of directors of commercial banks to ascertain their suitability.

CBK is the regulator of the National Payments System. Since the enactment of the National Payment Act 2014, Kenya has kept on modernising the National Payments System. This has led to lowered transaction costs. It has further improved the effectiveness of monetary policy instruments. It is the CBK that ensures these payment systems operate without major disruptions and in line with the specified regulatory legal framework.

CBK controls communication in the banking sector. Chase Bank (in receivership), was brought down by amongst other things, social media negative frenzy that triggered a bank run. In the spearheading of communication role, the CBK ensures dissemination of monetary policy decisions and background data.

This increases the efficiency of information transmission and managing expectations.  Patrick Njoroge, the current governor, has been holding regular governor’s Press Conferences on monetary policy decisions. The CBK website is fairly well maintained with constant updated.

Conclusion

In conclusion, Kenya’s monetary policy tools are conservative. Elsewhere, central banks have adopted some other unorthodox instruments such as helicopter money. We shall look at some of these in our next monetary policy paper.

Why Henry Rotich has banned Binary options in Kenya

Binary option
Photo: Courtesy

Rotich Henry, Treasury Cabinet Secretary, has made capital markets Regulations to regulate online foreign Forex traders in Kenya. In the Regulations, Rotich has banned binary options.

Many have been left wondering. What are binary options? Why should they be banned? We shall explain.

An option is a contract, that gives a buyer a right, but not an obligation, to buy (call option) or sell (put option) a financial asset (such as shares) at an agreed date (exercise) or other date (strike).

It may sound simple. For this is just an ordinary option. But Binary options, especially in currency exchange trading, are different.

Binary means two. Thus, in binary option, there only two possibilities. Of Yes or no.

How it works, is this way. You place a bet, by answering either yes or no, that during a certain time, a certain currency will go up, from a specified fixed price.

If you answered it the price will go up, and it goes down, you lose everything. This is unlike the normal option where a trader loses only the value of underlying assets.

Warren Buffet, the sage of Omaha, hates derivatives, options included. He says they are financial weapons of mass destruction. We do not disagree. Whereas equities are the sedatives of the market, derivatives are the aphrodisiacs. They hype trading.

But Warren maybe right. Indeed, binary options are lethal. To the market, they present a zero sum game. A Pareto efficiency, where for one to gain, another must lose. This is lousy.

But they make markets liquid. They promote activity by raising adrenaline. More so, during these called turbo trading, where trading is finalized in just a minute.

People from Jerusalem love binary options nevertheless. They have so many binary options dealers over there. But the frauds and scam dealers have equally nourished, spreading their crooked ways from Jerusalem to elsewhere, then everywhere.

Apart from giving market a hype, binary options serve no economic purpose. Rotich was right, to ban them.

New accounting standards could affect bank lending

By Gatuyu Justice

loans
Photo: Courtesy

This piece was first published in the Business Daily on Wednesday, September 20, 2017. It’s available here

One of Kenya’s biggest lenders has recently announced it was weighing the prospect of cutting back on disbursement of personal loans guaranteed by salaries.

This impending change in lending strategy is apparently being driven by expected coming into force of International Financial Reporting Standards (IFRS) 9, a new accounting guideline for financial instruments in January 2018.

IFRS 9 is expected to significantly alter the accounting treatment of financial instruments — these being contracts that give rise to a financial asset of one entity and equity instrument of another entity and includes cash and derivative instruments.It increases levels of required disclosures and has a bearing on firms in financial markets, legal approach to corporate transactions as well as taxation.

Mckinsey & Company, a strategy consulting firm, has predicted that the standard will specifically trigger a silent revolution in the banking industry and banks’ models.

Indeed, the revolution in banking has started as seen from the considerations of the Kenyan bank.

As a background, the accounting treatment for financial instruments such as collateralised debts, derivatives, has been blamed for triggering the financial crisis of 2007/08. The instruments were recognised in financial statements through their fair value, ordinarily determined in accordance with the intention of the company.

Such intention would be holding the instruments to maturity, for sale, recognising them through profit and loss, or having them as loans and receivables.

In the event the instruments are held for sale, the practice was that a company would always value them at market value. Where a firm intends to hold them to maturity, they would carry the instruments at cost, adjusting for impairment.

This accounting practice is messy. It results into a company having different values for one instrument depending on the intention.

Thus, companies kept on marking the instruments to market, sometimes on wishful valuations. Where panic hits the market as happened in 2007, firms rush to dispose of the instruments marked to market in rapid fire-sale, resulting to decline in prices that trigger collapse of the markets.

