SECTION 2SUBJECT NO. 10TAXATIONSTUDY TEXTDownload more free notes at www.kasnebnotes.co.ke
iiTA X AT I O NCopy r i ghtALL RIGHTS RESERVED.No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by anymeans, electronic, mechanical, photocopying, recording or otherwise without the prior written permission ofthe copyright owner. This publication may not be lent, resold, hired or otherwise disposed of in anyway of tradeS T U D YT E X Twithout the prior written consent of the copyright owner.ISBN NO: 9966-760-19-9 2009 STRATHMORE UNIVERSITY PRESSFirst Published 2009STRATHMORE UNIVERSITY PRESSP.O. Box 59857, 00200,Nairobi, Kenya.Tel: 254 (0) 20 606155Fax: 254 (0) 20 607498Design Concept & Layout - Simplicity Ltd - P.O Box 22586-00400 Nairobi. Email: info@simplicityltd.comDownload more free notes at www.kasnebnotes.co.ke
ACKNOWLEDGMENTiiiS T U D YWe gratefully acknowledge permission to quote from the past examination papers of KenyaAccountants and Secretaries National Examination Board (KASNEB).T E X TAcknowledgmentDownload more free notes at www.kasnebnotes.co.ke
TA X AT I O NS T U D YT E X TivDownload more free notes at www.kasnebnotes.co.ke
vTable of ContentsACKNOWLEDGMENT . . IIITABLE OF CONTENTS . VCHAPTER ONE . 3THEORY OF TAXATION . . 3CHAPTER TWO . . 37TAXATION OF INCOMES OF PERSONS. 37CHAPTER THREE .111TAXATION OF SPECIFIC SOURCES OF INCOME . .111CHAPTER FOUR . 131ADMINISTRATION OF INCOME TAX . 169CHAPTER SIX . 209VALUE ADDED TAX . 209CHAPTER SEVEN . 249ADMINISTRATION OF CUSTOMS & EXCISE . . 249CHAPTER EIGHT . 277OTHER REVENUE SOURCES . . 277CHAPTER NINE . 289KASNEB SYLLABUS FOR TAXATION 1 - REVISION AID . 289CHAPTER TEN . 293MODEL ANSWERS TO REVISION/EXAM QUESTIONS . 295GLOSSARY . 321INDEX . 327Download more free notes at www.kasnebnotes.co.keS T U D YCHAPTER FIVE . 169T E X TCAPITAL DEDUCTIONS/ALLOWANCES . . 131
TA X AT I O NS T U D YT E X TviDownload more free notes at www.kasnebnotes.co.ke
1STS TT SUU TDDUYYD YT EE TXX ETTX TCHAPTER ONETHEORY OF TAXATIONDownload more free notes at www.kasnebnotes.co.ke
TA X AT I O NS T U D YT E X T2Download more free notes at www.kasnebnotes.co.ke
3CHAPTER ONETHEORY OF TAXATION1.0OBJECTIVESAt the end of this chapter, the student should be able to:INTRODUCTIONWe start our study of taxation with a look at the basic concepts and purposes of taxation. Thechapter covers the general theory of taxation and forms the foundation of taxation. It containsmajor definitions that will be helpful in the subsequent chapters.1.5DEFINITION OF KEY TERMSTax: A compulsory payment by a tax payer to the state through the revenue authority withoutinvolving a direct repayment of goods and services in return.Budget: A budget is a statement which consists of the revenue and expenditure estimates of thegovernment for one particular year.1.3EXAM CONTEXTIn this chapter the main focus is to ensure that the student is conversant with all the basic conceptsand the purpose of taxation, the student should be able to demonstrate his understanding of thesame.Download more free notes at www.kasnebnotes.co.keT E X T1.2Understand the various types of taxes imposed in KenyaExplain the importance of taxes in a countryExplain the principles of taxationDifferentiate between direct and indirect taxationEstablish the different taxation systemsExplain the economical effects of taxationExplain the role of taxation in achieving budgetary objectivesS T U D Y
4TA X AT I O N1.4INDUSTRIAL CONTEXTAs indicated above, the chapter contains the general theory of taxation that will enable anyone including tax consultants and budget analysts gain a general understanding of the taxationframework in Kenya.S T U D YT E X T1.6TAXATION DEFINEDTaxation is the part of public finance that deals with the means by which the government raisesrevenue from the public by imposing taxes which revenue is used by the government to providegoods and services to the public or its citizens (to carry out government functions). Taxation maybe referred to as the revenue raising activity of the government.Public Finance is the department of economic theory that deals with public expenditure andrevenue. Economics deals with resource allocation and seeks to answer the three questions of:who to produce, how to produce and for whom to produce.We will start by exploring the government expenditure, which is characterised by the expectedactivities of a government. We will then look at the taxation as source of revenue to finance thegovernment expenditure.Government activitiesA government is expected to carry out some activities as part of its service to the public. Theseactivities are generally of universal application, but where applicable, a Kenyan example isgiven.These activities are:1.To maintain internal security and external defence and carry out general administration.In this respect, it will incur expenditure relating to:§§§The cost of police and judiciary for maintenance of law and order.The cost of the armed forces such as the army, navy and airforce for defenceagainst external aggression.Cost of provincial administration and general administration of law and order.Download more free notes at www.kasnebnotes.co.ke
