Taxation revision questions

Question One

Briefly explain the principles or canons of taxation.

(10 marks)

Principles/ canons of Taxation

1. Simplicity

A tax system should be simple enough to enable a tax payer to understand it and be able to

compute his/her tax liability. A complex and difficult to understand tax system may produce a

low yield as it may discourage the tax payer's willingness to declare income. It may also create

administrative difficulties leading to inefficiency. The most simple tax system is where there is a

single tax. However, this may not be equitable as some people will not pay tax.

2. Certainty

The tax should be formulated so that tax payers are certain of how much they have to pay and

when. The tax should not be arbitrary. The government should have reasonable certainty about

the attainment of the objective(s) of that tax, the yield and the extent to which it can be evaded.

There should be readily available information if tax payers need it.

Certainty is essential in tax planning. This involves appraising different business or investment

opportunities on the basis of the possible tax implications. It is also important in designing

remuneration packages. Employers seek to offer the most tax efficient remuneration packages

which would not be possible if uncertainty exists.

3. Convenience

The method and frequency of payment should be convenient to the tax payer e.g. PAYE. This

may discourage tax evasion. For example, it may be difficult for many tax payers to make a lumpsum payment of tax at the year-end. For such taxes, the evasion ratio is quite high.

4. Economic/Administrative Efficiency

A good tax system should be capable of being administered efficiently. The system should

produce the highest possible yield at the lowest possible cost both to the tax authorities and the

tax payer.

The tax system should ensure that the greatest possible proportion of taxes collected accrue to

the government as revenue.

5. Neutrality

Neutrality is the measure of the extent to which a tax avoids distorting the workings of the market

mechanism. It should produce the minimum substitution effects. The allocation of goods and

services in a free market economy is achieved through the price mechanism. A neutral tax system

should not affect the tax payer's choice of goods or services to be consumed.

6. Productivity

A tax should be productive in the sense that it should bring in large revenue which should be

adequate for the government. This does not mean overtaxing by the government. A single tax

which brings in large revenues is better than many taxes that bring in little revenue. For example

Vale Added Tax was introduced since it would provide more revenue than Sales Tax.

7. Elasticity or Buoyancy

By elasticity we mean that the government should be capable of varying (increasing or reducing)

rates of taxation in accordance to the circumstances in the economy, e.g. if government requires

additional revenue, it should be able to increase the rates of taxation. Excise duty, for instance,

is imposed on a number of commodities locally manufactured and their rates can be increased in

order to raise more revenue. However, care must be taken not to charge increased rate of excise

duty from year to year because they might exert inflational pressures on the economy.

8. Flexibility

It means that there should be no rigidity in taxation i.e. the tax system can be changed to meet

the revenue requirement of the state; both the rate and structure of taxes should be capable

of change or being changed to reflect the state’s requirements. Such that certain old taxes

are discouraged while new ones are introduced. The entire tax structure should be capable of

change.

9. Diversity

It means that there should be variety or diversity in taxation. That the tax base should be wide

enough so as to raise adequate revenue and also the tax burden is evenly distributed among the

tax payers. A single tax or a few taxes may not meet revenue requirements of the state. There

should be both direct and indirect taxes.

10. Equity

A good tax system should be based on the ability to pay. Equity is about how the burden of

taxation is distributed. The tax system should be arranged so as to result in the minimum possible

sacrifice. Through progressive taxation, those with high incomes pay a large amount of tax as

well as a regular proportion of their income as tax.

Equity means people in similar circumstances should be given similar treatment (horizontal

equity) and dissimilar treatment for people in dissimilar circumstances (vertical equity).

Question Two

Define a direct tax and explain some of its benefits

(10 marks)

A direct tax is one whose impact and incidence are on the same person.

A direct tax is one which is paid (incidence) by the person on whom it is legally imposed (impact).

Examples are income tax and corporation tax.

Advantages of direct taxes

1. They are economical in collection. For example, with income tax the collection is done

through employers who are unpaid "tax collectors".

2. Direct taxes, if progressive, can be made to fall equitably on all tax payers having

regard to their relative abilities to pay. Indirect taxes tend to be regressive; i.e. they take

more from the poor and relatively less from the rich.

3. Direct taxes are relatively more certain in quantity as opposed to indirect taxes e.g. a

sales tax whose yield would depend on the elasticity of demand for the goods taxed.

