3.1 Objectives

At the end of this chapter, the student should know the procedure for tax investigation under the 

following headings:

• Tax evasion, tax avoidance and fraud

• Events which may trigger an investigation

• Back duty and indepth examinations

• Methods of computing omitted and understated income

• VAT refunds, false claims and accountant's certificate

• Capital statements and ascertainment of income omitted or understated

• Customs and excise investigations

• Negotiation for settlement

• Tax audit 

• Application of relevant case law 

3.2 Key definitions

Tax avoidance is the use of existing law to reduce tax payable. It is legal and may be achieved 

through taking advantage of the knowledge about tax to reduce the tax burden or liability.

Tax evasion is the use of fraudulent and dishonest means to reduce tax payable. Generally 

speaking tax evasion is illegal. 

3.3 Introduction

In the previous chapter, we studied concepts on taxation of specialised institutions. In this 

chapter, we shall study the various approaches that can be used either by the enterprises or by 

the revenue authority to investigate tax compliance of a company. The tax concepts learnt in this 

topic will provide a practical basis in taxation. In the next topic we shall study concepts in crossborder transactions.

3.4 Exam Context

The procedure of tax investigation learnt in this topic will be tested in the application questions in 

the examinations. As such, a deep understanding of the same will be essential.

3.5 Industrial Context

This topic is designed to not only help the students tackle related exam questions, but also to 

help tax experts, revenue authority experts and finance managers conduct any tax investigation. 

With the aggressive nature of the revenue authority, different and more sophisticated approaches 

are being adopted while undertaking the audits. As such, the content in this text may not be 

exhaustive.

3.6 Tax evasion, tax avoidance and fraud

Tax avoidance is the use of existing law to reduce the tax payable. Tax avoidance is legal and 

may be achieved through taking advantage of the knowledge about tax to reduce the tax burden 

or liability. Some modes of tax avoidance include:

• Investment decisions: Do you buy an asset of capital nature and claim capital allowances 

or incur revenue expenditure?

• Personal investment decisions: Do you invest in debentures or ordinary shares? 

• Employment income:Take light loans to build a house or buy a house?

• Do you buy your own car and claim mileage or rely on the company car?

• Production for domestic or international: EPZ for exports are zero rated for VAT, they 

have a tax holiday of 10 years, import duty refund on raw materials imported, 25% 

corporate tax rate for years from 11 to 20, ID of 100%

• Financing decisions: Debt capital interest is allowable unlike equity where dividends 

are disallowable.

• Business ownership: Should it be a sole proprietorship, a partnership or a limited 

company?

• A limited company is a going concern, salary to directors is allowable, tax liability is 

on the company, tax 30% for company, personal relief for individuals, interest on debt 

capital is allowable unlike on partners capital which is disallowable.

Tax evasion is the use of fraudulent and dishonest means to reduce tax payable. Tax evasion is 

illegal. It can also be defined as the reduction of tax liabilities by illegal means such as concealing 

information or supplying false information Tax evasion may be achieved through:

- corrupt deals with tax officials,

- willful negligence in furnishing tax information(e.g. false returns),

- Non declaration of incomes.

- Alarming expenses, allowances and relief that one is not entitled to or

- Engaging in smuggling or black markets.

- Money laundering

- Barter trade transactions

- Lighting i.e. not declaring income related to extra employment

- Manipulation of accounts( creative accounting)

3.6.1 Anti-avoidance provision ( Sec 23 of the Income Tax Act)

Under S.23, the Commissioner of Income Tax is empowered to reject certain business transactions 

when he is of the opinion that the main purpose or one of the main purposes for effecting a 

transaction is evasion or reduction of tax liability. He can direct for necessary adjustment on 

taxable income and issue an assessment accordingly. If the taxpayer disputes the adjustment 

and the resulting assessment, the taxpayer can appeal to the Tribunal e.g.

• A Director buying a car from the company at a throw away price. He would be taxed 

on the difference between the low price he pays for the car and the market price for the 

car.

• A child paid very high salary for minor duties. The salary helps to spread tax payable but 

the parent controls the child’s income. The Commissioner of Income Tax would disallow 

the salary and tax it.

S.24-Anti-avoidance provision

Under S.24, the Commissioner of Income Tax is empowered to direct a company to distribute 

dividends to its shareholders i.e. when there is dividend distribution shortfall e.g. Fair Ltd had 

adjusted income for tax in 2005 of Kshs 10 million and dividend provided/declared was Kshs 1 

million. Dividend distribution shortfall would then be calculated as follow

The Commissioner of Income Tax can direct the company to distribute Kshs 1,800 to the 

shareholders and deduct withholding tax accordingly. If a taxpayer disputes an assessment

resulting from forced distribution, the taxpayer can appeal to the Tribunal.

