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1.1 Objectives
In this chapter, the student should be able to understand tax aspects of partnerships and
Limited companies. To enhance their understanding, various relevant case law examples have
been discussed.
1.2 Introduction
In the first taxation paper you were introduced with aspects of taxation of business income. In this
chapter, you will be introduced with concepts on advanced aspects of the taxation of business
income. Some of the issues to be discussed in this chapter are tax implications of various sources
of income for partnerships, and taxation of group of companies. In the next chapter you will cover
the taxation of specialized institutions.
1.3 Key Definitions
• Partnership: The relationship that subsists between persons carrying on a business in
common with a view to profit.
• Company: it’s an association of persons who contribute capital towards common
stocks for a common aim. Companies are incorporated under the Companies Act and
are legal persons.
1.4 Exam Context
This topic is highly examined. Students will be required to not only remember the content learnt
in their first taxation paper but also apply the knowledge learnt, in answering questions in this
paper.
1.5 Industrial Context
This topic will help businesses be able to deal with complicated and advanced aspects of taxation
of their businesses. The major beneficiary of the topic will be the finance manager, tax practitioners
and accountant who will apply the information in making key management decisions.
1.6 Partnerships
Provisions of the Income Tax Act Cap 470 Laws of Kenya
For purposes of imposing tax a "person" does not include a partnership. The income of a
partnership is assessed on the partners.
Under Section 4(b) of the Act, "the gain or profits of a partner from a partnership shall be the sum
of -
i. remuneration payable to him by the partnership together with interest on capital so
payable, less interest on capital payable by him to the partnership; and
ii. his share of the total income of the partnership calculated after deducting the total of
any remuneration and interest on capital payable to any partner by the partnership and
after adding any interest on capital payable by any partner to the partnership".
Where a partnership makes a loss as calculated in (ii) above, the gains or profits shall be the
excess, if any of the amount set out in (i) over his share of that loss.
Determining the existence of a Partnership
Under English and Kenya law a partnership is not a person but "the relationship that subsists
between persons carrying on a business in common with a view to profit".
Whether a partnership exists or not is a question of fact. The basic criterion is whether two or
more persons carry on a business in common with a view to profits.
This suggests that the persons involved bear the attribute of a proprietor and have a profit
motive.
Other useful guidelines include the following:
• Usually a partnership deed or written agreement will be drawn up
• There is a joint tenancy or tenancy in common
• There is sharing of gross receipts or profits
None of these circumstances of itself would constitute conclusive evidence of the existence of a
partnership.
Common situations which pose difficulties in proving a partnership are:
1. Whether joint transactions may constitute a partnership; and
2. Whether the parties concerned are partners or merely employees.
1. Joint transactions - JOHN GARDNER & BOWRING & CO V CIR
G arranged during a coal strike to buy imported coal from B. The coal was invoiced to G at cost
and the net excess of his sales were shared with B.
Judgement "whereas these cargoes of coal generally had been formally the simple transaction
of purchase and sale between the parties, they immediately became the subject of a transaction
in which both parties were interested, and in which when one of them had sold the coal, the sale
was not on his behalf but on behalf of the two together the net profit, so obtained was equally
divisible between them".
Held: The relation between these two parties constituted a partnership.
2. Employee or partner
The Deed of partnership does not necessarily constitute partners for income tax purposes.
Dickenson V Gross (Hmit)
A farmer named Dickenson, entered into a Deed of Partnership with his three sons with the
admitted intention of reducing income tax liability in respect of the profits. The deed provided
inter alia that two farms owned by D should be let to D and his sons at stated rentals, that
accounts should be made up annually, that the net profits should be divided equally between the
partners, and that the partners shall have the right to sign and endorse cheques on behalf of the
firm. No rent was paid and no accounts or books had been kept. No distribution of profits was
made. Cheques were signed by D and some business receipts were paid to his private bank
account.
Held: That as a partnership did not exist in fact, and that there was no partnership for purposes
of income tax.
E v CIT
E carried on business as a sole trader. In June 1942 he admitted his three daughters and
son as partners. A Deed was executed stating the partnership commenced on 1 June 1942.
The provision of the deed gave E sole and exclusive management and control of the business.
Neither the son nor any of the daughters contributed property, labour or skill to the partnership.
A Deed of covenant was executed whereby each of the daughters was to pay a fraction of her
partnership profits to her mother and other infant children of E.
Held: Both the local committee and the High Court ruled that there was no evidence that a
partnership in fact existed.
Sinclair J stated:
"The terms of the Deed of Partnership and the facts as a whole are, in my view, inconsistent with
the relation of a partnership. The other partners contributed neither property nor labour, nor skill.
