Why Treasury must aim for fair capital gains tax regime

The government is once again showing determination to increase its share of revenue from owners of capital with the publication of proposed changes to the capital gains tax (CGT).

The proposal to increase the tax rate from five per cent to 20 per cent in the next financial year has elicited multiple reactions from various stakeholders.

CGT is not a new tax in Kenya. It was re-introduced five years ago, after close to a 30-year break, in response to improved rate of economic growth and the ever rising revenue targets and public expenditure obligations that have to be financed.

The Treasury is selling the proposed changes to the tax system as a deliberate move aimed at widening the tax base and increasing revenue to fund President Uhuru Kenyatta’s Big Four agenda.

Besides, there is also the quest to tax wealth in line with international best practice of an equitable tax system.

Kenya’s Income Tax Act defines capital gains tax as ‘a tax chargeable on the gain accruing to a company or an individual on or after January 1, 2015 during the transfer of property situated in Kenya, whether or not the property was acquired before January 1, 2015.’

The taxable amount is arrived at by deducting the initial cost of the asset from the sales proceeds.

This law is rooted in the fact that the market value of an asset often increases over time such that when disposed of, a capital gain is realised.

The reality, however, is that when the value of an asset increases, only a fraction of the increase is due to actual appreciation of the asset.

The rest of the increase is attributable to inflation. A tax on the entire gain without isolating the two sources of increase in value essentially means that tax authorities impose tax on inflation, which is punitive on the investor.

The proposed CGT rules have, however, been a positive step in that they consider the impact of inflation on the assets.

The proposal involves adopting an indexation adjustment as a methodology in determining the fair value taxable gain.

Indexation is an adjustment to the capital gains calculation to eliminate the effect of inflation using the consumer price index (CPI).

So profoundly significant is this approach that in some cases, calculations have reduced the amount of CGT assessed by half when the effect of inflation is eliminated.

Globally, the UK, Australia and Uganda are examples of economies that have successfully implemented indexation allowance.

Kenya’s latest attempt is therefore a positive attempt at aligning the country with international best practice.

There are, however, some instances where the Treasury missed a valuable opportunity to align CGT with international best practice.

An example is in the definition of what constitutes a transfer. The law stipulates that a transfer will include, among other things, ‘abandonment, surrender, cancellation or forfeiture or the expiration of substantially all rights to, property, including the surrender of shares or debentures or the dissolution of a company’.

Generally, the decision to abandon an asset is normally based on the premise that pursuing the asset would not derive sufficient economic benefit to justify proceeding with its pursuit.

Imposing a CGT charge when this economic decision has been made is questionable and needs a fresh look with a view to repealing it.

There is also the very punitive aspect in the proposed repeal of the concept of ‘adjusted cost’.

With the proposed elimination of the Eighth Schedule, there will be no explicit provision in law to cater for improvements when taxing the gain on disposal.

Without isolating the effect of the cost of improvements, a proportion of what will be charged to tax, is the improvement cost.

The proposed legislation, however, states that ‘any other costs that are just and reasonable’ will be deductible.

What this means practically may be subject to interpretation and controversy between taxpayers and the Kenya Revenue Authority (KRA).

It will be prudent for the Treasury to unambiguously include costs of improvements as deductible expenses when computing the taxable capital gain.

Kuria is a Tax Advisor at KPMG Advisory Services Limited.

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