TAXATION OF BUSINESS INCOME (1)

Definition, Incomes from Business, Allowable and Disallowable Deductions

Business income is generally taxed through an annual tax return whether earned by a resident or
non-resident. Taxes are imposed on business entities under Sec. 3(2)(a)(I) of the Income Tax Act,
which reads, " Subject to the Act income upon which tax is chargeable under this Act is income in
respect of a business for whatever period of time carried on".

When considering how such income shall be taxed it is important to consider the form of business
organization.

Definition of Business
Under Sec. 2 of the ITA, "Business includes any trade, profession, or vocation and every
manufacture and adventure and concern in the nature of trade but does not include employment."

Factors to Consider when Ascertaining Whether a Business is the Nature of Trade is carried
on
a) Profit Motive; this is the "reason to be" for any trading concern. This must be the overriding and
not the incidental motive of the existence of a business.
b) Number of Transactions; a transaction that is one in a series indicates that it constitutes trade.
However, it is quite possible that a single isolated transaction may constitute trade.
c) Method of Financing; where the proceeds from the sale of goods are used to acquire more goods
for resale, it indicates that the goods are in a trade cycle and therefore implying a business in the
nature of trade being carried on.
d) Method used to Generate Sales; most businesses in the nature of trade promote sales through
advertisement, publicity and other forms of promotion.
e) Nature of assets acquired and the quantities involved e.g. a person who owns a lorry cannot deny
that he is doing transport business.

f) Mode of Acquisition of an Asset e.g. if a gift or inherited goods are sold, this may not constitute
a trade. If items are purchased for resale, this will constitute a trade. If items are bought for private
use but at a later date disposed off, this may not constitute a trade.
g) Length of Time the Asset is Held and How it is Used. e.g. if a car is bought and used for
sometimes before it is sold, the sale may be construed as a realisation of a capital asset.
However, if it is bought and sold before use, the sale may be taken as a trade.

Taxable Business Incomes

a) Trading profit
b) Where a resident person carries on a business partly in Kenya and partly outside Kenya, the gains
or profits are deemed to have been derived from Kenya and will be taxed in Kenya. Sec 4 (a).
c) Amount of an insurance claim received for loss of profit or damage or compensation for the loss
of trading inventory.
d) Amount of a trade bad debt recovered which was previously allowed when written off.
e) Balancing charge.

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f) Trading receipt.
g) Realised foreign exchange gain.
h) Where a person receives a sum of money after the cessation of his business, which, if it had been
received before the cessation would have been included in the gains or profits of the business, that
sum shall be income of that person for the year of income in which it is received (Sec. 28[1])

Non-Taxable Business Receipts

a) Income from overseas investments.
b) Reduction in the general provision for doubtful debts.
c) Additional capital introduced by the owners.
d) Recovery of a bad debt which when written off was not allowed for tax purposes i.e. the non-trade
bad debts.
e) Any income that is exempted from taxation under the 1st Schedule of the ITA.

Allowable and Disallowable Deductions

Expenses or Deductions Generally Allowed Against Income

Sec. 15(I) of the Income Tax Act generally allows expenditure, which is wholly and exclusively
incurred in the production of taxable income.

Sec. 15 (1): For the purpose of ascertaining total assessable income of a person, there shall be
deducted all expenditure, which is expenditure wholly and exclusively, incurred (by the person) in
the production of that income.
This can be said to be a general provision for allowing expenses of a business:
a) Which are charged in the profit and loss account under normal accounting practice subject to any
prohibition or extension made by the Income Tax Act.
b) Which are the usual commercial/operating expenses of a business e.g. wages, rent, purchases,
transport, salary, water.
The nature of the business is very important in determining the expenditure, which is wholly and
exclusively incurred in the production of income

Expenses Specifically Allowed against Taxable Income (Sec. 15 of ITA Cap 470)
In addition to Sec. 15(1) allowing expenditure, which is wholly and exclusively incurred in the
production of taxable income, Sec. 15(2) allows specific items of expenditure against taxable
income. The items of expenditure listed below must be allowed against taxable income where the
expenditure is incurred;
a) Bad debts written off and specific provisions
b) Capital expenditure for the prevention of soil erosion in a farmland
c) Capital expenditure on clearing and planting permanent or semi-permanent crops. .
d) Pre-trading expenses; this is expenditure incurred before the commencement of business, which
would be allowable, if the business was operating

e) Legal costs and stamp duty for registration of a lease of business premises. The lease period
must not be in excess of or capital of extension beyond 99 years.

