Finance Act: Why Presumptive Tax will Fail and Other News

1409011

By gatuyu t.j

Presumptive Tax: The Finance Act has scrapped the turnover tax and replaced it with the presumptive tax.

The scrapped turnover tax, introduced in the year 2008, was charged on persons who did not meet the VAT threshold to register for Value Added Tax (turnover of below KES 5Million).

However, it was optional, to the extent that eligible taxpayer was at liberty to opt out by writing to the commissioner and pay taxes in ordinary manner on business income. It was charged at a gross rate of 3%, with no expenses allowed. Turnover tax failed, hence the replacement.

The new presumptive tax takes the fashion of turnover taxes. By way of a primer, presumptive taxation is the use of indirect methods to determine tax liability. The method is not based on taxpayer’s accounts and taxable amount is inferred. It targets those not covered under usual tax coverage and at the same time have taxable capacity, such as the Jua Kali sector.

The introduced presumptive tax in Kenya will apply to persons issued or liable to be issued with a business permit or trade license by a county government. It is payable by to a resident person whose turnover from business does not exceed five million shillings during a year of income.

Any person with a turnover exceeding 5 million on taxable supplies is expected to register and charge value added tax and compute business income tax. However, it does not apply to income derived from management and professional services; or rental business; or incorporated companies.

Issuance of business permits, on which this tax is pegged, is a function of the county as demarcated under Part II of Schedule Four to the Kenyan Constitution. Most of the county governments have already enacted county legislation on trade licensing which issue guide on issuance of trade permits.

The third schedule to the ITA has been amended to provide the rate chargeable on presumptive tax to be an amount equal to 15% of the amount payable for a business permit or trade licence issued by a County Government, and it is the final tax. This means the amount chargeable tax is gross and no expenses are allowed. The turnover tax failed when the rate was 3%; how will this new tax have compliance when the rate is 15%?

However, just like it was for turnover tax, and just like other taxes such as residential rental income tax, a taxpayer is at liberty to opt out by making a notice in writing to the commissioner. By opting out, they would be expected to compute their taxes from business income from the normal way.

The due date for payment of presumptive tax is at the time of payment for the business permit or trade license or renewal of the same. This is an odd provision, with unhealthy assumptions. As explained, issuance of trade permits is a mandate of the county governments.

There is nothing that compels county governments to issue permits that are in line with ordinary fiscal year, whereas a year of income for purpose of taxes is usually a period of 12 months. Some counties may elect to have business permits that lasts more than a year.

Further, tying the tax payable with amount equal to trade permit may lead to revenue leakages. A county may opt to forgo permit fees, and issue permits at peppercorn, for whatever reasons, including encouraging setting business activities.

Again, it presents a retrogressive and unequitable tax. Most of the business permits are issued at standard amount, but are incomes from business standard? A mama mboga with a turnover of KES 95K and a big shopkeeper with a turnover of KES 4 Million will pay tax on the same amount?

It is as simple as that. Presumptive tax will fail, in a big way, just like turnover tax.

News Round up on Income Tax provisions

One, A 30% of the electricity cost of electricity cost, incurred by manufacturers in addition to the normal electricity expense, will be an allowable deduction under Section 15 of the ITA, subject to conditions imposed by the ministry.

Second, In taxation of insurance companies, capital gains tax would be charged on any gains arising from the transfer of property by an insurance company. However, property connected to life insurance business is excluded.

Third, Demurrage charges and insurance premium (except insurance premium paid for insurance of aircraft) will be treated as incomes and will be subject to withholding tax.

A Demurrage charge has been defined as the penalty paid for exceeding the period allowed for taking delivery of goods, or returning of any equipment used for transportation of goods.

Visibly, it is targeted towards ship operators who delay before clearing goods from the warehouses or ports. The rate of withholding tax payable, in case of demurrage charges paid to ship operators, is 20% of the gross amount. In case of an insurance premium, it is five per cent of the gross amount payable.

Lastly, where a company is conducting business jointly with government, in a special operating framework arrangement, hear this; it will not pay taxes at the normal rate. Instead, tax will be payable at the rate provided in the agreement. This was a terrible, terrible, provision.

Companies such as Lake Turkana Wind Power, those engaged in private public partnership, will naturally negotiate to pay taxes at a lower or at zero taxes in those framework agreements. To follow will be the multiple Chinese companies doing all manner of constructions.

We assume the companies with arrangements with governments are paid at arm’s length, in accordance with the procurement laws. Then, why shouldn’t they pay taxes, like others? The provision does smell mischief, whose results will be revenue leakages.

