By Bosire Nyamori
Interpretive challenges are a salient feature of tax legislation. The case of ‘Kenya Revenue Authority v Republic (Ex-parte Fintel Ltd) (KRA v Fintel)’, illustrates problems that come up when the precise meaning of words in a statute is uncertain and murky. The source of the problem was the word “paid” in Sec 2 and phrase “upon payment” in Sec 35(1) of the Income Tax Act. At issue is whether the obligation by the payer of interest to deduct and remit withholding tax is based on the accrual principle or the cash basis.
The Court of Appeal held that withholding tax is paid when a liability for interest is recorded in the payer’s books of account, rather than when the payer makes actual payment to the payee. By finding so, the Court overturns High Court decisions, upending long standing practice and interpretation.
On abroad canvas, this piece offers a critique of the ‘KRA v Fintel’ judgement. It concludes that the final decision reached with regard to crystallisation of liability for withholding tax was correct. However, it argues that the reasoning process in several aspects of the judgment are open to respectful criticism.
Fintel Ltd (Company) contracted China Jiangsu International Economic Technical Co-operation (Contractor) to construct a rental building. Clause 30(1)(b) of the contract required Fintel to pay the contractor interest on any fees that was not paid in time. Fintel was unable to pay the fees in time, so interest started accumulating.
Kenya, being a former British colony, still gives weight to English precedent as well as other Commonwealth countries. Thus, UK courts have, over the years, accepted accounting methods as basis for computing profits for the purpose of determining income and corporation tax. Under the accrual concept of accounting, revenue and expenses are recorded or recognised in financial statements when they occur or are incurred, rather than when cash is received or paid. Relying on this principle, Fintel recognised the interest owed to the Contractor as a liability and at the end of the financial year made provision for it in the financial statements. Simultaneously, Fintel treated the interest as deduction under Sec 15(1) of the Act, reducing its profits that were subject to corporation tax.
When it came to deducting and remitting withholding tax to KRA, however, Fintel relied on the cash or receipts basis. Under this method, expenses and liabilities are incurred when cash or its equivalent such as cheque is received or paid. In effect, Fintel intended to deduct and remit withholding tax to KRA at the time or when they made payment to the Contractor.
After an audit, KRA issued an assessment of Sh4,787,257 on grounds that Fintel had not withheld tax on interest and yet had claimed this as a deduction. KRA’s findings rested on interpretation of the word “paid” in Section 2 and, its interaction with the phrase “upon payment” in Section 35(1)(e) of Act as well as its proposition that once an the interest had been treated as expenditure, it followed that the interest should be subjected to withholding tax under Section 35(1)(2) of the Act.
Section 2(1) of the Act says the word “paid” includes, “distributed, credited, dealt with or deemed to have been paid in the interest or on behalf of a person.” Section 35 lists categories of income that are subject to non-residents withholding tax. Under Section 35(1)(e), every person is required to withhold tax upon payment of interest. Section 15(1) allows a person to deduct from income before payment of taxes, “all expenditure incurred in that year of income which is expenditure wholly and exclusively.”
The Decision of the High Court
Both Fintel and Kenya Revenue Authority’s agreed that the phrase “upon payment” is synonymous with the word “paid” and that the word “credited” denoted actual payment. They, however, differed on the best methodology to employ to establish when there is actual payment.
Fintel submitted that interpretation of the word “paid” in Section 2 of the Act and “upon payment” in Section 35(1)(e) meant they were to withhold tax to KRA when they paid the Contractor in cash, or a cash equivalent, such as a cheque. They admitted that the word “paid” includes ‘credited’, but their position was that this implied a recording of cash or its equivalents in an account.
