Tax Planning (Evasion and Avoidance), Kenyan Tax Law

By Kavossa Assava, LLB

Tax Planning

·         The base Case.

·         Source countries normally have a higher tax because of a lot of activity.

·         Objective: The aim is to reduce the tax liability in the source country and to send as much money away [through expenses] to the lower tax countries. [ this is usually anything that is below 15%]

·         Expenses: Interests, royalties, management fees, legal and accounting fees,

·         Transfer Pricing

·         Tax Mitigation

·         Tax evasion v Tax avoidance:

o   CIR v Willoughby; Tax avoidance is when a tax payer reduces his tax liability without incurring the economic consequences that Parliament intended to be suffered by a tax payer qualifying for such a reduction.

·         How to interpret tax laws: There is not too much tax jurisprudence in Kenya. There’s one case.

o   R v KRA ex parte Bata Shoe Company; Quoted a Malaysian case which stated that the words in a tax statute are to be given their ordinary meaning. Moral precepts are not applicable. You must look clearly at what is said. There is no room for intendment in tax. There is no equity about tax. Nothing is to be read in or implied. Only look fairly at the language used.

o   Literal Approach; first enunciated by courts in the UK

§  Partington v A.G; if a person comes within the letter of the law, he must be taxed. Eg. If a tax levy causes an injustice, it is not the duty of the tax law to remedy that injustice. If on the other hand the Crown seeking to recover the tax cannot bring the subject within the letter of the law, the subject is free, however apparently within the spirit of the law the case might otherwise appear to be.

§  Double tax agreement

§  Ayrshire Pullman Motor Services v IRC: No man in this country is under the smallest obligation, moral or otherwise to arrange his legal relations to his business or property as to enable the revenue authority to put the largest possible shovel into his stores.

§  IRC v The Duke of Westminster: every man is entitled if he can, to order his affairs so as the tax attaching, under the appropriate act, is less than it ought to be.  If he succeeds in ordering them so as to secure this result, then however unappreciative the Commissioners of the England Revenue or his fellow tax payers may deem of his ingenuity, he cannot be compelled to pay an increased tax. The so called doctrine of substance seems to me to be nothing more than an attempt to make a man pay notwithstanding that he has ordered his affairs that the amount of tax sort from him is not legally claimable.[tax avoidance is not illegal]

·         The Purposive era; the purpose of the tax levy.

o   W.T Ramsay v IRC: given that a document or transaction is genuine, the court cannot go behind it to some supposed underlying substance. This is a cardinal principle but it must not be overstated or over-extended. While obliging the court to accept documents or transactions found to be genuine, it does not condone the court to look at a document or transaction in blinkers isolated from any context to which it properly belongs. If it can be seen that a document or transaction was intended to have effect as part of an excess or nexus of transactions or an ingredient of a wider transaction intended as a whole, there is nothing in the doctrine to prevent it being so regarded. To do so is not to prefer form to substance or substance to form. It is the task of the court to ascertain the legal nature of any transaction to which it sort to attach a tax or a tax consequence. And if that emerges from a series or combination of transactions, if intended to operate as such, it is that series or combination which may be regarded.

·         The McNiven Era: Most recent cases. The focus is on only what Parliament intended and that is what is written in the laws.

Tax Evasion and tax avoidance

·         Developing countries, in contrast, are confronted with social, political and administrative difficulties in establishing a sound public finance system.

·         As a consequence, developing and emerging countries are particularly vulnerable to tax evasion and avoidance activities of individual taxpayers and corporations.

·         This can be considered one of the primary reasons for large differences in the ability to mobilize own resources between developed and developing countries.

·         Tax systems in many developing countries are characterized by tax structures being not in line with international standards, by lack of tax policy management, low compliance levels and inappropriate capacities in tax administration.

·         The difference in revenue mobilization also stems from economic conditions (size of the informal sector). In fact, most developing countries show a trend towards the prevalence of indirect taxation. Many of them rely to a great extent on indirect taxes such as value-added taxes (VAT) with indirect taxes amounting for up to two-thirds of total tax revenues.

·         It is important to recognize that tax losses that arise in the course of tax evasion and avoidance activities do largely contribute to the poor performance of state revenue mobilization in developing countries.

·         Tax evasion and avoidance are both phenomena that are probably as old as taxation itself.

·         Wherever and whenever authorities decide to levy taxes, individuals and firms try to avoid paying them.

·         Though this problem has always been present, it becomes more pressing in the course of globalization as this process extends the range of opportunities to circumvent taxation while simultaneously reducing the risk of being detected.

·         In the last couple of years, strengthening self-financing capacities of developing countries has become a topic of increased concern and interest.

·         Domestic revenue mobilization as a central issue of the international development agenda has been emphasized in both the Monterrey Consensus and the Paris Declaration on Aid Effectiveness. This is due to a number of reasons.

·         Firstly, the establishment of own revenue raising abilities is crucial for any state as it constitutes a prerequisite to ensure a sustainable development process and implement pro-poor policies.

