The Kenya Revenue Authority (KRA) will get powers to demand tax on 60 percent of unexplained retained earnings in the race to curb tax avoidance from non-payment of dividends.
The fresh powers to seek a piece of the retained earnings follow amendments to the Finance Bill, which has introduced a minimum share of 60 percent of unexplained retained earnings that the KRA can tap for withholding taxes.
The KRA will tax portions of the retained profits that companies cannot explain why they were not being distributed to shareholders as dividends.
Profits not distributed as dividends are recorded as retained earnings that can be used for expansion, acquisition and buffers against shocks. Locals pay a withholding tax of 10 percent on dividends while foreigners pay 15 percent.
Should the KRA commissioner, for instance, assess Sh1 billion as unexplained retained earnings or distributable income, the taxman can levy tax on a minimum of Sh600 million.
It will take Sh60 million as tax for a local company and Sh90 million for the unexplained retained earnings in foreign firms.
Tax experts worry that the adoption of the proposal would expose firms to additional taxes and could force some to declare shareholder dividends, even when they have compelling needs such as capital preservation for expansion.
The declaration of dividends is usually a reserve of the company’s board of directors.
Undistributed profits
Currently, the KRA commissioner can demand tax after an assessment on undistributed profits, but the law does not provide a minimum threshold.
‘This change is likely to have a significant impact on businesses with high retained earnings, particularly where profits are not distributed despite adequate liquidity,’ tax analysts at KPMG state.
‘By setting a minimum deemed-dividend threshold, the amendment reduces the scope of differing tax through profit retention and increases the likelihood of additional tax exposure. With this development, businesses that wish to grow organically by re-investing undistributed income will be required to provide sufficient supporting documentation to demonstrate that such retention is driven by genuine commercial needs.’
Kenyan property, rental and investment company Githima Limited was caught up in a dispute on undistributed earnings when the KRA demanded Sh3.7 million in income tax after an assessment covering the period between 2017 and 2019.
The taxman demanded the tax from a deemed dividend distribution of Sh271.2 million it flagged the non-distribution of dividends as a tax avoidance scheme.
The real estate firm won the suit after proving that the dividend retention was necessary to service a Sh2 million loan from Equity Bank.
The KRA was faulted for failing to properly apply the law on deemed dividends.
The taxman flags deemed dividends when their audits raise red flags on huge, retained earnings in the wake of the lack of dividend distributions.
Previously, the KRA would deem that only a smaller portion of the retained earnings was liable to income tax.
The KRA commissioner currently has the liberty to set the portion of retained earnings deemed undistributed dividends.
The new proposal has faced criticism for assuming that all firms have a flat dividend policy distribution, with a 60 percent requirement.
Most companies have dividend policies that set the distribution rate at between 30 and 50 percent of net income, but banks like Standard Chartered set their distribution to as high as 80 percent of net income, signalling a lower rate of capital retention to fund growth and expansion for the conservative lender.
‘A company would still be allowed to provide grounds for why they have not distributed dividends, but the proposal to set a minimum floor on this assessment at 60 percent might lead to a more aggressive KRA commissioner,’ said Robert Maina, a tax director at Ernst and Young (E and Y).
The KRA wants to weed out tax evaders and boost revenue by billions of shillings, as part of measures put in place to repair its coffers.
The drive to increase collections has seen the KRA increasingly use tech and third-party data to catch those who do not pay tax on their incomes.
Deemed dividends
Robert Waruiru, a managing partner and head of tax at Ichiban Tax and Business Advisory LLP, said the adoption of the floor on deemed dividends on undistributed profits could force some firms to make distributions even when having pressing needs for the cash.
‘As a company, you are really being forced to distribute dividends. If you don’t and are assessed to have avoided a tax liability, you will have to pay the dividends tax,’ Mr Waruiru said.
‘Forcing shareholder payouts will be a disadvantage to companies that would have benefited from redeploying retained earnings for use beyond payouts and could force firms to take out loans for growth as an alternative.’