On 5 February 2019, the Court of Appeal delivered its judgment in the judicial review case of Kenya Revenue Authority vs. the Republic of Kenya (ex-parte Fintel Limited). The Kenya Revenue Authority (KRA) had appealed a High Court judicial review decision in 2012 in which the court held that an actual payment in cash is a prerequisite for withholding tax to be applicable and an accrual of a money obligation (for example, the obligation to pay interest under a shareholder loan) would not result in withholding tax being applicable. The High Court defined payment as “the delivery of money or other valuable thing,” indicating that for the application of withholding tax an actual payment must be made by a taxpayer.
In an unexpected move, the Court of Appeal overturned the High Court decision and instead ruled that withholding tax is payable upon accrual, as well as upon payment.
In this Legal Alert, we discuss the salient issues arising from the Court of Appeal decision and we set out our views on the practical implications on businesses.
Fintel entered into an agreement with a third party contractor under which Fintel agreed to pay interest on any contractual fees paid late. As the project progressed, a number of payments due to the contractor were delayed and incurred interest. The interest was not actually paid by Fintel to the contractor, but the obligation to pay was recorded as a liability in Fintel’s books of accounts in accordance with accounting standards.
As interest is a business expense, Fintel used the interest as a tax deductible item thereby reducing its corporation tax liability. Following an audit of Fintel’s books of accounts, the KRA demanded immediate payment of the withholding tax due on the accrued interest. A tax dispute ensued in which the KRA claimed that by recognising accrued interest as a liability in its books of accounts, Fintel acknowledged that interest was credited to the account of the third party and therefore fell within the definition of the term “paid” as defined in section 2 of the Income Tax Act (the ITA). In KRA’s view, the accrual was therefore subject to withholding tax pursuant to the provisions of the ITA. The High Court disagreed with KRA’s interpretation, holding that “tax is withheld upon payment and payment is a necessary prerequisite for WHT to apply.”
The crux of the KRA’s case was that the term ‘’payable’’ in relation to withholding tax could be defined to mean a present liability or a future or contingent liability. The KRA also submitted that in Fintel’s case, the debt arose from the moment it featured in the books of accounts and was claimed as a tax-deductible expense by Fintel. Fintel, on the other hand, argued that “paid” can only mean delivery of money and discharge of settlement. Since Fintel neither settled the outstanding contractual fee nor paid any interest charged by the contractor, no withholding tax was due and withholding tax only becomes payable when the expenses are actually paid. According to Fintel, “upon payment” denotes a discharge of a debt or liability and it was premature for the KRA to demand payment of withholding tax before the actual payment of interest. For this reason, Fintel argued that the obligation to withhold tax under section 35 of the ITA arises on payment and not on accrual.
The Court of Appeal, in agreeing with the KRA’s interpretation, stated that Fintel was bound to withhold the tax on account of the third party contractor even if it had not paid out the interest, because an obligation to make payment had arisen as the payment was included in its books of accounts and used as a credit which reduced Fintel’s taxable income. While it is the case that tax laws are interpreted based on the strict words in the law, the Court of Appeal in an apparent departure from the norm adopted the contextual interpretation of the terms “payment,” “paid” and “upon payment” as derived from the definition of “paid” set out in section 2 of the ITA.
In the Court of Appeal’s view, because the definition of the term “‘paid’ includes distributed, credited, dealt with or deemed to have been paid in the interest or on behalf of a person,” the ordinary meaning of “upon payment” could not be applied to determine when the withholding tax obligation arose under section 35 of the ITA, and instead a special meaning of “paid” under section 2 of the ITA would apply.
The Court of Appeal stated that Kenya’s income tax regime is generally an “accrual system” based on section 3 of the ITA which provides that: “a tax to be known as income tax shall be charged upon all income of a person whether resident or non-resident, which accrued in or was derived in Kenya.” This would be an apparent misdirection of the term “accrued in” under section 3 of the ITA as it appears to have led the Court of Appeal to conclude that this referred to an accrual from an accounting perspective as being the basis for charging tax in Kenya. The position is that this term refers to the source of income which is taxable in Kenya rather than the accrual accounting system. The meaning of this term is recognised internationally in jurisdictions which apply a source based taxation system.
This judgment is a victory for the KRA as several taxpayers had previously relied on the High Court judgment to dispute withholding tax demands that had been raised on accrued costs. This decision sets a precedent which will be relied on going forward by the High Court and the Tax Appeals Tribunal on matters with similar facts.
With respect to periods prior to 5 February 2019, it is our view that taxpayers who relied on the High Court decision would be entitled to resist a demand levied by the KRA after 5 February 2019 for past periods on the basis that the High Court decision had set the precedent during that period. Taxpayers who receive assessments going forward should, therefore, consider their position carefully as there are a number of legal arguments which can be advanced to defend such an assessment.
The precedent which has now been set by the Court of Appeal is likely to result in cash flow constraints as taxpayers will now be required to account for withholding tax upon accrual of costs in their books, which is merely undertaken to comply with accounting requirements. In addition, from a contractual perspective, this could result in taxpayers being in an unfavourable position, where withholding tax has been accounted for on the basis of accrued costs which are subsequently reversed in the event that one of the parties to the contract fails to meet their contractual obligations. It would be interesting to see whether the KRA would grant a tax refund of the withholding tax paid in such circumstances.
While, in our view, it could be argued that the Court of Appeal decision may be challenged on the basis of interpretation of applicable law, Fintel would not have an automatic right to appeal the decision to the Supreme Court as it would be required to demonstrate that, amongst other things, the Court of Appeal decision involves a matter of general public importance. Although this remains an avenue which is open for Fintel to explore, we would expect that the KRA will set out a clear position on this matter in the Income Tax Bill before it is passed into law to provide certainty and clarity to taxpayers, which will avoid disputes and contribute to a favourable environment for doing business in Kenya.
In the meantime, taxpayers should ensure that their accounting systems are reconfigured immediately to ensure that withholding tax is accounted for once a cost is accrued in its books of accounts. A taxpayer should pay withholding tax to the KRA by the 20th day of the subsequent month after accrual of the costs to avoid penalties for late payment.
The content of this alert is intended to be of general use only and should not be relied upon without seeking specific legal advice on any matter.