Tax avoidance: Principles emerging from case law

Section 23 of the Kenya Income Tax Act empowers the Commissioner to order the adjustment of 

transactions which in his opinion are effected with the main aim of avoiding or reducing liability 

to tax.

Such a direction can only be challenged by appealing to the Income Tax Tribunal. This decision 

of the Tribunal is final and there is no right to further appeal.

However, the Commissioner rarely, if ever, does use such powers. Consequently, there is no 

such litigation in respect of tax avoidance schemes in Kenyan courts.

However, the following principles have emerged from UK Case Law and which may well be 

applied in Kenya:

1. The “Duke of Westminster” Principle.

Lord Tomlin stated: “Every man is entitled, if he can, to order his affairs so that the tax 

attaching ... is less than it would otherwise be.

2. The “Ramsay” Principle:

This was established in a Capital Gains Tax Case in relation to composite transactions.

At the time, the most prevalent scheme to avoid tax (especially Capital Gains Tax) was to enter 

into a series of transactions, which would facilitate the following:

(a) Conceal the sale of property subject to Capital Gains Tax (CGT)

(b) The exchange of shares for shares, which would not have CGT implications.

This interdependent series of transactions would normally be “circular and self- cancelling”.

The Ramsay doctrine provides that whether a series of transactions is genuine or artificial would 

be dependent on the end result. Transactions which have no commercial purpose are treated as 

a fiscal nullity. The preordained series of transactions are disregarded if they have no business 

purpose other than achieving the preordained end.

The same principle was extended in CIR vs Burmah Oil Co. Ltd.

3. Francis Vs Dawson

Facts of the Case

George Dawson and family owned two private companies which they wanted to sell. If they were 

sold in UK at a gain, it would be subject to Capital Gains Tax.

Dawson wanted to sell to W Ltd a UK company. He was advised to sell by an exchange of shares 

for shares with an offshore company, G Ltd.

G Ltd then sold its shares in the two companies to W Ltd. The scheme succeeded on the grounds 

that the end result led to “enduring legal consequences” and therefore the individual transactions 

had a business purpose and not artificial as in the Ramsay Case.

3.7 Events which may trigger an investigation

The following are some of the circumstances that trigger audits by the Kenya Revenue 

Authority:

(a) Self confession.

(b) Third party information

(c) Informers e.g. friend, a spouse, former spouse.

(d) Information from related company audits.

(e) Non compliance in the industry.

(f) Cessation of business or a large part of the business.

(g) Non compliance detected via compliance check

(h) Staff of the entity

(i) Public media (TV, Newspapers, magazines)

(j) Registrar of companies or business names.

(k) Large public company e.g. KCC

(l) Government parastatals.

(m) Local authorities.

(n) Investigation using the PIN number.

3.8 Back duty and indepth examinations

The obligation to declare all incomes for tax purposes rests with the taxpayer whether or not he 

has been specifically told to do so by the Domestic Taxes Department.

Back-duty refers to collection of all kinds of tax in arrears. The Income Tax Act requires every 

person assessable to tax to notify his liability within four months after the end of the year of 

income. Return forms/materials will be sent to taxpayers in the Domestic Taxes Department 

records though the Department is not obliged to issue necessary returns/materials.

Tax arrears normally arise under the following conditions:

1. Under declaration of income (incomplete and incorrect returns)

2. Non-declaration of income

3. Taxpayer claims expenses, allowances, reliefs he is not entitled to.

An offence will have been committed by a taxpayer under the above mentioned circumstances 

and his affairs will be dealt with as a back-duty case i.e. back-duty investigation will be instituted 

into the affairs of the taxpayer. Penalties may be charged including interest charges. Where the 

above circumstances are due to:

i) Gross or wilful negligence on the part of the taxpayer and his accountant, or;

ii) Fraud on the part of the taxpayer

Sources of information resulting to back-duty will be from: -

- Taxpayer himself

- Informers

- Public media

- Income tax departments

- Farming organisations

- Registrar General’s office

- Licensing Department offices etc.

Determination of income through back-duty cases

1. The taxpayer can declare income acceptable to the department supported by accounts and 

other relevant documentation.

