THE DEMISE OF COMPENSATING TAX
The dreaded Compensating Tax (CT) will cease to be law from the 1st of January 2019. However, its replacement may prove to be just as much of a problem…
The clock is ticking…
The history of CT
CT has been in force since January 1993 and, in some ways, it was a back door capital gains tax during the period in which the capital gains tax itself was not in force (capital gains tax was suspended in 1985 until its reintroduction in 2015).
CT was legislated to ensure that distributions out of untaxed profits were taxed. Effectively, the intention was to match distributions with the taxed profits that they were paid from. The major source of untaxed gains and profits were thought to be capital gains, which for thirty years had not been taxable in Kenya. Unfortunately, CT also caught instances where the law provided incentives or classed income as exempt from which companies were able to make distributions. It was never clear if this was always the intention but no significant changes were made to the original legislation over the years.
The tax was computed using a memorandum account called the Dividend Tax Account (DTA). The DTA was required to be maintained for tax purposes only and it formed part of a company’s tax return. The entries in the DTA comprised of:
- instances where the account is increased (credited) by one shilling for every shilling of tax paid;
- in the case of dividends received by the company, instances where the account is increased (credited) by one shilling multiplied by the fraction equal to the tax rate divided by one hundred percent minus the tax rate (i.e. 30/70 based on current tax rates); and
- for every shilling of dividend paid by the company to its shareholders in a given year of income, instances where the account is decreased (debited) by one shilling multiplied by the fraction equal to the tax rate divided by one hundred per cent minus the rate (i.e. 30/70).
At the end of the year CT was payable to the extent the debits exceeded the credits. If the credits exceeded the debits, the ensuing credit was carried forward to the next year. Companies that paid significant amounts of tax generally had a credit balance in their DTA allowing them to make distributions without attracting CT.
A distribution out of untaxed gains and profits could have attracted tax at an effective rate of up to 42.85%. Large infrastructure projects that were granted substantial investment deductions were severely affected by CT.
CT and the current State of Affairs
The Income Tax Bill 2018 (the Bill) proposed to remove CT and replace it with what is effectively a distribution tax. As the Bill has yet to go through the legislative procedures, the new provisions were introduced in the Income Tax Act (Cap 470) (ITA) through the Finance Act 2018.
Under the new law, a distribution out of gains or profits that have not been taxed will attract tax at the corporate tax rate which is currently 30%. With the reintroduction of capital gains tax, capital gains will have been taxed, albeit at a lower rate of 5%. This is sufficient for the gains to have suffered tax, as the law does not specify the rate at which gains and profits should suffer tax. Consequently, a distribution from a capital gain will not attract the new distribution tax.
Unfortunately, the new provisions do not deal with the instances of companies receiving investment deductions and exempt income which are distributed. As no tax will have been paid, any distribution of such income will attract 30% tax in addition to any withholding tax that may be due.
In addition, the new wrinkle is that a holding company, whose only source of income is exempt dividend income, will be making distributions to its shareholders out of untaxed gains and profits. These distributions will therefore attract the distribution tax of 30%.
Putting into perspective
Clearly, the repeal of CT is welcome and there is much to rejoice about. However, the new provisions bring with them some significant challenges for companies making distributions. Where these distributions are being made out of gains or profits that have not been taxed, the dividends will attract the 30% tax. While this is better than an effective rate of 42.8%, it is still a significant tax.
The fact that the law provides for exempt income and investment deductions and then promptly taxes distributions out of such gains and profits seems inequitable. It is a little like robbing Peter to pay Paul. This was one of the key issues under the CT regime.
It is also critical to remember that the law provides the Commissioner with powers to deem a distribution (declare that a distribution has been made by a company) if he believes that one has not made a distribution within a reasonable time (not exceeding twelve months). Clearly, doing this could bring into play the 30% distribution tax. A company can challenge this but it would need to prove that such a distribution will be prejudicial to its business. This should be possible to do, however it would require time and effort which could be better spent managing the business.
Of greatest concern, however, is the effect of the new provisions on holding company structures. A holding company that owns more than 12.5% of the share in its subsidiary is entitled to receive dividends from the subsidiary without such dividends being subjected to withholding tax. Indeed, the law clearly states that such dividend income is deemed not to be income chargeable to tax. A distribution to the holding company’s shareholders would therefore be one out of gains and profits that have not been subject to tax and will attract the distribution tax of 30%. If this was really the intention, a number of the structures in Kenya today could suddenly become more expensive.
We can but hope that the impact on holding company structures was an unintended consequence and that common sense will prevail. The legislation needs to be tweaked and urgently.
What you should do before 31 December 2018
If you were planning to pay a dividend in 2019 out of gains and profits that were not taxed you should consider bringing it forward to 2018. Before doing this you must review your DTA to ensure that you have sufficient CT credit to cover the dividend so you can avoid tax at 42.8% on the dividend.
What you must do in 2019
Before making a distribution, it is important to analyse the gains and profits out of which you will make the distribution. To the extent the distribution is out of gains and profits that have not been taxed, you will need to pay the 30% distribution tax. Careful planning and documentation could potentially avoid this.