Taxation Notes CPA 2 PDF

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SECTION 4 SUBJECT NO. 10

TAXATION STUDY TEXT

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C opyr i ght ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the copyright owner. This publication may not be lent, resold, hired or otherwise disposed of in anyway of trade

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without the prior written consent of the copyright owner.

ISBN NO: 9966-760-19-9

© 2009 STRATHMORE UNIVERSITY PRESS

First Published 2009

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ACKNOWLEDGMENT

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We gratefully acknowledge permission to quote from the past examination papers of Kenya Accountants and Secretaries National Examination Board (KASNEB).

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Acknowledgment

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Table of Contents ACKNOWLEDGMENT ............................................................................................................ III TABLE OF CONTENTS ...........................................................................................................V

CHAPTER ONE ....................................................................................................................... 3 THEORY OF TAXATION .......................................................................................................... 3 CHAPTER TWO ..................................................................................................................... 37 TAXATION OF INCOMES OF PERSONS .............................................................................. 37 CHAPTER THREE ................................................................................................................ 111 TAXATION OF SPECIFIC SOURCES OF INCOME ............................................................. 111 CHAPTER FOUR ................................................................................................................. 131

ADMINISTRATION OF INCOME TAX ................................................................................. 169 CHAPTER SIX ..................................................................................................................... 209 VALUE ADDED TAX ............................................................................................................ 209 CHAPTER SEVEN ............................................................................................................... 249 ADMINISTRATION OF CUSTOMS & EXCISE .................................................................... 249 CHAPTER EIGHT ................................................................................................................ 277 OTHER REVENUE SOURCES ............................................................................................ 277 CHAPTER NINE ................................................................................................................... 289 KASNEB SYLLABUS FOR TAXATION 1 - REVISION AID ................................................ 289 CHAPTER TEN .................................................................................................................... 293 MODEL ANSWERS TO REVISION/EXAM QUESTIONS .................................................... 295

GLOSSARY .......................................................................................................................... 321 INDEX ................................................................................................................................... 327

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CHAPTER FIVE ................................................................................................................... 169

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CAPITAL DEDUCTIONS/ALLOWANCES ........................................................................... 131

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CHAPTER ONE

THEORY OF TAXATION

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CHAPTER ONE THEORY OF TAXATION 1.0

OBJECTIVES

At the end of this chapter, the student should be able to:

INTRODUCTION

We start our study of taxation with a look at the basic concepts and purposes of taxation. The chapter covers the general theory of taxation and forms the foundation of taxation. It contains major definitions that will be helpful in the subsequent chapters.

1.5

DEFINITION OF KEY TERMS

Tax: A compulsory payment by a tax payer to the state through the revenue authority without involving a direct repayment of goods and services in return.

Budget: A budget is a statement which consists of the revenue and expenditure estimates of the government for one particular year.

1.3

EXAM CONTEXT

In this chapter the main focus is to ensure that the student is conversant with all the basic concepts and the purpose of taxation, the student should be able to demonstrate his understanding of the same.

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1.2

Understand the various types of taxes imposed in Kenya Explain the importance of taxes in a country Explain the principles of taxation Differentiate between direct and indirect taxation Establish the different taxation systems Explain the economical effects of taxation Explain the role of taxation in achieving budgetary objectives

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• • • • • • •

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1.4

INDUSTRIAL CONTEXT

As indicated above, the chapter contains the general theory of taxation that will enable any one including tax consultants and budget analysts gain a general understanding of the taxation framework in Kenya.

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1.6

TAXATION DEFINED

Taxation is the part of public finance that deals with the means by which the government raises revenue from the public by imposing taxes which revenue is used by the government to provide goods and services to the public or its citizens (to carry out government functions). Taxation may be referred to as the revenue raising activity of the government.

Public Finance is the department of economic theory that deals with public expenditure and revenue. Economics deals with resource allocation and seeks to answer the three questions of: who to produce, how to produce and for whom to produce.

We will start by exploring the government expenditure, which is characterised by the expected activities of a government. We will then look at the taxation as source of revenue to finance the government expenditure.

Government activities A government is expected to carry out some activities as part of its service to the public. These activities are generally of universal application, but where applicable, a Kenyan example is given.

These activities are: 1.    

