Executive summary

On 23 February 2024, the Tax Appeals Tribunal (TAT or Tribunal) in Kenya issued a ruling (M-Kopa LLC v. Kenya Revenue Authority, Tax Appeal No. 65 of 2023) in favor of a digital financial service provider, affirming that for nonresident companies the place of effective management (POEM) for tax-residency purposes, is determined based on the location where the board of directors met and made key management and commercial decisions necessary for the entity to conduct business. This decision also emphasized that the location of the majority of directors is vital in determining the POEM.

The implication of this judgment is that the place of a taxpayer's effective management is where the top level of management is exercised.

Detailed discussion

The appeal forming the subject of the ruling arose when the Kenya Revenue Authority (KRA) audited the Appellant's operations for the year 2017 and imposed a tax assessment of Kshs¹ 368,507,926 relating to corporate income tax (CIT), Pay As You Earn (PAYE) and withholding tax (WHT). The KRA asserted that the Appellant was a tax resident in Kenya in 2017 by virtue of the fact that its executive board members were tax residents in Kenya and 19 out of 27 board meetings held in the period 2012—2017 took place in Kenya.

The KRA's tax assessment deemed all of the Appellant's gains or profits in 2017 to have accrued in or been derived from Kenya. The Appellant averred that it was not a tax resident in Kenya because in 2017 only one of its four board meetings were held in Kenya and its headquarters was in the United Kingdom. In addition, the Appellant argued it was a holding company that was only mandated to oversee operations of the operating entities and therefore did not engage in any operational activities in the 2017 year of income.

Appellant's arguments

The Appellant asserted that the KRA had erred in concluding the company was tax-resident in Kenya and, therefore, the tax assessment should be set aside. The Appellant averred that it was a nonresident company and did not create tax residency in Kenya in 2017. It also contended that its board of management was composed of four shareholder representatives, each of whom was located outside of Kenya, and that those four shareholders had the power to approve and remove the three independent directors on its board of management, effectively giving them control over seven of the 10 seats on the board. It also stated that under the Organisation for Economic Co-operation and Development (OECD) Guidelines, a company or a body of persons is deemed to be resident where the POEM is situated, and that its POEM was in the United Kingdom where its board of directors were resident.

The Appellant further argued that the KRA erred by demanding corporate income tax of Kshs 74,016,426 (inclusive of penalties and interests) on grant income of Kshs 155,170,705 received by the Appellant in the year 2017. The Appellant relied on Section 3(2) of the Income Tax Act (ITA) and argued that grant income is not expressly provided for as a class of income that is subject to income tax.

Additionally, the Appellant contended that the Respondent had erred in assessing WHT of Kshs 203,551,655 (inclusive of penalties and interests) on preferred shares and interest on nonresident third-party loans because ITA Section 35(6), which provided for the collection and recovery of WHT and penalties, was repealed under the Finance Act of 2016, which became effective on 9 June 2016. Because this provision was repealed in 2016, there was no enabling legislation for collection of WHT. This was the case until the Finance Act of 2019 reintroduced Section 39A of the Tax Procedures Act (TPA) effective from 9 November 2019 giving the Respondent the power to demand WHT from persons who failed to deduct or remit it within prescribed timelines.

Finally, the Appellant contended that the Respondent erred in assessing PAYE of Kshs 90,939,845 (inclusive of penalties and interest) on employee remuneration granted in the form of stock options, because it issued its shares in many cases above the market price as at the date of grant and hence no taxable benefit accrued to the employees.

Respondent's arguments

Opposing the appeal, the Respondent argued that the Appellant was tax-resident in Kenya because it had made a declaration in the Securities and Exchange Commission (SEC) filings in the United States of America (USA) that its principal place of business was in Kenya and the addresses of all the executive directors were in Kenya. The Respondent also noted that from 2012 through 2017 the Appellant held 19 out of 27 meetings in Kenya and that all meetings held outside Kenya were held in locations that were not the Appellants' offices in those respective countries.

The Respondent also averred that the persons who were making executive decisions were based in Kenya and the board of directors merely met to rubber-stamp these decisions hence its conclusion that the Appellant was a resident of Kenya.

The Respondent further contended that the Appellant reported grant income of Kshs 173,215,886 and its Kenya registered subsidiary reported grant income of Kshs 18,045,181. The Respondent's noted that grant income was categorized as other operating income in the Appellants' 2017 financial statements. This amount was therefore taxed under ITA Section 3(1).

Regarding WHT on preferred shares, the Respondent held the view that the preferred units were liabilities/loan instruments. Therefore, deemed interest applied loans and as such Sections 10 and 35 of the ITA allowed the KRA to impose a WHT on deemed interest.

Regarding the PAYE assessment, the Respondent contended that the Appellant granted 47,568 options in 2017 with a weighted-average share price of US$38.04, giving rise to a taxable benefit of approximately US$1,809,487 (Kshs 187,119,022) on which the KRA correctly assessed a tax liability.

Tribunal determination

The Tribunal having considered the Appeal, established the following issues for determination.

1. Whether Appellant was tax resident in Kenya in 2017 year of income

The Tribunal noted that both parties agreed that only one board meeting was held in Kenya in 2017. The other meetings were held in other jurisdictions outside Kenya. Finding it apparent that all decisions made by board committees required the approval of the board of directors, the Tribunal stated that the KRA had failed to prove its assertion that the role of the board of directors was merely to rubber-stamp the decisions of the board committees.

2. Whether Respondent was justified in issuing Objection Decision on CIT, WHT and PAYE

The Tribunal noted that a textual reading of ITA Section 3(2)(a) makes it clear that grants have not been included in the exclusive list of sources of income that are chargeable to income tax. It thus considered whether the grants were gains and profits from business, employment or rights granted for the use of property or any other form of recognized income provided by the ITA. It concluded that the grant was received from a third party and was not consideration for services offered in the course of business. The TAT emphasized that tax statutes should be read based on the plain text and that nothing else should be construed and or inferred from them.

The Tribunal further noted that due to the repeal of ITA Section 35(6) by the Finance Act 2016, the Respondent could no longer recover tax from an entity that should have, but did not, withhold it. This position remained from 9 June 2016 until 7 November 2019.

Finally, the Tribunal stated that the KRA breached the dictates of ITA Section 5(5)(a), which required the tax authority to abide by a prescribed formula in determining the benefit obtained by the Appellants' employee who took up the share option. The KRA also ignored the Appellant's assertion that it had adopted the market price in the share option such that none of its employees derived a benefit from the transaction.

Findings

In the appeal, the Tribunal concluded that the Appellant had discharged its burden by demonstrating that its POEM was outside Kenya because the majority of its directors resided outside Kenya and only one of its four board meetings was held in Kenya in 2017.

Separately, the Tribunal emphasized and affirmed the importance of textual reading of tax statutes, forming the basis of its decision to set aside that tax assessment. It also found that grant income was not included in the ITA as taxable income and was thus not subject to corporate income tax.

The Tribunal also disagreed with the Respondent's assertion that the amendment to Finance Act 2016 relating to WHT only applied to resident persons and that the main effect of the repeal of the law should be interpreted differently for a nonresident person.

Finally, the Tribunal conclude that no benefits arose from the employee share option plan and hence there could be no imposition of income tax.

Implications

For nonresident companies, this decision affirms that the POEM for purposes of tax residency is determined by the place where the key management and commercial decisions that are necessary for conducting the entity's business are in substance made. This definition is aligned and consistent with the ITA, which has defined a resident in relation to corporate persons to mean the place where management and control of the affairs of the corporate body were exercised in a year of income.