Taxation on dividends distributed out of untaxed gains or profits

INTRODUCTION
This Note critically analyses the new regime of taxation of dividends distributed out of untaxed gains  or profits  in Kenya which  came into force on 1st January  2019 and which replaces  the compensating tax regime that was previously in place.
1.    S4 of the Finance Act 2018, which came into force on 1st January 2019, provides as follows:
“The Income Tax Act is amended by repealing section 7A and replacing it with the following new section—7A. Where a dividend is distributed out of gains or profits on which no tax is paid, the company distributing the dividend shall be charged to tax in the year of income in which the dividends are distributed at the resident corporate rate of tax on the gains or profits from which such dividends are distributed: Provided that this section shall not apply to registered collective investment schemes. “
1.    S2 of the Income Tax Act (“ ITA”) defines a dividend as follows:
“dividend” means any distribution (whether in cash or property, and whether made before or during a winding up) by a company  to its shareholders with respect to their equity interest in the company, other than distributions made in complete liquidation of the company of capital which was originally paid directly into the company in connection with the issuance of equity interests.
 
OUR ANALYSIS
1.    S. 7A of the ITA is only applicable where dividends are paid from out of distributable profits on which tax has not been paid.
As S. 7A of the ITA would not apply where tax on gains or profits has been paid, companies having both taxable and non-taxable gains or profits are faced with an issue of having to establish what they may distribute subject to payment of tax and what they may distribute free of tax.It would appear to us that the new S. 7A of the ITA is an additional charging clause which really ought with further  clarification,  to have been incorporated in S.3  of the ITA as it is permissible for dividends to be paid by any company out of gains or profits which may or may not have been subject to a charge to income tax e.g. a distribution of the proceeds of sale of a listed security traded on the Nairobi Securities Exchange which is exempt from capital gains tax .In the case of companies which receive dividends and re-distribute the monies received,   the taxation of dividends is already captured under   S. 3.2. (b) of the ITA  which provides as follows:
“Subject to , and in accordance with, this Act, a tax to be known  as income tax shall be charged for each year of income upon all the income of a person, whether resident or non-resident, which accrued in or was derived from Kenya.
(2) Subject to this Act, income upon which tax is chargeable under this Act is income in respect of
(b)  dividends or interest;…”
The 1994 amendment to S 7(2) of the ITA  exempts from  tax, dividend income of companies received by a resident company holding more than 12.5% of the voting power  of the paying company. There is no other provision on the ITA  which otherwise exempts dividends from inclusion as taxable income of companies. It would appear to us that the new S. 7.A of the ITA may be in conflict with S.7(2) of the ITA.
 
EXAMPLE OF PRACTICAL APPLICATION
ABC Limited (or ABC), a trading company, is a wholly owned subsidiary company of XYZ Limited (or XYZ), a holding company. Both are Kenyan resident companies.They are both separate legal entities even though they may be part of the same group or even though they may be under common beneficial ownership. ABC Limited pays a dividend to XYZ Limited (which holds more than 12.5 of the voting power of ABC Limited) out of its distributable gains or profits on all of  which  it has paid income tax pursuant to S. 3 of the ITA.
1.    S. 7A of the ITA would not apply to ABC Limited as the dividend paid by it was made out of gains or profits on which tax was paid.
The position is by no means clear where some of the distributable income was not liable to tax e.g. if it was exempt from capital gains tax or where no tax was payable due to  capital allowances. This aspect was previously addressed by the application of the compensating tax rules. In the case of XYZ, it receives a S 7.2 of the ITA non-taxable dividend   and subject only to S 7A of the ITA is it able to distribute that without any tax liability to itself.
If XYZ Limited is not qualified to receive an exempt dividend, then  the dividend would be taxable in the normal way   under  S 3 of the ITA  and the net of tax profits available for dividend  and when paid no further tax liability imposed on XYZ. Now let us say XYZ makes a redistribution of the tax exempt dividend received from ABC to the shareholders of XYZ.Such a redistribution of dividend would be caught by S. 7A of the   ITA  which requires payment of tax on such dividend by XYZ. The tax paid by ABC is irrelevant as that does not exempt XYZ  from payment of tax under S.7A of the ITA. ABC and XYZ are both separate legal entities and each of them are liable to payment of tax in their own right.
Note that distribution of dividends is also subject to the payment of withholding tax at the applicable rate as withholding tax is dealt with separately from income tax.
 
