4.2 Objectives

• Distinction between trading in and trading with a country 

• Double taxation agreements; theory, design and application 

• Regional perspective with reference to the East African Community (EAC) and the 

Common Market for Eastern and Southern Africa (COMESA) 

• Most favoured nation status

• Withholding tax provisions

• Transfer pricing

• Application of relevant case law

4.1 Introduction

In the previous chapter, we studied tax investigations. In this topic, we will discuss the various 

issues arising from the taxation of cross border activities. The world is slowly becoming a global 

village and as such there is an increase of cross border transactions that need to be regulated. 

Further, the concept of double taxation is crucial in the overall economic policy of a country. It 

refers to the imposition of comparable taxes in two or more states on the same income/same 

subject matter for identical periods of a named taxpayer. Income tax is imposed in Kenya on any 

person, whether resident or non-resident if the income accrued in or was derived from Kenya. 

This means that expatriates working in Kenya will be taxed in Kenya and also in their countries 

of origin. Where rates of tax are high, double taxation can be a serious obstacle to growth in 

international trade. 

In the next topic, we will cover concepts of tax planning.

4.5 Key definitions

Off shore taxation (Tax havens)

Refers to the principle of harmonising Company law, Trust law, Banking and Tax regulations with 

a view to attract investors. The measures put in place have to be tax effective as compared to 

those established in the average countries in the world.

4.3 Exam Context

The student is expected to demonstrate an understanding of the various taxation issues affecting 

cross border transactions. Further, the student should be able to identify any tax charged in 

excess of the expected amount where double taxation is evident. Questions on this topic have 

been preffered by the examiner in recent exam sittings.

4.4 Industrial Context

In the recent past, we have had many companies and individuals complaining of double taxation 

of their taxable gains. The student is expected to identify this problem and perform computations 

to solve it. 

4.6 Taxation of cross border activities 

These are the various transactions or activities that are exercised by a Kenyan resident in 

another country and vice versa. The issue here is: How is the income earned or derived from 

such transactions brought to charge?

The taxation of income of a person is based on the concept of residence.

Resident and non-resident persons 

There are conditions for being a resident in case of an individual and also in case of a body of 

persons.

a) Resident in relation to an individual means that the individual:

i) Has a permanent home in Kenya and was present in Kenya for any period during the 

year of income under consideration; or

ii) Has no permanent home in Kenya but was present in Kenya for a period or periods 

amounting in total to 183 days or more during the year of income under consideration; 

or

iii) Has no permanent home in Kenya but was present in Kenya for any period during 

the year of income under consideration and in the two preceding years of income for 

periods averaging more than 122 days for the three years.

b) Resident in relation to a body of persons means that:

i) The body is a company incorporated under the laws of Kenya; or

ii) The management and control of the affairs of the body was exercised in Kenya in the 

year of income under consideration; or

iii) The body has been declared, by the Minister for Finance by a notice in the Kenya 

Gazette, to be resident in Kenya for any year of income.

c) Non-Resident:

- Means any person (individual or body of persons) not covered by the above conditions 

for resident.

Note

- Residents have some tax advantages over non-residents which relate to tax reliefs, 

rates of tax, and expenses allowable against some income.

(Income) Accrued in or derived from Kenya

- The income which is taxable is income arising from or earned in Kenya.

- Under certain conditions, some business and some employment income derived from 

outside Kenya is taxable in Kenya.

Significance of the concept of residence

Residential status of an individual and body corporate is important in the following ways:

• Kenya resident individuals pay Kenya income taxes on their incomes from Kenya and 

worldwide employment, but Kenya non residents pay Kenya income taxes only on their 

income from Kenya.

• Residents pay income taxes at graduated scale rates but non residents pay income 

taxes at special rates on certain specified incomes or sources. 

• Resident companies are taxed at the rate of 30% on their taxable income while non 

resident companies with a branch in Kenya are taxed at a higher rate of 37.5%.

• Withholding taxes are deducted at source on all income of Kenyan non-residents but 

residents have withholding tax deducted on only some of their incomes.

• Non residents companies with no branch in Kenya have withholding tax deducted at 

source on all their incomes while resident and non resident companies with branches in 

Kenya have withholding tax deducted from only their dividend and interest income.

4.7 Distinction between trading in and trading with a country 

Trading in a country is where a person conducts their business within the domestic jurisdiction 

of a country. For example, a foreign company establishing a business in Kenya as a branch and 

then conducting its business activities in Kenya.

Trading with a country happens in situations where a person or the government enters into 

trading relations with another country.