To maintain internal security and external defence and carry out general administration. In this respect, it will incur expenditure relating to: § The cost of police and judiciary for maintenance of law and order. § The cost of the armed forces such as the army, navy and airforce for defence against external aggression. § Cost of provincial administration and general administration of law and order.

THEORY OF TAXATION

2.   

To provide infrastructure and communication such as:

3.      

To provide basic social services such as the cost of:

4.   

To participate in the production and marketing of commercial goods and services:



§ Cost of constructing roads, railways, airports and harbours. § Cost of constructing electricity and telephone networks, television and radio systems etc.

§ Cost of establishing public enterprises such as parastatals. § Combining with private business through purchase of shares in commercial enterprises. There is pressure all over the world for government to divest or privatise business enterprises. The Kenya government in the 1991 budget announced its plans to divest in 139 business enterprises. § Providing forms of easy loans not obtainable in financial institutions, and providing cheap business premises such as the Kenya Industrial Estates, Export Processing Zones etc. § Guaranteeing markets through protection from competition and preferential purchases.

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Influencing and guiding the level and direction of economic activities through various regulations:

 

§ Monetary policy (relating to interest and money supply); § Fiscal policy (deliberate manipulation of government income and expenditure so as to achieve desired economic and social goals).

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Redistributing income and wealth through taxation and public spending:

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§ Taxing the rich and those able to afford tax. § Cost of providing basic needs to the poor such as free education, medical care and housing. § Cost of relief of famine and poverty which may arise from unemployment, sickness, old age, crop failure, drought, floods, earthquakes etc.



To perform the above functions effectively and adequately, the government needs funds. Taxation is an important source of government income. The income of the government from taxes and other sources is known as public revenue.

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§ Medical services and medicine in hospitals. § Education in schools, colleges and universities. § Water supply and sewerage. § Sports and cultural activities. § Entertainment and information on radio and television.

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

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Public Revenue Sources Public revenue is all the amounts which are received by the government from different sources. The main sources of public revenue are as follows:

(a)

Taxes

Taxes are the most important source of public revenue. Any tax can be defined as an involuntary payment by a tax payer without involving a direct repayment of goods and services (as a "quid pro quo") in return. In other words, there are no direct goods or services given to a tax payer in return for the tax paid. The tax payer can, however enjoy goods or services provided by the government like any other citizen without any preference or discrimination.

The following features are common in any tax system:

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Taxing authority This is the authority with the power to impose tax e.g. the central government or a local authority. The taxes are received as public revenue. The taxing authority has power to enforce payment of tax. The central government imposes tax through the Kenya Revenue Authority (KRA).

Tax payer The person or entity that pays the tax e.g. individuals, companies, businesses and other organizations. The amount of tax is compulsory and there is punishment for failure to pay.

Tax The amount paid to the taxing authority as direct cash payment or paid indirectly through purchase of goods or services. The tax is not paid for any specific service rendered by the tax authority to the tax payer. The tax paid becomes revenue and is used to provide public goods and services to all citizens.

In addition to the above common features of tax, the defi nitions of tax by some tax experts as listed below are important: a.

A compulsory contribution to a public authority, irrespective of the exact amount of service rendered to the tax payer in return.

b.

A compulsory contribution from a person to the government to defray the expenses incurred in the common interest of all.

c.

A compulsory contribution of wealth by a person or body of persons for the service of the public. There is a portion of the produce of the land and labour of country that is placed at the disposal of the government for the common good of all.

NATURE, PURPOSE AND CLASSIFICATION OF LAW

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Income tax — this is tax imposed on annual gains or profits earned by individuals, limited companies, business and other organisations. The income tax will be explained in chapters 2 to 5.

ii.

Value added tax (V.A.T.) — This is tax imposed on sale of commodities and services introduced in Kenya with effect from 1.1.90. VAT is discussed in detail under chapter 6 herein..

iii.

Turnover Tax — Is charged on income or receipts from business by taxable persons of a turnover between Sh. 500,000 and Sh. 5 million within a period of 12 months with effect from 1.1.2008. The Turnover Tax is explained in chapter 5 in detail.

iv.

Sales tax — This is tax imposed on sale of commodities which was abolished in Kenya on 31.12.89 and replaced with value added tax.

v.

Excise duty — This is tax imposed on commodities produced locally or imported. It targets specific commodities, for example, luxuries and commodities that are detrimental to heath. The details of this are in chapter 7.

vi.

