[2024] KETAT 1433 (KLR)

Chania Power Company Limited v Commissioner of Legal Services and Board Coordination (Tax Appeal E605 of 2023) [2024] KETAT 1433 (KLR) (27 September 2024) (Judgment)

Neutral citation: [2024] KETAT 1433 (KLR)

Republic of Kenya

In the Tax Appeal Tribunal

Tax Appeal E605 of 2023

CA Muga, Chair, BK Terer, EN Njeru, E Ng'ang'a & SS Ololchike, Members

September 27, 2024

Between

Chania Power Company Limited

Appellant

and

Commissioner of Legal Services and Board Coordination

Respondent

Judgment

Background 1. The Appellant is a limited liability company duly incorporated in the Republic of Kenya. The Appellant operates Chania Small hydro plant downstream of the Chania River.

2. The Respondent is a principal officer appointed under Section 13 of the Kenya Revenue Authority Act, CAP 469 of Kenya’s Laws. Under Section 5 (1) of the Act, the Kenya Revenue Authority is an agency of the Government for the collection and receipt of all tax revenue. Further, under Section 5(2) of the Act with respect to the performance of its functions under subsection (1), the Authority is mandated to administer and enforce all provisions of the written laws as set out in Part 1 and 2 of the First Schedule to the Act for the purposes of assessing, collecting and accounting for all revenues in accordance with those laws.

3. The Respondent subjected the Appellant to a tax returns review covering income tax based a review of the Appellant's return. The Respondent noted that the review revealed that the Appellant had both business income and interest income. The Respondent then issued assessment order numbers KRA 20230xxxxxxx, KRA 202307xxxxxxx and KRA20230xxxxxxx dated 11th May, 2023 and the demand notice dated 15th May,2023 amounting to Kshs 10,935,438. 07

4. The Appellant, being aggrieved by this decision objected to the assessment vide the letter dated 9th June,2023. The Respondent then issued an objection decision dated 7th August,2023. The Appellant being aggrieved by the Respondent’s decision lodged this appeal vide the notice of appeal dated 6th September,2023 and filed on the even date.

The Appeal 5. The Appellant filed a Memorandum of Appeal dated 19th September,2023 and filed on 20th September,2023. The appeal is premised on the ground that the Respondent erred in law and fact by disallowing the interest expenses claim against interest income.

The Appellant’s Case 6. In support of its case, the Appellant relied on its statement of facts dated 19th September,2023 and filed on 20th September,2024.

7. The Appellant stated it is owned by three shareholders namely; Mataara Tea Factory (holding 51%), Ngerere (holding 42%) and KTDA Power Company (holding 7%). The Appellant operates Chania small hydro plant downstream of the Chania River which was commissioned on April 2017. The plant is the major source of electricity power serving the two tea factories, Mataara and Ngerere with any excess exported to Kenya Power and Lighting Company (KPLC).

8. The Appellant’s case was that its estimated project cost in 2010 was USD 6,700,000. 00 translating to Kshs 640,000,000. 00. The capital structure reflected 65%:35% (Debt/Equity). The equity capital of Kshs 221,900,000. 00 was paid up by the respective shareholders in proportion with their respective shareholding weight.

9. To materialize the debt financing, the Appellant stated in July 2014 it acquired a construction loan from Co-operative Bank of USD 1,630,000. 00 (Kshs 142,500,000. 00) representing 40% of the required debt equivalent. This loan played a key role in paying up its contractual obligations over the construction period.

10. In July 2014, construction began with financing of 35% Equity and 65% Debt. Co-operative Bank released 40% of the 65% of debt financing to it. By December 2015, the construction was still in progress though the Appellant had exhausted the equity financing and the 40% of the debt financing.

11. The Appellant stated that in January 2016, there was delay in releasing the 60% balance of the debt financing which resulted in it borrowing internally from other Regional Power Companies to bridge the gap in financing. In April 2017, the Project was completed and commissioned.

12. In September 2019, Co-operative Bank released the remaining 60% of debt financing, it did not use the monies to offset the outstanding loans it had taken to finance the Project as other Regional Power Companies had started construction and their financing had delayed.