4.8 Double taxation agreements; theory, design and application 

Double taxation arrangements may take the form of:

a) Bilateral conventions or agreements relief

b) Unilateral relief

a) Conventions and agreements

These are bilateral agreements for relief from double taxation. This involves countries affected 

negotiating an agreement with a view to minimise or eradicate effects of double taxation. Most 

double taxation agreements are based on the Organisations for Economic Cooperation and 

Development (OECD) recommended models articles. Each agreement is peculiar to itself 

depending on how it was negotiated.

A double taxation agreement/treaty would have articles addressing the following:

1. Persons to which the convention applies

2. Taxes covered

3. Definition of terms

4. Rules for determining tax residence (fiscal domicile)

5. Incomes affected by the agreement

6. Tax on capital

7. Diplomatic and consular officials

8. Termination of the agreements, etc.

Most countries usually give the country in which the income arises prior right of levying tax.

b) Unilateral relief

Due to the difficulty involving double taxation negotiations, it is possible for an individual country 

to remove the burden of double taxation from international trade by opting to give relief for foreign 

taxation on a unilateral basis i.e. without regard to whether the other taxing country extended 

relief or not. This may be triggered by a representation by the business community.

A unilateral approach is usually a last resort where negotiations have proved difficult due to 

political and other reasons. It is possible to have both arrangements in place to take care of 

different income sources and persons. Up to 1972, there existed the commonwealth income tax 

relief confined to member countries. The authority was contained in the East African Income tax 

Management Act and is not available in the Kenya Income Tax Act.

Double taxation agreements are reached with the following in mind:

1. Attraction of foreign investors through tax incentives

2. Encouragement of mobility of labour to attract expertise

3. Tax incentives as loss of revenue to government

4. Level and areas of economic interaction between states concerned

5. Overall cost and benefit principle

6. Political climate/relations

Authority to grant double taxation in Kenya

The Income Tax Act section 41-43 gives authority to grant double taxation itself.

S41:

Authorises the Minister for Finance to make arrangements with other countries for relief from 

double taxation.

S42 (3):

Double tax relief shall be granted provided that “the tax chargeable upon the income of a person 

in respect of which a credit is to be allowed ... shall be the amount by which the tax chargeable 

... in respect of his total income”

S42 (4):

“The amount of credit allowed shall not exceed the tax chargeable”. For example, if the foreign 

tax is equivalent to Kshs160,000 and the tax chargeable in Kenya is Kshs100,000, the amount 

of relief from the foreign tax shall be limited to Kshs100,000.

S42 (5):

Relates to the treatment of foreign tax on dividends not specifically covered under special 

arrangements with another country. In such a case if the dividend is paid to a company, which 

controls 0% or more of the voting power of the company paying the dividend, a credit shall be 

obtained in the same way as if a special arrangement existed.

S43:

Any claims for allowance by way of credit should be made to the commissioner within six years 

from the end of the year of income to which it relates.

Kenya has tax treaties for relief from double taxation on income arising in Kenya with the following 

countries: United Kingdom, Germany, Denmark, Norway, Sweden, Zambia, Canada and India.

Withholding tax on payments to countries with which Kenya has double tax treaty are as 

follows:

Note:

Credit will be given after such taxpayer proves:

(a) That tax was actually deducted in that other country.

(b) The tax so deducted is not more than the tax he would have paid in Kenya if he had 

been wholly charged in Kenya, i.e. tax credit is limited to the amount by which his tax 

increases because of inclusion of the income from foreign country.

(c) The time limit for claims is six years since the occurrence of the tax liability.

(d) With effect from 1 January 2002, a taxpayer with foreign employment income shall 

be granted double taxation relief whether Kenya has an agreement with that other 

country.

Illustration 1:

Chris Ouma, a married Kenyan resident, had income of Kshs360,000 for year of income 2007 

and also received income from Zambia net of tax Kshs180,000. The tax deducted in Zambia was 

Kshs 60,000. Kenya has a double taxation relief treaty with Zambia.

Required:

a) The double taxation relief in Kenya

b) The tax payable by Ouma in Kenya

Double taxation relief shall be the Kshs 54,467, i.e. the lower of foreign tax and increase in 

Kenyan tax by inclusion of foreign income in tax computation – (Kshs 60, 000 or KShs 54,467)

Double tax treaties are important to multinational corporations, which have international trade 

spread across several countries. These corporations derive benefits by exploiting national law 

so as to maximise their results. Negotiating tax treaties internationally facilitate an enabling trade 

environment for companies operating in these countries.