For these reasons, the International Accounting Standards Board decided to change the practice of financial instruments

The board introduced IFRS 9, which generally introduces three issues. First, is the classification and measurement of financial instruments. Second, hedge accounting and third, impairment of financial instruments.

On classification, the standard requires financial liabilities to be categories either at “fair value” or at “amortised cost.” The latter is where amortisation loss has been factored into the value of the instrument.

However, a rider is, a financial instrument will only be categorised at amortised cost where the business model of an entity is to hold that instrument until its maturity for the purpose of collecting contractual cash flows, which should constitute “solely payment of principal and interest.”

Such a treatment will impact more on classifying instruments such as exchange traded derivatives that have historically been used for trade speculation.

On hedge accounting, the standard has streamlined how hedge instruments are accounted for. This is geared to reduce volatility caused by marking-to-market of instruments such as derivatives, which result to large to price fluctuations.

The standard aims at aligning entities’ hedging practice with their risk management activities. It further improves hedge effectiveness on account of enhanced disclosures.

Entities such as Kenya Airways , which recently suffered the wrath of hedging instruments on oil forward contracts, will take note of this development.

On impairment, the standard has changed the practice where firms account for loss on credit exposures only when such loss has been incurred.

Firms will now adopt “expected loss model” which involves approximating expected credit loss for the whole life of the exposure of the instrument.

The requirement of approximating “expected loss” on credit exposures is one proving to be a hard pill to swallow for banks. For instance, on loans, banks must approximate anticipated losses from their lending.

With such a requirement, Kenyan banks will generally have the following options:

One, for loans not backed by sound collateral, banks could lend at high interest rates to limit credit default exposures. Due to interest rates caps, this may not be tenable. In such case, banks may reduce lending periods for high-risk borrowers to limit probability of default.

Second, banks may increase the provisioning or increase the insurance cover for approximated defaults on unsecured loans. This will certainly increase expenses and reduce recognised profits. StanChart  seems to have taken this option.

Third, banks would abandon extending personal loans or on collaterals that cannot be foreclosed on default. Equity Bank  seems to moving towards this strategy.

Further, IFRS 9’s introduction of a universal way of classifying financial instruments should help in combating international tax avoidance by multinationals.

This will help to reduce hybrid mismatches, which arise where firms classify financial instrument differently, either as a debt in one jurisdiction and as equity in another.

This exacerbates the problem of base erosion and profit shifting, especially in countries where instruments are classified as debt, which is tax deductible.

Banks and other firms operating in financial markets will need to review their operating framework and rethink strategies in line with this new accounting standard.

Ingenuity in Structuring Islamic Banking Products

By gatuyu t.j

Teach them, the Sunnah. Read them, the Quran. And they, will be commercially inspired.

In the year 1998, the Islamic board of the Dow Jones Index issued a fatwa. It decreed certain “permissible impurities” in issuance of equity Islamic instruments and set out methods of cleansing them. With that, modern Islamic financial markets breathed.

Islamic finance, differs from ordinary finance, by being insulated from the rough hedges of capitalism. It must be shari’ah principles. The shari’ah principles ban elements such as interest (riba), speculation (gimar), gambling (mysir) and uncertainly (gharar) in Islamic financing.

Islam

In any structuring of Islamic finance product, these condemned elements should not be present. But in both banking and long term financing, the industry has adopted a practices that navigates through, and emerges clean and compliant.

What elsewhere is secured lending, in an Islamic banking it will be “diminishing musharakah”.

You want a loan from the bank, secured by your land. The arrangement shouldn’t have interest. Let’s structure.

You will sell the land to the bank at the spot price. The bank will immediately sell it back to you, at a higher price, on deferred payment terms. Then secure land by registering a charge. You have your loan. The bank has profit. And Allah is happy, there is no riba.

What if I have no collateral such as land. I want a loan on personal guarantee. Can I be helped? Yes. Let’s structure.

We will still have diminishing musharakah. But this is bay al’ inah, meaning the customer has nothing. Here it is the bank which will take one of their asset and sell it to the customer at a spot price payable on deferred payment terms.

Then the customer, now a owner, will immediately sell the asset back to the bank, at a price lower that spot price, and the bank will pay. Customer now has money, secured by a pledge or personal guarantee.He will repay up the spot price.

Islamic banking is spreading, for it is more ethical than the ordinary banking, hinged on exploitative tendencies.

In international Islamic capital markets, the issuance of Sukuk al ijara has become popular. Kenya recently amended the tax statutes to ensure any possible flotation by the country of Sukuk products will be offered tax neutrality.

Sukuk, due to the nature of structuring, in view that it is guaranteed by real assets, cannot trigger sovereign debt crisis, like other international debt instruments such as Eurobond.