2. A capital statement may be prepared as sufficient estimation of growth in assets and 

therefore estimate income for such taxpayer if there are no reliable records/accounts. A 

capital statement consists of details of assets and liabilities as at a given date or period. 

This would show changes in total worth of a taxpayer between two or more periods. The 

capital statement also considers capital losses or gains, living expenses, income tax paid 

etc.

Where the capital statement covers more than one year, the resultant figures will be divided by 

number of years involved giving rise to a uniform figure as estimate measure per year.

Capital statements must appear reasonable to be acceptable by the Income Tax Department and 

must

Steps

1) Add all assets of taxpayer both tangible and intangible for a given period. Deduct all liabilities 

both personal and business used to finance the assets. Net result will be Net assets for the 

period.

2) Calculate the growth or loss in Net assets for each time period by taking the Net Assets 

of the period and comparing it with the Net Assets of the previous period. This represents 

additional assets that the taxpayer acquired or disposed in the time period.

3) Deduct any non-taxable income that was used to finance the above growth in Net assets – 

e.g. income or assets from a legacy or inheritances, capital gains, gifts, money from friends 

and relatives.

4) If looking for only the undeclared business profits taxable, then deduct any non-trading 

business income from growth in Net assets. The net figure would represent Net Business

savings.

5) Add to the balance (4) living expenses such as water & electricity, income tax paid, interest 

on loans, premium on various types of insurance, rents and rates as supported by bills or 

invoices. Add also personal expenses such as food, services, clothing, toiletries, medical 

expenses, house servant, holidays, amusements, private motor vehicle running and 

maintenance costs, harambee contributions, donations and any cash stolen from house or 

shop etc.

6) If capital assets are sold at a loss, add the loss. If sold at a profit, deduct the profit. Deduct 

any income declared during the year – balance is undeclared income.

7) Other considerations

• Taxpayers’ standard of living/lifestyle/cost of living, property and assets alienated to 

other persons.

• Any remittances abroad

• Marital status or status in society

• Dwelling place.

Procedure:

Determine the capital at the beginning and end of the period. An increase in capital may be due 

to: -

a) Fresh capital introduced (not income).

b) Profit earned (may or may not be taxable)

c) Gifts, awards, windfall gains (may not be taxable)

A decrease in capital may be due to: -

a) Capital withdrawn

b) Losses (allowable or non-allowable)

The increase in capital is adjusted for the following items:

Deduct:

Legacies, gifts not taxable, income already taxed at source and not subject to further taxation, relief 

and allowances, windfall gains, inherited wealth/property, life policies matured/surrendered.

Add:

Taxes paid, gifts or donations made, non-allowable losses e.g. loss on sale of investments/

assets, personal expenditures, unexplained payments.

Further information that may be required

1. Are there other expenses not deductible?

2. Does the taxpayer have any other income source?

3. Does the taxpayer lease the freehold land or does he farm it and what is the income?

4. Why has the taxpayer not claimed capital allowances?

5. Does the taxpayer have a life insurance policy with a Kenyan company? If so, how much 

are the premiums he pays?

3.9 VAT refunds, false claims and accountant's certificate

Refund of tax

If, for any tax period, a person has overpaid tax, i.e. the input tax claimed exceeds the output tax 

for the period, the excess amount is carried forward to be set-off against output tax for the following 

period. However, if this position is a regular feature of the business then the Commissioner shall 

refund the excess amount.

No tax is refundable if the registered person is not up to date in the submission of VAT returns.

The claim for refund must be made on the appropriate form within a period of 12 months.

The Commissioner VAT may refund tax under the following circumstances:

• Where payment has been made in error e.g. overpayment of VAT, use of wrong rate, 

miscalculation etc.

• Where input tax persistently exceeds output tax and this is a regular feature of the 

business.

• Where goods are imported, VAT charged and then exported before being used, VAT 

paid will be refunded.

• When payment for supply of goods/services have been received (bad debts) under 

Sec. 24. A refund for bad debt is made within 5 yrs.

• VAT refund for bad debt is claimable if:

(i) The debtor had been declared legally insolvent or

(ii) The debt has been outstanding for more than 3 years.

• Where input VAT was charged on goods purchased, civil works, building constructed 

etc. for making/manufacturing taxable supply before an individual became registered. 

Such claim for refund is made in form VAT 5 within 30 days from the date of approval of 

registration by the Commissioner VAT.

• Where refund is in public interest in the opinion of the Minister for Finance. Such a 

claim is made in for VAT 4 within 12 months of paying VAT.

