Taxation of Professional Fees Under the Kenya-South Africa Double Tax Agreement
On 26 November 2010, the Kenyan and South African Government entered into a Double Taxation Agreement (the DTA) whose purpose was to ensure resident persons and resident companies avoid double taxation and prevent fiscal evasion with respect to income taxes. The DTA subsequently entered in force on 1 January 2016.
Article 2 of the DTA provides for the types of taxes covered under the DTA which include in the case of South Africa: the normal tax, the secondary tax on companies, withholding tax on royalties and tax on foreign entertainers and sportsmen while in the case of Kenya, the DTA covers income tax covered under the Income Tax Act, Cap 470 of the laws of Kenya. Pursuant to the DTA, companies which are residents of the Contracting states enjoy various treaty benefits which include reduced withholding tax rates on specific payments made in a contracting state.
Contention on taxation of professional fees under the Kenyan-South Africa DTA
Over the years, tax disputes have emerged between various taxpayers whose transactions are covered under the DTA and the Kenya Revenue Authority (the KRA) in relation to the interpretation of the DTA. More often, the disputes have been centered upon interpretation of Articles 7 and 22 of the DTA which provide for taxation of business profits and other income respectively. Primarily, the key issue for determination in the tax disputes has been whether professional fees derived by a South African entity for provision of professional services to a Kenyan entity should form part of business profits as provided for under Article 7 of the DTA or whether the fees fall under Article 22 of the DTA.
There is an important distinction to be noted. Where Article 7 of the DTA applies, South Africa would have taxing rights over the profits generated in Kenya by a South African resident who does not have a permanent establishment in Kenya. On the other hand, where Article 22 of the DTA applies, Kenya would have taxing rights over the profits generated in Kenya by the South African resident, regardless of whether the South African resident has a permanent establishment or not.
By way of example, if a South African consultant was providing IT consultancy services in Kenya for a short period of time, pursuant to an application of Article 7, his fees should be paid free of any Kenyan withholding taxes. If Article 22 of the DTA was applied instead, his fees would be subjected to withholding tax at 20percent. This has been a significant issue for South African entities which have been providing services into the Kenyan market over the years.
The KRA has through various private rulings over the years pronounced its position on this issue, indicating that they believed that the relevant Article of the DTA that would be applied was in fact Article 22 of the DTA, which would result in the application of withholding tax of 20percent on management and professional fees charged by South African providers to Kenyan resident persons.
This position has now been clarified by the Tax Appeals Tribunal (the Tribunal) in the recent case of Mckinsey and Company Inc. Africa Proprietary Limited vs Commissioner of Legal Services and Board Coordination (the McKinsey case). In this case, the TAT held that income paid by a Kenyan resident entity to a South African entity should be subject to tax pursuant to Article 7 of the DTA and not Article 22 of the DTA. According to the Tribunal such professional fees should not be subject to withholding tax in Kenya and should be taxed as business profits in South Africa.
We highlight below, salient features of the decision in the McKinsey case and what it means for the various taxpayers going forward.
Brief facts of the case
Mckinsey and Company Inc. Africa Proprietary Limited (Mckinsey), is a limited liability company incorporated in South Africa and operates a branch in Kenya and its principal activity is provision of consultancy services.
The KRA carried out an audit on Mckinsey’s tax affairs for the years 2014 to 2018 and subsequently raised an assessment demanding withholding tax amounting to KES 455,457,019 (approx. USD 4.3 million). Mckinsey objected to part of the assessment amounting to KES 179,956,998 (approx. USD 1.7 million) relating to professional fees paid to its related party, Mckinsey South Africa and conceded to the rest of the assessment. However, the KRA subsequently issued an objection decision confirming its assessment in respect to the withholding tax assessment in relation to professional fees paid to Mckinsey South Africa. Being aggrieved by the decision, McKinsey appealed to the Tribunal.
Submission by the Parties during the hearing at the Tribunal
During the hearing at the Tribunal, Mckinsey argued that professional ventures/activities are business activities and therefore professional income/profits constitute business profits. In this regard, the KRA had erred by concluding that professional fees paid by Mckinsey cannot be construed as business profits under Article 7(1) of the DTA and that the same should be taxed under Article 22 of the DTA which deals with other income. According to Mckinsey, the KRA ought to have considered provisions of Paragraph 77 of the Commentary on Article 7 of the 2010 OECD Model Articles which sets out that income by way of management or professional fees is to be taxed under business profits in the absence of a specific article dealing with the taxation of management or professional fees in the DTA.
Conversely, the KRA argued that the professional fees paid by the Kenyan entity to the South African entity cannot constitute business profits taxable under Article 7 of the DTA but rather as “other income” under Article 22 of the DTA. According to KRA, professional services are not provided for under a separate article of the DTA and thus could only be dealt with under Article 22 and thus liable to withholding tax in Kenya.
The Tribunal in upholding Mckinsey’s appeal, held that the KRA erred in demanding withholding tax from McKinsey. According to the Tribunal, the professional fees paid to the South African entity falls within the definition of business profits and therefore Article 7 of the DTA would apply, as opposed to Article 22 of the DTA.
The Tribunal buttressed the fact that it was not established that the South African entity had a permanent establishment in Kenya and therefore the taxing rights under the terms of the DTA would fall with South Africa. According to the Tribunal, Article 22 of the DTA comes in only where income has not been dealt with in any of the previous Articles which was not the case in the present dispute.
The upshot of this case was that payment of management or professional fees by a Kenyan resident person to Mckinsey in South Africa should not have been subjected to withholding tax on the payments.
What does this decision in the Mckinsey case mean to the various taxpayers?
A decision by the Tribunal has effect and is enforceable unless overturned by a superior court. We understand that the KRA has not yet appealed this decision, but it may do so in the coming days. For the time being, the decision in the Mckinsey case sets a precedent on the taxation of professional services under the Kenyan- South African DTA and provides important clarification on the question of whether withholding tax applies on management and professional fees paid when a DTA is in force.
In our view, this decision is a welcome move to the Kenyan entities providing professional services to South African entities as it puts to rest uncertainty regarding taxation of professional fees under the DTA. Specifically, what this means then is that going forward and pursuant to the decision, professional fees paid by a Kenyan entity to a South African entity will not be subject to Kenyan withholding tax but will be taxed in South Africa pursuant to provisions of Article 7 of the DTA. In addition, pursuant to this decision, taxpayers who have erroneously deducted withholding tax in respect to payments for professional fees made to South African entities, in the instances the contracts are ‘’grossed up’’, may be eligible for a refund of the withholding tax paid in error upon satisfying the Commissioner that they are eligible for such refunds. However, it could be argued that in the instances where the contracts are not grossed up (net contracts), then the party who should apply for a withholding tax refund is the non-resident party who is paid the professional/management fees. In our view, a non-resident party would be faced with various practical challenges in pursuit of obtaining withholding tax refunds from the KRA in such circumstances.
ALN Kenya | Anjarwalla & Khanna
ALN Kenya | Anjarwalla & Khanna