Kenya’s Exchequer crossed into the New Year with a wider net following the introduction of a number of taxes, including a digital services tax.
It’s been argued that the digital services tax is retrogressive to the Kenya’s digital ambitions and its quest to be the continent’s innovation hub. On the other hand, the government contends that the tax is designed to achieve fairness in taxation by limiting the amount of untaxed outflows by foreign digital companies operating in Kenya. But is it possible to spur innovation in Kenya by having a favourable tax regime while achieving fairness in taxation?
There have been a number of efforts to enhance tax incentives in favour of technology startups and businesses in Kenya. The Startups Bill, 2020, sponsored by Senator Johnson Sakaja, provides that the Cabinet Secretary (CS) of Information Communications and Technology shall in consultation with the the Treasury CS put in place measures for the granting of fiscal incentives, including tax incentives for the development of startups in Kenya. In addition, the Building Bridges Initiative (BBI) taskforce report has recommended a tax policy that gives incentives for value creation, innovation and investment over value creation.
Whereas the recent numbers from the Treasury may lead to a preliminary conclusion that there is little or no fiscal room to accommodate tax incentives on account of lower tax collections for the Exchequer, a targeted tax incentive framework for the innovation space is worth considering.
The role of innovation in Kenya’s economic development could be significant as it will likely lead to increased value creation, employment opportunities, and enhanced competitiveness that benefits Kenyan consumers and increased standards of living. In addition, if the growth trajectory of the big technology companies is anything to go by, the innovation space could in the long term result in increased tax collections.
A key factor in fostering innovation is a country’s legal system for the protection of intellectual property rights (IPRs). IPRs encourage innovation by granting successful inventors temporary and limited monopoly power over their innovations. The resulting profits generate the returns on the successful investment in research and development (R&D), which must be large enough to compensate for the nvestment that is unsuccessful. IPRs are therefore an appropriate incentive for investing in R&D that leads to innovation.
Arguably, Kenya has a robust legal framework for the protection of IPRs that SMEs and innovative startups could take advantage of. Of course there is more to be done in terms of training and creation of awareness about the existing protections.
So, what is the economic ecosystem around IPRs? If a business successfully creates and registers a patent/utility model in Kenya, it could commercialise it by licensing it or granting a right to use it, absolutely transfer or sell it to another business or sell products and services embedded by that IPR.
On the other hand, that business most likely incurred significant capital costs such as R&D costs in developing the patent/utility model and getting it to market. A legal system for the protection of IPRs provides a business with the exclusivity and limited monopoly over the IPR that the business can commercialise to recoup the investment and generate profits.
However, the period between the R&D process, obtaining legal protection (where applicable), commercialising the IPR and recouping the investment can be lengthy and a tax incentive framework that lessens that period could be advantageous. Kenya could legislate an innovation or patent box that will enable inventors and investors to recoup their investments and profit off inventions at a faster pace.
An innovation or patent box is a preferential tax regime that allows businesses to apply a lower tax rate to the income earned from commercialising their IPRs. For example, if a business licenses out its patent and receives a licence fee, it would be allowed to charge that income to a lower rate of income tax instead of the applicable rate. Although the introduction of the minimum tax could make such an incentive redundant, the IPR-generated income could be exempted and subjected to the specified lower income tax rate under the IPR regime.
Currently, Kenya has adopted an input-based approach with respect to tax incentives for IPRs, as it allows a business to deduct expenditure incurred on scientific research — defined as activities in the fields of natural or applied science for the extension of human knowledge. This is a limited definition that carves out many of today’s technological innovations. Unlike the current input-based approach, an innovation box targets successful R&D activities that result in commercially viable products as the special tax rate would only apply to the income generated by the IPR. It essentially conditions the tax incentive on the success of the innovative activity.
If Kenya legislated an innovation box, it would allow resident innovators to subject income earned from their IPRs whether as royalties or from the sale of products embedded with the IPRs to a lower income tax rate. This could be implemented by requiring businesses to separate their IPR-related income from other income and subjecting the two income categories to the respective tax rates and regimes.
To ensure that the innovation box is not used as a tax avoidance scheme, we could limit the tax incentive to companies that actually incur the R&D cost for the IPRs, or exclusively acquired an IPR or significantly contributed to the development of the IPR — what is referred to as a nexus approach.
An innovation box would promote investment in innovative activities, limit tax-motivated income shifting out of the country, increase tax-motivated income shifting into the country, attract mobile IPR income and R&D activities in the country. In addition, it would lead to an increase in the quality of products or services, increased need for skilled jobs and an increase in IPR registration applications.
Ndegwa is a corporate/commercial & tax lawyer