INTRODUCTION TO TAXATION &EMPLOYMENT INCOME DEFINATION OF TAX Tax is compulsory contribution by citizens (tax payers) to the government /state for it to fund public expenditure such as; education, security, health and sanitation, roads for the benefit of all the people in that state. Characteristics of tax
Compulsory- where it is levied one is expected to pay. Levied on income and expenditure There is no direct benefit expected by the tax payer. Penalties are imposed on tax evaders i.e. it is an offence to evade tax. Purpose for taxation • • • •
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Raising revenue-the primary objective of taxes is to generate revenue to divert control of economic resources from tax payers to the government for its direct utilization for provision of essential services.
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Fair distribution of income-this is done partly trough the tax rates. the rich pay taxes at higher rates compared to the poor in order to provide essential services to all
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Achieve economic stability-taxes can be used as a tool of fiscal policy i.e. where the government uses deliberate expenditure patterns to steer the economy in a given direction and revenue generation to achieve intended economic objectives. During inflation the tax rates are raised to reduce the amount of money in circulation while during deflation the tax rates are reduced.
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Protection and development of local industries -the government gives generous tax allowances (tax incentives and holidays) to certain industries of national priorities within different sectors of the economy e.g. capital allowances are granted for capital expenditure on building and machinery.
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Discourage production and consumption of certain products -in order for the government to prohibit certain actions, it imposes high taxes on certain products such as beer and cigarettes, luxury goods in order to discourage their production and consumption Encourage production of exports hence generation of foreign currencies -producers of goods for export enjoy better tax terms as compared to those who produce for local consumption.e.g EPZ industries does not pay tax for the first ten years, a modest of 25% for the next ten years and they are zero rated for VAT purposes.
Encourage saving and investment-income from savings and and investment is taxed only once. This encourages people to save and invest which creates capital for growth and investment. Canons/ principles of a good tax system •
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Equity-tax payers should be treated fairly and no one should escape his tax liability and let others meet the social cost for him. We have two types of equity; horizontal and vertical equity. In horizontal equity all people in the same tax bracket should be treated equally i.e. pay the same amount of tax. In vertical equity those people in different tax brackets should be treated proportionately unequally.
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Certainty-tax system should leave no doubt as who to pay taxes, how much and when to pay taxes; this makes it more acceptable to the tax payers. The government should also be in a position to predict tax revenues for budgeting purposes. Lack of certainty gives room for malpractices and bribery.
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Economical- the cost involved in the collection of taxes should not outweigh the revenue collected. Convenience-the tax payer should be asked asked to pay taxes in the most convenient manner manner possible.i.e when they have money ,a tax system is said to be convenient when the taxes are paid in small installments as opposed to lump sum payments
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Simplicity-taxes should be simple enough in order to ensure that everyone understands what they are required to pay and how much. The implementers should also be in a position to understand it.
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Productivity-the tax payer should be aware that the taxes they pay is put in productive use.
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Elasticity-a good tax system should be easily adjustable depending on the prevailing economic situation. Tax laws should be easily amendable and also the tax rates. Classification of taxes A) According impact and incidence Impact of tax refers to the person on whom tax is imposed while incidence refers to the person who ultimately bears the tax burden.under this we have: 1) Direct taxes-where the impact and the incidence is on one person e.g. income tax and corporation tax •
2) Indirect taxes- where the impact and incidence is on different persons e.g. VAT, import duty excise duty etc b) According to base of tax -this refers to the item on which tax is imposed. Taxes are calculated as a given percentage of some Value say X, e.g. 10% of X ,where X is the base. Under this we have: 1) Income tax- levied on incomes 2) VAT- Levied on value added on goods and services 3) Corporation tax – levied on corporation profits/gains 4) Import duty –levied on imported goods c) According to rates –rate is the percentage of the tax to the base of that tax, e.g Y % of 100, 000, where x is the tax rate. Under this we have: 1) Proportional tax-tax whose rate structure is such that after exempting threshold levels(low incomes) it takes away a constant percentage as income increases,i.e the rate does not change regardless of the income level. Income SH. 12000 14000 15000 20000
Tax rate % 10 10 10 10
Tax amount SH. 1200 1400 1500 2000
increase in income % 16.6 7.14 33.3
increase in tax % 16.6 7.14 33.3
2) Progressive tax-tax whose rate structure is such that after exempting the low income levels it takes away an increasing percentage as the income increases. Income Tax rate Tax amount increase in income increase in tax SH % SH % % 12000 10.0 1200 14000 10.4 1456 16.6 21.3 15000 10.8 1620 7.14 11.3 20000 11.2 2240 33.3 38.3 N/B The percentage increase in tax is higher than the percentage increase in income.
