Financial derivatives the new frontier in tax base expansionMonday September 19 2022
Trading in financial derivatives is increasingly growing as an integral part of the financial market. There has been significant growth and development of the derivatives market in the world in the last three decades.
In Kenya, the Nairobi Securities Exchange Derivatives Market was launched on July 4, 2019, with the aim of facilitating the trading of future contracts on the Kenyan market. The market operates in compliance with the Capital Markets (Derivative Market) Regulations Act of 2015.
What exactly are financial derivatives and why all the interest on them from both a business and government revenue generation standpoint at this time? Simply put, financial derivative is an instrument whose value depends on its underlying asset. It is primarily a business risk or volatility management tool.
The outcome of a financial derivative is a transfer or exchange of cash flows at defined future points in time. Specifically, financial derivative instrument is used to hedge or reduce exposure to market variables such as interest rates, share values, bond prices, currency exchange rates and commodity prices.
The simplest form of a financial derivative is a forward contract. Traders and investors who wish to manage their risk exposure use forward contracts. Often used to hedge against price fluctuations, forwards are traded over the counter and are characterised by the actual delivery of the underlying asset at a predetermined date.
The second category of a financial derivative is a future contract. Under this contract, one party agrees to sell to the other party on a specified future date, a specified asset at a price agreed at the time of the contract and payable at the maturity date. The agreed price is called “strike price”.
The main difference between a future and a forward contract is that futures are usually settled by the payment of the difference between the strike price and the market price on the fixed future date, and there is no physical delivery. Further, futures are traded on an organised market (e.g. the Nairobi Securities Exchange Derivatives Market).
The third category is the option contracts. Option contracts give a right, but not an obligation to the buyer or seller to buy or sell an underlying asset on the date of exercising the option. There are two types of options; a “put” option and a “call” option.
A “put” option is a right, but not an obligation to sell an asset in future at a predetermined price. Conversely, a “call” option is a right, but not an obligation to buy an asset in future at a predetermined price. The buyer of an option has to pay a premium for purchasing an option.
Therefore, the maximum loss that a buyer of an option may suffer is the amount of premium paid. On the other hand, the seller of an option has unlimited risks because the buyer can by exercising his option insist on performance.
The last category of financial derivatives is a swap contract. This refers to a contract whereby parties agree to exchange obligations that each of them have under their respective underlying assets. There are largely two types; interest rate swap and currency swap contracts.
As already mentioned, the Finance Act 2022 introduced taxation of gains accrued or derived from Kenya from financial derivatives by non-resident persons.
The amendment is indeed a very positive development for Kenya as it provides a good platform to deepen the tax base and spread the burden of tax across the tax-paying public; both residents and non-residents who derive or accrue income from Kenya.
To allow for growth in the nascent financial derivatives market, the Finance Act has exempted gains arising from transactions in the Nairobi Exchange Derivatives Market.
Kenya joins a host of other jurisdictions that have introduced provisions to bring to tax gains from derivative transactions. These include; United Kingdom, Brazil, US, India and Belgium among others.
It is important for both the tax administration and practitioners to note that taxation of financial derivatives is as complex as the transaction itself. The issue of the existing double taxation agreements will definitely be a debatable issue as the country progresses towards implementation of the new provision.
Going forward the treaty negotiation teams should take focus on this and ensure clarity on the instruments without losing the taxing rights.
In conclusion, it is a fact that derivative transactions are still in nascent stages, not only in Kenya but also in all developing countries. There are few or no precedents on the subject. However, businesses have recognised the importance of risk management role that financial derivatives play in businesses generally.
Kenya’s effort to trailblaze on this by developing appropriate legislation and infrastructure to support the growth of this sector is commendable.
The writer is Deputy Commissioner, Corporate Policy, Kenya Revenue Authority (KRA)
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