THEORY OF TAXATIONTo provide infrastructure and communication such as:§§To provide basic social services such as the cost of:§§§§§4.To participate in the production and marketing of commercial goods and services:§§§§5.Cost of establishing public enterprises such as parastatals.Combining with private business through purchase of shares in commercialenterprises. There is pressure all over the world for government to divest orprivatise business enterprises. The Kenya government in the 1991 budgetannounced its plans to divest in 139 business enterprises.Providing forms of easy loans not obtainable in financial institutions, and providingcheap business premises such as the Kenya Industrial Estates, Export ProcessingZones etc.Guaranteeing markets through protection from competition and preferentialpurchases.Influencing and guiding the level and direction of economic activities through variousregulations:§§6.Medical services and medicine in hospitals.Education in schools, colleges and universities.Water supply and sewerage.Sports and cultural activities.Entertainment and information on radio and television.Monetary policy (relating to interest and money supply);Fiscal policy (deliberate manipulation of government income and expenditure soas to achieve desired economic and social goals).Redistributing income and wealth through taxation and public spending:§§§Taxing the rich and those able to afford tax.Cost of providing basic needs to the poor such as free education, medical careand housing.Cost of relief of famine and poverty which may arise from unemployment,sickness, old age, crop failure, drought, floods, earthquakes etc.To perform the above functions effectively and adequately, the government needs funds. Taxationis an important source of government income. The income of the government from taxes andother sources is known as public revenue.Download more free notes at www.kasnebnotes.co.keT E X T3.Cost of constructing roads, railways, airports and harbours.Cost of constructing electricity and telephone networks, television and radiosystems etc.S T U D Y2.5
6TA X AT I O NPublic Revenue SourcesPublic revenue is all the amounts which are received by the government from different sources.The main sources of public revenue are as follows:(a)TaxesTaxes are the most important source of public revenue. Any tax can be defined as an involuntarypayment by a tax payer without involving a direct repayment of goods and services (as a "quidpro quo") in return. In other words, there are no direct goods or services given to a tax payerin return for the tax paid. The tax payer can, however enjoy goods or services provided by thegovernment like any other citizen without any preference or discrimination.The following features are common in any tax system:S T U D YT E X TTaxing authorityThis is the authority with the power to impose tax e.g. the central government or a local authority.The taxes are received as public revenue. The taxing authority has power to enforce payment oftax. The central government imposes tax through the Kenya Revenue Authority (KRA).Tax payerThe person or entity that pays the tax e.g. individuals, companies, businesses and otherorganizations. The amount of tax is compulsory and there is punishment for failure to pay.TaxThe amount paid to the taxing authority as direct cash payment or paid indirectly through purchaseof goods or services. The tax is not paid for any specific service rendered by the tax authority tothe tax payer. The tax paid becomes revenue and is used to provide public goods and servicesto all citizens.In addition to the above common features of tax, the definitions of tax by some tax experts aslisted below are important:a.A compulsory contribution to a public authority, irrespective of the exact amount ofservice rendered to the tax payer in return.b.A compulsory contribution from a person to the government to defray the expensesincurred in the common interest of all.c.A compulsory contribution of wealth by a person or body of persons for the service ofthe public. There is a portion of the produce of the land and labour of country that isplaced at the disposal of the government for the common good of all.Download more free notes at www.kasnebnotes.co.ke
NATURE, PURPOSE AND CLASSIFICATION OF LAW7Income tax — this is tax imposed on annual gains or profits earned by individuals,limited companies, business and other organisations. The income tax will be explainedin chapters 2 to 5.ii.Value added tax (V.A.T.) — This is tax imposed on sale of commodities and servicesintroduced in Kenya with effect from 1.1.90. VAT is discussed in detail under chapter 6herein.iii.Turnover Tax — Is charged on income or receipts from business by taxable personsof a turnover between Sh. 500,000 and Sh. 5 million within a period of 12 months witheffect from 1.1.2008. The Turnover Tax is explained in chapter 5 in detail.iv.Sales tax — This is tax imposed on sale of commodities which was abolished in Kenyaon 31.12.89 and replaced with value added tax.v.Excise duty — This is tax imposed on commodities produced locally or imported. Ittargets specific commodities, for example, luxuries and commodities that are detrimentalto heath. The details of this are in chapter 7.vi.Customs and excise duty — This is tax imposed on import or export of commodities.The details of this tax are in chapter 7.vii. Stamp duty — This is tax that is aimed at legitimizing transactions. It is imposed onincrease of share capital, transfer of shares, mortgages, charges, the transfer of propertyamong others. The details of this tax are in chapter 8.(b)Land rent and ratesThese are levies imposed on property. Rent is paid to the Central Government on some landleases while rates are paid to the Local Authority based on the value of property. This is discussedfurther in Chapter 8.(c)FeesFees is an amount which is received for any direct services rendered by the Central or LocalAuthority e.g. television and radio fees, national park fees, airport departure fee, airport landingand parking fee, port fee by ships, university fee, etc.(d)PricesPrices are those amounts which are received by the central or local authority for commercialservices e.g. railway fare, postage and revenue stamps, telephone charges, radio and televisionadvertisement etc.Download more free notes at www.kasnebnotes.co.keS T U D Yi.T E X TKinds of taxes