3) Regressive tax - tax whose rate structure is such that after exempting the low incomes it takes away a decreasing percentage as the income increases.
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Income tax rate SH % 12000 10.0 14000 9.4 15000 9.0 20000 7.4 Digressive tax - tax whose rate structure is such that after exempting low income levels, it takes away an increasing percentage just as the progressive taxes, however the percentage increase in taxes lags behind the percentage increase in income. The tax rate increase is mild and may reach a point and stagnate. Income Tax rate
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12000 14000 15000 20000
10.0 10.1 10.2 10.2
Advantages of direct taxes •
Equitable-where progressive rates are used, direct taxes are more equitable as those with high incomes pay taxes at higher rates compared to those with low incomes
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Reduces income inequalities-when the rich pay more taxes than the poor with no option of transferring the burden, this reduces the gap between the rich and the poor.
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Economical- most of these taxes are collected at the source/pay point which reduces their levying costs
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Certain-the tax payers are aware of their tax liabilities and the government can also predict easily the amount of tax revenue to be collected.
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Simple-direct taxes are easy and simple to understand both by the taxpayers and the implementers.
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Creates awareness among tax payers -so that they become interested in government issues and know whether the funds are utilized efficiently.
Disadvantages of direct taxes •
Unpopular with tax payers -this is because the tax payers cannot shift/transfer the burden on these taxes.
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High chances of tax evasion -mostly the taxpayer declare their incomes and the tax payable thereof, therefore it is easy to give wrong information regarding their incomes
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Discriminative-as those with lower incomes pay less taxes or no taxes than those with high incomes. Direct taxes punish those with more incomes
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Inconvenient-direct taxes are paid in lump sum (at once) which makes it inconvenient to the tax payers.
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Reduces disposal income.-this decreases their ability to save and create capital for investment
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Discourages the will to work -taxing those with high income highly discourages the will to work and by extension affects production and the economy.
Advantages of indirect taxes •
Convenient-indirect taxes are paid in small installments when one is buying products or services.
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Non-discriminative- all income groups (the rich and the poor) contribute towards these taxes at the same rates.
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Diversity – these taxes are levied on a wide range of goods and services at every level of production.
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Less chances of evasion- as the taxes are not paid by the person on whom they are imposed, the burden can be shifted to others. The person paying the tax may not be aware he is paying it.
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Restrict certain actions-can be used to reduce consumption and production of harmful and nonessential products e.g. beer, cigarettes and luxurious products.
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Protect local industries-this is by levying high import duties on imported goods making them more expensive to the locals compared with locally manufactured goods.
Disadvantages of indirect taxes • They are less equitable in nature as the poor and the rich pay taxes at the same rate i.e. they do not reduce the gap between the rich and the poor. •
Indirect taxes are uncertain as it is not easy to predict the consumer behavior .It is difficult to determine the amount of revenue that can be raised from these taxes.
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They feed inflation-through the increase in the prices of goods and services, which increases the cost of production resulting to even higher prices. Affect production and employment- as increase in the prices of goods and services reduces demand for that product this leads to lower production which may lead to loss of jobs through retrenchment. It does not create civic awareness among tax payers as most of them are not aware that they are paying taxes.
Tax shifting –this is the process where the tax burden can be transferred from one person to another .tax shifting can be either backward on forward. Forward shifting –refers to the shifting tax burden to consumers through increase in selling prices of goods and services. this is possible for inelastic goods e.g. basic food stuffs. Backward shifting –refers to transfer of tax burden by producers to suppliers of goods and services through other factors of production i.e. land, capital and labour. This is possible for elastic products e.g. goods having substitutes, luxury goods etc. FACTORS AFFECTING INCIDENCE SHIFTING •
Type of tax- direct taxes cannot be shifted because the person on whom it is imposed is the ultimate payer e.g. income tax, while indirect taxes can be shifted to other persons e.g. VAT
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Advertising and publicity- due to long usage of advertising and publicity some prices come to be fixed and accepted as normal, therefore not easy to shift the taxes by (way) means of a price increase. However a possibility may exist to shift the tax by deteriorating the quality or reducing the sizes of the taxed object e.g. in restaurants.
