Do you plan your taxes before you invest or manage taxes after you have made a profit or accumulated wealth? The former is ideal and most recommended but rarely practised in Africa.
I recently sat with a friend who was very happy that his company had won its first international contract where they are going to earn a cool 30 per cent profit margin.
On further enquiry and evaluation of the tax implications, my friend was disappointed that due to lack of tax planning before executing the contract, his company will only realise less the 10 per cent net earnings. Simply because the client was from a country that levies 20 per cent withholding tax on the contract value.
To make matters worse, he had signed off on the tax obligations clauses with the client.
To add salt to the wound, Kenya does not have a double tax agreement with the country where the client was located, so his company was not even going to get the consolation of a tax relief of the tax withheld on its Kenyan tax obligations. Is there anything that he could have done differently if he had engaged a tax consultant, oh yes!
Importance of contract review for tax implications
If my friend had asked me for help to structure his contract, he probably would have saved a big portion of the tax leakages that have cost him a significant part of his hard-earned profit.
Contract review for tax implications can easily identify the required amendments to reduce the tax leakages that will arise if the contract is signed in its current form. There are clauses in contracts that would create permanent establishments in those countries that you are providing services or selling your goods.
Permanent establishments can lead to significant tax obligations in countries that you are doing business, but not incorporated or registered for tax. Some clauses will expose you to withholding taxes and sometimes at higher rates. Also, how you structure a contract could limit you from enjoying existing double tax treaty benefits.
The most common review of contract done for legal implications. Rarely is the tax review element considered.
Therefore, contract review for tax implication can help save a lot in taxes and your take-home profit or return on investment; hence helping you retain more money to either reinvest in the business or pay yourself.
Structuring to pay shareholders or project partners efficiently
After the hard work is done, how do I pay myself as shareholder in the most tax efficient way? Again, it is an after-thought with most businesses and often it is too late to restructure the business for tax efficiency.
When most people have a brilliant business idea, the first thing they do when they get together is to legalise their arrangement, they rush to call their lawyer and ask for incorporation of a limited liability company (LLC). There is no thought about the most tax friendly vehicle for executing their brilliant idea or big project.
There are more benefits for managing such kind of businesses under a limited liability partnership (LLP). But it is a rarely considered vehicle of executing projects or running our businesses.
How you structure financing of projects could also significantly affect the earnings of the shareholders or project partners. Debt financing or equity injection (both cash and in kind) should be evaluated in detail to identify the most tax efficient option.
Paying yourself through interest on loans you issue to your company could be significantly more tax-friendly than getting dividends on equity injection.
Every person who starts a business needs to think about the most tax-efficient way of paying themselves or tax-friendly option of reinvesting the profits.
Tax incentives for real estate sector
The majority of Kenyans now prefer real estate investments as a means of building wealth. There are a number of tax incentives available for the real estate sector that very few investors have taken advantage of.
One example is Real Estate Investment Trusts (Reits) which are exempted from income tax. It is a scheme that many real estate projects would qualify for after meeting the laid out requirements.
Another is investments into low cost housing projects that are subject to income tax at a reduced rate of 15 per cent instead of 30 per cent.
Location is key
In business, they say location is key to success. Sometimes the same applies to taxation. We often see big companies in manufacturing sector building big factories on the Nairobi side of the border of the capital city and Machakos county. However, for taxation purposes they are on the wrong side of the border.
A factory within the city or municipalities of Kisumu and Mombasa gets 100 per cent investment deduction while another outside these cities qualifies for 150 per cent investment deduction.
For example if two companies have built factories costing Sh4 billion each in Nairobi and Machakos, the owners of those two factories will realise different returns on their investments assuming all other factors remain constant.
The factory in Machakos will get an investment deduction of Sh6 billion while the one in Nairobi will get Sh4 billion investment deduction. The owner of the factory in Machakos will save Sh600 million (30 per cent of the additional investment of Sh2 billion) more in taxes than the owner of the factory in Nairobi.
What options do the employed have?
The structuring of your pay package and also the investments or savings decision made thereafter have significant tax implications. There are some schemes that if you invest or save into, you would qualify for deductions or relief from Pay-As-You-Earn (PAYE).
Unfortunately, employed people mostly invest or save through means that do not entitle them to a lot of the tax benefits available in our tax laws.
Even when they have opted for savings and investments options that have tax benefits, neither them nor their employers are aware of the tax deductions or reliefs that should be claimed. They end up overpaying PAYE.
Think about tax before signing on that dotted line
Information has come out that most of the valuable and reputable companies in the world have some of the lowest effective tax rates – some as low as three per cent. Did tax planning aid them in their journey of becoming the most valuable companies in the world? Your guess is as good as mine.
I cannot imagine that there is a prudent business owner who would not think about managing a cost that eats about at least 30 per cent of his profit. Tax just does that.
The examples given in this article highlights some of the many opportunities for managing the taxes on your investments to increase your returns and hence the value of your companies or wealth.
So, before you sign that contract or commence that project, stop and evaluate what are the tax implications and how you can structure the project or contract to maximise your returns after taxation.
Johnson Ngila Mutuku is Director at Stratton Consulting Limited.