The whole of the capital was provided by the appellant. The partners in fact drew no profit. It was
evident that the appellant intended to retain control, not only of the management of the business
but also of the share which he gave to the children.
CIT V Williamson
A farmer and his sons for several years leased and worked in a farm jointly, but without any deed
of partnership. He supplied the capital, conducted all buying and selling and controlled the bank
account which was in his name.
He made no regular payments to his sons but supplied them, on request, with such monies as
were necessary for their requirements. No record of these disbursements or the financial results
of the farm was kept.
The respondent appealed against additional assessment to income tax in respect of the farm,
raised on the basis that he alone was assessable.
Held: That the facts did not justify the inference that a partnership had existed.
Opinions
The Lord President (Clyde)
"My Lords the question before us is whether there was a partnership between the father and his
three sons in whose joint names the lease ... was taken ... No doubt the lease was in joint names
... That it is in vain to constitute a partnership and the whole capital belonged to the respondent
... There is no record of any kind to show the existence of any contractual relation of any sort.
The bank account was the respondent's bank account and his alone. It was never operated
by anybody but him ... The sons got no wages ... You do not constitute or create or prove a
partnership by saying that there is one. The only proof is proof of the relations of agency and of
loss and profits and of the sharing in one form or another of the capital".
Lord Sands
"Stated all the facts and circumstances of the case otherwise, except the matter of the lease,
appear to be against and, indeed almost exclusive of the idea of a partnership".
Pratt V Strick
P agreed to purchase a medical practice. A Deed of assignment was exercised on 15 July 1929
whereby the vendor agreed to stay on in the practice for three months to introduce P to his
patients, with a view to maintaining the connection of the practice and generally to aid and assist
him in the practice. It was agreed that the earnings and expenses of the practice during the three
months be borne by the vendor and purchaser in equal shares.
P contended that the practice was sold outright to him on 15 July 1929 and that his income tax
liability should be computed on the basis the practice was commenced anew by him on that
date.
Held: That there was an out-and-on sale of the practice on the 15th July, 1929, and that there
has been no partnership. The practice was assessable as a new business in the name of the
purchaser only, and the vendor was in receipt of remuneration for services rendered.
Waddington V O'callaghan (Hmit)
The appellant, who had for many years carried on, solely, a practice as solicitor, informed his son
on 31 December, 1928, that it was his intention to take him into partnership as from that date.
On 1 January, 1929, he instructed another firm of solicitors, by letter, to draft a partnership deed.
The deed was executed on 11 May 1929 to have effect from 1 January 1929.
No formal notice of the partnership was at any time given by advertisement, circular or otherwise.
No alteration of the name under which the practice was carried on, or in the business bank
account, was made until after the date of the partnership deed. From 31 December 1928 the son
was credited with the share of profits to which he was entitled under the partnership deed.
Held: The Partnership constituted by deed commenced on the date of the deed and that there
was no knowledge of the existence of a partnership before.
Steps in Computing tax on Partnership Income
1. Determine or compute the adjusted income or loss for the partnership in the normal way,
except that: -
(a) Salary to partners is not allowable expense
(b) Interest paid to partners is not allowable
(c) Interest paid by partners is not taxable
(d) Wife’s salary is not allowable
(e) Drawings of commodities dealt with in the partnership are added back at cost. Note
that no profit is to be made from another partner.
2. Allocate the income adjusted to the partner by first isolating salaries to partners, interest on
capital (net) to partners, bonus to partners, commissions, etc. The balance is either profit or
loss to be shared out among partners according to profit sharing ratio or as per partnership
agreement
Note
The figure of the total profits to be shared is derived from the difference between the adjusted
profits plus interest on drawings minus salaries and interest on capital. It is apportioned to the
partners in their profit and loss sharing ratio.
Computing taxable income of a partnership where the partner has no proper books of
account
Jimna and Mwala are in partnership trading as Jimna Enterprises and sharing profits and losses
in the ratio of 2:1 respectively. The partnership has however not been maintaining proper books
of account.
The following information relates to the financial year ended 31 December 2007:
1. The firm’s assets and liabilities as at 1 January 2007 comprised:
3. The cash sales deposited are after deducting Sh.3,000 per month taken as imprest by each
partner in order to pay for goods drawn from the firm. No entries have been made to record
the imprest or drawings of goods.
4. Trade debtors and creditors balances as at 31 December 2007 were Sh.1,200,000 and
Sh.160,000 respectively.
5. Salaries and wages include salaries to partners paid during the year amounting to Sh.165,000
and Sh.160,000 to Jimna and Mwala respectively.
6. Legal expenses comprise:
1. Miscellaneous expenses include estate valuation fee of Shs.4,000 in relation to insurance of
the shop premises.
