A business is defined to include every trade, manufacture, adventure in the nature trade. According to Section 3 (2) Business income is chargeable to tax for whatever period carried on provided it is carried on in the nature of trade. If a business is carried on in the nature of trade the accounts have to be adjusted in order to establish the taxable profits.
Factors to consider in determining whether a business in the nature of trade is carried on;
- Profit motive
To determine whether a person is trading it is important to consider the motive behind the transaction and the subject matter involved. In a classical case a tax payer(Rutledge ) acquired 1,000,000 rolls of toilet paper. It is not possible to acquire such quantities without the intention of doing business
- Frequency of transactions
Transactions which may, in isolation, be considered of a capital nature will be interpreted as trading transactions where the frequency indicates the carrying on of trade. For example where a person sells a personal asset like a car, he will be said to have realized a capital asset but if a number of cars are sold within a year then the person will be considered to be selling his inventory in the name of cars
- Length of ownership
Where an a private asset is used for sometime then sold, this will not constitute trade but an asset sold off immediately after purchase may imply a business in the nature of trade is carried on
- Supplementary work and marketing
When work is done to make an asset more marketable or promotional activities carried out to find purchasers, it will imply that a business is carried on.
- The way in which the asset sold was acquired
If goods are acquired deliberately and later sold, trading may be indicated. If goods are acquired unintentionally for example a gift or inheritance, there sale is unlikely to be considered as trading
- Nature of assets acquired
A person who owns a lorry cannot deny that he is using it for business
Taxable business incomes
- Where a business is carried on or exercised partly within and partly outside Kenya by a resident person, the whole of the gains or profits from that business shall be deemed to have accrued in or to have been derived from Kenya;
- A sum received under an insurance against loss of profits, or received by way of damages for loss of trading stocks
- Reduction in specific provisions for bad debts which were allowed when created
- Recovery of bad debts which were allowed when written off
- Balancing charge which arises when the business is ceasing
- Trading receipt arising when a continuing business sells all assets in a class of wear and tear
- Foreign exchange gain which has been realized,
Format for adjusting income for tax purposes
- Start with the reported profits as per financial accounts (net Profit)
- Add back disallowable deductions e.g. depreciation
- Add taxable incomes not included in accounts
- Less Income included in accounts not subject to tax final
- Less incomes subject to final withholding tax
- Less allowable expenses not included in accounts e.g. capital allowances
- The resultant figure is the taxable profits taxed at the appropriate rates
Ascertainment of total income
Allowable deductions Section 15 (1),(2)
Section 15 (1) States “For the purpose of ascertaining the total income of a person for a year of income there shall, subject to section 16, be deducted all expenditure incurred in that year of income which is expenditure wholly and exclusively incurred by him in the production of that income” This is the general criteria for charging expenditure against revenue to arrive at taxable income.
Specifically allowable expenditure Section 15(2)
In computing for a year of income the gains or profits chargeable to tax under section 3(2)(a), the following amounts shall be deducted –
(a) bad debts incurred in the production of those gains or profits which the Commissioner considers to have become bad, and doubtful debts so incurred to the extent that they are estimated to the satisfaction of the Commissioner to have become bad, during that year of income.