• Refund of input tax on capital investments incurred where the input tax exceeds 

Kshs1,000,000 and investments are used in making taxable supplies.

Documents accompanying claim for refund under Sec. 24 (bad debts)

• Confirmation from liquidator that debtor has become insolvent and proof of debt 

amount.

• Copies of relevant tax invoices issued at the time of supply to the insolvent debtor,

• A declaration that the debtor and taxpayer are unrelated companies/persons.

• Records/documents showing input tax paid by the taxpayer e.g. VAT account, bank 

pay-in-slips etc.

VAT refund audit procedure

• Under legal notice issued 18/11/99, tax refunds and claims for tax relief exceeding Kshs 

1,000,000 shall be accompanied by the auditor’s certificate.

• The certificate should state that the claim is true and the amount claimed is properly 

refundable under VAT Act.

• The following audit procedure is followed by the auditor before issuing such a VAT 

refund certificate.

(It is not exhaustive and may require tailoring to suit circumstances).

1. Review and document the adequacy of the system of recording and accounting for VAT.

2. Ensure that the VAT 4 corresponds with the supporting VAT return and that the entries in the 

return agree with the books of account.

3. Establish why the trader is in refund position (e.g. trader in an exporter, inputs taxed at 

higher rate than outputs, significant capital expenditure, seasonal trading/purchases, etc). 

The reason for the refund must be soundly based.

4. Check if the trader is subject to partial exemption rules, and if so, whether the rules have 

been applied correctly as required by regulation 17, especially the annual adjustment.

5. Select a sample of invoices from VAT 4 and perform the following tests where applicable:

• Input tax has been claimed within 6 months after the issue of the invoice.

• The invoices meet the requirement of Regulation 4.

• Simplified tax invoices have not been used to claim relief.

• The invoices are not photocopies or fax copies.

• Ensure that input tax in respect of imported goods is properly supported by a Customs 

Entry form and contained within an original KRA receipt for payment of duty and VAT.

• Ensure that tax has been properly accounted for in respect of imported services (reverse 

charge).

• Ensure the input tax does not relate to items scheduled on the blocking order VAT 

Order, 1994.

• Ensure input tax has not been claimed in advance.

• Trace the invoices to the relevant ledger accounts.

• Confirm that the expenditure is business related and not private.

6. Obtain the workings supporting the output tax on the VAT return, if any, and select a sample 

and perform the following tests where applicable:

• Check that the correct rate of VAT was applied.

• Ensure that sales were accounted for in the correct tax period.

• Trace the invoices to the relevant ledger accounts.

• In the case of exports, ensure a payment has been received in respect of the goods or 

services exported and the proper documentation supporting export is in place.

• Ensure that VAT has properly been accounted for in respect of miscellaneous sales.

7. Ensure, where applicable, that VAT on intra-group transactions has been properly accounted 

for.

8. Ensure all VAT returns were submitted on time. If not, compute the penalties and interest to 

be deducted from the claim, if the trader has not done so.

9. Prepare a statement analysing the current claim

3.10 Capital statements and ascertainment of income omitted or understated

A capital statement may be prepared as sufficient estimation of growth in assets and therefore 

estimate income for such taxpayer if there are no reliable records/accounts. A capital statement 

consists of details of assets and liabilities as at a given date or period. This would show changes 

in total worth of a taxpayer between two or more periods. The capital statement also considers 

capital losses or gains, living expenses, income tax paid etc.

Where the capital statement covers more than one year, the resultant figures will be divided by 

number of years involved giving rise to a uniform figure as estimate measure per year.

Capital statements must appear reasonable to be acceptable by the Income Tax Department and 

must

Steps:

1) Add all assets of taxpayer both tangible and intangible for a given period. Deduct all liabilities 

both personal and business used to finance the assets. Net result will be NET ASSETS for 

the period.

2) Calculate the growth or loss in Net assets for each time period by taking the Net Assets 

of the period and comparing it with the Net Assets of the previous period. This represents 

additional assets that the taxpayer acquired or disposed in the time period.

3) Deduct any non-taxable income that was used to finance the above growth in Net assets – 

e.g. income or assets from a legacy or inheritances, capital gains, gifts, money from friends 

and relatives.

4) If looking for only the undeclared business profits taxable, then deduct any non-trading 

business income from growth in Net assets. The net figure would represent Net Business

savings.

5) Add to the balance (4) living expenses such as water & electricity, income tax paid, interest 

on loans, premium on various types of insurance, rents and rates as supported by bills or 

invoices. Add also personal expenses such as food, services, clothing, toiletries, medical 

expenses, house servant, holidays, amusements, private motor vehicle running and 

maintenance costs, harambee contributions, donations and any cash stolen from house or 

shop etc.