Customs and excise duty — This is tax imposed on import or export of commodities. The details of this tax are in chapter 7.

vii. Stamp duty — This is tax that is aimed at legitimizing transactions. It is imposed on increase of share capital, transfer of shares, mortgages, charges, the transfer of property among others. The details of this tax are in chapter 8.

(b)

Land rent and rates

These are levies imposed on property. Rent is paid to the Central Government on some land leases while rates are paid to the Local Authority based on the value of property. This is discussed further in Chapter 8.

(c)

Fees

Fees is an amount which is received for any direct services rendered by the Central or Local Authority e.g. television and radio fees, national park fees, airport departure fee, airport landing and parking fee, port fee by ships, university fee, etc.

(d)

Prices

Prices are those amounts which are received by the central or local authority for commercial services e.g. railway fare, postage and revenue stamps, telephone charges, radio and television advertisement etc.

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Kinds of taxes

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(e)

External borrowing

This is done from foreign governments and international financial institutions such as World Bank and International Monetary Fund (IMF).

(f)

Fines and Penalties

If individuals and firms do not obey the laws of the country, fines and penalties are imposed on them. Such fines and penalties are also the income of the government.

(f)

State Property

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Some land, forests, mines, national parks, etc. are government property. The income that arises from such property is also another source of public revenue. The income will arise from payment of rents, royalties, or sale of produce.

(g)

Internal Borrowing

The government usually raises revenue through issue of treasury bills and treasury bonds in the local market.

1.7

WHY THE GOVERNMENT LEVIES TAXES

The raising of revenue is not the only purpose for which taxes are levied. The taxes are levied for various purposes as follows:

a. Raising Revenue The main purpose of imposing taxes is to raise government income or revenue. Taxes are the major sources of government revenue. The government needs such revenue to maintain the peace and security in a country, to increase social welfare, to complete development projects like roads, schools, hospitals, power stations, etc.

THEORY OF TAXATION

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b. Economic Stability Taxes are also imposed to maintain economic stability in a country. In theory, during inflation, the government imposes more taxes in order to discourage the unnecessary expenditure of the individuals. On the other hand, during deflation, the taxes are reduced in order to encourage individuals to spend more money on goods and services. The increase and decrease in taxes helps to check the big fluctuations in the prices of goods and services and thus maintain the economic stability.

c. Protection Policy

Some commodities such as wines, spirits, beer, cigarettes, etc. are harmful to human health. To discourage wide consumption of these harmful commodities, taxes are imposed to make the commodities more expensive and therefore out of reach of as many people as possible.

e. Fair Distribution of Income In any country, some people will be rich and others will be poor due to limited opportunities and numerous hindrances to becoming wealthy. Taxes can be imposed which aim to achieve equality in the distribution of national income. The rich are taxed at a higher rate and the amounts obtained are spent on increasing the welfare of the poor. That way, the taxes help to achieve a fair distribution of income in a country.

f. Allocation of Resources Taxes can be used to achieve reasonable allocation of resources in a country for optimum utilization of those resources. The amounts collected from taxes are used to subsidise or finance more productive projects ignored by private investors. The government may also remove taxes on some industries or impose low rates of taxes to encourage allocation of resources in that direction.

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d. Social Welfare

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Where a government has a policy of protecting some industries or commodities produced in a country, taxes may be imposed to implement such a policy. Heavy taxes are therefore imposed on commodities imported from other countries which compete with local commodities thus making them expensive. The consumers are therefore encouraged to buy the locally produced and low priced goods and services.

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g. Increase In Employment Funds collected from taxes can be used on public works programmes like roads, drainage, and other public buildings. If manual labour is used to complete these programmes, more employment opportunities are created

1.8

PRINCIPLES OF AN OPTIMAL TAX SYSTEM

These are the principles of an optimal tax system, what are known as Canons of taxation, some of which were laid down by Adam Smith.

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1. Simplicity A tax system should be simple enough to enable a tax payer to understand it and be able to compute his/her tax liability. A complex and difficult to understand tax system may produce a low yield as it may discourage the tax payer's willingness to declare income. It may also create administrative difficulties leading to inefficiency. The most simple tax system is where there is a single tax. However, this may not be equitable as some people will not pay tax.

2. Certainty The tax should be formulated so that tax payers are certain of how ...