Why indexation on capital gains is necessary

The Minister tabled the Finance Bill several days ago which included the announcement of proposed changes to the Capital Gains Tax (CGT) regime in Kenya. The minister proposed a rise in CGT from five percent to 12.5 percent. The rise in the tax was expected as Kenya has maintained a low rate compared to the rest of the region. Uganda and Rwanda, for example, apply CGT rates of 30 percent.

The proposed change is a deliberate move to widen the tax base thereby increasing revenue to fund President Uhuru Kenyatta’s Big 4 agenda, as well as a move to tax wealth, which is aligned with international best practice of an equitable tax system.

The Income Tax Act defines capital gains tax (CGT) as ‘a tax chargeable on the gain accruing to a company or an individual on or after January 1, 2015 on 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.

Often, the market value of an asset increases over time such that when disposed, a capital gain is realised. However, the reality 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 proposal is therefore heavy-handed as it failed to take into consideration the impact of inflation on the assets. Treasury should have considered adopting an indexation adjustment as a methodology in determining the fair value to tax.

Indexation is an adjustment to the capital gains calculation to eliminate the effect of inflation using the Consumer Price Index (CPI), which is an indicator for inflation in the economy.

The writer is Senior Tax Advisor with KPMG Advisory Services Limited.