4. They are usually less inflationary than indirect taxes. Usually indirect taxes are imposed

on goods thus raising the price of goods (through forward shifting). The cost of living

rises and this may trigger off serious confrontations between workers and employers,

as the workers seek salary increases. If the employers grant such increases, it will lead

to higher costs of production and prices. Higher prices will affect workers leading to a

damaging wage-price spiral.

Question Three

Explain the Benefit Theory.

(5 marks)

The benefit theory

This dictates that tax is apportioned to individuals according to the benefit they derive from

government activity and spending. The state is regarded as a market and taxes are treated as a

payment for the goods and services provided by the state.

According to the principle, the provision of government goods and services, will, like the provision

of private goods and services be dictated by market demand. This provision is inadmissible as

it goes against the aims of taxation, which are also the duties of the government in a market

economy, namely the redistribution of income and the clearing of market imperfections. In

addition, the principle may have application in limited areas where a close relationship between

government expenditure and benefit to the tax payer can be identified. For example road licenses

charges are paid by the owners of vehicles who are the road users. However, even in such

instances, the road users may not obtain benefit from such payment if the revenue so raised is

not applied for the benefit of road users

Question Four

Distinguish between regressive and digressive taxes

(5 marks)

Regressive Taxes

A regressive tax is one where the rate of tax falls as income rises. Here, the poor are called upon

to make a greater sacrifice than the rich.

Digressive tax

These are taxes that call upon the higher income earners to contribute less than their due

contribution compared to the lower income earners. i.e.

(a) The burden is relatively less since the tax is mildly progressive-the rate of progression

is not sufficiently steep. Or

(b) There is progression up to a certain point beyond which the rate becomes

proportional.

PAST

Question Five

Differentiate between Low interest benefit and fringe benefit

Low interest Benefit

This benefit arises from the difference between the prescribed rate and the interest rate charged by the employer for loans provided by the employer on or before 11th June 1998. This benefit is taxable on the employee

Fringe benefit

This benefit arises from the difference between the Market Interest rate andthe employer’s interest rate for loans provided after 11th June 1998 or loans provided on or before 11th June 1998 whose terms and conditions have changed after 11th June 1998. Such a benefit is taxable on the employer at the corporation Tax Rate. The Tax on Fringe Benefits is known as Fringe Benefit Tax.

Question six

Briefly discuss the taxation of royalties under the Income Tax Act.

It is income earned by a person for rights granted to others to use his intellectual properties.

These properties include:

i. Copyright, Literary, artistic or scientific works.

i. Cinematograph including film or tape used in radio or any other form of broadcasting.

ii. Patents, trademarks, designs, model, plan or formula.

iii. Any industrial, commercial or scientific equipment or information concerning industrial

commercial or scientific equipment.

Expenses will be allowed as long as they were incurred wholly and exclusively in earning such income

For residents, a 5% withholding tax is first deducted before determining net royalty income. It is

then deducted from gross tax liability of the resident individual as a tax credit.

Question seven

List four dividend incomes exempt from Taxation in Kenya

Dividends exempt from tax;

i. Dividends from outside Kenya or from non-resident companies

ii. Dividends received by a resident company which controls more than 12 ½ % of the

voting power of the resident company paying the dividend

iii. Dividends received by a resident insurance company from its investments income of

the life insurance fund

iv. Dividend amount being the discount factor on the issue of debentures or redeemable

preference shares or ordinary shares if it is less than 5% of par value

The Dividends received by a financial institution specified in the fourth schedule are no longer

exempt from tax following an amendment in the 2008 Finance Act that is applicable with effect

from 13.06.2008

Question Eight

List the allowable expenses against rental income

This is income earned by a person for rights granted to others to occupy his property. In determining

the taxable rent income, all expenses incurred wholly and exclusively in earning such income are

allowed (deducted) against such income. These expenses include the following:

a) Bad debts and rental losses.

b) Advertising and promotional costs of revenue nature.

c) Legal costs and stamp duty on acquiring a lease of less than 99 years.

d) Water and rates

e) Management and Agency fees.

f) Insurance

g) Staff wages and salaries.

h) Repairs and maintenance

i) Structural alterations on the building necessary to maintain existing rent.

j) Heating and lighting.