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f) Legal costs and other expenditure including capital expenses related to the issues of shares,
debentures or similar securities offered for purchase to the general public.
g) Expenditure on structural alterations to enable premises to be let
h) Cash donations to charitable organizations
i) Diminution or decrease in value of implements, utensils etc
j) Entrance fees and annual subscription paid to a trade association e.g. Kenya Chamber of
Commerce and Industry and Kenya Association of Manufacturers.
k) Expenditure incurred in scientific research whether of capital or revenue nature.
l) Amount of contribution to a scientific research association, which undertakes research, related to
the class of business of the contributor.
m) Amount of contribution to a university, college or research institution approved by DTD for
scientific
n) Contributions by employer on behalf of employees to national social security fund (NSSF) -
pension or provident fund.
o) Expenditure on advertising that’s revenue in nature
p) Mortgage interest.
q) Club subscriptions for use by employees
r) The amount of loss brought forward from previous year
s) Amount of trading loss that arises the where business is continuing and all the assets in a class of
wear and tear allowance are sold for less than the written down value (see chapter on capital
allowances).
t) Amount of balancing deduction. The balancing deduction arises where a business has ceased and
all the assets of a class of wear and tear allowance are sold for less than the written down value
(see chapter on capital allowances).
u) Amount of interest on money borrowed and used in the production of income e.g. interests on
loan, overdraft, debentures etc.
v) Amount of realised foreign exchange loss.
w) Capital deductions under the Second Schedule of the Act (see chapter on capital allowances).
x) Where a sum is paid by a person after the cessation of his business, which if it had been paid
prior to the cessation, would have been deductible in computing his gains or profits from that
business, it shall be deducted in ascertaining his total income for the year of income in which it
paid. (Sec. 28[2])

Expenses or Deductions Not Allowed against Taxable Income

Sec.16 (I) of the Income Tax Act generally disallows expenditure, which is not incurred in the
production of taxable income.
Sec.16 (1): for purpose of ascertaining the total income of the person no deduction shall be allowed
in respect of expenditure, which is not wholly and exclusively incurred by the person in the production
of income.
This is a general provision for disallowing:
a) Expenses which under normal accounting practice are not allowable against income, subject to
any extension made by the Income Tax Act;
b) Expenses that are not commercial/operating expenses of a business e.g. notional rent salary to
self-etc.

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Specific Items of Expenditure Not Allowable Against Taxable Income (Sec. 16[2]) of ITA Cap
470)
In addition to Sec.16 (I) generally disallowing expenditure, which is not wholly and exclusively
incurred in the production of taxable income, Sec.16 (2) disallows specific items of expenditure if
charged against taxable income. The items of expenditure listed below must be disallowed where
charged against taxable income.
Amount of capital expenditure, capital loss, diminution or exhaustion of capital e.g. depreciation,
amortisation, write-off of assets, loss on disposal of non-current asset etc. These are disallowed
unless specifically allowed in the Income Tax Act.
a) Amount of personal expenditure incurred by an individual in the maintenance of himself, his
family or for domestic purpose
b) Amount of expenditure or loss recoverable under insurance contract or indemnity.
c) Amount of premium paid under an annuity contract. This is paid to an insurance company for the
purpose of receiving annuities (regular amounts annually) in future especially for retirees.
d) The amount of expenditure in the production of income by a non-resident person with no
permanent establishment in Kenya. The income is taxable at source at non-resident rates of tax.
The expression of a permanent establishment is defined by the Act as a fixed place of business in
which that person carries on business. A fixed place means building site or a construction or
assembling project that has existed for six months or more in relation to a person.
e) Amount of loss from hobby business. This is business is not carried on with a view to making
profit e.g. keeping of three cows on the estates of a Nairobi suburb. The issue of losses from
hobby business has been weakened by the concept of specified sources of income. Sec. 16(2) (h).
Where more than 25% of the business expenditure is for personal or domestic nature, the business
is outright hobby business.
f) Amount of appropriations of profits to reserves, provisions, dividends and other appropriations.
It should be noted that the provision for specific trade bad debts is specifically stated to be
allowable expenditure.