·         Secondly, fair and efficient tax systems can contribute to good governance, accountability of the state and democracy by establishing a bargaining process between the state and its citizens: Governments that rely on broad based taxation are forced to take the demands of their taxpayers into account. At the same time, the way in which a government levies taxes essentially affects the citizen’s identification with the state and its governmental agencies, potentially increasing trust and compliance of its citizens and ultimately promoting political participation.

·         Thirdly, revenue raising systems typically include the entire population, thereby exhibiting a direct effect on the poor and their household income. Designing a tax system in a pro-poor way can e.g. be achieved by including a redistributive component.

·         Tax evasion in general refers to illegal practices to escape from taxation.

o   To this end, taxable income, profits liable to tax or other taxable activities are concealed, the amount and/or the source of income are misrepresented, or tax reducing factors such as deductions, exemptions or credits are deliberately overstated

o   Tax evasion can occur as an isolated incident within activities that are – in other aspects – legal.

o   Or tax evasion occurs in the informal economy where the whole activity takes place in an informal manner – this means the business is not only evading tax payments but is also not registered as formal enterprise at all.

·         Tax avoidance, in contrast, takes place within the legal context of the tax system that is individuals or firms take advantage of the tax code and exploit “loopholes”, i.e. engage in activities that are legal but run counter to the purpose of the tax law.

o   Usually, tax avoidance encompasses special activities with the sole purpose to reduce tax liabilities.

o   An example for tax avoidance is strategic tax planning where financial affairs are arranged in such a manner in order to minimize tax liabilities by e.g. using tax deductions and taking advantage of tax credits.

o   The taxpayer is not obliged to follow the spirit or the underlying purpose of the tax code but only the letter of the law

o   Tax avoidance often takes place at the margins of the tax code, in areas where the code is ambiguous and in need of interpretation.

·         In many instances, the distinction between tax avoidance and tax evasion is clear only from the ex post perspective, ultimately a post-court perspective.

·         For this reason, tax evasion and tax avoidance are usually treated jointly, despite their differences

·         The tax gap – or tax revenue gap is defined as the difference between the tax revenue which would be raised under hypothetical, perfect enforcement of taxes and the actual tax revenue.

·         A policy intended to fight tax evasion and avoidance is a policy to narrow the tax gap.

·         The tax gap sometimes is used as an indicator for the level of tax evasion and avoidance.

·         International and national perspective: The international dimension of tax evasion and avoidance can be divided into two stylized strands:

1.        On the one side, one can find legal or natural persons taking advantage of differences in tax laws or rates and the resulting tax liabilities between countries resulting in attempts to shift tax liabilities to low-tax countries. This starts with efforts to reduce tax payments in a private environment, e.g. tax-induced cross-border shopping and tank-tourism, and ends with the flight of financial capital to low tax destinations or tax havens.

2.       On the other side, the international dimension of tax evasion and avoidance covers all kinds of tax evasion and avoidance activities which occur as a result of international trade, the international division of labour, and international competition for foreign investment

·         Besides the international perspective there also exists a national dimension.

§  This relates to all incidents in which individuals or firms evade or mitigate taxes within their country of residence while no transactions with companies or individuals abroad are involved.

§  The national perspective comprises incomes and revenues generated in the domestic informal economy, income not reported by a legal or natural person and other means of ‘getting around’ solely domestic tax liabilities.

·         Due to insufficient data and different estimation techniques, existing estimates on the tax gap resulting from tax evasion and avoidance are difficult to compare and often cover a broad range:

·         There are various reasons for tax evasion and tax avoidance.

·         These reasons can be filed in two categories.

§  The first category comprises factors that negatively affect taxpayers’ compliance with tax legislation. These factors can be subsumed either contributing to a low willingness to pay taxes (low tax morale) or to high costs to comply with tax laws.

§  The second category contains reasons for the low ability of tax administration and fiscal courts to enforce tax liabilities. These factors can be summarized as resulting from insufficiencies in the administration and collection of taxes as well as weak capacity in auditing and monitoring tax payments which limit the possibility to detect and prosecute violators.

      Low tax morale: Tax morale is, however, not easy to establish. Especially countries without a deep-rooted ‘culture’ and habit of paying taxes find it difficult to establish tax morale.

·         This “willingness to pay” of the taxpayer is influenced by the following factors:

• Low quality of the service in return for taxes. In general, citizens expect some kind of service or benefit in return for the taxes paid. If the government fails to provide basic public goods and services or provides them insufficiently, citizens may not be willing to pay taxes and tax evasion and avoidance will be the consequence

• Tax system and perception of fairness. Some studies suggest that high tax rates foster evasion. The intuition is that high tax rates increase the tax burden and, hence, lower the disposable income of the taxpayer. However, the level of the tax rate may not be the only factor influencing people’s decision about paying taxes. In fact, the structure of the overall tax system has an impact as well. Tax rates and the overall structure of the tax system, therefore, have a significant effect on the disposition to evade and avoid taxes.