The following bad debt expenses are allowable
- Trade bad debts written off
- Specific provision for doubtful debts (due from an identified person)
The following bad debts are not allowable
- Non Trade bad debts written off
- General provision for doubtful debts commonly created as a percentage of debtors
From the above it should be noted:
- Recovery of a bad debt previously allowed when written off is taxable in the year of recovery
- Release of specific provision is taxable in the year of release
- Recovery of a non trade bad debt is not taxable since it was not allowable when written off
- Reduction in general provision for doubtful debts is not taxable
(b) Capital allowances to be deducted under the Second Schedule in respect of that year of income;
(c) expenditure of a capital nature incurred during that year of income by the owner or occupier of farm land for prevention of soil erosion; e.g on gabions terraces, planting windbreaks e.t.c
(d) expenditure of a capital nature incurred in that year of income by a person on legal costs and stamp duties in connection with the acquisition of a lease, for a period not in excess of, or expressly capable of extension beyond, ninety-nine years, of premises used or to be used by him in the purposes of his business;
(e) expenditure, incurred in connection with a business before the date of commencement of that business where the expenditure would have been deductible under this section if incurred after that date, so, however, that the expenditure shall be deemed to have been incurred on the date on which that business commenced;
(f) in the case of the owner of premises, any sums expended by him during that year of income for structural alterations to the premises where the expenditure is necessary to maintain the existing rent; but no deduction shall be made for the cost of an extension to, or replacement of, those premises;
(g) the amount considered by the Commissioner to be just and reasonable as representing the diminution in value of any implement, utensil or similar article, not being machinery or plant in respect of which a deduction may be made under the Second Schedule, employed in the production of gains or profits;
(h) an entrance fee or annual subscription paid during that year of income to a trade association which has made an election under section 21(2); not to be treated as trading
(i) in the case of gains or profits of the owner of land from the sale of, or the grant of the right to fell, standing timber which was growing on the land at the time the owner acquired the land –
- Where the land was acquired for valuable consideration, so much of the consideration as the Commissioner may determine to be just and reasonable as representing the cost of the standing timber; or
- Where no valuable consideration was given for the land, so much of that amount as the Commissioner may determine to be just and reasonable as representing the value of the standing timber at the time the owner acquired the land, as is attributable to the timber sold during that year of income;
(j) in the case of gains or profits from the sale of standing timber by a person who has purchased the right to fell that timber, so much of the price paid for that right as the Commissioner may determine to be just and reasonable as attributable to the timber sold during the year of income;
(l) expenditure of a capital nature incurred in that year of income by the owner or tenant of agricultural land, as defined in the Second Schedule, on clearing that land, or on clearing and planting thereon permanent or semi-permanent crops;
(n) expenditure incurred by a person for the purposes of a business carried on by him being –
- Expenditure of a capital nature on scientific research; or
- Expenditure not of a capital nature on scientific research; or
- A sum paid to a scientific research association approved for the purposes of this paragraph by the Commissioner as being an association which has as its object the undertaking of scientific research related to the class of business to which the business belongs; or
- A sum paid to a university, college, research institute or other similar institution approved for the purposes of this paragraph by the Commissioner for the scientific research
(o) any sum contributed in that year of income by an employer to a national provident fund or other retirement benefits scheme established for employees throughout Kenya by the provisions of any written law;
(p) expenditure on advertising in connection with a business to the extent that the Commissioner considers just and reasonable; and for this purpose “expenditure on advertising” includes expenditure intended to advertise or promote, whether directly or indirectly, the sale of the goods or services provided by that business; But this does not include costs of capital nature e. g bill boards, signposts, passenger sheds e.t.c
(s) expenditure of a capital nature incurred in that year of income by a person on legal costs and other incidental expenses relating to the authorization and issue of shares, debentures or similar securities offered for purchase by the general public;
(ss) expenditure of a capital nature incurred in that year of income by a person, on legal costs and other incidental expenses, for the purposes of listing on any securities exchange operating in Kenya, without raising additional capital.
(u) expenditure of a capital nature incurred in that year of income by a person on rating for the purposes of listing on any securities exchange operating in Kenya.
(v) club subscriptions paid by an employer on behalf of an employee;
(w) any cash donation in that year of income to a charitable organization registered or exempt from registration under the Societies Act or the Non-Governmental Organizations Coordination Act, 1990, and whose income is exempt from tax under paragraph 10 of the First Schedule to this Act, or to any project approved by the Minister for Finance.
(x) Expenditure of a capital nature incurred in that year of income, with the prior approval of the Minister, by a person on the construction of a public school, hospital, road or any similar kind of social infrastructure.
(y) Expenditure of a capital nature incurred in the purchase or acquisition of an indefeasible right to use a fibre optic cable by a telecommunication operator, provided the amount of deductions hall be limited to five per cent per annum.
Other allowable deductions
- Amount of trading loss that arises the where business is continuing and all the assets in a class of wear and tear allowance are sold for less than the written down value (see chapter on capital allowances).
- Amount of balancing deduction. The balancing deduction arises where a business has ceased and all the assets of a class of wear and tear allowance are sold for less than the written down value (see chapter on capital allowances).
- Amount of interest on money borrowed and used in the production of income e.g. interests on loan, overdraft, debentures etc.
- 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.
- Where a sum is paid by a person after the cessation of his business, which if it had been paid prior to the cessation, would have been deductible in computing his gains or profits from that business, it shall be deducted in ascertaining his total income for the year of income in which it paid. (Sec. 28)
- The amount of loss brought forward from previous year’s income. The losses should be on the basis of specified sources of income. Sec. 15 (7) (e).
