Taxation of Businesses operated by Individuals who are not employees

A Taxpayers concerned

Individuals who are not employees: There are taxpayers required to pay income tax on business benefits who are physical people and who carry on activities involving financial remuneration on a purely personal basis. In other words, such taxpayers are not employees contracted to an employer or a corporate or business entity. These latter situations are assessed for employment or corporate income tax respectively.

Examples of the former taxpayers would include generally tradesmen or ‘liberal professions’ such as lawyers, doctors and consultants.

Like “employees”, these taxpayers are assessed according to Chapter II of Law 16/2005 of 18/08/2005 on Direct Taxes on Income … (the DTI)

Corporate or business entities are covered by Chapter III of the DTI.

But much in Chapter II of DTI also applies to businesses which fall into the categories covered by Chapter III

Taxes are assessed on the profits made by a business. As covered in the first course, profits are Income less expenses. But not all items of expenditure can be deducted from profits for tax purposes.

Deductible items

General

Any expenditure which complies with Art 21 of the DTI may be offset against taxable income or business profits:

Such expenditure must be committed for the direct need and the normal requirements of the company;
They must be supported by appropriate documentation to confirm that they have been incurred;
They must involve a reduction of the net assets of the company;
They must be included for tax purposes in the expenditure of the period during which they are committed.

But some types of expense are not “tax-deductible”. These include in particular:

Cash bonuses, attendance fees and other similar payments allocated to the members of the Board of directors;
Declared dividends and participations in profits;
The surplus of interest paid on loans made out in a foreign currency, compared to the interbank rate offered in London or “London Inter-Bank Offered Rate ” (LIBOR) at the beginning of the fiscal year increased by one percent (1%); (Law No. 73/2008 Article 2 para 3)
Contributions to reserves, provisions and other funds with specific purposes, others than those envisaged by the tax law.
Fines and other penalties;
The proportion of any gift (donations in cash or the equivalent value of gifts in kind) which exceeds one percent (1%) of sales turnover. However if these gifts are granted by persons or entities carrying on a gainful employment, the gifts will not be entirely non-deductible;
Income tax of businesses that is paid abroad and value-added tax (VAT);

Indeed, tax paid abroad is not deductible from the tax base under consideration – it instead constitutes a foreign tax credit. Also the VAT cannot be deductible expenditure since it is offset against output VAT. However, all other taxes are deductible from the tax base, as the law only specifically prohibits the deduction of the two taxes discussed above;

Personal consumer expenditure and any entertainment expenditure provided that this expenditure was not already included on income tax of employment (EIT).

Special attention should be given to Art 22 DTI but see also Law No. 73/2008 of 31/12/2008 which modifies the DTI.

Those reserves, provisions and funds which are mentioned by the tax law, and which consequently are accepted as deductible, include in particular qualifying pension funds (art.14 4º DTI) and investment provisions (Article 26 DTI);

Depreciation

Depreciation is an annual charge against the profits of a company to take account of the reduction in value resulting from the use of fixed assets belonging to the organisation. It therefore forms deductible expenditure for the fiscal year under consideration. However, some assets that are not subject to physical deterioration and associated depreciation in the same way are not allowable. These include in particular land, works of art and heritage assets (art 24 paragraph 2 DTI).

The law outlines four (4) categories of acceptable charges relating to depreciation (article 24 para. 3, 4 and 5 DTI) which have their own specific allowable rates as follows:

Construction of, or the costs of acquisition of, costs of improvement, restoration or rebuilding of tangible assets. The annual allowable rate of depreciation is 5% of the cost price. Examples: of such assets include industrial buildings themselves plus equipment which forms part of the building such as elevators, light fittings, airconditioning and conveyors where these are built into the fabric;
Development or costs of acquisition, costs of improvement, restoration or rebuilding of the intangible assets, which includes goodwill acquired from a third party. Annual rate of depreciation is 10% of the cost price. The assets thus will be entirely depreciated in ten (10) years. Example: Goodwill, concessions, patents, licences, etc.;
Computers and their accessories, information systems and communication. Annual rate of depreciation: 50% of the carried forward balance of the asset net of depreciation. An IT system costing Rwf20m will be valued at 2% of its cost price by year 6
Other assets of the company: 25% of the carried forward balance of the asset net of depreciation. Examples: machine tools, work benches, seed cleaners etc. motor vehicles, furniture, etc. That is the assets are depreciated on a reducing balance basis; by year 9 the WDV will be 2.5% of cost – cf IT equipment
Not only is depreciation is calculated in two different ways according to whether the asset falls into the first two, or the last two, categories described but:
For the first two categories (depreciation of 5% and 10% of the cost price), depreciation is calculated individually, asset by asset, and is based on the original cost i.e. straight-line basis. Additions are simply treated at cost and sales are set against the relevant individual asset.
For the second two categories (50% and 25% rates of depreciation), depreciation is not calculated by individual asset, but by total pool category (article 24 of DTI); And the depreciation is calculated on the depreciated value at the beginning of the year (NBV – net book value or WDV – written down value) brought forward e. on a Reducing Balance basis.
For the “pooled” assets, additions are added to or sales are subtracted from the pool value at the beginning of the year – Art 25 DTI).
For all categories, due allowance must be made where due to abnormal occurrences, assets are damaged or devalued.

However, for the four (4) categories of allowable assets, when a used and depreciated asset (either completely or partially depreciated) forms part of a business acquired by a taxpayer, then annual instalments of depreciation are calculated on the price at acquisition (if in the first two categories) or on the depreciated value (‘net book value’) of the asset at the date of acquisition if in the last two categories.

It is important to categorise the assets correctly and ensure that the depreciation is correctly calculated.

It should be noted that if the depreciated value of the assets at the beginning of a year (the depreciation base) does not exceed 500,000 Rwf, the full amount constitutes a deductible running cost (art.25 of the DTI).

Finally, if the net book value is negative (as would be the case for example if the selling price of certain assets of the category are higher than the cost price of all the assets in the category of costs), this net amount is treated as a gain and is added to profits and the assets base valuation amount becomes nil (art 25 al.2 DTI).

Investment allowance

Where the business is a registered investor and is able to take advantage of the investment allowance, the profits in year 1 would be dramatically different. But this is also the year when start-up costs are expected to be greatest and so the chances of profits slimmer.

According to paragraph 26 of the DTI, an investment allowance of forty percent (40%) of the amount invested in new or used assets may be depreciated excluding motor vehicles that carry less than eight (8) persons, except those exclusively used in a tourist business. This amount is deductible for a registered investor in the first tax period following the purchase and/or of use of such assets if:

the amount of business assets invested is equal to thirty million (30,000,000) Rwandan francs; and
the business assets are retained for at least three (3) tax periods after the tax period in which the investment allowance was taken into consideration.

The investment allowance becomes fifty per cent (50%) if the registered business is located outside Kigali or falls within the priority sectors as described by the Investment Code of Rwanda.

The investment allowance effectively increases the depreciation charge to business profits and for pooled assets, reduces the value of these assets carried in subsequent years. – next year’s depreciation for pooled assets is calculated against the written down value as at the 1^st of the period plus the cost of any acquisitions made in the period.

If the business asset that is granted an investment allowance is disposed of before the end of the period mentioned in the above point 2, the reduction of income tax stemming from the investment allowance must be paid back to the Tax Administration unless such an asset is destroyed by natural calamities or other involuntary conversion. The repayment amount is calculated back to the acquisition date of the relevant asset.

To be eligible for the Investment Allowance, the following conditions must be fulfilled:

It is necessary to be a recognised and registered investor;
The acquired asset cannot be a vehicle capable of transporting less than eight (8) passengers unless it is used solely for tourist business;
The amount invested must be at least 30 million francs;
The assets must be held for at least three (3) fiscal years from the time that the provision for investment was taken into account;

For ease of book-keeping and to make year-end work much easier perhaps the entity should adopt the RRA depreciation rates and then there would be no need to make adjustments.