KRA’s argument, on the other hand, followed a two-step approach. First, they submitted the definition of the word “paid” to include the term “credited”. In accounting, to credit denotes making an entry in the books of accounts, as a result recognising revenue and liabilities. In KRA’s view, Fintel had, by recognising interest as a liability in its books of accounts, and treating it as a deduction under Section 15(2), made actual payment or settled their liability to Fintel. Put differently, KRA’ s position was that as soon as a debt came into existence and Fintel received an invoice or bill from the Contractor demanding payment, there was an obligation to deduct and remit withholding tax. The fact that Fintel had not paid the Contractor was irrelevant. Secondly, albeit not explicit, KRA was wondering why Fintel enjoyed a tax benefit, through deduction, yet refused to extend the same to the state through withholding and remitting the tax.
Justice Majanja ruled in favour of Fintel, relying on the literal interpretation of the word “paid” and the phrase “upon payment”. According to the Court, actual payment of interest by Fintel to the Contractor was a condition precedent for imposition of withholding tax.
Decision of the Court of Appeal
On appeal, the Court of Appeal (CoA) gave judgement for KRA. The Court observed that from a strict or literal perspective, the phrase “upon payment” and the words “payment” or “paid” had the same meaning, namely, “to be given money for something in exchange.” However, it rejected this method, terming it “narrow construction” and one which gave the word “paid” a technical as opposed to an ordinary definition. Because of this, the judges favoured a contextual approach. The Court justified its position on the ground that “tax law is ever changing, complicated and highly technical.”
The contextual approach is the dominant approach in the European Court of Justice. It emphasizes the purpose and object of legislation. In tenor and effect, it corresponds more with the purposive approach than the literal approach. Indeed, courts in common law countries have been shifting away from the literal rule towards the purposive approach when interpreting tax legislation. The CoA, in ‘Independent Electoral & Boundaries Commission v Maina Kiai & 5 Others’  eKLR, heralded use of purposive approach in statutes. It is fair to surmise that the CoA may have been following the path of these developments. In this piece , the author, therefore, uses the contextual and purposive approaches interchangeably.
The Court referred to the Indian case of ‘Reserve Bank of India v. Peerless General Finance and Investment Co. Ltd., 1987 SCR (2)1 (Reserve Bank Case)’ for its synthesis of the contextual approach, holding, “a statute ought to be looked at, in the context of its enactment and as a whole as opposed to picking and choosing words in isolation.” In summary, the Court’s approach is as follows: first, ascertain the context of the statute and, secondly, analyse the text or statute as “a harmonious whole.”
When considering context of a legislation, the Court’s interpretation seeks to give effect to the objective and purpose of the legislation. The goal is to “give effect so far as the language permits to the intention of the legislature.” In ‘The Engineers Board of Kenya v. Jesse Waweru Wahome & others’ (2012) eKLR, the Court emphasized that legislation must be “interpreted within their broader statutory context in a manner that furthers statutory purpose.” In ‘Maunsell v Olins’ (1975) AC 373, Lord Simon explained the approach thus:
“The first task of a court of construction is to put itself in the shoes of the draftsman – to consider what knowledge he had and, importantly, what statutory objective he had …being thus placed…the court proceeds to ascertain the meaning of the statutory language.”
To discover Parliament’s intention, the legislation is analysed by reference to its history, that is, why it was enacted and how it came to be. Also, the approach more readily embraces the use of extrinsic materials, for instance the Hansard.
After discovering the object and purpose, the Court observed that a legislation ought to be analysed “as a whole as opposed to picking and choosing words in isolation.” In essence, the Court is recommending, quoting the ‘Reserve Bank’ case that “the statute must be read, first as a whole and then section by section, clause by clause, phrase by phrase and word by word” so that “no part of a statute and no word of a statute can be construed in isolation. Statutes have to be construed so that every word has a place and everything is in its place.” The goal is to achieve a harmonious whole.
Basically, the Court was saying that the contextual meaning is the proper one because the literal meaning does not harmonise with another part of the statute and, presumably, because it does not factor that “tax law is ever changing, complicated and highly technical.”
On account of the contextual approach, the Court concluded that Fintel had paid the Contractor by recording interest as liability in the financial statements. Compared to the HC, the CoA held that payment of cash was not a pre-requisite to the imposition of withholding tax. In effect, the Court gave imprimatur to the use of accrual accounting when determine the tax point for withholding tax.