BUSINESS INCOME 2

Taxation of Sole Proprietorships

A sole proprietorship does not have a separate legal entity and for this purpose it is not treated as a
separate taxable entity. The gains or profits from this form of business organization is taken to be the
income of the individual running the business and will be taxed on him as income from a separate
source.
For this purpose, income from all sources including gains from business will be taxed as an aggregate
amount using the individual scale rate of tax. Any additional capital is not regarded as a taxable
income. Drawings by the owner and other private expenses are not tax deductible. All provisions of
Sec. 15 (allowable deductions) and Sec. 16 (disallowable deductions) of the ITA will apply
accordingly.
Medical expenses and medical insurance are allowable up to a maximum of sh.1, 000,000.

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 METHOD OF ADJUSTING FOR PROFIT
INCOME TAX COMPUTATION
YEAR OF INCOME 20XX

K£ K£
Net profit as per accounts xx

Add back: Disallowable expenses xx

Taxable income omitted xx

Deduct: Non-business income xx

Allowable expenses omitted xx (xx)
Total taxable profit xx

BUSINESS INCOME 3

Taxation of Partnerships
A Partnership Business Is Not Recognised In Law As A Legal Entity. This Applies Equally As Far
As Tax Law Is Concerned (Income Tax Act Cap 470). A partnership is a business relationship that
subsists between two or more persons carrying on a business with view of making profits/sharing
losses. The adjusted income from the partnership (for tax purposes) shall be allocated amongst
partners at their profit sharing ratios as stipulated in the partnership deed. Each of the partners shall
then be taxed on his share of partnership income as a distinct individual.

A partner shall be taxed on the aggregate of the following incomes from a partnership Sec. 4(b):
a) Remuneration paid to him by the partnership; and
b) Any interest on capital paid to him by the partnership i.e. interest on capital, less any interest
paid by him to the partnership, i.e. interest on drawings; and
c) Share of the adjusted partnership income, adjusted with (I) and (ii) above.

The income from partnership will be added to the partner’s assessable incomes from other sources
and tax on them calculated on the partner as an individual at the personal/graduated scale rate of tax.
Where a partner’s adjusted share is a loss, this can be offset against any other income that he may
have in that year or be carried forward and offset on any other income in future years without any
limit.
All provisions for Sec. 15 (allowable deductions) and Sec. 16 (disallowable deductions) of the
Income Tax Act shall apply accordingly.
The specific disallowable deductions of a partnership are interest on capital, salaries paid to partners
and any other form of appropriation.
Medical expenses and medical allowance are allowed up to a maximum of 1 million per partner.

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Distribution of Profit Schedule
A B C Total
Salaries xx xx xx xx
Interest on capital less interest on drawings xx xx xx xx
Profit/loss share (using profit ratio) xx xx xx xx

Adjusted taxable partnership profit xx xx xx xx

== == == ==
Add Other Assessable Incomes:
Rent xx xx xx xx
Interest from third parties xx xx xx xx
Employment xx xx xx xx
Dividends xx xx xx xx
Total taxable income xx xx xx xx
== == == ==

BUSINESS INCOME 4

Taxation of Legal Persons- Limited Companies

A limited company/corporation has a separate legal entity whose existence is quite distinct from that
of the owners/shareholders. For this purpose a company/corporation is a separate taxable entity and
its income will be taxed on its own name and not on the names of its owners. Companies are taxed at
the corporation tax rates ruling in a certain year. The corporation tax rate is a proportional tax levied
at a flat rate irrespective of the size of income. Corporation tax rates are 30% for resident companies
and 37.5% for non-resident companies (2006).