8TA X AT I O N(e)External borrowingThis is done from foreign governments and international financial institutions such as World Bankand International Monetary Fund (IMF).(f)Fines and PenaltiesIf individuals and firms do not obey the laws of the country, fines and penalties are imposed onthem. Such fines and penalties are also the income of the government.(f)State PropertyS T U D YT E X TSome land, forests, mines, national parks, etc. are government property. The income that arisesfrom such property is also another source of public revenue. The income will arise from paymentof rents, royalties, or sale of produce.(g)Internal BorrowingThe government usually raises revenue through issue of treasury bills and treasury bonds in thelocal market.1.7WHY THE GOVERNMENT LEVIES TAXESThe raising of revenue is not the only purpose for which taxes are levied. The taxes are leviedfor various purposes as follows:a. Raising RevenueThe main purpose of imposing taxes is to raise government income or revenue. Taxes are themajor sources of government revenue. The government needs such revenue to maintain thepeace and security in a country, to increase social welfare, to complete development projects likeroads, schools, hospitals, power stations, etc.Download more free notes at www.kasnebnotes.co.ke
THEORY OF TAXATION9b. Economic StabilityTaxes are also imposed to maintain economic stability in a country. In theory, during inflation,the government imposes more taxes in order to discourage the unnecessary expenditure of theindividuals. On the other hand, during deflation, the taxes are reduced in order to encourageindividuals to spend more money on goods and services. The increase and decrease in taxeshelps to check the big fluctuations in the prices of goods and services and thus maintain theeconomic stability.c. Protection PolicySome commodities such as wines, spirits, beer, cigarettes, etc. are harmful to human health.To discourage wide consumption of these harmful commodities, taxes are imposed to make thecommodities more expensive and therefore out of reach of as many people as possible.e. Fair Distribution of IncomeIn any country, some people will be rich and others will be poor due to limited opportunitiesand numerous hindrances to becoming wealthy. Taxes can be imposed which aim to achieveequality in the distribution of national income. The rich are taxed at a higher rate and the amountsobtained are spent on increasing the welfare of the poor. That way, the taxes help to achieve afair distribution of income in a country.f. Allocation of ResourcesTaxes can be used to achieve reasonable allocation of resources in a country for optimumutilization of those resources. The amounts collected from taxes are used to subsidise or financemore productive projects ignored by private investors. The government may also remove taxeson some industries or impose low rates of taxes to encourage allocation of resources in thatdirection.Download more free notes at www.kasnebnotes.co.keS T U D Yd. Social WelfareT E X TWhere a government has a policy of protecting some industries or commodities produced in acountry, taxes may be imposed to implement such a policy. Heavy taxes are therefore imposed oncommodities imported from other countries which compete with local commodities thus makingthem expensive. The consumers are therefore encouraged to buy the locally produced and lowpriced goods and services.
10TA X AT I O Ng. Increase In EmploymentFunds collected from taxes can be used on public works programmes like roads, drainage, andother public buildings. If manual labour is used to complete these programmes, more employmentopportunities are created1.8PRINCIPLES OF AN OPTIMAL TAX SYSTEMThese are the principles of an optimal tax system, what are known as Canons of taxation, someof which were laid down by Adam Smith.S T U D YT E X T1. SimplicityA tax system should be simple enough to enable a tax payer to understand it and be able tocompute his/her tax liability. A complex and difficult to understand tax system may produce alow yield as it may discourage the tax payer's willingness to declare income. It may also createadministrative difficulties leading to inefficiency. The most simple tax system is where there is asingle tax. However, this may not be equitable as some people will not pay tax.2. CertaintyThe tax should be formulated so that tax payers are certain of how much they have to pay andwhen. The tax should not be arbitrary. The government should have reasonable certainty aboutthe 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 investmentopportunities on the basis of the possible tax implications. It is also important in designingremuneration packages. Employers seek to offer the most tax efficient remuneration packageswhich would not be possible if uncertainty exists.3. ConvenienceThe method and frequency of payment should be convenient to the tax payer e.g. PAYE. Thismay 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.Download more free notes at www.kasnebnotes.co.ke
THEORY OF TAXATION114. Economic/Administrative EfficiencyA good tax system should be capable of being administered efficiently. The system shouldproduce the highest possible yield at the lowest possible cost both to the tax authorities and thetax payer.The tax system should ensure that the greatest possible proportion of taxes collected accrue tothe government as revenue.5. Taxable CapacityAbsolute taxable capacityRelative taxable capacityAbsolute taxable capacity is measured in relation to the general economic conditions andindividual position e.g. the region, or
Taxation is the part of public finance that deals with the means by which the government raises . § The cost of police and judiciary for maintenance of law and order. § The cost of the armed forces such as the army, navy and airforce for defence against external aggression.
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