The Finance Act, 2018 amended the Income Tax Act by repealing section 7A and replaced it with a new compensating tax provision (the New Provision) with effect from 1 January 2019.
The New Provision provides that where dividends are distributed out of gains or profits on which no tax has been paid, the company distributing the dividend will be charged tax in the year of income in which the dividends are distributed, at the resident corporate tax rate on the gains/profits out of which the dividends are distributed.
Previously, a company would be liable to pay compensating tax if it made a distribution from untaxed earnings, or where the distribution was out of income that was subject to tax at a rate lower than the resident corporation tax rate applicable to the company. Compensating tax, which was previously imposed at a rate of up to 42.86 percent, resulted in cash lock-in, acting as a disincentive to investments in certain sectors in Kenya. The repeal of the compensating tax provision was therefore a welcome move.
However, the New Provision has brought uncertainty among many companies operating in Kenya. In particular, it was not clear whether exempt dividends received by holding companies and gains that had been subject to Capital Gains Tax (CGT) at the rate of 5 percent could be distributed without triggering compensating tax.
The KRA Notice
On 11 February 2019, the Kenya Revenue Authority (the KRA) issued a public notice (accessible here) clarifying the extent of the application of the New Provision. The KRA Notice provides that the New Provision does not apply to distribution of income as dividends where the income:
1. Is received by a registered collective investment scheme;
2. Is a dividend received by a resident company from a subsidiary, whether local or foreign;
3. Has been subjected to a capital gains tax; or
4. Has been subjected to final tax.
It should be noted that save for the income received by a registered collective investment scheme, the other categories of income listed in the KRA Notice are not expressly exempt from compensating tax under the New Provision.
a) Dividend income received by a resident company from a local or foreign subsidiary
Dividends are exempt from tax in Kenya in certain circumstances, for example, if a Kenyan
company holds 12.5 percent or more of the shareholding of the company paying the dividends, or the dividends are received by a Kenyan holding company from a foreign subsidiary (foreign dividends are not taxable in Kenya pursuant to Kenya's source based taxation system).
Although the New Provision could be interpreted to apply to distributions of dividends out of exempt income as discussed above, pursuant to the KRA Notice, it is now clear that the distribution of dividends by a Kenyan company (received in either of the circumstances set out above) to its shareholders is not subject to tax under the New Provision.
a) Capital gains already subjected to CGT
Gains arising from the disposal of property such as land or unlisted shares by a Kenyan company are subject to CGT at the rate of 5 percent. The KRA Notice has clarified that the distribution of such gains (which have been subjected to CGT) to the shareholders will not be subject to further tax under the New Provision.
Further clarity on certain types of income required
i. Income not subject to tax under the Income Tax Act
We note that the KRA Notice has not provided guidance on whether the New Provision applies to distribution of income that is exempt from tax under the provisions of the Act.
Some of the income which is exempt from tax under the Act includes:
- Capital gains arising on the sale of listed shares;
- Capital gains arising from the disposal of agricultural land of less than 50 acres located outside a municipality; and
- Interest income derived from infrastructure bonds.
While we believe that distribution of gains arising from gains or profits that are exempt from tax under the provisions of the Act should not trigger tax under the New Provision, it would be useful for the KRA to confirm this position.
This would ensure that the rationale for having the tax exemptions in place is not watered down by the unintended consequences of the New Provision.
ii. Profits arising as a result of claiming tax incentives
When a company claims tax incentives such as capital allowances, it could result in the company being in a tax loss position. However, such a company is likely to accumulate accounting profits over time and the distribution of dividends while in a tax loss position could trigger compensating tax under the New Provision.
In our view, the New Provision should not be applicable on a distribution made when a company is in a tax loss position that has resulted from claiming capital allowances as it would be against the rationale for granting the tax incentives, which is to attract investments in key sectors in Kenya.
The KRA notice is a welcome move as it has provided much awaited clarity to taxpayers on the application of the New Provision. We expect that the clarity under the notice, in addition to the pending grey areas highlighted above, will be entrenched in the law in the coming budget cycle through an amendment to Section 7A.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.