The Impact of Redefinition of Preferential Tax Regime
Initially, Transfer pricing regulation was only applicable to transactions between a resident corporate entity and a related non-resident entity operating or a resident-related entity in a preferential tax regime.
The Finance Act 2022 expanded the definition of a preferential tax regime to include the following:
- Any Kenyan regulation that provides a preferential rate of tax on income or profit, including a reduction in the tax rate or the tax base,
- A foreign jurisdiction that does not tax income,
- A foreign jurisdiction that taxes income at a rate that is less than 20%,
- A foreign jurisdiction that does not have a framework for the exchange of information,
- A foreign jurisdiction that does not allow access to banking information,
- A foreign jurisdiction that lacks transparency on corporate structure, ownership of legal entities located therein, beneficial owners of income or capital, financial disclosure or regulatory supervision.
Who will be affected by the Redefinition of Preferential Tax Regime?
While the scope of the preferential regime has been expanded, the impact will be felt across many businesses i.e;
- Companies that perform and/or receive administrative services on behalf of any related non-resident entities in the SEZ or EPZ or countries with corporate tax rate below 20% like UK, Hungary, Mauritius, Cyprus, Bermuda, Bulgaria, Ukraine, Cayman Island, and Singapore.
- Companies that receive financial assistance like loans from the countries with corporate tax rate below 20% like UK, Hungary, Mauritius, Cyprus, Bermuda, Bulgaria, Ukraine, Cayman Island, and Singapore.
- Companies that sell products/services to the countries with corporate tax rate below 20% like UK, Hungary, Mauritius, Cyprus, Bermuda, Bulgaria, Ukraine, Cayman Island, and Singapore.
- Companies whose trade names/trademarks relating to marketing activities are owned by countries with corporate tax rate below 20% like UK, Hungary, Mauritius, Cyprus, Bermuda, Bulgaria, Cayman Island, Ukraine, and Singapore
- Companies that trade with related entities in Kenya which enjoy lower tax rates or at least have a reduction in their tax base. Such may include companies located in the Special Economic Zone (SEZ) and Export Processing Zones (EPZ) which enjoy lower tax rates.
- Other companies that are enjoying lower tax rates e.g. the shipping industry that is taxed at 15% corporate tax, are not excluded from this new definition of preferential tax regimes.
How will companies be affected by the Redefinition of Preferential Tax Regime?
By expounding on Section 18 of the Income Tax Act to include the above preferential tax regimes the companies involved in the above transactions shall be required to maintain Transfer Pricing policy documenting the nature of their transactions with the companies in the preferential tax regime in compliance with arm’s length price.
Of close interest are the resident entities that will be required to maintain a transfer pricing policy for transacting with another resident entity that falls under the ambit of preferential tax regime. Therefore, transfer pricing will equally apply to transactions between resident entities just as it applies to resident entities transacting with related non-resident entities.
We note that the documentation of Transfer Pricing Policy by companies in Kenya trading with independent third parties will have several setbacks especially with obtaining critical information like costing/ pricing method required for Transfer Pricing.
How will Business between Kenya and UK be affected?
One of the countries that fall under the preferential tax rate include Kenya’s trade partner United Kingdom which has a corporate tax rate of 19%.The UK accounted for Kenyan exports worth US$450.58 Million during 2021. The exporters will have an extra compliance cost of maintaining a transfer pricing policy to justify the arm’s length range of the goods exported to UK. This will be a disincentive to exporters both in the EPZ and the local region.
This continuous scrutiny and amendment of transfer pricing regulations is actually proposed at a time when majority of tax jurisdictions including Kenya are trying to comply the international best practices in line with measures put in place to fully implement Base Erosion and Profit shifting (BEPS) Action 5 which is intended to counter harmful tax practices among the Multinational Enterprises (MNEs) established in law tax jurisdictions commonly known as tax havens.