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New law subjects multinationals to wider transfer pricing rules

Thursday, 22 September 2016 00:00
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Multinational enterprises (MNEs) setting up in Kenya have the option of incorporating a subsidiary or registering a branch. Subsidiaries in Kenya, just like other incorporated companies, pay corporate taxes at the rate of 30 per cent. Foreign branches pay corporate taxes at the rate of 37.5 per cent.

Despite the high corporate tax rate, some MNEs prefer to operate as branches. This may be driven by a host of reasons ranging from global structural strategy, the need to reduce the effective tax rate and local legal considerations.

For instance, some tax jurisdictions allow the tax deduction of branch start-up losses. Therefore, the head office may adopt a global strategy of shifting branch start-up losses to such a jurisdiction.



 

In Kenya, there is a large disparity between the tax treatment of a branch and a subsidiary. For example, compensating tax (a tax on distribution of dividends out of untaxed earnings), is only applicable to resident companies.

Payments by a branch to the head office such as management or professional fees do not attract withholding tax.

Branches have their downside. For instance, any interest, royalties, management or professional fees paid by a branch to the head office is not tax deductible. MNEs usually carry out comparative tax modelling to determine the most optimal structure for their business.

Transfer pricing is the pricing of cross-border, intra-firm transactions between related parties. Revenue authorities have accused MNEs of distorting their cross-border, intra-firm transactions to avoid taxes.

Currently, the law in Kenya has a loophole and some foreign branches could argue that the transfer pricing regime is not applicable to them. Section 18(3) of the Income Tax Act anchors the arm’s length standard in the Kenyan tax regime.

Transactions

It regulates transactions between a non-resident person and a related resident person. Foreign branches are treated as permanent establishments of non-resident persons unless the management or control of the branch is exercised in Kenya or the branch is declared by the Treasury Cabinet Secretary to be resident in Kenya.

Legally speaking, section 18(3) of the Income Tax Act is clear that it does not apply to transactions between foreign branches (non-resident persons) and related non-resident persons.

On the other hand, Rule 5 (b) of the Transfer Pricing Rules provides that the rules apply to transactions between a permanent establishment and its head office or other related branches.

However, the legal validity of this rule is doubtable in light of section 31(b) of the Interpretation and General Provisions Act which provides that no subsidiary legislation shall be inconsistent with the provisions of the parent statute.

Treasury seeks to seal this loophole through the proposed Finance Bill. Section 9 of the Finance Bill seeks to amend section 18(3) of the Income Tax Act by providing that the subsection also applies to transactions between permanent establishments and related non-resident persons.

This provision is scheduled to take effect on 1st January, 2015. Foreign branches will now be subject to the transfer pricing rules as a matter of law.

 

They will be required to develop an appropriate transfer pricing policy. KRA may also require them to provide documentation to show that their related party transactions are conducted at arm’s length.

Following these developments, the KRA should consider devising clear guidance on the attribution of profits to permanent establishments. Parliament and the Treasury should also consider devising legal reforms to eliminate the current disparity between the tax treatment of a foreign branch and a subsidiary.


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