4.9 Regional perspective with reference to the East African 

Community (EAC) and the Common Market for Eastern and 

Southern Africa (COMESA) 

4.9.1 East Africa Community (EAC)

The East African Community (EAC) is the regional intergovernmental organisation of the republics 

of Kenya, Uganda, the United Republic of Tanzania, Republic of Rwanda and Republic of Burundi 

with its headquarters in Arusha, Tanzania

The first major step in establishing the East African Federation was the East African Customs 

union signed in March 2004 and commenced on 1 January 2005. Under the terms of the treaty, 

Kenya, the region's largest exporter, will continue to pay duties on its goods entering the other 

four countries until 2010, based on a declining scale. A common system of tarrifs will apply to 

goods imported from third-party countries.

The EAC was originally founded in 1967, but collapsed in 1977.It was officially revived on7 July 

2000. EAC is one of the pillars of the African Economic Community. In 2008, the EAC, after 

negotiations with the South African Developement Community (SADC), and the Common Market 

For East and Central Africa (COMESA) agreed to an expanded Free Trade Area covering the 

member states of all three.

At the moment, the member states of the EAC have negotiated the East African Community 

Customs Management Act (2004) agreeing on common tariffs.

East African Community Customs Management Act (2004) 

This is an Act that came into force in 2005 following the revival of the East Africa Community 

Customs Union. Customs control is therefore under the East Africa Customs Union and excise 

duty will be under the control of respective partner states. Under the Union, goods traded within 

the partner sates will be zero rated except for certain specified items from Tanzania and Uganda 

albeit for a transition period only.

Goods are classified under the Harmonised System Convention (HSC) that forms the basis for 

tariff classification of goods traded in the international market as listed in Annex 1 to the Protocol 

on the Establishment of the East African Community Customs Union.

4.9.2 Common Market for Eastern and Southern Africa (COMESA)

The Common Market for Eastern and Southern Africa, is a preferential trading area with 19 

member states stretching from Libya to Zimbabwe. COMESA was formed in December 1994, 

replacing the Preferential Trade Area which had existed since 1981. Nine of the member states 

formed a Free Trade Area in 2000 (Djibouti, Egypt, Kenya, Madagascar, Malawi, Mauritius, 

Sudan, Zambia and Zimbabwe), with Rwanda and Burundi joining the FTA in 2004 and the 

Comoros and Libya in 2006.

COMESA is one of the pillars of the African Economic Community.

In 2008, COMESA agreed to an expanded free-trade zone including members of two other 

African trade blocs, the East African Community (EAC) and the Southern Africa Development 

Community (SADC).

4.10 Most favoured nation status

Tax policy is used to promote international trade by grouping countries into trade blocs. Countries 

belonging to trading blocs enter into treaties harmonising the customs and excise duty rates in 

order to make exports and imports price within the bloc attractive as compared with the same 

commodities outside the particular trade bloc. The inter-state transactions will be governed/

facilitated by terms of agreements in their particular area to the exclusion of outsiders. Uniform 

customs tariffs would be geared towards increased welfare, economies of scale obtained, 

increased competition results in higher production and improved quality of products, flow of 

investments in the region. It provides good ground for emergence of customs union, common 

market and economic union. Trade blocs include the European Union, The East African 

Community, COMESA, ECOWAS (West Africa), The North American Free Trade Area (USA, 

Mexico & Canada), Southern Africa Development Community (South Africa, Botswana, Lesotho, 

Swaziland).

Most favoured nation status

Trade agreement legislation can be based on the most-favoured nation principle. This is nondiscriminate principle extended to all trade partners such that any reciprocal tariff reductions are 

negotiated. Member countries who are signatories of the most-favoured nation status benefit 

from negotiations to boost international trade. The problem with this arrangement is that tariff 

negotiations may be on certain few commodities only. Also benefits may leak to other nonmember countries hence diluting the real purpose of the arrangement.

Off shore taxation (Tax havens)

Refers to the principle of harmonising Company law, Trust law, Banking and Tax regulations with 

a view to attract investors. The measures put into place have to be tax effective as compared to 

those established in the average countries in the world.

Some of the benefits extended to investors include:

- Tax free bank interest

- Tax free dividends paid by companies domiciled in these countries.

- Fixed corporate tax based on level of capital investment.