The rules of ascertaining taxable income for sole traders and partnership will be applied. Attention
will be paid to the following:
a) Salaries and allowances paid to directors are allowable.
b) Transactions between the company and directors or shareholders are treated as business for tax
purposes.

Where a company derives income from other sources other than from its principal activity (trading),
this shall be taken to be incomes of the company and will be taxed in aggregate at the corporation
tax rate. The rules for final tax on dividends shall apply.

Other corporations include: trusts, co-operative societies, insurance companies, charitable

organisations, members’ clubs, sporting associations etc. the incomes of such entities will be taxed
at the corporation tax rates

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 BUSINESS INCOME 5

Taxation of Farming Income

References: Sec. 2, 15, 16 and 17 of the Income Tax Act Cap 470.

Introduction
Farming (and market gardening to some extent) has been recognised by most legislatures as a
somewhat special operation. It derives its profits from the soil and is in the unique position of
buying its materials retail and selling its produce wholesale. It may confine its operations to one
crop – tea, coffee, sisal, sugar, rice, cotton etc, or mix one or more. It may confine itself to cattle
ranching, fruit and/or flower growing. It is subject to more natural hazards, to economic and
social pressures – subsides, quotas, marketing boards – etc. Its produce is a chattel in
international bargaining;- import duties, common market, commonwealth preference etc.

a) Definition
Farming is not defined by the ITA but a farmer is defined as “any person who carries on pastoral,
agricultural, or other similar operations”. “Agricultural Land” is defined in the Second Schedule
paragraph 24 as land occupied wholly or mainly for the purposes of a “trade” or husbandry: crop
and
animal husbandry.

b) Charge to Tax
Sec. 3 of ITA charges the income derived from Kenya by a person (whether resident or non-
resident) in respect of gains or profit from “business” etc. Sec. 2 defines “business” as including
any trade, profession or vocation, and every manufacture, adventure and concern in the nature of
trade, but does not include employment. Farming is not one of these activities but is included in
the general term “business” e.g. Sec. 17(7)(e) mentions a farmer making up accounts of his
farming “business”. It might be of interest to say that the Kenyan legislation has had to “deem”
farming to be a “trade” to bring it within the Kenya charging section.

c) Computation of Gains and Profits

The profits arising from farming activities are subject to all the relevant sections of the Act in the
same
way as trades, professions and vocations, i.e. commercial profits subject to Sec.15 (allowable
deductions) and Sec. 16 (disallowable deductions)etc., but Sec.17 is limited in its application to a
farmer
and his farming “business”.

d) Capital Expenditure

(i) As a Revenue Expense:

Sec. 15 (2)(a) allows as a deduction any expenditure of a capital nature incurred by the owner or
occupier of farmland for the prevention of soil erosion, e.g. contours, terraces, gabions,
windbreaks etc. Sec. 15 (2)(1) allows as a deduction any expenditure of a capital nature incurred

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by the owner or tenant or agricultural land on clearing such land or on clearing and planting on
it permanent or semi-permanent crops which are defined in Sec. 2 and include: cashew nuts,
citrus, coconuts, coffee, passion fruits, paw-paw, pineapples, pyrethrum, sisal, sugar-cane, tea,
apples, pears, peaches, plums, bananas, roses etc

(ii) As Capital Deductions

This is covered fully in a chapter dealing with capital allowances; ‘deductions in respect of
capital expenditure on agricultural land or farm works”. Briefly this is what it says: Farm works
are structures necessary for the proper operation of a farm and include fences, dips, drains, water
and electricity works (other than machinery), windbreaks etc, as well as farm buildings. Only
one-third of the cost of a farmhouse may be claimed

e) Allowable Expenses/Deductions Against Farming Income

- Capital expenditure incurred in preventing soil erosion.
- Capital expenditure incurred on clearing and planting semi and permanent cash crops.
- Farms works deduction on farm structures needed for the proper operation of the farm to earn
farming taxable income.
- Purchase of livestock seeds and fertilizer.
- The cost of standing timber sold.
- Other expenses wholly and exclusively incurred for farming activities.