The Death of Dividend Tax Account and Resurgence of Compensating tax

Review of the Finance Act 2018

1200px-Ledger

The Dividend tax account, loathed by accountants and detested by revenue officers, has been scrapped. The Finance Act 2018 has repealed and replaced section 7A of the Income Tax Act which required resident companies that pay dividends to maintain a dividend tax account.

Section 7A was unnecessarily prescriptive. It went into overkill, providing details on how the dividend tax account should be maintained.  The aim was to facilitate computation of Compensating tax, which would arise if a resident company distributed dividends from untaxed gains.

The new section introduced by the Finance Act simply requires that a company that distributes gains that have not been taxed should pay a compensating tax. The qualifier that the company has to be a resident company has been removed.

The new section reads;

“Where a dividend is distributed out of gains or profits on which no tax is paid, the company distributing the dividend shall be charged to tax in the year of income in which the dividends are distributed at the resident corporate rate of tax on the gains or profits from which such dividends are distributed.” However this section shall not apply to registered collective investment schemes.

Apart from removing onerous requirement of maintaining a dividend tax account, the new section has clarified the rate of compensating tax payable to be a normal corporate tax rate. Before, compensating tax was a punitive, with various tax consultants providing compensating tax rate to be 42.8%. We are not aware how they arrived at this figure but now it matters no more.

A company may distribute dividends from untaxed profits in instances where it has received generous capital allowances such as investment deduction. This may leave the company with an accounting profit, but when adjusted for tax purposes, would leave the company with no taxable income. The compensating tax is intended to act as a disincentive for distribution in such circumstances and compel such company to reinvest the gains.

Taxation of Dividends and Deemed Dividends under the Finance Act 2018

 

NO DIVIDENDS

By gatuyu t.j

Section 3 (2) (b) of the Income Tax Act brings to tax income in respect of dividends and interests. The details on the forms of dividends subject to tax is provided for under Section 7, which enumerates events that lead to dividends or deemed dividends. The Finance Act 2018, assented by President Kenyatta on September, has repealed and replaced these provisions.

The general rule on taxation of dividend has been retained. A dividend paid by a resident company is deemed to be income of the year of income it was payable. Therefore, the year of income in relation to dividends is the year the dividend was declared, and not necessarily the year it was paid.

However, Finance Act introduces five circumstances when an amount would be deemed to be a dividend distributed by a company to a shareholder, irrespective of whether there was a declaration to that effect. In that case, dividends would be deemed where:

(a)   any cash or asset is distributed or transferred by that company to or for the benefit of that shareholder or any person related to that shareholder;

(b)  the shareholder or any person related to that shareholder is discharged from any obligation measurable in money which is owed to that company by that shareholder or related person;

(c)    the amount is used by that company in any other manner for the benefit of the shareholder or any person related to that shareholder;

(d)  any debt owed by the shareholder or any person related to that shareholder to any third party is paid or settled by that company;

(e)  the amount represents additional taxable income or reduced assessed loss of that company by virtue of any transaction with the shareholder or related person to such shareholder, resulting from an adjustment.

Indicatively, for tax purposes, notional definition of dividend to be only share of the after-tax profit of a company, distributed to its shareholders, is abandoned. Other distributions to shareholders for their benefit, apart from being dis-allowable expenses in computation of taxable income, they will further be subject to the withholding tax chargeable to dividends.

The repealed provisions on deeming dividends in the ITA were ambiguous and out of touch on the corporate law developments. They provided that distribution of assets or cash would only be deemed to be dividends where a company was being wound up voluntarily.

The repealed provisions also provided for deeming of dividends where a company would issue debentures or redeemable preference shares for free. In such a case, the higher value between the nominal or redeemable value of the issue would be deemed to be dividends.

Lastly, the repealed provisions provided where a company would issue shares or rights to acquire shares, to any of its shareholders in a ratio not proportionate to their existing equity, the excess issue would be treated as a dividend to the recipient shareholders.

These were narrow dividend deeming provisions, hence the cause of their replacement. Now, it does not matter whether the benefit to shareholders is in the context of winding up or preference given in context of financing.

There will be deemed dividends where cash or assets is distributed to a shareholder for their benefit; where obligations due to a shareholder is discharged; where a company uses money for personal benefit of a shareholder; where debt for shareholder is settled by the company (for whatever purpose); or in transactions a company deals with shareholders in non arm’s length basis.

The development aligns the tax treatment of dividends in Kenya with what is provided for under Article 10, paragraph 3, of both the UN and the OECD Model Conventions . These Conventions include income from other corporate rights, such as money or money’s worth, as forms of dividends.