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Tax rates - If the tax is quite small and the market is competitive, the sellers may choose to absorb the tax in order to maintain goodwill of the buyers, this is less likely when the tax is large.
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Availability of substitutes-it it difficult to shift the tax burden to the consumers for products with effective substitutes because consumers will shift their demands to the untaxed substitutes eg coffee and tea.
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Geographical coverage - if the untaxed good is still available in the neighboring areas, there will be great resistance by the buyer to bear the tax burden as opposed to when the geographical coverage is wide.
Objectives of budgetary policies in the economy • Increase in capital accumulation • Exchange stability • Price stability •
Fiscal policies- this is the use of government expenditure and revenue collection to influence the economy in a given direction. It attempts to stabilize the economy by interest rates and supply of money Objectives of fiscal policies • To raise employment levels • Maintain fair distribution of national income • Maintain economic stability • Increase in the rate of economic growth Categories of taxable incomes
1) Employment income 2) Business income 3) Farming income
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4) Rental income 5) Investment income 6) Pension/provident fund income above tax exempt Categories of non taxable incomes 1) Dividends from investment outside Kenya. 2) Dividends received by a company from a subsidiary of which it controls more than 12.5% of its share holding 3) Interest from post office saving fund 4) Interest from tax reserve certificates 5) Interest from a registered retirement benefit fund 6) Interest from home ownership saving plan Characteristics of taxable income: 1) The income must have been earned or accrued in Kenya 2) The services must have been rendered in Kenya 3) The payment of the service must have originated in Kenya even if the services were rendered elsewhere. Exception to the above characteristics:
1) For a resident person employment income is taxed regardless of where it has been earned 2)
For a resident person carrying out a business partly in Kenya and partly outside Kenya, the whole of business income is taxable. Meaning of a resident to an individual; 1. A person who has a permanent home in Kenya and was in Kenya for any period during the year of income. 2. A person who has no permanent home in Kenya but:
a) Was in Kenya for an aggregate period of 183 days during the year of income. b) Was in Kenya in the year of income and the two preceding years for an average of more than 122 days. Meaning of a resident to corporate bodies: 1) The company was incorporated in Kenya under the Kenyan law (Companies Act).
2) The management and control of the company was exercised in Kenya during the year of income. 3) The company has been declared by the minister of finance to be a resident through a gazette notice. Significance /importance of a resident: 1) For a resident, employment income is taxed regardless of where it was earned while for a non resident only employment income earned in Kenya is taxable.
2) For a resident, business income for a business carried partly in Kenya and partly outside Kenya is wholly taxable while for non residents only business income from Kenya is taxable. 3) For residents rental income is taxed at the individual tax rate while for non residents is taxed at the withholding tax rates. 4) For residents personal and insurance relief are granted while for non residents do not enjoy the relief. 5) Resident companies pay taxes at the rate of 30% while non resident companies pay taxes at the rate of 37.5%. EMPLOYMENT INCOME This is the income received by an employee for rendering services to the employer. An employee is any holder of an office for which remuneration is payable, whether the office is private or public in nature.
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An employer is any person responsible for the payment of remuneration to an employee or any agent or representative of a non-resident employer or any paying officer of the government or other public bodies or any trust or insurance company or person paying pension. The employer has the power to select, dismiss, remunerate (pay) and exercise control over the work done by the employee. Employment income is therefore income received from a contract of employment. This income is taxed under the pay as you earn (PAYE) system, where the tax is withheld at the source or pay point by the person making the payments. It is the duty of the employer/paying person to deduct the income tax payable on employment income and remit the tax to the relevant tax authority Where the employer fails to deduct the tax due on employment income, he is liable to certain penalties. This penalty is equivalent to the higher of Sh.10, 000 or 25% of the tax involved. Income tax is deducted from all sources of employment income except wages received from casual employment i.e. where the contract of employment is less than one month. Taxable employment benefits; a) Cash payments-wages,salaries,sick pay ,leave pay, overtime bonuses, commission b) Cash allowances –travelling, medical, house, entertainment allowances etc.
