Compensating tax was introduced to discourage companies distributing dividends while enjoying a tax holiday, but instead reinvest the profits in the business. PHOTO | FILE
Shareholders invest in entities with the expectation that they will receive periodic returns from their shares in the form of dividends distributions.
Other than share interest, corporations may also make distributions for other reasons, for example, where a shareholder is also an employee of a lender to the corporation. In such a case, the distribution may be made with respect to an employment or lender relationship.
Determining the tax consequences to both shareholders and corporations calls for a careful examination of all these distributions.
Where the shareholder wears more than one hat, a fact and circumstances analysis is necessary to distinguish distributions made with respect to his share interest (i.e. dividends) from payments.
There can be two types of distributions where one has a share interest in a corporation; a liquidating and a non-liquidating distribution. A non-liquidation distribution is one that is made to shareholders during the corporation’s lifetime.
The most common example is a simple pro rata cash distribution in which the amount of each shareholder’s distribution is determined according to their proportionate interest in the corporation.
These are usually paid from the corporation’s pool of “after-tax” earnings and profits. A liquidation distribution, on the other hand, is a non-dividend distribution made to shareholders who want to cash out of their investment in a corporation.
These are not paid solely out of the profits of the corporation, and can be viewed as a return of capital to the shareholders rather than only the earnings.
At the shareholder level, a non-liquidating distribution can produce a variety of tax consequences, including taxable dividend treatment, capital gain or loss, or a reduction in basis of shares.
At the corporate level, the corporation will be required to withhold tax and at the same time such a distribution may trigger corporate-level capital gain or compensating tax.
The corporate-level tax consequences of a non-liquidating corporate distribution depend on whether the distribution consists of cash or property (other than cash) and whether the corporation has any earnings and profits.
Jurisdictions with more progressive capital gains tax laws look at non-liquidation distributions in three distinct parts. First, there is the portion of the distribution that is considered dividend income in the shareholders’ hands and which the corporation is required to withholding tax when making payment.
Where the distribution exceeds the earnings and profit, the second portion is applied against and reduces the value of shareholders’ interest (but not below zero).
Finally, any remaining portion should be treated as a capital gain or loss from disposal of the shareholders’ shares in the corporation.
Let me illustrate this using numbers. John invests in shares worth Sh200,000 in a corporation and after a few years receives Sh2 million in a non-liquidation distribution from the corporation’s “after-tax” pool of earnings and profits which stands at Sh1 million.
The tax consequences of this payment is such that countries follow this three-step trilogy. The first Sh1 million amounts to a dividend paid to John which will be subject to withholding tax (it is assumed that the entire earnings and profits pool was paid to John with respect to his shareholding interest); the next Sh200,000 is a return of John’s capital investment, which is not subject to tax and since John should not receive more than his investment back tax-free, the remaining Sh800,000 is a capital gain.
In Kenya, however, the practice is different. The entire Sh2 million would be treated as dividend paid to John, which is subject to withholding tax (except under share buy-back, reduction of capital or liquidation where the Sh200,000 would be excluded).
In Kenya, the corporation would be subject to compensating tax where the distribution is made from “before-tax” earning and profits or untaxed capital gains.
This arises where the corporation incurs substantial capital expenditure on which it claims tax depreciation at rates that are more favourable compared to those used for accounting purpose.
Due to differences in these rates, such an entity will probably have an accounting profit but will likely be in a tax loss position with no corporate tax to pay or have much lower taxable profits.
A non-liquidating distribution by such a company to its shareholders from its ‘before-tax’ profits would trigger both withholding tax and compensating tax at the rate of 42.8 per cent.
This provision normally often plagues corporations during their initial years of operations, or those with significant capital expenditure.
Fortunately, compensating tax can avoided by deferring any non-liquidation distribution to a time when the corporation has an ‘after-tax’ earnings and profits.
Compensating tax was introduced to discourage companies distributing dividends while enjoying a tax holiday, but instead reinvest the profits in the business.
Given the ideal trilogy that non-liquidating distributions should ideally follow in determining the tax consequences of a distribution, it is perhaps time the government considered abolishing compensating tax.
It is often the case that jurisdictions with capital gains tax do not have compensating tax. Indeed, compensating tax was introduced as a disguised tax on capital gains tax when capital gains tax was suspended.
