The decision in Aquavita Kenya Limited v Commissioner of Domestic Taxes is important since the Tribunal emphasized that the substance of a transaction prevails over its legal form and that KRA cannot impose taxes inconsistently on the same transaction.
The matter arose after KRA conducted a tax compliance audit on Aquavita Kenya Limited for the 2017–2020 period and issued assessments relating to VAT and Withholding Tax. The dispute mainly dealt on the tax treatment of redeemable preference shares issued by the taxpayer to its UK parent Company, Aquavita UK.
The taxpayer argued that the redeemable preference shares were equity instruments and therefore could not attract Withholding Tax on deemed interest. KRA, on the other hand, argued that although the instruments were called “preference shares”, these were in substance debt instruments, redeemable and created an obligation for repayment. KRA therefore treated these as interest free loans and imposed Withholding Tax on deemed interest under the Income Tax Act.
The key issues before the Tribunal were:
- Whether the redeemable preference shares constituted a debt or equity for tax purposes;
- Whether KRA was correct in imposing Withholding Tax on deemed interest arising from the redeemable preference shares;
- Whether KRA could simultaneously treat the same instruments as giving rise to dividends and impose withholding Tax on deemed dividends;
- Whether KRA could introduce new tax issues at the objection decision stage that were not considered in the original assessment; and
- Whether the VAT assessments arising from variances between VAT returns and income tax returns were justified.
Analysis
a. Redeemable preference shares
The Tribunal agreed with KRA on the first issue and held that the redeemable preference shares were in substance debt instruments rather than equity instruments. In reaching this conclusion, the Tribunal relied heavily on the economic substance of the arrangement and on IAS 32 accounting principle relating to financial liabilities. The Tribunal noted that the shareholder had a right to demand redemption and repayment, meaning the company had a repayment obligation similar to debt.
The Tribunal therefore held that the instruments created indebtedness and consequently fall within the scope of the deemed interest provisions under the Income Tax Act. Since no interest had been charged on the funding, KRA was entitled to assess Withholding Tax on deemed interest.
b. Deemed dividends
However, the Tribunal rejected KRA’s attempt to also impose Withholding Tax on deemed dividends arising from the redeemable preference shares. The Tribunal held that once the instruments had been classified as debt for tax purposes, KRA could not simultaneously characterize these as equity for purposes
of taxing dividends. This treatment would amount to inconsistent tax treatment and effectively leading to double taxation.
c. Introduction of fresh issues in the objection decision
The Tribunal further emphasized that KRA cannot introduce entirely new tax issues at the objection decision stage if these were not part of the original assessment. Any new issue must first be formally assessed and subjected to the objection process under Section 51 of the Tax Procedures Act.
d. Additional VAT assessments
On the VAT issue, the Tribunal reiterated that the burden of proof rests on the taxpayer under Section 56 of the Tax Procedures Act and Section 30 of the Tax Appeals Tribunal Act. The taxpayer therefore had the responsibility to sufficiently explain and support the variances between the VAT and income tax returns with documentary evidence.
Summary
- The Tribunal’s decided opinion can, therefore be summarized as follows:
- The substance of a financial instrument overrides its label, written contract or legal form;
- Redeemable preference shares may be treated as debt where these create repayment obligation;
- Deemed interest provisions apply to interest free financing arrangements that are in substance debt;
- KRA cannot tax the same instrument inconsistently as both debt and equity;
- New tax issues cannot lawfully be introduced at the objection decision stage without a fresh assessment; and
- The burden of disproving a tax assessment lies with the taxpayer.