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Introduction to transfer pricing in Kenya
Transfer pricing rules
- Section 18(3) of the Income Tax Act CAP 470 provides that, 'Where a non-resident person carries on business with a related resident person or through its permanent establishment and the course of that business is so arranged such that it produces to the resident person or through its permanent establishment either no profits or less than the ordinary profits which might be expected to accrue from that business if there had been no such relationship, then the gains or profits of that resident person or through its permanent establishment from that business shall be deemed to be the amount that might have been expected to accrue if the course of that business had been conducted by independent persons dealing at arm's length'.
- In addition to the above, a multi-national enterprise (MNE) is required to comply with The Income Tax (Transfer Pricing) Rules, 2006 which offer guidelines on how to apply the arm’s length principle.
- The rules prescribe a general overview on the application of transfer pricing rules and Kenya heavily relies on the OECD guidelines which offer a more formulaic expression on implementation.
- The TP rules empower the Commissioner of Domestic Taxes (KRA) to request for TP documentation to any Multinational enterprise operating in Kenya on transactions where transfer pricing is applicable.
- The Income Tax (Transfer Pricing) rules offer the actual framework for MNE to adopt in relation to the intercompany transactions.
- Additionally, an MNE is allowed to apply these rules hand in hand with OECD Transfer Pricing guidelines which offer a more procedural or formulaic expression on the application of the Arm’s length principle and the methods of transfer pricing.
Transfer pricing methods
- Paragraph 4 of the Transfer pricing regulations grants the taxpayer the liberty of choice of the method to apply in valuation of the arms- length price of intercompany transactions.
- The Income Tax Transfer Pricing Regulations 2006 recognizes five methods to apply in determination of the arm’s length price of transactions as outlined below:
- The comparable uncontrolled price (CUP) method
- The resale price method(RP)
- The Cost plus method
- The profit split method (PSM)
- The Transactional net margin
- such other method as may be prescribed by the Commissioner from time to time, where in his opinion and in view of the nature of the transactions, the arm’s length price cannot be determined using any of the methods contained in these guidelines.
- Kenya operates a self-assessment regime. The duty of developing a transfer pricing policy solely lies on the taxpayer. Currently, there is no penalty for not maintaining a policy, however, failure to have a document in place sets the stage for scrutiny from the Commissioner of Domestic Taxes.
- A company that fails to maintain TP documentation would be in a disadvantaged position when defending its intercompany pricing with related parties.
- For this reason, it is highly advisable to have a TP policy should a KRA audit take place, then there is minimal risk of wrongful estimation of the value of intercompany transactions.
Transfer pricing documentation
Preparation of transfer pricing documentation
- Kenya recognizes the OECD transfer pricing documentation model based on the Master File and Local File (BEPS Action 13) approach.
- Paragraph 11 of the Eighth Schedule of the proposed Income Tax Bill expected proposes to enact Country by Country (CBC) reporting as a mandatory requirement for entities.
- Currently, the KRA may request a taxpayer to submit the following documentations for purpose of transfer pricing.
- Books accounts
- The selection of the transfer pricing method and the reasons for selection
- The application of the method, including the calculations, made and price adjustment factors considered
- The global organization structure of the enterprise;
- The details of transactions under consideration
- The assumption, strategies, and policies applied in selecting the method
- Background information as may be necessary regarding the transaction.
All documentation is required to be prepared in or be translated into the English language.
Master and local file
- In an effort to keep pace with BEPS action point 13 Kenya highly observes and is developing rules with regard to TP documentation to enhance transparency in TP matters.
- This will go hand in hand with Chapter 5 of the OECD Guideline to ensure allocation of income and taxes correctly reflects where value is created.
- The presence of the documentation assists tax authorities in filling of TP questionnaires and proving that the arms-length principle has been well applied.
- The local and master file offer useful information to authorities on the evaluation of the functions carried out by an organisation and the comparability data of similar transactions worldwide.
- Transfer pricing documentation should be available within 30 days upon request by KRA.
Some risk factors for challenge
- Online platforms and complex business models offering IT services and have a digital presence in the Kenyan market.
- Limited legal remedies to cope with the rapidly changing framework of international business models and treaty agreements which offers legal loopholes for MNC to avoid taxation.
- Limited risk distributor and contract services/ contract R&D arrangements could also potentially be affected, especially where significant people functions are in Kenya.
- Post-restructuring arrangements may pose certain challenges with respect to the identification of potential comparable in cases where the restructuring implements a business model that is hardly found between independent enterprises.