- Attractive corporate tax rates including nil tax for specified periods

- No capital gains tax

- Tax free profit repatriations etc

The countries most involved in utilising the principle of tax haven are those with resources 

requirement and depend on the financial investment attracted:

Examples of tax havens: Other tax havens:

- Seychelles

- Gibraltar

- Bahamas

- Cyprus

- Panama

- Netherlands

- British Virgin Islands

- Isle of Man (UK)

- Channel Islands (UK)

- Liechtenstein

4.11 Withholding tax provisions

Income subject to withholding tax or tax at source for non-resident persons

Certain incomes derived from Kenya and paid to non-residents with no permanent establishment 

in Kenya are taxed at source at special non-resident tax rates as follows

The incomes of the non-residents are taxed gross, that is, no expenses are allowed against the 

income.

The withholding tax must be remitted to the Domestic Taxes Department within 20 days of its 

being deducted. There is no further tax for the non-resident after the withholding tax is paid as 

far as our country is concerned.

4.12 Transfer pricing

Transfer pricing for goods or services is important in international taxation and will be subject to 

specific laws. Transfer pricing is widely in use by multinational entities, which are involved, in 

international trade in several countries.

Laws guiding multinational corporations ensure that transfer pricing is not abused because several 

nations have a tax interest in their operations. There is a pending bill in parliament regarding 

Transfer pricing and the tax implications for multinational companies.

Transfer pricing is a problem of apportioning taxable income among various jurisdictions where 

an enterprise engages in more than one country or it belongs to a group of companies that are 

located in more than one country and have relations with one another. This phenomenon is as old 

as international trade and as old as the existence of tax boundaries. It is an issue that may arise 

in relation to any type of income, such as the purchase or sale of goods, the provision of services, 

the payment of royalty fees and of interest on loans for instance.

The real culprit is transfer pricing manipulation; a phenomenon discouraged by governments. The 

fixing of prices based on non-market criteria results in saving company tax by shifting accounting 

profits from high tax to low tax jurisdictions. This amounts to moving one nation’s tax revenue to 

another.

Transfer pricing also leads to balance of payments distortions between the host country and home 

country bordering on undermining sovereignty of the host nation.

Transfer pricing has become a critical consideration in location of production as well as employment 

because multinational corporations tend to open subsidiaries in countries where production is most 

profitable and the tax burden is less. Therefore, a country with no transfer pricing controls would 

be most attractive to foreign investors. It is for this reason that the Asiatic locations of Hong Kong 

and Singapore have succeeded in attracting foreign direct investments.

Most countries enforce tax laws based on the arms length principle as defined in the Organisation 

for Economic Co-operation and Development (OECD) model. The following methods or definitions 

are based on the OECD guidelines:

i) Uncontrolled price method (CUP)

This method compares the price at which a controlled transaction is conducted to the price at 

which a comparable uncontrolled transaction is conducted.

ii) Cost plus method (CP)

Is a method generally used for the trade of finished goods and determined by adding an appropriate 

mark-up to the costs incurred by the selling party in manufacturing/purchasing goods and services 

provided with the appropriate mark-up being based on the profits of other companies comparable 

to the tested party. 

The method is generally accepted by the tax customs authorities, since it provides some indication 

that the transfer price approximates the real cost of item.

iii) Resale price method (RP)

This method is similar to cost plus method except it is found by working backwards from 

transactions taking place at the next stage in the supply chain, and is determined by subtracting 

an appropriate gross mark-up from the sale price to an unrelated third party with the appropriate 

gross margin being determined by examining the conditions under which the goods or services 

are sold and comparing said transactions to other third party transactions.

iv) Profit split method (PS)

Is the method applied when the businesses involved in the examined transaction are too 

integrated to allow for separate evaluation and so the ultimate profit derived from the endeavour 

is split based on the level of contribution of each of the participants in the project.

If, for example, Company A sent three researchers to its subsidiary to aid in the development 

of a product designed for use in country X market while the subsidiary allocated six identically 

compensated researchers to aid in the development of the product, then we would expect that 

the subsidiary pays 3/6 that is 50% of the ultimate profits as a royalty fee for the technical 

knowledge provided by Company A’s researchers.

v) Transactional net margin method (TNMM)

Is a method that uses arm’s length operating profit – that is earnings after all operating expenses, 

including overhead, but before interests and taxes earned by one of the entities in the transaction. 

Relative operating profit relative to sales, costs or assets allows comparisons between different 

transactions and is a more robust measure of an arms length result.

Other available methods include advance pricing agreement between the tax authorities and 

the tax payer and also mutual agreement procedure for purposes of relief from international tax 

grievances.