The distinction between capital gains and trading gains for tax purposes has been a bone of contention between tax payers and the Kenya Revenue Authority (KRA).
The importance of distinguishing between the two is the underlying tax rate. Capital gains attract tax at the rate of five per cent while trading gains attract corporate tax at a higher rate of 30 per cent.
Due to the higher tax yield resulting from corporate tax, the KRA is often inclined towards making corporation tax assessments whenever a tax payer, especially a company, has sold property.
In the recent past, the KRA has made numerous erroneous assessments relating to sale of real estate property by companies. However, most of these have been successfully challenged at the Tax Appeals Tribunal by the aggrieved tax payers.
The line between capital gains and trading gains is thin. It is determined by the type of gains accrued on disposal of property, which is more of a question of fact than law.
The subsisting legal provisions do not draw the line between trading and capital gains and the classification is heavily dependent on analogous interpretation of the relevant provisions of the law as well as accounting standards and international best practices.
Over time, judicial precedents and practice has led to evolution of a criteria for classification of gains accruing from the sale of property. This criteria, dubbed badges of trade, can be traced back to the Common Law and its application has gained universal acceptance in many jurisdictions.
The badges of trade provide a multifaceted approach based on the inherent characteristics of the transaction and the circumstances surrounding it.
The first issue to look at is whether there was a profit motive in disposing the property. If the intention of the sale was to make a profit, then the gains realised are considered to be trading gains as opposed to capital gains.
The motive can be inferred from the reasons for the sale. A proper reason for sale, save for profits can negate corporation tax assessment.
Secondly, the frequency of similar transactions determines if the sale is a habitual exercise. If the person has made other similar transactions in the past then the trend is perceived to be of a trading nature, hence a trading gain.
Thirdly, the nature of financing in acquisition of the property helps in determining the intention of the tax payer. The general assumption is that if the asset was acquired though long-term financing, then the intention was not to resale it for profit. However, short-term financing connotes intention to dispose the property due to the associated costs.
Fourthly, modification of tangible property before the sale indicates a trading motive. If modification is done to the asset with the intention to make the asset salable or fetch better value in the market, then it is deemed to be a trading gain.
Fifthly, the length of ownership of the property is also considered. The shorter the duration of ownership, the more likely its sale would be deemed to be of a trading nature. Disposal of property held for a long duration of time is likely to be deemed a capital disposal.
Lastly, the principal activities of the company are also paramount in determining the nature of the sale. For investment holding companies, gains from sale of a property are deemed as capital while for investment dealing companies, the gains accrued are considered trading gains.
In conclusion, one has to consider all the factors surrounding the sale transaction to be able to correctly classify the gains realised.
Even so, this criteria is heavily subjective and is largely dependent on the supporting documentation and evidence.
Samuel Kioko is Senior tax associate at KN Law LLP.