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Introduction
On 12 May 2023, the High Court delivered a judgment in our client’s favour, allowing an investment deduction in respect of capital expenditure incurred on the construction of a building and the installation of machinery. The Court also disallowed a withholding tax assessment issued by the Kenya Revenue Authority (KRA). The judgment arose from an appeal filed by the Commissioner of Domestic Taxes challenging the decision of the Tax Appeals Tribunal (TAT).
Brief Background
The taxpayer completed construction of a building in January 2019 and began installation of electrical, mechanical works and machinery for purposes of commencing the manufacture of animal feeds. The manufacturing plant was completed in June 2019 and a taking over certificate issued by the contractor indicating the handover date as 12 June 2019. The plant was also inspected, and a certificate of compliance issued. Following the completion of these works, manufacturing commenced in June 2019, with two batches produced in that month. The units produced were subsequently sold.
The taxpayer claimed investment deduction for the building and machinery at the rate of 150% of the cost incurred in the financial year 2018/2019 in accordance with Paragraph 24(1)(f) as read with Paragraph 24(2)(c) of the Second Schedule (now repealed) to the Income Tax Act, Cap 470.
KRA disallowed the investment deduction claim of KShs.423,033,494 and demanded for payment of corporation tax amounting to KShs.29,317,209, indicating that the claim could not be made under the period 2018/2019 but in 2019/2020 on the basis that manufacturing commenced in 2019/2020. KRA’s contention was that the production levels in June 2019 were very low and constituted test runs and not manufacturing. KRA also indicated that payments made on behalf of foreign contractors in respect of rent, housekeeping and taxi services constituted consultant fees, which fell within the definition of management fees and were subject to withholding tax at non-resident rates, amounting to KShs.1,662,542.
We had successfully represented the taxpayer at the TAT, which allowed its appeal against KRA’s objection decision and set aside KRA’s entire assessment. The Commissioner of Domestic Taxes then filed an appeal to the High Court.
The Commissioner’s Position
The Commissioner’s position presented at both the TAT and the High Court was that: -
- The taxpayer’s building was not used for manufacturing in 2018/2019. The units produced in June 2019 were below optimum levels, and as such, the production of two batches in June 2019 was a test run, which is ancillary to manufacture. The building was therefore put into first use in the year of income 2019/2020 (i.e., between 1 July 2019 and 30 June 2020), meaning that the taxpayer could only claim the investment deduction in the year 2019/2020.
- Notably, the Tax Laws (Amendment) Act, 2020, which came into effect on 25 April 2020, reduced the amount of investment deduction allowable from 150% of the capital expenditure incurred to 50%. The Commissioner’s position was therefore that the taxpayer could only claim investment deduction in the year 2019/2020 at the rate of 50%.
- The payments made to local service providers in respect of rent, housekeeping and taxi services on behalf of the foreign contractor involved in installation of the manufacturing plant constituted income to the contractor and as such, it was subject to withholding tax at non-resident rates.
Taxpayer’s Position
The basis of the taxpayer’s claim for an investment deduction was Paragraph 24(1)(f) as read with Paragraph 24(2)(c) of the Second Schedule (now repealed) to the Income Tax Act, which provide as follows: -
Paragraph 24(1)(f): -
“Subject to this schedule, where capital expenditure is incurred on the construction of a building, or purchase and installation of machinery outside the city of Nairobi or the Municipalities of Mombasa or Kisumu whereof the value of investment is not less than two hundred million shillings: there shall be deducted, in computing the gains or profits of the person incurring that expenditure for the year of income in which they were first used (hereinafter referred to as the year of first use of the building or machinery referred in subparagraph (f)), a deduction referred to as an investment deduction.”
Paragraph 24(2)(c): -
“The amount of investment deduction under subparagraph (1) shall in the case of an investment referred to in subparagraph (1)(f), be equal to one hundred and fifty percent of the capital expenditure.”
The arguments presented on behalf of the taxpayer were that: -
- Tax statutes must be strictly construed. Paragraph 24(1)(f) did not provide that a building must be used for manufacture in the year of first use in order to qualify for an investment deduction. It simply provided that an investment deduction would be allowed in the year of income when it is first used. If the drafters of the provision had intended that the building must have been used for manufacture, they would have stated so.
- In any event, the building was used in manufacture in the year of income 2018/2019. Manufacturing commenced in June 2019 when the first and second batches of the taxpayer’s product were manufactured.
- By contending that the manufacturing activities were test runs since the units produced were below optimum levels, and that test runs are ancillary to manufacturing, the Commissioner was applying a tortured and laboured construction of the definition of manufacture.
- Activities that are “ancillary to manufacturing” were defined under the Second Schedule to include design, storage, transport and administration. Test runs result in actual manufacture of finished goods that are approved for sale and do not fall within the same class as the listed activities. Therefore, even if the production of the two batches was to be considered a test run, it still constituted manufacture and not activities ancillary to manufacturing.
- The Tax Laws (Amendment) Act, 2020, came into force on 25 April 2020 and could not apply retrospectively to a claim. Section 23(3)(c) of the Interpretation and General Provisions Act (“IGPA”) prohibits the retrospective application of the law and provides that the repeal of a law shall not affect a right, privilege or obligation that was acquired or accrued under a written law so repealed. As such, the amendment could only apply if the year of first use of the building commenced on 1 July 2020.
- The payments made to local service providers on behalf of the contractor did not constitute income to the contractor or fall within the definition of management fees. They were not payments made to a non-resident person or consideration for services provided.
The Court’s Findings on the Issues Raised
The Court analyzed the parties’ respective positions and concurred with the taxpayer’s position on the issues raised. The Court found that: -
- The rule when interpreting tax statutes is that they ought to be strictly construed. There is no room for intendment, reading in or implying meaning.
- The Court considered the Tax Laws (Amendment) Act, 2020 in light of the provisions of the IGPA and found that the right acquired by the taxpayer under the repealed Second Schedule could not be affected by the repeal. The repeal came in after the construction of the building was complete and even if it were to be decided that the first use was in August 2019 and not June 2019, the existing framework at the time was still the Income Tax Act prior to the 2020 amendments.
- Based on the definition of “manufacture” under the Second Schedule, there was actual manufacturing of the first and second batches in June 2019.
- The payments made by the taxpayer on behalf of the non-resident contractor were made to local service providers and constituted the taxpayer’s expenditure, not income accrued by the contractor. They did not fall within Section 35(1) as read with Section 10 of the Income Tax Act. KRA was therefore in error in claiming withholding tax from the taxpayer.
Orders Issued by the Court
The Court found that the TAT judgment was not erroneous and it dismissed the Commissioner’s appeal.
Effect of the Judgment
The judgment is instructive on the prospective application of amendments to tax statutes especially where the amendments affect rights that have already accrued to a taxpayer. It also reaffirms the position on strict construction of tax statutes and on what constitutes management fees.
This article was published by our Member Firm in Kenya, Viva Africa Consultiong LLP.
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