QUESTION ONE
Mobile Options Ltd. is a distributor of mobile phones and accessories. The profit and loss account
for the year ended 31 December 2020 is as follows:

Sh. Sh.
Purchases 12,000,000 Sales 18,000,000
Salaries and wages 2,000,000 Discount received 400,000
Rent and rates 125,000 Insurance recovery 180,000
Distribution and office 480,000 Profit on sale of assets 240,000
expenses Provision for bad debts 80,000
Traveling and subsistence 336,000
Subscriptions 50,000
Licenses and permits 200,000
Legal fees 436,000
Depreciation 670,000
Audit fees 130,000
Loss on sale of assets 240,000
Bank charges and interest 96,000
Bad debts 415,000
Discount allowed 336,000
Repairs and maintenance 705,000 _________

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 Net profit 681,000 18,900,000
18,900,000

Notes:
1. Distribution and office expenses include the following:
Sh.
Subscriptions to Wananchi sports Club for employees’ benefit 180,000
Directors’ personal expenses 96,000
Donations to charitable organisation 50,000
2. 15% of rent and rates relate to payments in connection with directors’ private residences.
3. Insurance recovery is in connection with mobile phones stolen while on transit to a client.
4. Bad debts provision represents a reduction in the general provision for bad debts.
5. Legal fees include the following:
Sh.
Debt collection 80,000
Employment contracts 60,000
Acquisition of trade mark 120,000
Renewal of lease – 50 years 60,000
Legal suit in relation to counterfeit
Handsets found in the company’s 116,000
warehouse 436,000

6. Subscriptions are to the Mobile Phone Dealers Association.

7. Licenses and permits represents sh.150,000 paid to the Communications Commission of
Kenya (CCK) and Sh.50,000 relates to the single business permit paid to the Nairobi city
Council.
8. Repairs and maintenance include an extension to the warehouse at a cost of Sh.450,000.
9. Travelling expenses include sh.240,000 incurred by the sales manager when he travelled
to South Africa to attend a mobile phones and accessories trade fair.
10. Capital allowances have been agreed with the Commissioner of Income Tax at Sh.860,000.

Required:
(a) Compute Mobile Options Ltd.’s taxable profit or loss for the year ended 31 December
2022. (12 marks)

Computation of taxable business income:

Net profit reported 681,000
Add: Disallowable expenses:
Rent and rates for Directors residence 18,750

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Directors personal expenses 96,000
License paid to CCK 150,000
Acquisition of trade mark 120,000
Legal suit in relation to counterfeits 116,000
Depreciation 670,000
Loss on sale of assets 240,000
Warehouse extension 450,000

Less: Non-Taxable income:

Profit on sale of assets (240,000)
Reduction in provision for bad debts (80,000)
Capital allowances (860,000)
Taxable income 1,361,750

(b) Compute the tax payable thereon. (2 marks)

Tax payable = 30% 1,361,750 = Sh.408,525

(c) Assuming that Mobile Options Ltd.’s taxable income for the year ended 31 December 2021
was sh.1,000,000, indicate the due dates for the tax you have computed in (b) above
showing the amounts payable. (4 marks)

Last year’s actual tax liability = 30%*1,000,000 = sh.300,000

Estimated installment tax for current year (2022) = 110%*300,000 = sh.330,000 (payable by
20th day of the 4th, 6th, 9th and 12th months in equal instalments).