But, and this is a big BUT, the business profits for management Account purposes in any one period could be markedly affected and thus the ratios such as Return on Capital Employed, RoI, ratios which are most important for the investor, would be affected. Calculations such as WACC could become invalid and these inaccuracies could in turn lead to incorrect investment decisions.

When making decisions to select asset lives and how to depreciate assets, the implications must be carefully assessed before going ahead. Once a specific accounting policy has been properly adopted, changes in later years can affect the accounts and reports for “prior” years. d. Expenses for training and research

Art. 27 DTI prescribes that expenses of training and research during a fiscal year are deductible expenses.

All Training and Research expenses incurred which promote business activities during a tax period are considered as deductible from taxable profits in accordance with provisions of Article 21 of this law.

Such expenses, when they are incurred as part of process to purchase of land, buildings and other immovable properties including renovation or reconstruction as well as exploration expenses and other assets, are considered as part of the capital cost and will be added to the cost of the asset.

To understand this concept more clearly, it is necessary to refer to relevant “International Accounting Standards” (IAS). In IAS 9 regarding “activities of research and development” (August 1991), the IAS established a distinction between:

Research: this relates to original research undertaken in order to acquire original scientific and technical knowledge;
Development: this relates to the translation of the results of research into a plan of production of materials, apparatus, products, processes, systems and services new or substantially new before the commencement of production or commercial exploitation.

Commentators have opined that, by expenses of research, the law wanted also to include the expenses of development because the two expenditures are often part of the same aim or project. See IAS on R&D and the way these costs are treated in the books of accounts

Bad debts

The deduction of bad debts is allowed for tax purposes but a bad debt is regarded as irrecoverable only if the loss has acquired a final and irreversible nature during the fiscal period. Exactly when a bad debt becomes irrecoverable is an issue of fact and the final decision lies with the tax department, but the business must have good evidence that the debt is not recoverable.

To be considered irrecoverable the bad debt must meet certain conditions in order to be fiscally deductible (article 28DTI):

This bad debt has been previously included before in the income of the taxpayer;
The bad debt has then been cancelled for accountancy purposes;
The taxpayer has taken all reasonable steps to recover the debt and has conclusive evidence confirming the insolvency of their debtor or other proof of inability to pay.

Recoverable losses

As its name indicates, income tax relates to profits earned by a taxpayer. However a taxpayer may not generate profits during a fiscal year. He/she can also incur losses. In this case, not only does the taxpayer avoid a tax liability during the fiscal year, he/she also has the right to carry forward this loss to the next year, so that profits in year 2 can be reduced by the loss incurred in the year before – up to five years before.

Article 29: Loss Carried Forward

If the determination of business profit results in a loss in a tax period, the loss may be deducted from the business profit in the next five (5) tax periods, earlier losses being deducted before later losses.

However: per Article 20 of Law 16/2005 (DTI) “A loss in tax period in which a long-term contract is completed may be carried back and offset against previously taxed business profit from that contract to the extent it cannot be absorbed by business profit in the tax period of completion

However, losses incurred overseas cannot be offset against any profits of Rwandan origin during the same fiscal year, or against any future or previous profits of Rwandan origin.

Article 29 Para 3 (DTI) If during a tax period, the direct and indirect ownership of the share capital or the voting rights of a company, whose shares are not traded on a recognized stock exchange changes more than twenty five per cent (25%) by value or by number, paragraph one of this Article ceases to apply to losses incurred by that company in the tax period and previous tax periods.

Article 20: Long-term contract

The timing of inclusion in and deduction from business profit relating to a long-term contract is accounted for on the basis of the percentage of the contract completed during any tax period.

The percentage of completion is determined by comparing the total expenses allocated to the contract and incurred before the end of the tax period with the estimated total contract expenses including any variations of fluctuations.