When they adopted the contextual approach, the judges heralded a departure from a strict and literal interpretation of tax legislation which has been salient and prominent feature of Kenyan tax jurisprudence over the decades (again, because “tax law is ever changing, complicated and highly technical.” )
It is far from clear how this rationale was impetus for the shift in the ‘KRA v Fintel’ though, opening the decision to challenge and criticism. In other words, what was complex and technical about the word “paid” and the phrase “upon” payment” that the Court had to depart from the literal meaning? There are court decisions which say that when a provision in a legislation is reasonably capable of having only one meaning, the Courts are required to give effect to this meaning, regardless of the consequences.
Presumably, just as courts in some common law jurisdictions have shifted from literal to purposive interpretation, the Court’s position was informed by concerns that the literal rule gave rise to interpretations that favoured taxpayers over KRA. It’s probable that Fintel, by using the accrual principle for purpose of deduction and cash basis with regard to withholding tax, improved its cash position somewhat. After all, the shilling today is worth more than one tomorrow, when one considers this under time value of money. Perhaps this is the benefit that the CoA forestalled without saying so. However, this is no justification for overriding a clear and unambiguous word in a statute.
This is not the first time the CoA is grappling with the place of purposive approach. In the earlier case of ‘Stanbic Bank Kenya Limited v KRA (2009) eKLR’, itrejected a push by one of the parties to adopt a purposive approach so as to resolve a dispute between KRA and a taxpayer over the interpretation of Sec 35(1)(a), dealing with imposition of withholding tax on management and professional fees. Unfortunately, the Court did not give reasons for refusing the suggested approach, other than to say the accepted approach to statutory interpretation of tax legislation in the country is the literal one. The decision garnered a first also, christening the purposive method as “purposeful,” leaving analysts wondering whether the judges had fully grasped what was being canvassed before them.
Apart from concerns about the logic and soundness of the decision, there are other aspects of the judgement that are a source of concern and, therefore, warrant further consideration.
First, the Court referred to the Reserve Bank Case to support its proposition that the Kenyan tax laws ought to be interpreted using a contextual approach. The Reserve Bank Case revolved around interpretation of contractual obligations. Indeed, contextual method is used often when interpreting contracts. Indian courts have made several decisions approving use of purposive approach in interpretation of tax legislation. It begs the question why the Court had to take recourse to a principle prevalent in law of contract while ignoring the one central to tax legislation.
Secondly, there are very principles known to the tax community in common law jurisdictions but the source concept is one of them. Kenya’s income tax system is partly based on the source concept. In Sec 3(1) of the Act, only profits which “accrued in “or “were derived from” Kenya are taxable here. Yet, in its analysis of the KRA v Fintel, the Court equated the source concept with the precept of accrual in accounting. With respect, this is an enormous misapprehension of the law.
Lastly, when canvassing their case, KRA argued that the High Court had failed to appreciate the nuances and application of the accrual and cash basis of accounting in the dispute and thereby arriving at the wrong conclusion. Although the accrual precept and cash basis are explicitly referred to in the HC judgement, the KRA and Fintel submissions and analysis were, by and large, informed by these. This was also the situation in the CoA when, for instance,
the judges refereed to book entries being a sufficient condition for imposition of withholding tax. It is, thus surprising that the judges concluded that the issue was not argued at the High Court so gave it short shrift.
Certainty is one of the pillars of a good tax system and requires tax legislation to state how the amount of taxes to be paid are determined as well as when and how payment is to be made. The Act does not meet this criterion. Taxpayers are unable to determine their tax liabilities with reasonable certainty, the reason why this issue keeps coming up in court. Perhaps it is easier for Parliament to amend the provisions so as to remove the source of uncertainty and, thereby forestall the many disputes between taxpayers and KRA.
Author is an Advocate of the High Court of Kenya