Therefore, unpaid tax will be (408,525 – 330,000) = sh.78,525 (payable by 30th day of 4th
month ie. 30th April 2023)

(d) Compute the penalties payable by Mobile Options Ltd. if the company pays the tax of
Sh.78,525 in (c) above on 30 June 2023. (2 marks)

Late penalty = 20% of unpaid tax ie. 20%(78,525) = 15,705

Monthly interest on unpaid tax = 2% ie. 2% (78,525) = 1,570
Total penalty Sh.17,275

Total amount payable on 30th June 2023 = (78,525 + 17,275) = Sh. 95,800

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QUESTION TWO
The management of Mapato Ltd. presented the following income statement of the company for
the year ended 31 December 2022

Mapato Ltd.
Income statement for the year ended 31 December 2022

Note Sh.
Gross profit 1,864,000
Investment income 1 284,636
Profit on sale of shares 216,324
2,364,960

Directors remuneration 2 1,020,000

Interest 3 273,600
Audit fees and expenses 4 216,000
Bad debts 5 158,400
Depreciation 344,760
Miscellaneous expenses 6 133,600
2,146,360
Net profit 218,600

Notes
1. Investment income:
Dividends from shares in Ushindi Commercial Bank Ltd. 72,000
Interest on fixed deposit account 58,760 (Net)
Interest on Treasury bills 93,876 (Net)
Dividends from a subsidiary company 60,000
284,636
2. Directors remuneration:
Directors fees 240,000
Travelling expenses - directors 400,000
Payment to directors’ pension scheme 160,000
Compensation to a former director wrongful termination of contact 220,000
1,020,000
3. Interest expenses:
Interest on bank overdraft 151,200
Interest on loan from a foreign bank 50,400
Interest on loan to purchase investment shares 72,000

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4. Audit fees and expenses:
Audit fees 68,000
Tax appeal against assessment 32,000
Book keeping fees 48,000
Audit expense paid in relation to a discontinued business line 68,000
216,000
5. Bad debts:
Embezzlement by staff 21,600
Insurance compensation on embezzlement (12,000)
Bad debts written off 28,800
General provision for bad debts 120,000
158,400
6. Miscellaneous expenses:
Acquisition of a 100-year lease on business premises 28,000
Directors Christmas party 24,000
Subscriptions to a trade association 30,000
A.S.K show contribution 10,000
Donation to a children’s home 41,600
133,600
7. Capital allowances have been agreed with the Commissioner of Income Tax at Sh.368,207.

Required:
Determine the adjusted taxable profit or loss of Mapato Ltd. for the year ended 31 December 2022.
(16 marks)
(Total: 20 marks)
Solution:

Computation of taxable income for Mapato ltd. For the year of income 2022:

Reported profit 218,600

Add back: Disallowable deductions

Travelling expenses - directors 400,000
Compensation to a former director wrongful termination of contact 220,000
Interest on loan to purchase investment shares 72,000
Tax appeal against assessment 32,000
Audit expense paid in relation to a discontinued business line 68,000
Embezzlement by staff 21,600
General provision for bad debts 120,000
Acquisition of a 100-year lease on business premises 28,000

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Directors Christmas party 24,000
Depreciation 344,760
Interest on fixed deposit account (100/85 *58,760) 69,129 Gross
Interest on Treasury bills (100/85 *93,876) 110,442Gross

Less: Non-business and exempt incomes

Insurance compensation on embezzlement (12,000)
Dividends from shares in Ushindi Ltd. (WHT final) (72,000)
Dividends from a subsidiary company (Exempt) (60,000)
Capital allowances (368,207)
Profit on sale of shares (216,324)

Taxable income 1,000,000

Tax payable: 30% * 1,000,000 300,000

Less: WHT on Interest:
- Fixed deposit account (69,129 - 58,760) = (10,369)
- Treasury bills (110,442 – 93,876) = (16,566)
NET TAX PAYABLE 273,065

MR. KIMANI JM(CPA)

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