Compensating tax

This is a form of income tax that is rarely talked about. Many Taxation students go through their courses having heard about compensating tax only in passing. Many Taxation teachers give it only a marginal mention while teaching. As a consequence, not many Taxation graduates know about compensating tax. Even in professional practice, not many are concerned with the tax. Part of the reason many teachers superficially teach about the tax is that a large number of them lack a proper understanding of it. However, what generally accounts for the limited attention given to this tax is the fact that the Kenya Revenue Authority (KRA) is not keen on enforcing it. It is lost to many that the tax is payable at a punitively high rate and is capable of negating the value of, inter alia, exemptions from income tax and tax incentives such as capital allowances. This is explained in greater detail below.

Compensating tax is payable pursuant to section 7A of the Income Tax Act. Only resident companies are liable to pay the tax. It arises where a company distributes dividends from income on which income tax has not been paid at the corporate tax rate.

The Dividend Tax Account

It is calculated using an account known as a Dividend Tax Account. The account is debited with:

1. Income tax paid by the company. This does not include withholding tax on qualifying dividends (which is final tax) paid by the company.  
2. A fraction of dividends received by the company from another company. The fraction is determined as follows: Amount received x 30/70.  

The account is credited with a fraction of the amount of dividends paid, determined by multiplying the amount paid by 30/70. Compensating tax is payable if the account has a credit balance, i.e., the credits exceeds the debits. The amount of tax payable is the balancing figure. If the account has a debit balance, the balance is carried down to the next year of income.

Say a company, A Co. Ltd., makes a pre-tax trading profit of sh. 600m in the year 2016. It also sells shares in companies listed in the Nairobi Securities Exchange and makes a profit of sh. 200m. The company resolves to distribute all the year’s profits as dividends. What compensating tax, if any, is payable?

The company’s corporation tax for the year is sh. 180m (30% of 600m). No tax is payable on the gain on sale of the listed shares. The total profits distributed are sh. 620m (420m + 200m).

Compensating tax

Tax paid           180m     Dividend x3/7  265.71m
C. tax (bal fig)  85.71m
                           265.71m                         265.71m

The amount of compensating tax is 42.8% of the untaxed gain. This is much higher than the corporate tax to which the rest of the income is subject. If a company pays tax only out of taxed gains, the balance of the Dividend Tax Account is zero; the corporate tax paid equals the dividend fraction.

Any transaction that increases accounting profits over tax profits can give rise to compensating tax liability. Notably, liability arises only if the amount distributed in form of dividends is higher than the tax profit. Capital allowances cause accounting profits to be higher than taxable profits if the rates of capital allowances for a year of income are higher than the depreciation rates for the same period.

Take the case of a new company, B Co. Ltd., which incurs capital expenditure of sh. 1.5b in purchase of new manufacturing machinery which qualifies for investment deduction at the rate of 100% of the expenditure. The company makes a profit of sh. 600m before deduction of capital allowances/depreciation. Its policy is to depreciate machinery at rate of 15% on a reducing balance basis.

The pre-tax accounting profit is sh. 375m (i.e. sh. 600m – 15% of sh. 1.5b). However, the company has a taxation loss of sh. 900m (sh. 600m – sh. 1,500m). Thus no tax is payable. All the accounting profit is available for distribution. If the company decides to distribute the accounting profit in dividends, sh. 160.71m compensating tax will be payable.

Interestingly, even where gains are taxable at a rate lower than the corporation tax rate compensating tax is still payable. However, the rate is lower than that applicable where income is not taxed at all. Capital gains tax was reintroduced in 2015. The rate applicable is 5% and this tax is final tax. With the tax rate at 5%, the compensating tax rate is 35.7%. The effective tax rate is 40.7% (35.7 + 5%), two percentage points below the rate in cases the gain is not subjected to any tax at all.

In the first scenario, assume that the shares sold were held in an unlisted company. The gain is then subject to a tax rate of 5%. The income tax paid increases to sh. 190m. The company has sh. 610m available for distribution. If the company distributes the whole amount, it will pay sh. 71.42m compensating tax.

Administration

Compensating tax is payable on or before the end of the 6th month after the end of the company’s year of income. Companies are also required to prepare a return of assessment of compensating tax and submit it to the Commissioner by the same date. A person is liable to pay additional tax equal to 5% of the compensating tax for every month during which the return remains unfiled. A penalty of 20% is immediately payable for failure to pay compensating tax when it is due. Interest is also payable on compensating tax remaining unpaid after the due date. These sanctions are applicable in addition to criminal sanctions applicable under the Income Tax Act.

Critique

Distribution of dividends is what may trigger compensating tax liability. The wisdom of exempting gains from corporation tax only to subject them to a higher rate of tax than the corporation tax rate has been questioned. The same question arises with respect to the generous rates applicable to capital allowances. The net effect of compensating tax is that for resident companies, what appears to be an incentive can be a prohibitive disincentive.

It appears that compensating tax is intended to act as a disincentive for distribution of untaxed gains or tax incentives. The present taxation regime favours reinvestment of gains arising from incentives to give rise to gains taxable at the corporation tax rate. Notably, the tax is not payable by non-resident companies with a permanent establishment in Kenya, which like resident companies are liable to corporation tax.

End.