Kenya: Assertive KRA Challenges KCB Tax Payment in Precedent-Setting Case
Friday, 20 June 2008
In the budget 2008/09, Finance Minister Amos Kimunya set in motion a proposal to raise the minimum capital for banks from the current KES250m to KES1bn in the next two years, effectively meaning that banks in Kenya will have to work harder to maintain profits, raise their minimum capital and not eat into their reserve capital. Kimunya had tried to raise the amount last year, but the banking industry lobbied hard in parliament and the proposal was eventually shot down. The minister's new move is therefore expected to face the same challenge this year, but if it succeeds, it is likely to lead to a number of mergers and acquisitions in the Kenyan banking sectors as the small banks join forces to conform with the law, or are acquired by the larger banks seeking to expand their presence in the country or just stifle competition.

Kimunya's move is based on the premise that Kenya's banking sector has too many small and unviable institutions incapable of investing in modern technology and competency required to provide modern and efficient banking services to Kenyans. This, reckons the minister, has led to the dominance of the local banking sector by foreign owned institutions: "To facilitate the transformation of the large number of small banks in our economy to fewer, larger and stronger banks, I propose to amend the Banking Act to raise the minimum core capital requirement for banks and mortgage financial institutions from the current Kes250m and KES200m respectively to KES1bn over a period of two years," he said during the reading of the budget in mid-June 2008.

But a more ominous challenge faces the banking industry from an increasingly assertive Kenya Revenue Authority (KRA), as evidenced by an ongoing tax suit before lady justice Jessie Lessit at the Milimani Commercial Courts instituted by the Kenya Commercial Bank (KCB): KRA claims tax arrears from an account that KCB has with a foreign bank in another country, and the implications of this case are potentially huge: A win by the tax authority in this case will be an additional tax payment for the over 45 commercial banks that operate in Kenya and have foreign accounts, and the multinationals that have numerous accounts in foreign jurisdictions across the globe will be hit hardest. For the KRA, a win will mean a new avenue for revenue collection, and although the amount being claimed from KCB is just KES57m, a green light from the High Court will mean a more aggressive KRA that will pursue more money from nostro accounts held by the 45 commercial banks in Kenya.

At the heart of the suit also is whether royalties, in this particular case license fees for the use of software, are subject to withholding tax and most importantly whether payments for interest and other incidental charges levied on nostro accounts held by bank's outside Kenya are subject to withholding tax. A nostro account is an account that a bank holds with a foreign bank usually in the currency of the foreign country. This allows for easy cash management because currency does not need to be converted. The Income Tax Act states that where a resident person or a person having a permanent establishment in Kenya makes a payment to any other person in respect of a royalty, the amount thereof shall be deemed to be income was derived from Kenya.

According to documents filled in court, KCB argues that KRA had no power to tax its nostro accounts since as a bank, it only comes to know about the interest in its nostro account only after the correspondent bank abroad has sent a statement which is done on a quarterly basis. Under the circumstances, it is impossible for KCB to withhold the tax on money in a foreign jurisdiction. The tax authority on the other hand is arguing that KCB may not plead business impossibility of effecting the deduction of tax. KRA is arguing that KCB should have factored in the withholding tax when entering into contract with the correspondent banks in foreign jurisdictions.

The case stems from June 2001 when KCB entered into a software license and services agreement with Infosys Technologies Ltd of India, headquartered in Bangalore, India, a leading consulting and IT service solution provider. Infosys was to supply software equipment and other related services to KCB, and the terms of payment where generally described as either software license fees or service payments. KCB states that in the course of the agreement and before completion of its obligations under the agreement, Infosys from time to time raised invoices for settlement by KCB.

KCB settled the invoices, but treated the amounts that were being paid as deposits and not as payments for services rendered. KCB thus claims that on that basis, they treated such payments in its accounts as capital-work in progress. In May 2004, KCB decided to terminate the contract with Infosys and informed the revenue authority accordingly.

KRA claimed that withholding tax is applicable to the payment made to Infosys, whether the payment was made in total or partial fulfillment of the contract, and that the license fees paid in respect of the computer software constitutes royalties and are therefore subject to withholding tax. But KCB is arguing that withholding tax is not deductible from deposits paid to Infosys, more so since the payments were not for services rendered. The bank argues that KRA's claim would expose them to double taxation as the write offs in respect of the deposits paid are not allowable for tax purposes, being capital in nature.

In its documents filled in court, KCB states that it maintains accounts with correspondent banks abroad principally to facilitate its customer's transactions. When the accounts fall in debit balances, interest is levied. Other charges are also levied for operating accounts. KCB claims that it only comes to know about the interest payable for the period when the accounts are in debit once the correspondent bank has sent a statement and that tax charged on the interest on the deposits is charged outside the Kenya tax jurisdiction.

According to an audit done by Ernest and Young on KCB's deal with Infosys and presented to the Senior Deputy Commissioner of the Income Tax Department, Ernst and Young stated that in the year 2001, KCB incurred KES55.7m, capitalized in the company records. There was a resultant balance of KES287m that was carried forward in the Capital Working Progress Account and the same was reflected in KCB's balance sheet as at 31 December 2001 and carried forward to the year 2002 accounts. Ernst and Young stated that as a result of various core banking system transactions additions, transfers, write-offs and disposals the balance carried forward in the Capital Working Progress Account was KES307million: "From the foregoing, it is evident that amounts paid for the Infosys Project were treated as a deposit and capitalized."

However, the KRA did not agree with the report by Ernst and Young and as a result, the matter was taken to the Income Tax Local Committee to be decided upon. In August last year, the committee agreed with KRA's assessment and held that the correct practice in relation to nostro accounts was that the accounts attracted withholding tax. Similarly, the committee held that the payment to Infosy system was in respect of a royalty as defined in the Income Tax Act and therefore subject to withholding tax. The KCB's loss at the committee is what led to the current case in the High Court that is being heard before justice Lessit.  

KCB is, however, not the only bank that the KRA is after: Citi Group-Kenya is currently in negotiations with the revenue authority for an out-of-court settlement of over KES800m that the KRA is claiming. This particular case involves a foreign account Citi Group maintained with its subsidiary in Citi Group Brunei. The negations are expected to end this week. Since the introduction of performance contracts and revenue targets were introduced in 2003, the KRA has been extremely ambitious in collecting taxes to beat its revenues. Last year, it lost a KES1bn case against a local fortified wine marker, Keroche Industries, that it claimed had not been paying the requisite excise duty on its fortified wines. KRA is, however, appealing the High Court decision in the Court of Appeal.

Revenue collection by the KRA has been a major success under the Kibaki administration. Revenue collected increased from KES210bn in the financial year 2002/03 to KES376bn in the financial year 2006/07. While Kimunya had estimated last year that the total revenues collected would be Kes428 billion, this year he told parliament during the reading of the 2008/09 budget that KRA expected to exceed this target by KES19.9bn. Consequently, total likely revenue outturn for this year has been revised from KES428bn to KES448.8bn.

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