TAX PLANNING QUESTIONS AND ANSWERS

QUESTION 1

Discuss four tax incentives that could “have contributed to the growth of financial markets in your country.

  • Withholding tax on dividends of 5% is final.
  • Flotation cost of securities is an allowable expense.
  • Companies which issue a given percentage of shares to the public through the stock markets are taxed at a lower rate.
  • The interest on government infrastructure bond is exempt from tax – Venture capital companies enjoy a 10 year tax holiday

 

QUESTION 2

a) Briefly explain how firms or individuals could mitigate tax exposure through.

i) Stock dividends 

Stock dividends –Payment of withholding tax on dividend can be avoided if companies pay dividends to shareholders by way of bonus shares or by way of a share repurchase program. Bonus shares issued on a prorate basis to existing shareholders are not taxable currently in cases where they are not issued on a prorate basis to shareholders.

ii) Share repurchases programmes.

  • Share repurchases programmes – This is a method of distributing profits where the shares are bought from shareholders usually at a price higher than the market value. The shareholder will not be subjected to withholding tax and capital gains are not taxable

iii) Registered venture capital entities.

  • Registered venture capital entities – The dividend received by venture capital entities are not subjected to tax i.e. they are exempted for tax When they sell the shares at a value which is higher than value of investment, they get capital gains which are tax exempt

 

QUESTION 3

 Describe ways in which related parties could be transfer pricing systems to avoid tax ii)  Discuss three reasons that related parties may give to justify the continued use of transfer pricing systems.  

 

i) Two ways related parties may use to avoid tax

  • Undercharge for services rendered to another related party in order to minimise revenue for tax purposes. This would be most applicable in a situation where the firm providing the service is in a high tax rate country.
  • Acquire goods at a mark-up, rather than at cost, from a related party. This would mainly apply where the party receiving goods wishes to overstate its purchases and thus reduce the profit.
  • A related party entity may sell goods to another related party at below market rates in order to minimise sales, reduce revenue and thus avoid taxes such as value added tax, turnover tax or corporation tax.

 

        ii)      Justifications for transfer pricing

  • Transfer pricing can be used to motivate divisional managers especially where their remuneration is based on divisional profits
  • Transfer pricing can provide a reliable base for decision making and ensure that optimal decisions are made.

To allow performance evaluation of divisions and gauge divisional performance.

To ensure divisional autonomy.

To value intra-group transactions involving semi-finished items without a competitive market.

 

QUESTION 4

 Tax refunds and tax credits are increasingly being used by governments in the information and modernization taxation policies. Required:

Citing examples distinguish between a tax refund” and a “tax credit”

 

A tax refund, also called a tax rebate, is an-amount payable to a taxpayer when the tax liability is less than the tax paid. Taxpayers can often get a tax refund on their income tax if the tax they owe is less than the sum of the total amount of the withholding taxes and estimated taxes that they paid. Tax refunds are given back at the end of the financial year.

A tax credit is a sum deducted from the total/amount a taxpayer owes to the state. Most tax credits are set off at source before remission of tax to the state. Tax credits may be granted in recognition of taxes already paid and cover various taxes including income tax, property tax and value added tax

 

  1. Evaluate the fundamental role of tax refunds and tax credits in a government’s developments agenda

 

QUESTION 5

What techniques or ways can individuals take advantage of to avoid taxes? 

 

Tax deductible contribution to registered retirement benefit scheme

Income tax act have provided that contribution to registered retirement benefit schemes can be deducted from gross income before taxable income is determined. The tax deductible contributions is currently set at a maximum of sh. 24,000 per annum

Mortgage interest deduction

Interest incurred on personal mortgages is deductible from gross income before arriving at taxable income subject to a limit of 12,500 per month or 150,000 per annum

Establishment of charitable trust or foundations

Section 10 of the 1st schedule of the income tax act provides that the income of an institution body of persons or irrevocable trust of a public character establishment solely for the purposes of poverty elevation or distress of the public as the advancement of religion or education or for public benefit shall be tax exempt.

Relief

Resident individuals are entitled to relief of 15% of premiums paid on life insurance policies, education with a maturity of at least 10 years or health policies taken not for oneself or for one’s spouse or child. This combined relief is subject to a maximum of 60,000 per annum

 

QUESTION 6

How can corporates avoid taxes?

