Taxation of Business Income
Income Tax
Taxation of Business Income
Syllabus tag: KASNEB CPA | Intermediate Level | CA26 Public Finance and Taxation | Topic 4 Taxation of Business Income
Rates check. Figures reflect the position in 2026. Confirm current rates and thresholds on the KRA website.
Lesson objectives
By the end of this topic, you will be able to:
- Identify what constitutes business income
- Apply the "wholly and exclusively" test to expenditure
- List the expenses specifically disallowed by the Act
- Compute adjusted taxable profit for a sole trader
- Explain how losses are carried forward
Why this matters
Section 15 of the Income Tax Act allows a deduction for expenditure incurred wholly and exclusively in the production of income. Nearly every dispute between a taxpayer and KRA over business expenses turns on that phrase.
What is business income
Income from any trade, profession or vocation, whether carried on by an individual, a partnership or a company. It includes:
- Trading profits
- Professional fees
- Rental income from business premises
- Balancing charges on the disposal of business assets
- Insurance recoveries for trading losses
Income is taxed on an accruals basis for businesses, unlike employment income which is taxed when received.
The "wholly and exclusively" test
Three conditions must all hold for an expense to be deductible:
- It was actually incurred — not merely provided for
- It was incurred wholly and exclusively for the business
- It is revenue rather than capital in nature
The word exclusively does real work. Expenditure with a dual purpose — partly business, partly private — fails the test unless the business portion can be separately identified. A trader's ordinary clothing is not deductible even though he must be dressed to trade; protective clothing required for the work is.
Expenses specifically disallowed
| Disallowed | Reason |
|---|---|
| Depreciation | Replaced by capital allowances |
| Capital expenditure | Relieved through capital allowances instead |
| Fines and penalties | Public policy: the law will not relieve a breach of itself |
| Interest on late tax | Same reason |
| Donations to unapproved bodies | Not incurred to produce income |
| General provisions | Not actually incurred; only specific provisions qualify |
| Private and domestic expenditure | Fails the exclusively test |
| Drawings and owner's salary | An appropriation of profit, not an expense |
Note the general versus specific provision distinction. A specific provision against a named debtor known to be in difficulty is deductible; a general provision of 5% against all receivables is not, because no particular debt has yet gone bad.
Expenses specifically allowed
- Bad debts actually written off, and specific provisions
- Legal costs of renewing a short lease, though not of acquiring one
- Repairs and maintenance, though not improvements
- Contributions to a registered pension scheme, within the cap
- Advertising and promotion
- Interest on borrowings used in the business, subject to the interest limitation rules
Repairs and improvements is a recurring examination point. Restoring an asset to its former condition is a repair and deductible; making it better than before is an improvement, therefore capital, and relieved only through capital allowances.
A worked computation
A sole trader reports a net profit of KES 8,400,000.
| KES | |
|---|---|
| Net profit per accounts | 8,400,000 |
| Add: depreciation | 1,600,000 |
| Add: owner's drawings charged as salary | 450,000 |
| Less: capital allowances | (2,100,000) |
| Less: rental income taxed separately | (350,000) |
| Adjusted taxable profit | 8,000,000 |
The trader then adds this to any other income and pays at the graduated individual rates, not at the corporation tax rate. A sole trader is not a company.
:::checkpoint The trader argues that the KES 450,000 he pays himself is a genuine business cost, since he would have to pay a manager if he did not work in the business. Explain why the Act still disallows it. :::
Losses
A trading loss may be carried forward and set against future profits from the same source. The Finance Act 2021 removed the earlier limit of nine years, so losses may now be carried forward indefinitely.
Two restrictions still apply. A loss from one source cannot be set against income from a different source in the same year, and the loss must be claimed in the return for the year in which it arose.
Turnover tax
Small businesses within the statutory turnover band pay turnover tax at 3% of gross sales instead of computing adjusted profit.
The simplification has a cost. Turnover tax is charged on gross receipts with no deduction for expenses at all, so a business with thin margins can pay more under turnover tax than it would on its actual profit. A trader with turnover of 9,000,000 pays 270,000 whether the year produced a profit or a loss.
:::checkpoint A business has turnover of KES 8,000,000 and an adjusted profit of KES 600,000. Compute the tax under turnover tax and compare it with tax at the graduated rates on the profit. Say which basis the business should prefer. :::