Capital gains tax to be reintroduced - potential consequences for IP transactions

Capital gains tax is set to be reintroduced in Kenya as from January 1 2015 after being suspended for close to 30 years, in 1985. While the Finance Act 2014, which reintroduced capital gains tax, provides a relatively benign rate of 5% as the tax on the gain made on transfer of property, it is thought that this fairly low rate of capital gains tax is merely the beginning of what will be significant tax in future budgets, gleaning at the wider region’s capital gains tax rates, such as 30% in Uganda.

Capital gains tax applies to literally all property owned and to be transferred by corporate entities, while for individuals, it is limited to real estate and marketable securities.

For companies holding IP assets in Kenya, capital gains tax will now be payable on transfer of such IP assets given the wide definition of ‘property’ in the Eighth Schedule to the Income Tax Act as including property of every description.

While it comes as no surprise that the transfer of IP assets will be subject to capital gains tax - given similar treatment in many countries worldwide - the Income Tax Act, as it currently stands, fails to provide an appropriate mechanism for valuing these assets. This is largely due to the fact that the capital gains tax framework being reintroduced is pre-1985, which obviously fails to take into account the economic changes Kenya has undergone in the last three decades, including tremendous growth of, investment in, and legal and economic recognition of IP assets, evidenced by growing multi-national presence in Kenya in the form of technology hubs and firms like IBM and Microsoft, and international franchises including Subway, L'Oréal, KFC, Nando’s, Baby Shop, Levi and OLX.

The mechanism provided for in the Income Tax Act for determining the gain that is subject to capital gains tax is the net of acquisition cost and sale price of property, a model that is hardly workable for determining the capital gain for various IP assets, particularly outside an M&A transaction, as there is no ‘purchase’ cost of IP.

It is also anticipated that capital gains tax will apply not only in respect of assignment and such outright transfer of IP assets, but also in the case of licences or registered user, franchise and dealership agreements because ‘property’ includes an interest in property.

Further, where IP assets that a company wishes to transfer have not been subjected to a valuation and are, say, not recognised balance sheet assets, this will lead to a fairly drawn out process given the limited machinery the taxing authority, KRA, has. The Income Tax Act provides for instances, such as when acquisition cost of an asset cannot be valued, where the commissioner of domestic taxes will make a determination of the cost to be considered as its purchase cost. This will likely require lengthy discussions with the commissioner in valuations of IP assets, all of which must be factored in structuring and timing IP and IP-inclusive transactions to be undertaken in Kenya.

The Value Added Tax Act 2013, now just over a year old, introduced VAT on dealings in IP and, to date, KRA has yet to put in place a mechanism for assessing and collecting VAT on IP transactions, such as assignments and licences.

The capital gains tax law fails to provide indexation relief, and seemingly capital gains tax would tax IP assets ‘acquired’ decades ago in the same way as similar assets acquired a year prior to transfer. It is also possible that the Kenyan government could tax cross-border transfer of IP assets held by Kenya resident companies, assuming the necessary economic link with Kenya is made.

Overall, there are several grey areas and gaps to be filled by subsidiary legislation so as to give a clear and fair way of taxing capital gains, particularly in respect of the transfer of IP assets.

Judy Chebet, Coulson Harney Advocates, Nairobi