6) If capital assets are sold at a loss, add the loss. If sold at a profit, deduct the profit. Deduct 

any income declared during the year – balance is undeclared income.

A capital statement may be required where:

• no accounting records are kept by the taxpayer

• taxpayer maintains incomplete records

• when a self assessment has been filed but indepth assessment has to be carried out.

3.11 Customs and excise investigations

Under Customs & excise, the revenue authority can carry out a post clearance audit.

Post clearance audits

According to the taxpayer’s charter, a taxpayer may be selected for a post clearance audit 

on all Customs related transactions. The scope of audits may include visits to the taxpayer‘s 

premises. The taxpayer will be notified in advance of the intention to carry out an audit before its 

commencement. However, under certain circumstances depending on the factors surrounding 

the case, it may be necessary to conduct a surprise audit. The audit may be completed within 14 

days from the date of commencement of audit.

• A post clearance audit is mostly conducted where fraud is suspected.

• This examination is carried out after the completion of import clearance.

• The audit inquiry is carried out at the importer’s offices, and is made not only of the 

importer but also of other people concerned.

• The audit is done in order to:

• Check whether the importer’s own initiative declaration was true and correct.

• See whether the basis of assessment and other matters contained in the declaration 

of imported goods were correctly established.

• Confirm whether the declared value of the imported goods was correct

Customs audits verify:-

• Tariff classification,

• Valuation,

• Country of origin,

• Financial information and

• Documentation the importer is required to maintain.

3.12 Tax audit 

The Kenya Revenue Authority may carry out either a compliance check or a comprehensive 

audit. A compliance check is like a spot check to confirm summaries from the ledger/ returns with 

the taxpayer’s sales and purchases journal. A comprehensive audit is an audit covering many 

types of taxes and multiple issues in the accounts of a taxpayer.

KRA may select a taxpayer for audit on Income Tax, Pay As You Earn (PAYE), Value Added Tax 

(VAT), Excise or Customs duty or any other tax administered by the Authority. Sometimes the 

taxpayer may be selected for audit in respect of multiple taxes. In most cases, the audits will be 

field audits i.e. they will be carried out in your premises. In the majority of cases, the taxpayer 

will be notified in advance of the intention to carry out an audit before the commencement of the 

audit. However, under certain circumstances depending on the factors surrounding the case, it 

may be necessary to conduct a surprise audit. In order not to inconvenience the taxpayer, and 

subject to the taxpayer’s co-operation with KRA officers, KRA shall endeavour to complete the 

audit within:

• 10 days from the date of commencement of single issue audits.

• 30 days from the date of commencement of comprehensive audits.

• One day for a general inspection of an excise factory.

• 7 days for any other tax administered by the authority.

If the taxpayer has been selected for audit by the Large Taxpayer Office or the Investigations 

Department all the multiple taxes will invariably be audited. It is expected that the audit by the 

Large Taxpayer Office will take no more than two months to complete. Cases under investigation 

will be completed within a period of between two to six months. Complex cases may take a 

longer period to complete.

The taxpayer may also be subjected to a compliance check (e.g. computation and intelligence 

information) to verify certain information. A visit by a KRA official to check on the taxpayer’s 

compliance does not amount to a comprehensive audit.

An audit is considered complete when the findings have been fully explained in writing to the 

taxpayer giving specific details on how additional tax liability if any, has been arrived at. The 

taxpayer will also be informed in writing if the audit results in no additional tax.

The commissioner general, a departmental commissioner or headquarters tax programmes will 

require that the taxpayer be re-audited if it is discovered that the taxpayer’s case was settled 

irregularly, or is dissatisfied with the manner in which the case was completed. 

Objections

The taxpayer is entitled to object to an assessment (Income Tax, VAT, Customs and Excise 

Duty, or other assessment issued under KRA) if you believe you have been assessed wrongly 

or unfairly. You must exercise your right to object within a specific period and comply with the 

requirements, which include submission of returns together with all supporting documents for the 

objection to be valid. You may also attach your own workings accompanied by new evidence, 

which can be taken into consideration in reviewing the objection. 

Once you have filed a valid notice of objection KRA shall conduct an impartial review of your case. 

KRA shall acknowledge your objection within 7 days and endeavour to resolve the objection 

within 30 consecutive days.

Complex cases may take more than 30 days to resolve.