• Low transparency and accountability of public institutions. Lack of transparency and accountability in the use of public funds contributes to public distrust both with respect to the tax system as well as the government. This, in turn, increases the willingness to evade taxes

• High level of corruption. If due to high levels of corruption, citizens cannot be certain whether their paid taxes are used to finance public goods and services, their willingness to pay suffers and it becomes more likely that they evade their tax liabilities. A taxpayer might consider evading taxes if the cost of bribing a tax auditor is lower than the potential benefit from tax evasion.

• Lack of rule of law and weak fiscal jurisdiction. Strong fiscal courts are essential to protect taxpayer’s rights and safeguard them from arbitrariness. If the legal system does not operate in accordance with the rule of law, citizens have to fear arbitrariness, discrimination, unequal attendance in court, etc. The lack of rule of law reduces transparency of public action and fosters distrust among citizens. As a result, citizens may not be willing to finance the state through taxes, and decide to evade these liabilities

·         High compliance costs. that is the costs the taxpayer has to bear to gather the necessary information, fill out tax forms etc, can be an additional reason for tax evasion and avoidance.

      Weak enforcement of tax laws

·         There exist several circumstances that restrain tax administrations from performing their functions properly thereby increasing the possibility of tax evasion.

o   Insufficiencies in tax collection: many developing countries face difficulties with respect to important premises for a well functioning tax administration, especially with respect to identifying and administering those citizens and firms that are liable to tax payments. registers still pose severe difficulties in many developing countries. Problems of insufficient capacity may also occur due to the organizational set up of the tax administration and its relationship to the ministry of finance. In general, there are two approaches for the organizational set up of tax administration. The first option is where the ministry of finance itself assumes the tax administration function and departments within the ministry of finance collect taxes. The second option is a semi-autonomous revenue authority where tax administration is moved out the ministry of finance into a separate entity. Often, tax administration and collection by ministries of finance were considered inefficient and suffering from corruption and high compliance costs (see Fjeldstad/Moore, 2009). Therefore the creation of semi autonomous revenue authorities has been pursued in many developing countries mostly as part of comprehensive tax administration reforms Additionally, unclear responsibilities regarding the collection and administration of specific types of taxes by different institutions can lead to inefficiencies and tax losses and require a reorganization of the tax administration. Typically, an organizational approach according to the functions of tax administrations is considered more efficient than one following different tax and revenue types. Moreover, one has to bear in mind that tax administration and tax policy are intertwined spheres. Tax policy directly affects the costs and the organization of the tax administration. Additionally, the capacities of tax administration influence the way tax policy is implemented. Thus, both areas tax policy as well as tax administration have to be taken into consideration when designing successful tax reforms. Otherwise, the proper functioning of the overall system is affected. For this reason, the tax system should be aligned to the adminis trative and legal prerequisites of the respective country Qualified, well trained and motivated tax officials are crucial for the collection of taxes and the performance of tax administration bodies as a whole. In order to motivate tax officials to work in accordance with the interests of the government and to reduce their vulnerability to corruption, attention has to be given to wages and other incentives. Finally, insufficiencies in tax collection result from the fact that economies of most developing countries are characterized by a large informal sector. Firms and individuals active in the informal sector usually do not pay direct taxes on personal or business income, and they do not charge consumption taxes or excises on their sales. The state loses these potential tax revenues and, as a consequence, lacks necessary funds to provide goods and service. Often, the reasons to be active in the informal economy are not directly related to attempts to avoid taxation but rather to limited options or excessive adminis trative requirements to enter the formal economy or excessive costs of labour regulations. However, there are also cases where individuals and companies choose to be active in the informal sector with the intention to escape their tax liabilities. Nevertheless, tax evasion does not need to be the primary reason why firms remain or become informal.

o   Weak capacity in detecting and prosecuting inappropriate tax practices: A well-functioning body of tax investigation is essential for the detection and prosecution of cases of tax fraud. The lack of sufficient capacities in tax administrations reduce the probability of detection that again influences the decision of a taxpayer as to whether evade or not. Additionally, the legal framework is an important prerequisite for any enforcement activity. For example, the size and nature of penalties that are incurred after evasion has been detected is directly connected to the level of tax compliance (Finally, tax laws in many countries, especially in developing countries, changes rapidly, thus producing instability and low transparency of the tax code. As a result, complicated tax legislation and ongoing changes of the tax code confuse tax administrators and taxpayers alike. This produces ample opportunity for tax avoidance (Mo, 2003). Furthermore, it results in tax evasion which is not intentional, but occurs due to lack of knowledge ignorance. In extreme cases, tax evasion and avoidance even become inevitable when the tax system becomes too complex and/or contradictory to follow.

·         The reasons listed above do not occur in isolation and some are mutually enforcing. Often, tax evasion and avoidance are by-products of deficient political, economic and social governance in a country.

Modes of tax avoidance and evasion in developing countries

·         Tax Havens: It is worth noting that this does not only include accounts in tax havens as not every low-tax country can be classified as a tax haven.

·         Usually, tax havens show two common features:

1.        Little or none of the real commercial activity of the registered companies occurs in the haven country; and

2.       most tax havens use a tax and regulatory regime that distinguishes between local investment and investment made by foreigners, with the latter given favourable treatment (so called “ring-fencing”).