Globally, withholding tax is a mechanism where the recipients of qualifying goods and services are required to deduct a percentage of income tax at source on payments made to their suppliers and remit this to the revenue authority as an agent.
Generally, there are three principal objectives, which inform the reasons why countries operate a withholding tax mechanism.
First, it provides an avenue for boosting government cash flows as an advance tax payment. Where withholding tax is not final, as is the case for qualifying dividends in Kenya, the amount withheld is available as a tax credit, which may be utilised to fully or partly offset a taxpayer’s instalment or balance of tax obligations.
Second, for countries which operate a source-based taxation model like Kenya, withholding tax allows all income derived from that country, even if the individuals do not have a presence in it, to be taxed.
Simply put, source-based taxation model means that for any income to be subjected to taxation, it must have been derived or accrued from the country where the economic activities are undertaken to derive it happened.
Finally, withholding tax is used to protect a country’s tax base from erosion by multinational enterprises through treaty shopping.
Treaty shopping is where multinationals establish entities and channel income to jurisdictions with low tax rates or no tax to take advantage of the treaties that these countries have signed with the income source countries.
To mitigate this, various countries have adopted different mechanisms. They have done this primarily by way of including in their tax treaties with other countries, certain rules that limit the benefit each country receives in certain circumstances. For example, Kenya has adopted rules which are typically called Limitation of Benefits (LoB).
In Kenya, withholding tax is largely applicable on income derived or accrued in the country by both resident and non-resident persons.
Such income includes dividends, interest, royalties, rent, professional and management fee.
Additionally, in Kenya, unlike other jurisdictions such as Ethiopia, withholding tax is not applicable to the supply of goods. For non-residents, withholding tax may not be applicable on certain streams of income if an operational tax treaty between Kenya and the other contracting state explicitly excludes such income from withholding tax by shifting the taxing right from one State to the other to avoid double taxation.
However, the Finance Bill, 2019 proposes to widen the withholding tax base by including incomes derived from security services, cleaning and fumigation, catering services offered outside hotel premises, transportation of goods excluding air transport services, sales and promotion, marketing and advertising services within the withholding ambit.
The proposed changes are likely to become effective from October 1. As such, these services shall be subject to withholding tax at the rate of five percent for resident persons and 20 per cent for non-residents respectively where there is no operational tax treaty between Kenya and the country where the non-resident person resides. However, preferential rates may apply where there exists a tax treaty.
This proposition is ultimately meant to enhance the level of compliance by bringing most of the suppliers of the said routine services within the tax net.
Evidently, the majority of suppliers of these services operate within the micro, small and medium-sized enterprises (MSMEs) space. Various initiatives to bring the MSMEs within the tax net have to a great extent not been fruitful.
However, with this initiative, once MSMEs income is subjected to withholding tax and the recipient of the services accounts for it through the iTax platform, the MSMEs have to declare this income when they file their returns. Consequently, this will enhance their level of compliance as well as shore up the tax revenues.
Despite the noble objective of widening the tax base as well as enhancing the level of compliance particularly in the elusive MSMEs sector, the proposed changes will be administratively onerous to the recipients of these services who are expected to deduct and remit the tax to the Kenya Revenue Authority (KRA).
This is further aggravated by the fact that if the recipients of the services do not comply with their agency obligations, then the KRA will collect the principal withholding tax in question including penalties and interest from them, thereby legally shifting the tax burden.
To alleviate this burden, we expect a legislative change when the tax Bill is debated to introduce a minimum payment threshold of Sh24,000 per month for the local supply of these services to qualify for withholding tax. This will align it with the applicable withholding tax obligation threshold on the local supply of professional or management services.
The writer is senior manager in the tax and regulatory services department at KPMG Advisory Services Limited.