Long-term contracts

Within the meaning of the law, a long-term contract is a contract for manufacture, installation or construction, or the provision of services relating to these activities, which is not completed during the fiscal year in which it began. This excludes any contracts whose completion was at the outset envisaged to be within twelve (12) months of commencement (art.20 DTI).

For these contracts, the following rules apply:

Business profit relating to a long-term contract is accounted for on the basis of the percentage of the contract completed during any tax period. As per ISA standard IAS 11, the percentage of profit is calculated from the percentage of completed and takes into account estimation future costs. Effectively, if the estimated final cost is expected to be greater than the sale value, then 100% of the loss to date is taken to the SoCI.
Para 3 allows that where a long term contract subsequently makes a loss where previously a profit was anticipated and duly assessed, the realised loss can be offset against the previously taxed profit of that contract. Where the overall business profit is insufficient to cover the loss, the loss can be set against the profits attributed to that contract in previous years.

A is performing a long-term contract which started in Jan 2010 and expected to last until 2012. At the end of 2010, completion so far was calculated as 25% and the final sale at Rwf1,000,000,000 and expected profit was 10%, Rwf100,000,000. Rwf25,000,000 would have been assessed at 30% payable to RRA.

At the end of 2011 the valuations were 70% complete and profit was expected to be 7.5% of the sale value which was now 1,200,000,000.

Profit assessable for tax = 7.5% x 1,200,000,000 x 70% = 63,000,000 at 30% = 18,900,000 less 30% x 25,000,000 charged in 2010.

If in 2012 the contract is completed as forecast in 2011, the tax charge for 2012 would be:

7.5% x 1,200m x 30% = Rwf27m less tax charged in 2010 and 2011

But suppose the contract finally made a loss of Rwf20,000,000 and the remaining business profits were not sufficient to cover this sum, the profits of the previous years could be adjusted by readjusting the profit of the long-term contract from Rwf63m to Rwf 43m. In this way tax due in respect of the previous year could be adjusted downwards and a refund added to the calculation for the current year.

Readjusted tax for 2011: 30% of Rwf43m = Rwf12.9.

Tax paid in 2011 was Rwf 11.4 m. Tax refund = Rwf1.5m

Agricultural and breeding activities

The tax law exempts from tax the income arising from agricultural and breeding activities if annual turnover does not exceed twelve million (12.000.000 Rwf) Rwandan francs during a fiscal year (Article 18 DTI).

This measure is intended to take into account the significance of these activities in the Rwandan economy reality where more than 90% of the population relies on subsistence agriculture with the sale to local markets of any surplus from their harvests. However, when the value of such sales exceeds the amount indicated, the law takes the view that the related agricultural activity is no longer one of subsistence. Therefore, the income of these activities will be taxed.

If the business profits are less than 20,000,000 francs i.e. the business is “small” (Article 2 of DTI) then the tax assessed could be a lump sum of 4% of turnover.

The law is not specific regarding produce taken from the farm into the home, but the wording refers to turnover and so it might be assumed that the turnover is that portion of output which is sold in a market and not used in the home.

. Tax on actual profits

This type of taxation automatically applies to taxpayers whose annual sales turnover is equal to, or higher than, 20 million Rwandan francs per fiscal year. The taxable amount is not in this instance the sales turnover but the profit earned.

As is the case for income tax on employment, the assessed income is rounded down to the nearest thousand RwF (Article 41 DTI). Whilst Article 11 says “rounded to the nearest thousand”, Article 41 says “rounded down to the nearest thousand”

Declaration and payment of tax

Whilst an annual return must be completed and filed with the tax authorities before the 30^th day of the March after the end of a fiscal period (or the 30^th day of the 3^rd month where the fiscal period does not end 31 December) it is also important to remember that a business either as an individual or company must pay each quarter a 25% portion of what was paid in tax for the previous year. This will become the prepayment for the current year.