15 (4) states Where the ascertainment of the total income of a person results in a deficit for a year of income, the amount of that deficit shall be an allowable deduction in ascertaining the total income of that person for that year and the next TEN succeeding years of income; i.e losses can be carried forward and be offset against gains for four years
Disallowable deductions Section 16
Section 16 (1) States “Save as otherwise expressly provided, for purposes of ascertaining the total income of a person for a year of income, no deduction shall be allowed in respect of –
- Expenditure or loss which is not wholly and exclusively incurred by him in the production of the income;
- Capital expenditure, or any loss, diminution or exhaustion of capital.
This is said to be the general criteria for disallowing. In addition Section 16(2) sets specific items of expenditure that must not be allowed against income
Specific items not allowable
(a) expenditure incurred by a person in the maintenance of himself, his family or establishment or for any other personal or domestic purpose including the following –
- Entertainment expenses for personal purposes; or
- Hotel, restaurant or catering expenses other than for meals or accommodation expenses incurred on business trips or during training courses or work related conventions or conferences, or meals provided to employees on the employer’s premises;
- Vacation trip expenses except passages for expatriate staff section 5(4)(a);
- Educational fees of employee’s dependants or relatives; or
- Club fees including entrance and subscription fees except for the benefit of employees
(b) expenditure or loss which is recoverable under any insurance, contract, or indemnity;
(c) income tax or tax of a similar nature including compensating tax paid on income; but, save in the case of foreign tax in respect of which a claim is made double taxation rules- a deduction shall be allowed in respect of income tax or tax of a similar nature paid on income which is charged to tax in a country outside Kenya to the extent to which that tax is payable in respect of and is paid out of income deemed to have accrued in or to have been derived from Kenya;
(d) sums contributed to a registered or unregistered pension, savings, or provident scheme or fund,
(e) a premium paid under an annuity contract;
(f) expenditure incurred by a nonresident person not having a permanent establishment within Kenya; (non residents are taxed on gross incomes
(h) a loss incurred in a hobby business
(j) interest payments in proportion to the extent that the highest amount of all loans held by the company at any time during the year of income exceeds the greater of –
(i) three times the sum of the revenue reserves and the issued and paid up capital of all classes of shares of the company; or
(ii) the sum of all loans acquired by the company prior to the 16th June, 1988 and still outstanding in that year,
(k) Amount of appropriations of profits to reserves, provisions, dividends and other appropriations. It should be noted that the provision for specific trade bad debts is specifically stated to be allowable expenditure.
Taxation of Sole Proprietorships
A sole proprietorship is not a separate legal entity and for this purpose it is not treated as a separate taxable entity. The gains or profits from this form of business organization is taken to be the income of the individual running the business and will be taxed on him as income from a separate source.
All his incomes (from all sources) are assessed on him at the individual scale arte of tax
Drawings by the owner and other private expenses are not tax deductible. All provisions of Sec. 15 (allowable deductions) and Sec. 16 (disallowable deductions) of the ITA will apply accordingly.
Note: In computing the total income of a sole proprietorship, there shall be deducted the cost of medical expenses or medical insurance cover for the benefit of sole proprietor , subject to a limit of one million shillings per year.
Taxation of Partnerships
A Partnership Business Is Not Recognized In Law As A Legal Entity. This Applies Equally As Far As Tax Law Is Concerned (Income Tax Act Cap 470). The incomes of the partnership are therefore assessed in the name of the individual partners.
The gains or profits of a partner shall be the sum of –
- Remuneration payable to him by the partnership (salaries commissions bonuses)
- Interest on capital so payable, less interest on capital payable by him to the partnership; and
- His share of the adjusted income (loss) of the partnership, (after deducting i and ii above) this is shared as per the agreed profit sharing ratios
Appropriation of the profits to the partners in the form of, salaries, interest on capital are not allowable.
The provisions on taxable incomes, allowable deductions and disallowable deductions apply accordingly.
Note: In computing the total income of a partnership, there shall be deducted the cost of medical expenses or medical insurance cover paid by the partnership for the benefit of any partner, subject to a limit of one million shillings per year.
Taxation of Legal Persons- Limited Companies
A limited company/corporation has a separate legal entity whose existence is quite distinct from that of the owners/shareholders. This applies as far as taxation is concerned. A body corporate is taxed in its own name at the prevailing corporation tax rates. Currently 30% for resident companies and 37.5% for non residents
Transactions between the company and the directors or shareholders are treated as transactions between two independent taxable entities; for that reason salaries and benefits and drawings by the directors from the company are allowable