They are set between two or more parties and can be traded on a securities exchange or over the counter (OTC).
Derivatives at an exchange are traded and settled in a recognised futures exchange such as the London Metals Exchange or the Nairobi Securities Exchange.
OTC derivatives, on the other hand, are bi-laterally traded derivatives between two counterparties.
The counterparties assign each other limits and sign an International Swaps & Derivatives Association agreement, Credit Support Annex and any other agreements that allow for bilateral trade.
The financial market space in Kenya is dominated by OTC derivatives.
This also forms the main focus of the proposed tax.
The expansion of Kenyan banks in East Africa has seen most of the traded derivatives centrally managed out of Kenya.
This has complemented the efforts of Nairobi International Financial Centre to make the city a financial hub.
The central advantage that Kenya has is Nairobi being perceived as a financial powerhouse driving commodity trading such as Robusta coffee from Rwanda, copper from the Democratic Republic of Congo and gold from Tanzania, among others.
These trades are mostly pushed through Kenya. The taxation of such transactions will inevitably impact future trades. The pricing will have to include any resultant tax obligations.
From a regional perspective, this tax cost will be passed to the non-resident regional banks, making any derivative contracts uneconomical.
To cover any trading risks, the regional non-resident banks in wider East Africa, who provide reasonable derivative income and business to their Kenyan parent banks, will have to get alternative hedging counterparties where a similar tax is not applicable, including London, Johannesburg and Dubai.
This effectively transfers the corporate income tax from margins currently being accrued in Kenya to these other countries.
Practical Uses of Derivatives
Derivatives are the equivalent of insurance policies for businesses and trades. The best examples would be as listed in the cases below:
Case 1: Oil prices in 2021 crushed to lows of $20/barrel. Consumers of oil had the opportunity to lock in these prices for up to 5 years using derivative contracts while guarding against the financial pains of the crush.
Case 2: Following the buildup of Russia’s invasion of Ukraine in January 2021, wheat-importing entities/countries had the opportunity to lock in purchases of wheat contracts at $ 300/MT.
Prices eventually reached highs of $ 400/MT by March 2021 resulting in higher costs of food items.
Case 3: Coffee prices have been trading at multi-year highs over the last 2 years due to bad weather in Brazil, a major global producer, and local farmers have been enjoying these high prices.
The tables have now turned as Brazil is making a comeback. Prices are now falling. Coffee exporters had the opportunity to lock in prices and ensure good FX flows through derivatives.
The impact of derivatives is endless and cuts across various asset classes that touch specific elements of our daily lives, including Forex and related costs or savings, Interest Rates and the related costs or savings and Commodity and food prices.
The Derivatives Market and the Implication of Taxation
Income Tax (Financial Derivatives) Regulations
Whilst principles of taxation require, amongst others, that the tax should be fair and certain, the Regulations have defined more of the financial derivatives, but not so much on the actual mechanics of taxing the gains.
It is therefore not clear how this new provision, which is going to be effective in slightly over one month, will be implemented.
It is appreciated that “kulipa ushuru ni kujitegemea,” would be prudent for the regulators to facilitate the compliance of a taxpayer by ensuring clarity and certainty of the arising tax obligations.
This would include what gains are deemed to be in a typical derivative transaction.
There are derivative structures that are priced as zero-cost, some have accumulator or extinguishing features and others have inherent complexities that only traders can break down.
The draft Regulations have also made significant assumptions such as deeming a local loss as the equivalent of a corresponding gain to the non-resident.
They have also inadvertently deemed premiums and other payments as gains for purpose of this new tax alongside a myriad of other issues.
This is likely to complicate the pricing of financial instruments in Kenya vis-à-vis international norms. For instance, a commodity trade being settled with an international bank based in London would require the Kenyan bank to withhold tax before making any payment to the counterparty.
In the alternative, the Kenyan bank would have to bear this tax based on the ISDA terms and conditions for trading.
This pricing model would be new for any global counterparty. Kenya is struggling to make a name for itself in the international financial markets – it is still not a Netting Jurisdiction under ISDA Agreements, the legal document that governs derivatives.
The focus should shift to passing laws to facilitate and make trading in financial instruments with Kenyan counterparties “cleaner,” easier, and cheaper.
The proposed Tax is likely to alienate Kenya further from the rest of the international financial markets.
It is understandable that Tax Revenues should be generated; however, taxing the actual flow of derivative transactions is equal to killing the goose that is expected to lay the golden egg, i.e. it’s a risk on Corporate Income Tax.
The focus should be on creating an enabling environment in line with international market standards, passing netting laws and encouraging regional consolidation of the derivative trades.
It is anticipated that OTC derivative business will take a pause in 2023, especially given that International Counterparties fall in the non-resident bracket - and so will the expected CIT equally reduce.
Maina is a financial analyst.
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