c) Private expenditure paid by the employer on behalf of the employee e.g. grocery bills,electricity,water,telephone bills, school fees etc. d) Benefits in kind (non-cash benefits) e) Gifts and rewards. COMPUTATION OF EMPLOYMENT INCOME FORMAT NAME OF THE EMPLOYEE------------------------TAXABLE INCOME FOR THE YEAR ENDED 31 DECEMBER 20— Employment income; Basic salary p.a Add employment benefits Telephone Insurance premiums Free meals /transport/goods Housing allowance Medical allowances Entertainment allowance Housing allowance Sick/leave pay Bonuses/gifts/rewards Overtime pay Motor vehicle/car benefit Commission Less allowable employment benefits; Subscription to a professional body Mortgage interest Contribution to home ownership saving plan TAXBLE EMPLOYMENT INCOME ADD OTHER INCOMES (if any) Business income Investment income
Sh.
xx xx xx xx xx xx xx xx xx xx xx xx
xx xx xx
xx xx
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Sh. xx
xx XX
xx XX
Rental income Farming income e.t.c
xx xx
TOTAL TAXABLE INCOME
xx XX
Gifts and rewards are taxable if: 1) Paid by the employer /customer in course of employment or business 2) They are paid frequently 3) Paid in relation to services rendered 4) There is a contract of its payment 5) Customarily paid in such kind of employment. EMPLOYMENT BENEFITS. An employment benefit is any advantage or facility enjoyed by an employee in connection to services rendered to the employer. The benefits should be included in the determination of taxable employment income.i.e the benefits are chargeable to tax as if it was income received from employment. The following benefits from employment are taxable;
1. Any benefit whose aggregate value is Sh.36, 000 p.a with effect from 1/1/2006 and Sh.24, 000 in the year 2004 and 2005. 2. Telephone services (private) - the taxable benefit is 30% p.a of the telephone bills.
3. Furniture benefit-the rate is 12% p.a of the cost of the furniture to the employer, if the furniture is hired, the cost of hiring will be taken into consideration.
4. Motor vehicle benefit- this arises where an employee is provided with a motor vehicle by the employer for both official and private use, the chargeable value for this benefit is the higher of the rates determined by the commissioner or the prescribed rates. Prescribed rates Saloon cars, hatch backs and estates
Sh.(p.a)
Up to -1200cc 1201 -1500cc 1501 -1700cc 1701 -2000cc 2001 - 3000cc Over 3000cc Pick-ups, panel vans (unconverted ) Up to 1750 cc Over 1750cc
43,200 50,400 69,600 86,400 103,200 172,800
Land rovers/cruisers
86,400
43,200 50,400
Determined rate – it is 24% p.a of the cost of the motor vehicle to the employer. N/B Where the motor vehicle is hired from a third party the taxable is the higher of the cost of hiring or the rate determined by the commissioner.
5. Low interest rate benefit - arises where an employee is provided with a loan by the Employer for which the employer charges an interest rate which is below the prescribed rate of interest. The chargeable benefit is the difference between the prescribed rate of interest and the interest by the employer multiplied by the loan amount. Taxable benefit = loan amount (prescribed rate- interest charged by employer)
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With effect from 11 June, 1998, the low interest rate benefit is no longer charged on the employee, in its place the fringe benefit was introduced. Fringe benefit is payable by the employer who provides a loan to an employee at an interest rate lower than the prescribed rate of interest, however the fringe benefit tax applies to loans given on 12 June 1998 onwards. any loan given before 12 June, 1998 are still taxable under the low interest on the employee until fully paid. Fringe benefit=30%*loan amount (prescribed rate-interest charged by the employer). N/B the fringe benefit is payable by the employer with other PAYE remittances.
6. Housing benefit-this benefit arises where an employer provides housing to an employee, the house may be owned by the employer, leased or rented from a third party. For the purpose of determining housing benefit employees are categorized into; •
Directors
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Whole-time service directors
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Ordinary employees
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Agricultural employees
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Employee receiving meals and accommodation.
Director-a director of a company is; •
A member of B.O.D for a company managed by B.O.D
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A member of a company that is managed by members themselves. A manager who manages the company single handed.