If the taxpayer began his activities during the preceding fiscal year, the quarterly instalment is equal to twenty five percent (25%) of the amount of the tax due arising in the preceding fiscal year, adjusted by dividing by the number of months during which the taxpayer undertook his activities during this preceding period and multiplying by twelve (12).

Tax on investment incomes

Tax base

As far as investment income is concerned, the tax law aims to tax any payment received in cash or in kind by an individual in the form of interest, dividends, royalties or rent and which was not taxed as a business profit (art.32 DTI – Income from Investments). In other words, any income from investments received by commercial companies will not be subject to withholding tax if the quarterly tax calculations include this income. (Section 3 Article 31 DTI).

Income in the form of interest includes any income arising from loans, deposits, guarantees and current accounts. It also includes income from government securities, income from bonds, and negotiable securities issued by public and private companies and income from cash bonds

Dividend income, as mentioned in the Law No 16/2005 on Direct Taxes on Income , is subject to a flat tax of fifteen percent (15%).

If dividend distribution was subjected to withholding tax as stipulated in the law, the taxpayer does not pay tax on income.

Dividend income includes income from shares and similar income distributed by companies and other entities.

In the determination of business profits of a resident company, dividends and other profitshares received from a resident entity are exempt.

The profits which pay dividends have been taxed at 30% before the dividend is deducted. One could thus argue that the dividends have already been subjected to tax.

Income in the form of dividends includes income arising from shares and participation in the profits in any type of company as well as similar incomes distributed by any entity enumerated by article 38 of the law. Withholding tax is 15%

The term “royalty income’ includes all payments of any kind received as a payment for the use of, or the right to use, any copyright of literary, craftsmanship or scientific work including cinematograph films, films, or tapes used for radio or television broadcasting. The term also includes any payment received from using a trademark, design or model, computer application secret formula or process. It also includes the price of using, or of the right to use, industrial, commercial or scientific equipment or for information concerning industrial, commercial or scientific knowledge. Royalty income also includes payments for natural resource payments. Again tax is 15% flat rate

Rental income: All revenues derived from rent of machinery and other equipment and land including livestock in Rwanda, are included in taxable income, reduced by:

ten per cent (10%) of gross revenue as deemed expense;
interest paid on loans;
depreciation expenses as determined according to Article 24of the DTI. Income derived from the rent of buildings or houses incorporated as assets mentioned in Article 38 of this law is subject to corporate income tax and is exempted from rental income tax.

Rental incomes arising from houses and buildings incorporate as assets of qualifying entities (Art 38) are subject to corporation income tax and are exempted from rental income tax. (Article 36 DTI).

Finally, it should be noted that some incomes can be compared to investment income as they are deducted at source using a rate identical to that used on investment income. These incomes include any profits from the lottery or any another games of chance (art. 51 DTI). And yet more finally, lottery and gambling winnings are also subject to withholding tax at 15% and this deducted at source.

All withholding tax agents must complete returns and payments within 15 days of the period end,.

Payment of tax

The rate of income tax applied to investments is not applied on a progressive basis as is the case for the majority of income tax payments described above. They are instead applied using a proportional rate which is fixed at fifteen percent (15%) of the assessed incomes (Article 33 parag.1 DTI).

“A withholding tax of fifteen percent (15%) is levied on the following payments made by resident individuals or resident entities including tax-exempt entities:

These incomes are any dividends, except those paid between companies, any interest paid on deposits, royalties, payments for performance by musicians, artist sportsperson and the profits of lotteries and other games of chance which have a monetary value (Article 51 DTI). The payments are subject to tax even when paid by or through an entity not resident in Rwanda For other investment incomes (interest other than that paid on money deposits, or rental incomes, other than those on houses and buildings and received by physical persons) the recipient will have to submit an annual declaration and to pay tax at a proportional rate of 15% by, at the latest, the 30th day of the sixth month of the following fiscal year (Article 12 DTI).

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