2. Five percent of the trade debtors outstanding as at 1 January 2007 were uncollectible during
the year and were written off.
3. Stock as at 31 December 2007 amounted to Sh.128,000
Required:
i) Adjusted partnership profit or loss for the year ended 31 December 2006 (Hint: start
with sales) (12 marks)
ii) Allocation of the profit or loss in (b) (i) above to the partners.
(2 marks)
(Total: 20 marks)
Attempted solution
Step 1: Compute the figures not provided. In this case, ascertain the sales and purchases
figure by drawing the relevant account
Total wear and tear allowance (275 + 22.5) = 297.5
Note:
No written down values have been provided for wear and tear assets as at 1/1/2006. The net
book value has been used instead as representative of written down values at the beginning of
the year.
Step 2: Allocate the profits or losses to the partners according to the profit and loss sharing
losses taking into considerations the provisions of Section 4 (b) of the Income Tax Act..
iii) ALLOCATION OF PROFIT IN (b) (i) ABOVE
1.7 Limited companies
Limited companies in Kenya can either be private or public. There are no fundamental differences
in the taxation of either private or public companies.
Companies incorporated in Kenya are expected to pay instalment tax before the end of the
accounting year. Therefore, the amount of tax payable shall be determined at the beginning of
each year. This is based on the lesser of:
• The budgeted profits of the year or
• 110% of the last year’s tax liability.
Once determined, the instalment tax is payable as follows
1.7.1Corporation Tax Rates.
In Kenya, the corporate tax rate for a resident company is 30% whilst the tax rate for a permanent
establishment of non resident company is 37.5%. A non resident company can have a permanent
establishment in Kenya by opening a branch. However, different rates of taxes apply for the
following:
i. Newly listed companies
Companies newly listed on any securities exchange approved under the Capital Markets Act
enjoy favorable corporation tax rates as follows:
• If the company lists at least 20% of its issued share capital listed, the corporation tax
rate applicable will be 27% for the period of three years commencing immediately after
the year of income following the date of such listing.”
• If the company lists at least 30% of its issued share capital listed, the corporation tax
rate applicable will be 25% for the period of five years commencing immediately after
the year of income following the date of listing.”
• If the company lists at least 40% of its issued share capital listed, the corporation tax
rate applicable will be 20% for the period of five years commencing immediately after
the year of income following the date of such listing.
The corporate tax rate applicable to the company may therefore change if the percentage of the
listed share capital exceeds 20% of the issued share capital. The applicable tax rate will depend
on the percentage of the issued share capital listed at the Nairobi Stock Exchange.
ii. Export Processing Zone Companies
Companies operating within EPZ have the following benefits:
1. A ten year tax holiday –This is an exemption from corporation tax for the first ten years
of trading.
2. A lower corporation tax rate of 25% for the subsequent years after the ten years tax
holiday.
3. An exemption from all Withholding tax on dividends and other payments to non residents
during the first 10 years.
4. Investment deductions are 100% of the capital expenditure claimable in the 11th year
after commencement of production.
5. Zero rated for purposes of VAT
6. There is a refund of import duty on raw materials to manufacture exports.
Note
EPZ enterprises must submit annually returns of income and supporting accounts to the
commissioner of income tax.
• Emoluments paid to employees and resident directors of EPZ enterprises must subject
to PAYE deductions as required by law even during the period the enterprise is exempt
from tax.
iii. Resident companies mining specified minerals
Resident companies mining specified minerals under the Income Tax Act – for the first 4 years of
mining operations income is taxed 27.5% per year, while normal rates shall apply from the fifth
year of operations.
1.7.2 Tax Effects of Shortfall Distribution of Company Profits (Section 24)
The profits of a company after taxation may be distributed to the shareholders in full as dividends
or retained to provide finance, or be partly distributed and partly retained. If a company fails
to distribute as dividends that part of its income which in the opinion of the Commissioner is
in excess of its requirements within a period of twelve months after the accounting period, the
Commissioner may direct that that income be deemed to have been distributed to the shareholders
as dividends.
The Act requires that a company paying dividends to deduct tax at source and remit it to the
Commissioner. The company is entitled to recover such from the shareholder. When the profits
are subsequently distributed, they will not be taxed on the shareholders.
In practice, the Commissioner usually allows for the retention of 60% of the profits after tax
derived from trading income. Profits after tax from investment income are distributed in full. Nontaxable dividends are also distributed in full.
Illustration
Limited made a pre-tax profit of Kshs.100m comprising of:
a. Trading profits Shs.60m
b. Investment income Shs.10m
c. Dividends from B. Limited (a subsidiary) Shs.30m