The change brought by the Finance Act will have deep practical implications in the corporate world. It will also be a festival for KRA officers in the audit department. Going forward, a company that gifts cars (and the like) to shareholders, sells goods to shareholders at a preferential price (less than market value), pays loans on behalf of the directors, sponsors chairman’s holiday in Bahamas! All these will be deemed to be dividends, and taxed accordingly.

How Joe Wanjoi’s Put Option Milked Old Mutual Billions

JOE
Joe Wanjoi: Photo credit, Nation Media group

This is the story. Of Joe Wanjoi, and the put option.

By now, Old Mutual, a London based underwriter, must be regretting for making a bid to acquire UAP. It was a bad deal, and a swamp for Kenyan billionaires to milk them.

When Old Mutual made the first bid, it is Chris Kirubi who decided to the South Africans investing manners. He deceived them to buy his shares at almost 3 times their book value.

The gullible Old Mutual paid a whooping Sh20.8 billion to acquire a 60.7% of UAP from Kirubi and Africinvest. But this 60.7% interest had only book value of Sh8.9 billion at the time. Kirubi and Africivest got a free Ksh 11B

No sooner had the transaction been closed, than Old Mutual realized they have been conned. They wrote off an extra 9 billion paid from their books through impairment of goodwill.

As this was going on, Professor Joe Wanjoi, also an investor in UAP, was watching. He decided to piggyback on Kirubi’s deal to make a killing.

Although, unlike Kirubi, he was a minority shareholder, he asked Kirubi to sit, watch and learn. At the time of signing of the deal, Wanjoi said he was not selling, but willing to sell.

He entered into a put option with the company. A put option is a financial instrument that gives the holder a right, but not an obligation, to sell shares at an agreed price on or before a particular date.

The put option said, its exercise price would be equal to the price they paid Kirubi, but increased by one year treasury bond rates and reduced by any dividends declared by UAP.

This was terrible arrangement on part of Old Mutual. Apart from being given raw deal by Kirubi, they would again pay for that raw deal plus an incremental interest.

Joe Wanjoi bayed his time. This week, the old Joe decided to exercise his put. He told Old Mutual, I want out. They had no option but to buy. That way, Joe Wanjoi made a tidy sum of Ksh 3 billion, 31% more in value, of what was paid to Kirubi.

Warren Buffet, the sage of Omaha, said options (and other derivatives) are financial instruments of mass destruction. Old Mutual must be writhing.

How Peer-to-peer platforms are disrupting banks

By gatuyu t.j

Why, the market based finance ticks, is the ability to connects firms and households directly through platform. This is opposite of intermediary based finance, where for a household to access funds, they must pass through a financial intermediary, such as banks or assets managers.

p2pPeer-to-peer (P2) platforms have become the biggest disruption in recent years. This has largely been due to efficiency gains and reduction in costs these platforms have introduced.

Traditionally, lending and borrowing in financial markets occurs through the use of financial intermediaries.These institutions like banks, will use depositor’s funds, incur such costs and other administrative expenses, and lend these funds in their own personal capacity.

Depositors are compensated for providing liquidity by earning interest, typically less than what the bank charges the borrowers. The borrowers are charged fees commensurate with their risk profiles as the institutions try to recoup expenses to profit from these transactions.

Peer-to-peer lending on the other hand,as the name suggests,is just that, interaction between peers. Whether it be individuals or businesses looking to lend, there are no intermediaries involved in the process except the one that creates a marketplace for the activity to occur.

It is not a new concept. Women, especially in rural areas, have practiced it for years through merry go round. The only limitation has been overly reliance on trust and geographical inhibitions.

This market based finance has gained popularity because it is instrumental in promoting financial inclusion. Individuals who would typically face high interest rates, or would otherwise be rejected from a loan due to their poor credit history, have been provided with easy access to the credit market.

Lenders are also able to earn a higher return on investments than through traditional lending channels. These services are generally provided through online platforms where borrowers and lenders are matched.

However, not all online lending platforms are peer-to-peer lending channels. For instance, Tala and Branch are online Shylocks, not P2P lenders. They are just traditional lending institutions, difference being they take advantage of the efficiency gains and reduction in costs that come with the use of new technology. outside of legacy systems.

So, how exactly does peer-to-peer lending work? Well, borrowers take loans from individual investors who are willing to lend their own money at an agreed upon interest rate. Investors are able to assess the borrower’s risk profile in order to determine the desired rate of return.

Depending on the lender’s appetite for risk, a borrower might receive the full loan amount or only a portion, but this does not mean the borrower will not be fully funded.

These loans are generally structured like syndicated loans. This is a loan offered by a group of lenders referred to as the syndicate that work together to provide funds for a single borrower. It’s then entirely possible that a single loan would be funded by multiple peers.