- Lack of alignment of transfer pricing outcome with value creation undertaken in the country.
- There is no penalty for not maintaining the TP documentation unlike in many countries worldwide.
- It is good to note that the Income Tax Act has provisions related to the underpayment or under declaration of income earned in Kenya. This implies that failure to maintain proper documentation sets up an organisation open to the scrutiny of risk exposures related to transfer pricing.
- The Tax Procedures Act, 2015 section 84 provides for a tax shortfall penalty should there arise undeclared tax amounts upon self-assessment. The penalty is 20%. Tax shortfall resulting from false or misleading state attracts 75% penalty.
- The Income Tax Bill expected to be enacted by end of 2020 proposes a 2% penalty for TP non-documentation.
Economic analysis and how to demonstrate an arm’s length result
- Economic analysis involves searching and selecting comparable transactions or companies considering the quality of data, assumptions and comparability factors and selection of the appropriate economic and statistical data related to a transaction.
- Paragraph 10(c) of the Income Tax Act (Transfer Pricing Regulations) states that 'where a person avers the application of arm’s length pricing, such person shall avail documentation to evidence their analysis upon request by the Commissioner'.
- The local TP guideline does not offer specific guidelines to be followed, however, from practice, the Authorities heavily rely on OECD guidelines
Advance Pricing Agreements (APAs), dispute avoidance and resolution
- There are no Advanced Pricing Agreements (APAs) in Kenya, however, the Law allows for taxpayers to seek a private ruling with respect to transaction needing clarification.
- Currently, there are no exemption criteria in place.
Digital services tax
- Kenya rolled out the Income Tax Bill (ITB)2018 which seeks to widen the ambit of transfer pricing in Kenya. The new ITB has provided for transfer pricing adjustment on cost contribution arrangement, intangibles as well as other financial services previously not mentioned in the Income Tax Act exclusively.
- The Bill also redefines the transfer pricing documentation necessary and makes it mandatory for businesses to have them in place, failure to which attracts a 2% tax penalty.
- Schedule 8 of The Income Tax Bill 2018 provides for taxation of cross-border transactions and requires transfer pricing adjustments to be made on transactions where a multi-national enterprise deals with a non-resident located in a preferential tax regime, beneficial regime or any other company that transacts with a non-resident party.
- The positive benefits of the digital economy are coupled with new challenges on how businesses should account for corporate income taxes earned in different jurisdictions. The transformation of the digital economy has also led to a rise in base erosion profit shifting and OECD has developed BEPS Action point 1 to address the challenges of the digital economy.
- Kenya in a bid to prevent base erosion profit shifting has introduced Digital Service Tax (DST) via the Finance Act 2020 to counter the boundary-less online market. This will be applicable to Business to Business (B2B) and Business to Consumers (B2C) transactions. The DST will be applied at 1.5% on the gross value of the online transactions on goods and services sold vide online platforms.
- Relatedly, Kenya has introduced the Minimum Tax regime that is 1% on gross turnover of business sales effective January 2021. This will address the challenge of loss-making enterprises that pay no corporate taxes. This intends to expand revenue collection and deter businesses from under-reporting profits in Kenya.
- The new regulations are aimed at extending the tax base and patching revenue spillage commonly associated with cross border activities.
KRA and taxpayer behaviour
- In an effort to promote professionalism and improve credible tax returns the Commissioner of Domestic Taxes (KRA) issued out guidelines in 2019 to regulate the conduct of tax agents in regard to tax matters and taxpayer interactions.
- The Tax Procedures (Tax Agents) Regulations, 2019 offer guidance as to how tax agents should conduct themselves.
- This will assist the taxpayers to attain the compliance standards set on the drafting of TP policy, undertaking reviews on functions, assets, and risks as well as in undertaking comparability studies.
- This improves the relationship between KRA, Taxpayer, and Tax Agent.
- In the wake of the pandemic, Kenya has not lagged behind in seeking contingent measures to address the changing business environment.
- The Tax Amendment Act, 2020 and Finance Act 2020 regulations are aimed at easing the negative impact of reduced business activity in the wake of COVID-19 times and seek alternative revenue sources as well as expand the tax base.
- The advent of COVID has seen many local and international businesses launching online platforms as the new modus operandi.
- The government via the above legislations has seen the introduction of the digital service tax to tap into the new online market space. This will necessitate businesses to align their TP documentation accordingly to accommodate the new methods and online international transactions.