Let’s tap intangible assets to broaden revenue base

In recent years, there can be no denying that the knowledge economy has and continues to triumph over the industrial economy.

The knowledge economy is characterised by an accumulation of intangible assets, whose value has exceeded capital assets in leading firms around the world.

Intangible assets are identifiable, non-monetary holdings without a physical substance but grant their owners certain rights and huge economic benefits.

Unlike capital assets, intangible assets are not diminished by use. They are non-rival, have non-linear returns and often benefit from legal protection.

Contract-related intellectual properties such as licensing and royalty agreements, and technologies such as software and designs, are the most renowned intangible assets. But there are other classes, including non-contractual customer relationships, and digital assets, among others.

In the changing terrain, it is only wide that business entities leverage on growing wealth of intangibles to maximise their returns.

Similarly, governments deserve a pie of the boom through taxation.

Unfortunately, Kenya like many other emerging economies is yet to find mechanisms of tapping intangibles to broaden its revenue base. This is partly because the interdependency between intangible assets and taxation remains a complex affair.

Physical limitations, which have long defined traditional taxation concepts, are inapplicable. In Kenya, for instance, the tax regime is yet to be aligned with the growth of digital and knowledge economy.

The main form of extracting tax from intangibles is through royalties. But this is insufficient. To optimise revenue collection, necessary reforms are required in the entire supportive framework.

READ: Kenyans face hurdles in search for intellectual property rights

The Constitution defines the term ‘property’ to include ‘intellectual properties’ and ‘choses in action.’ Further, the country has enacted the Movable Securities Assets Act, 2017, which enables collateralisation of intangible assets for use as collateral in borrowings.

The accounting for intangible assets is in accordance with International Accounting Standard (IAS) 38. This standard provides guidance on recognition, acquisition and measurement of intangible assets. The criterion for recognition is the expected future economic benefits flowing to the entity is attributable to the asset and the cost of the intangible that can be measured reliably.

Unfortunately, Kenya remains without a uniform framework for valuation of intangibles.

The International Valuation Standards Council, a standards organisation, has developed International valuation standards (IVS) 210 to guide in the valuation of intangible assets, which Kenya could adopt.

The IVS 210 outlines approach to valuing intangible assets. These include the income approach that considers the net present value of future benefits from the intangible, the market approach that considers a fair value of an intangible in case of an outright sale, and the cost approach where intangible assets are valued on the basis of their ‘cost to create’.

Appropriate valuation is critical to determining a fair value of an intangible asset. This is useful not only for tax reporting reasons, but also for financial reporting, quantifying damages in litigation, and evaluating prospects of business combinations.

Tax treatment of intangibles, just like tangible assets, depends on who owns the asset, who makes the payment, and the nature of activity it is employed for.

As earlier observed, Kenya has no bespoke provisions for taxing intangibles. Further, there are no specific tax incentives extended to creators of these assets. Under the Income Tax Act, intangibles are charged to tax in three provisions.

First, on gains or profits accruing from a right granted in the use of these properties.

Second, there is a tax on the person who makes payment in respect of “a royalty or natural resource income.”

Lastly, there is withholding tax on payment of royalties. Royalties are outlined as a specific source of income, meaning taxes from them are computed separately from other incomes. In addition, double taxation treaties applicable in the country have provisions on taxation of royalties in cross-border transactions.

Intangibles, being properties like any other, attract capital gains tax on adjusted gains in event of their disposal. Unfortunately, there being no standard valuation models, it is difficult for the revenue authority to enforce capital gains on them, especially in a transaction where parties put their value at peppercorn.

This equally affects the payment of stamp duty, levied on the instrument of conveyance and computed based on value. The Stamp Duty Act was enacted in 1958 with token amendments over the years. It needs to be aligned with the knowledge economy.

The Excise Duty Act does not classify creating intangibles as a ‘manufacture’ and therefore, no excise duty is levied on them.

The use of intangible assets by multinationals, majorly through manipulation of transfer pricing, to avoid taxes has become rampant.

Global firms are creating complex corporate structures with entities in low tax jurisdictions to hold their intangible assets, which they lease to other intermediate and ultimate entities at inflated periodic royalty payments.

Regulating transfer pricing on intangibles remains a big challenge. The main difficulty is in applying the arm’s length principle as the case with tangible assets.

In fact, transfer pricing on intangibles is one of the action plans under the OECD base erosion and profit shifting project. Kenya needs to update her 2006 transfer pricing regulations to provide guidance on the definition, identification and characterisation of intangibles related transactions and the application of arm’s length principle.

The conclusion we must derive from this is that Kenya, as well as other emerging economies, needs to tap the new assets presented in the knowledge economy, to get more revenue. This can be achieved through the creation of supportive policy and legal framework.

Loopholes multinationals exploit by using intangibles to avoid taxes need to be sealed.

Further, the industry needs to be incentive to grow. For instance, research and development costs in the creation of intangibles could be capitalised and routine expenses incurred to be treated as tax allowable. Accounting rules only provide for recognition and impairment of goodwill.

Similar guidelines ought to be extended to the spectrum of other intangibles to provide for tax amortisation relief. Such reforms will boost continued development of intangible assets industry and the knowledge economy, and further, create a revenue stream which government would tap by way of taxation.