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The housing benefit for directors is 15% of the total taxable income from all sources .however where the premises are owned by the employer the housing benefit shall be the fair market rental value. where the premises is rented from a third party under an agreement which is not at arm’s length the housing benefit shall be the higher of the fair market rental value or the rent paid by the employer. N/B A transaction at arm’s length is where the buyer and the seller of a product /service act independently and have no relationship to each other. Whole-time service director - this is the director who devotes most of his time in managing the affairs of the company and does not control more than 5% of the company’s shareholding The housing benefit is 15% of the employment income excluding the value of those premises. The same conditions as those of directors for a premise owned by the company or rented from third parties apply. Ordinary employees- the housing benefit is 15% of the employment income excluding the value of those premises or the rent paid by the employer to third parties under an agreement made at arm’s length whichever is higher For premises owned by the employer or rented under an agreement not at arm’s length the same conditions as for directors apply. Agricultural employees-is an employee who is required by the nature of his job to reside in a farm. The housing benefit is 10% of the employment income N/B directors are not regarded as agricultural employees, but whole-time service directors are. Employees receiving meals and accommodation-if an employee is accommodated within the employer’s premises and is also provided with meals, the value for he benefit shall be 10% of the employment income for meals and 10% for accommodation, making a total charge of 20% NOTES; i) Any contribution by an employee towards rent should be deducted when determining the housing benefit. If an employee occupies premises for part of the year the housing benefit shall be 15% of the ii) employment income relating to that period.
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7. Other benefits include servants, water, security staff, electricity e.tc.these are taxable at the higher of the cost to the employer or the fair market value Non- taxable employment income: a) Non- cash benefits below Sh.36, 000 p.a from 1.1.2006.eg free meals, free transport, free goods etc.
b) Passages- cost of traveling into and out of the country by an employee and his family , only and if •
only the employee; Is not a Kenyan resident
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Was recruited from outside Kenya
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Was in Kenya solely for the purpose of serving his employer and does not engage in any other business. The passages are spend exclusively for traveling purposes and not for any other purposes.
c) Medical benefits if available to all employees d) Pension contribution by the employer on behalf of the employee to a registered or Unregistered pension or provident fund. e) School fees paid by the employer on behalf of an employee provided it has not been taxed on the employer. f) Reimbursement by the employer to an employee for employment expenses incurred.
Deductions allowable against employment income: a) Contribution to a professional organization e.g. L.S.K, ICPAK, I.C.M ,K.M.A etc
b) Contribution by an employee to a registered pension/provident scheme that is: the lower of: i) 30% of employment income ii) Actual contribution iii) Ksh. 240,000 p.a c) Deposits to an approved financial institution under the home ownership saving plan (HOSP) up to a maximum of Ksh.48, 000 p.a d) Owner occupied mortgage interest up to a maximum of Ksh. 150,000 p.a. N/B i) The interest will be apportioned in accordance with the period of occupation. ii) Only one residential house qualifies for owner occupied interest deduction.
e) Any expenses incurred by an employee in the course of employment. Reliefs –these are deductions from the gross tax payable for residents individuals only, we have: Personal relief -available to all resident individuals at the rate of Ksh.13944 p.a.This is granted automatically to all resident individuals in receipt of income liable to tax .An individual is entitled to only one personal relief i.e. where a person earns income from various sources he can only deduct personal relief from one source. Unutilized personal relief can be carried forward from one month to another within the same year but not from one year to another. Insurance relief - this was re-introduced with effect from 1 January, 2003. It is granted to resident individuals at the rate of 15% of the premiums paid or Sh.60, 000 which ever is lower. It is granted for: a) Life insurance premiums paid by an individual for his life, his wife or his children b) Life insurance premiums paid by the employer on behalf of the employee which has been taxed on the employee as a benefit
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c) An education policy with a maturity period of not less than 10 years. Wife’s income: Wife’s employment, self employment are gains or profits arising from a business carried on by a married woman living with her husband ,it is chargeable to tax on the woman except if she is an employee of : 1. Her husband 2. A partnership in which the husband is a partner
3. A company in which the wife and/ or the husband or both have an aggregate of more than 12.5% of the voting power. 4. Any settlement created by the husband for the benefit of children. A married woman is treated as living with her husband unless they are separated: Under a court order Under a written agreement of separation In circumstances likely to be permanent • • •
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She is a resident and the husband is not.
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