Most peer-to-peer intermediaries provide a range of services for both borrowers and investors. This includes online investment platform that enables borrowers to attract lenders and investors to identify and purchase loans that meet their investment criteria.

They also generally provide verification services for borrower identity, bank account, employment, and income, allowing them to filter out unqualified borrowers. Payments processing and servicing of the loans are also tasks generally undertaken by the lending platforms.

When explained, the concept may look a tad aloof. In practice, it is easier than it sounds.

The Legacy of Basel III and the case for Basel IV

Basel III was formulated to address the issues of under capitalization and illiquidity spirals that triggered the collapse of banks in the great recession.  However, a new financial landscape has emerged, including Fintechs and platform lending. Thus, the systemic risk that was inherent in banks is significantly stymied. Basel III has served its purpose, but it is now spent. It is time for Basel IV.

By gatuyu t.j

After the global financial crisis, the banking industry has witnessed fundamental changes, most substantial being an overhaul of the regulatory framework in an attempt to seal gaps that triggered the crisis.

One of the issues cited as a trigger of systemic risk against banks during the crisis is banks were under-capitalized, with limited ability to absorb losses. It is true that banks had accumulated too much debt matched with insufficient equity, hence making them prone to illiquidity.

This made most of the post crisis regulations to be targeted towards creating stable banks. Basel III regulations on banks are the most famous, perhaps only second to Dodd Frank Wall Street reforms . Basel III is an international banking regulations made by the Bank of International Settlement, a central bank for central banks, with aim of enhancing supervision and risk management within the banking sector.

Basel 3

One of the undoing on banks during the global financial crisis was the illiquidity spirals, where falling prices of assets prompted banks to reduce supply of credit, causing further asset price falls and insufficient capital. The banks ran out of liquidity forcing central banks to pump large amounts of liquidity.

The other undoing was insufficient capital. This is where, as it turned out, many banks were undercapitalized and did not have enough capital to withstand large shocks. The insufficiency was exposed by contagion, where one bank defaults on borrowings from another bank, caused other bank to default as a consequence.

These kinds of systemic risks, contagions and illiquidity spirals had not been foreseen by the earlier Basel I and II. As a background, the frame of Basel I was geared towards regulating capital adequacy of active banks, to ensure they had adequate “capital cushion” to cover unexpected losses.

The frame of Basel II was aimed at providing incentives for banks to enhance their risk measurement and management capabilities. Basel III took into account failings of these regulations especially on capital regulation.

It is why a fundamental inclusion of Base III did was sharpening the definition of ‘capital’, making it stricter in contexts of banks. The second issue was outlining higher minimum capital requirements. The third issue was providing on how to manage capital risks by introducing risk weights to ensure appropriate leverage.

Further, to deal with insufficient capital, the Basel III introduced capital buffers. Such include a counter-cyclical capital buffer, an idea that financial crises are more likely when banks give out more loans. The capital buffer is aimed to incentivize banks to hold more capital when the economy is booming. Theory shows that the period systemic risk builds up. Counter-cyclical buffer is set by banks at their own discretion.

The second form of capital was the capital conservation buffer. Unlike the counter-cyclical capital buffer which can be 0, and where almost all countries have not provided for it, conservation buffer is designated as 2.5% of the total capital of a bank.

The aim of a conservation buffer is to account for losses that come from illiquidity spirals and from losses in securities holdings. To ensure this buffer, there was formulated the liquidity coverage ratio and the net stable funding ratio.

Banks are required to have a certain amount of liquid assets to their relatively short term liabilities and to hold certain amount of their funding as stable funding. This averts bank runs on account of maturity mismatches.

Basel III introduced additional rules for the ‘too big to fail’ banks. These are specific large or systemically important financial institutions, which have to comply with even stricter capital requirements. The two target liquidity, and not just capital and riskiness.

The liquidity coverage ratio requires banks to have relatively more liquid assets, such as government bonds or high quality corporate bonds. Loans, for example, would not be very liquid, because they are difficult to sell.

These additional buffers constitute the core of Basel III, which has tried to remedy wrongs in the financial system. After other measures such as forward looking IFRS 9 on accounting for financial instruments, the banking system may be in better health than it was before the crisis.

However, though the repairing of financial institutions and focus on the basic rebuilding of balance sheets and profitability, not to mention trust, innovation and customer centric thinking has been largely ignored.

This has allowed the rise of market based finance, where platforms are instruments for financial intermediation. It has also led to the growth Fintech businesses which has grabbed a share of the banking industry.

In this new, fractured financial landscape, traditional banks face the challenge of protecting market share from challengers, answering new regulation, and managing the core fundamentals. Basel III has served post crisis era well. Time is ripe for Basel IV.