The Income Tax (Financial Derivatives) Regulations, 2023

a) Introduction

This alert brings to your attention the Income Tax (Financial Derivative) Regulations, 2023 (the Regulations) that were published on 27 January 2023 by the Cabinet Secretary, National Treasury and Economic Planning (CS National Treasury) pursuant to Section 9(4) of the Income Tax Act (ITA) which required the CS National Treasury to issue regulations to actualise the taxation of gains from financial derivatives.

The Regulations provide additional guidance on the taxation of gains accruing to non-resident persons without a permanent establishment in Kenya from financial derivative contracts.

The ITA defines a financial derivative as “a financial instrument the value of which is linked to the value of another instrument underlying the transaction which is to be settled at a future date.”

With the Regulations coming into force, withholding tax (WHT) of 15% will apply on the gains at a rate of 15% of the gross amount with effect from 1 January 2023.

We have analysed the Regulations and summarise below the key provisions:


b) The scope of the Regulations

Regulation 2 and 3 provide for definitions of terms and set out the transactions which are subject to the Regulations. Regulation 3 defines the taxable derivatives to include future contracts, forward contracts, swap contracts and options contracts, unless expressly exempted by the ITA. An option contract in this context is defined as a financial derivative which offers the holder the right, but not the obligation, to buy or sell the underlying asset or security at a specific price on or before the option’s expiration date. Under the Regulations, option premiums accruing to a non-resident person, other than a non-resident person having a permanent establishment in Kenya, are also considered taxable financial derivatives subject to tax under the Regulations. An option premium is defined as, the price an option holder pays to buy options or sell options at a fixed rate when the term of the contract expires. The Regulations do not apply to financial derivatives traded at the Nairobi Securities Exchange.
 

c) The point of taxation

Under Regulation 4(1), a gain or loss is deemed as realized at the earlier of: when the underlying asset changes hands, or on settlement of the contract, or on the payment of option premium, or on the expiry of the financial derivative contract.

Regulation 4(2) requires that the financial derivatives be treated as a separate source of income, which means that losses from the derivatives transactions can only be set-off against gains from similar transactions.


d) Record keeping and characterization for purposes of tax returns

Regulation 5(1) requires a party to a financial derivative transaction to keep records including contracts relating to such transactions.

Regulation 5(2) further provides that income from financial derivatives must be characterized as “other income’ (financial derivative gains/losses)” in a resident person’s tax returns and treated as a separate source in accordance with Section 15(7) of the ITA. This requirement will make it easier for the KRA to review and confirm that withholding tax is correctly accounted for. 

Even though the Regulations have not specified a definite period within which a person shall be required to keep records, Section 23 (1)(c) of the Tax Procedures Act requires a taxpayer to maintain records for at least 5 years from the end of the reporting period to which it relates, or such shorter period as may be specified in a tax law. 

within which a person shall be required to keep records, Section 23 (1)(c) of the Tax Procedures Act requires a taxpayer to maintain records for at least 5 years from the end of the reporting period to which it relates, or such shorter period as may be specified in a tax law.


e) Tax due date

Regulation 6 provides that the tax payable under the Regulations is due by the 20th day of the month after which the loss from the transaction with the non-resident person is realized.


f) Conclusion

The taxation of derivatives is one of the measures that the Kenya government is implementing to widen the tax base. While the exemption from tax of gains from financial derivatives traded on the Nairobi Securities Exchange is welcome, the new provisions present several challenges for businesses.

For resident persons, separate sourcing financial derivative transactions means that they cannot set-off losses from the transactions against gains from their normal business operations but will need to generate a gain from similar transactions for them to get a deduction. This is likely to discourage hedging transactions which are critical in these times of supply chain disruptions and foreign currency supply and price fluctuations.

Many derivative contracts with non-resident persons are negotiated on a net of tax basis which means that the local counterparties will be forced to bear the impact of the withholding tax. This is likely to make such transactions less attractive.

While the change in law initially targeted non-resident persons without permanent residence in Kenya, the regulations have extended the scope to negatively impact resident persons who have been subjected to separate sourcing and have the additional obligation of withholding and accounting for the tax on behalf of the KRA. KPMG is happy to assist on any issues arising from this alert.

KPMG is happy to assist on any issues arising from this alert.