THE KENYA REVENUE AUTHORITY (“KRA”) PUBLIC NOTICE
In the light of confusion and evident concern expressed by holding companies receiving S 7.2 of the ITA exempt dividends, the Commissioner for Domestic Taxes published a KRA Public Notice dated 8th February, 2019 titled: “Taxation of Untaxed Profits Distributed as Dividends”.
The contents of the Public Notice are with regard to clarification of interpretation of the new Section 7A of the ITA; The Public Notice is in our opinion,  contrary to what we believe is a strict interpretation of  the provisions of the ITA.
The Public Notice provides that:
“The new section 7A of the Income Tax Act, Cap 470 does not apply to distribution of income as dividends, where the income;
•    Is received by a registered collective investment scheme;
•    Is received by a resident company from a subsidiary, whether local or foreign;
•    Has been subjected to capital gains tax provisions; and
•    Has been subjected to final tax.”
The Public Notice seeks to reverse the effect of S. 7(A) of the Income Tax Act. However, only the
legislature has the power to amend legislation. The KRA does not have such power to revise the effect of legislation in this manner and in our view, S. 7(A) of the  ITA  remains applicable  until and unless amended by the legislature.
The   Public Notice also raises questions in respect of the position of resident companies which are not a subsidiary but do hold more than 12.5% of the Voting power and which therefore receive S 7.2 of the ITA tax exempt dividends.  Are they now liable to tax under S 7A of the ITA? Furthermore, the Public Notice is probably defective for the following reasons: Under Part X (Rulings) and Section 62 of the Tax Procedures Act (“the TPA”):
•    The Commissioner – General (“Commissioner”) of the KRA has the power to make a public ruling setting out the Commissioner’s interpretation of a tax law;
•    The ruling must be in accordance with Section 63 of the TPA for it to be binding on the Commissioner until it is withdrawn by the Commissioner; and
•    The public ruling shall not be binding on a taxpayer.
 
Moreover, Section 63 of the TPA outlines the specific conditions that will make a public ruling binding on the Commissioner. It states that a public ruling shall:
•    Be made by publishing a notice of the public ruling in at least two newspapers with a nationwide circulation;
•    State that it is a public ruling and have a heading specifying the subject matter of the ruling and an identification number;
•    Take effect on the date specified in the public ruling or, when a date has not been specified, from the date the ruling is published accordingly; and
•    Set  out  the  Commissioner's  opinion on  the  application  of  a tax  law in the
circumstances  specified  in  the  ruling;  and  shall  not  be  a  decision  of  the
Commissioner for the purposes of the TPA or the Tax Appeals Tribunal Act, 2013

The Public Notice does not appear to meet the requirements of amounting to a public ruling on the grounds that:
(a) There is yet to be any notice of the so called “public ruling” in at least two newspapers with nationwide circulation.
(b)  The Public Notice does not state that it is indeed a public ruling nor does it have an identification number,  despite the fact that it has a heading specifying the subject matter accordingly.
Another point to note is that the Public Notice is made by the Commissioner for Domestic Taxes and not by the Commissioner–General as provided for by law.
The Public Notice therefore does not amount to a Public Ruling and nonetheless, it does not bind a taxpayer but instead acts as a non-binding opinion of the KRA to the public at-large, which may be challenged in court by any interested person.
 
This Note is for information purposes only and does not constitute legal advice. If you require legal advice, please contact Hamish Keith or Shitul Shah.