 

1. Use of debt in the capital structure

–      In Kenya as in many other countries, interest on cooperative debt is tax deductible companies can take maximum advantage of this tax deducting by determining the optimum amount of debt they can take and work with. It  should be noted that the revenue authorities attempt to limit  abuse of tax deductibility

2. Capital investment allowances

The income tax act enables companies to change against their income certain allowance on capital expenditure. These allowances include wear and tear allowances for fixed assets on capital expenditure. These are covered under section 15 (2) and the 2nd schedule of the income tax act. These allowances serve as investment incentives

 

3. Export processing zones

Business where principal markets are foreign can set up a licensed export processing zones and enjoy a rating of tax incentives.

This include a 10 year tax holiday and modest 25% for the next 10 years exemptions from withholding taxes on dividends and other payments to non-residents for the first 10 years exemptions from VAT and investment deduction of 100 %

 

4. Off share business structure

The sparse collection of double taxation treaties to which Kenya is a party subjects international business and investment to multiple taxes on the same income

 

QUESTION 7

What should individuals and corporates put in mind to mitigate their tax exposure or avoid being taxed unfairly? 

   

i.       Keeping complete and accurate records

Proper record keeping enables individuals and companies to support allowable deductions from their gross income. Accurate records will help in the event of tax form their gross income. Accurate records will also help in the event of tax audit and other proceedings against the tax payable.

ii.      Getting timely and competent tax advice

Working with a competent tax consultant enables individuals and corporate entities to conduct their affairs in compliance with existing laws.  iii. Challenging tax assessment in legal tribunals 

The tax statutes provide avenues for individuals and companies to challenge tax assessment made upon them by tax authorities. Further, tax demands can be challenged in courts an example of the latter is the recent successful judicial review application brought by a beverage company against the Kenya Revenue Authority on an assessment and demand on the company for excise, VAT and income taxes cumulating to about 1.1 billion

iv.      Compliance

Tax payers can avoid exposure to tax programs such as stiff penalties, interests, possible shut down of business, distraction from usual activities etc. by complying with established laws and requirements. However it is illegal to arrange one’s affairs in such a manner as to minimize their tax burden.

 

 

QUESTION 8

Explain the meaning of transfer pricing?

 

Transfer pricing refers to the pricing of contributions such as assets, services or funds transferred within an organization e.g. goods from production division may be sold to the marketing division or goods from parent company may be sold to a foreign subsidiary.

 

QUESTION 9

Explain the methods applied in adjusting transfer prices.  

 

  1. Comparable uncontrolled price method (CUP)  CUP method corporate the price at which a comparable and uncontrolled transaction is conducted.  Comparability between these transactions i.e. (controlled and uncontrolled) exist where there are no difference between transaction or if there is when such differences do not have a material effect or for which reasonable adjustment can be made hence an arm length transfer prices can be determined through a comparison with a sales price between 2 unreleased incorporations executing a comparable transaction. However the fact that virtually any minor differences in the circumstances of trade may have a significant effect on the price make it exceedingly difficult to find a transaction that are sufficiently comparable.

2. Cost plus method (CP)

This method is generally used for the trade of finished goods, it is determined by adding’:  an appropriate mark up to the costs incurred by the selling party in manufacturing or  purchase the goods provided with the appropriate markup been based on the profits of  other companies comparable to the involved parties. Cost based approaches are however  not transparent as they appear. A company can easily manipulate its cost accounts to alter  the magnitude of the transfer price.

3. Re-sale price method (RP)

This is found by working backwards from transactions taking place at the next stage in the supply chain and is determined by subtracting an appropriate gross mark-up from the sales price to an unrelated third party with the appropriate gross margin been determined by examining conditions under which the goods or services are sold and comparing the) said transactions to third party transactions.

4. Profit split method (PS)

This method is applied when the business involved in the examined transactions are too  integrated to allow for separate evaluation and so the ultimate profit derived from  the endeavor is split based on the level of contribution. It is often determined by some  measurable factors such as employees’ compensation. Payment of administration expenses of each participant in the project.

 

 

QUESTION 10

Related companies may understate their taxable profits by engaging in transfer pricing. With  reference to Section 18 (3) of the Income Tax Act (Cap. 470), briefly explain three transactions that may constitute transfer pricing.”   

Transactions that may give rise to transfer pricing

  • Where goods are transferred/ sold to the parent non- resident company at a price below the prevailing market.
  • Where the head office determines the sale price and retains proceeds overseas.
  • Where transfer of fixed assets between the two companies is not done at arm’s length.
  • Where the exchange rate two companies is not at the prevailing market rates.

 

 

QUESTION 11

Define the term ‘tax planning

Tax planning is the arrangement of tax affairs in business activities of a tax payer, be it an  individual or a body corporate, in such a way so as to achieve the lowest possible tax  liability, at the lowest possible cost, without flouting any tax laws or regulations tax  planning can be carried out for any form of taxation.

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