13. The Appellant maintained that it had in its hands excess cash which it used to lend to other Regional Power Companies hence generating the interest income. In May 2023, the KRA issued additional assessment order numbers KRA20230xxxxxxx, KRA20230xxxxxxx and KRA20230xxxxxxx posted to its i-Tax Ledger on 11th May,2023 amounting to Kshs. 10,935,438. 07 being interest income for the period ended June 2019, 30th June,2020 and 30th June, 2021. Consequently, the Respondent issued a Demand Notice dated 15th May, 2023 which was received by the Appellant via electronic mail on 15th May, 2023.

14. The Appellant, being aggrieved by this decision objected to the assessment on the basis that the Respondent did not consider the fact that interest expenses had a direct relationship with the interest income and that the interest expense should not have been apportioned.

15. In further support of the appeal, the Appellant filed written submissions dated 2nd May,2024 wherein the Appellant identified the following three issues for determination:a.Whether the Respondent erred in disallowing the Appellant's interest expense;b.Whether interest expenses is an allowable deduction against interest income for tax claimed against interest income; andc.Whether the Appellant is allowed to apportion interest expense between business income and interest income.

16. Having examined the Appellant’s written submissions, the Tribunal notes that the contents of the written submissions and the statement of facts are substantially the same. However, the Appellant added that in July 2014, construction began with financing of 35% Equity and 65% Debt. Co-operative Bank released 40% of the 65% of debt financing to it.

17. The Appellant submitted that the funds were not sufficient to construct and on 25th November,2014, it obtained approval from the Board to obtain an amount of Kshs. 144,000,000. 00 pursuant to minute 7/2014 of the Board meeting of 25th November, 2014.

18. The Appellant added that on 9th December, 2014, it received approval from the Board to request Co-op Bank to top up an additional USD 2,450,000. 00 to finance the funding gap of the project due to cost escalations between the feasibility study and funding gap.

19. The Appellant further stated that a request was also confirmed in the Board meeting of 14th July, 2016 vide Minute 2. 4. The Appellant submitted that Co-operative Bank did not approve the loan until September 2019, when it disbursed the remaining 60% of debt financing. The Appellant also submitted that it had borrowed internally from other Regional Power Companies to bridge the gap in financing. In April 2017, the Project was completed and commissioned.

20. The Appellant also submitted that upon the receipt of the second loan, it did not use the monies to offset the outstanding loans it had taken to finance the Project but lent it other to other Regional Power Companies and KTDA managed factory companies where it generated the interest income.

21. It further submitted that out of the loan of USD 2,450,000. 00 (Kshs 254,587,585. 00) it lent Kshs 215,954,379. 00. It also submitted that when filing the annual return, it offset the interest expense against its interest income.

22. The Appellant relied on Section 3(1) and (2)(b) of the Income Tax Act Cap 470 of the Laws of Kenya, (hereinafter “ ITA”), which provides as follows:“Subject to, and in accordance with, this Act, a tax to be known as income tax shall be charged for each year of income on all the income of a person, whether resident or non-resident, which accrued in or was derived from Kenya.(2)Subject to this Act, income upon which tax is chargeable under this Act is income in respect of(b)dividends or interest".

23. The Appellant also relied on section 15 (1) of the ITA which provides as follows:“For the purpose of ascertaining the total income of any person for a year of income there shall, subject to section 16 of this Act, be deducted all expenditure incurred in such year of income which is expenditure wholly and exclusively incurred by him in the production of that income.’

The Appellant’s Prayers 24. The Appellant herein prayed for the following Orders:a.That the Appeal be allowed;b.That the Appellant's objection dated 9th June 2023 be allowed and the Respondent's objection decision dated 7th August 2023 be set aside; andc.That the Respondent be prohibited from demanding the tax, any penalties and/or interest claimed or arising from the objection decision dated 7th August 2023.

The Respondent’s Case 25. The Respondent’s case is premised on its statement of facts dated 18th October, 2023 and filed on 19th October,2023.

26. The Respondent’s case was that it subjected the Appellant to a tax returns review covering income tax. The assessments were based on the review outcome of the Appellant's return. The Respondent noted that the review of the income tax returns revealed that the Appellant had both business income and interest income.

27. It stated that the business income related to sale of power to Mataara and Ngerere tea factories and KPLC, while interest income was generated from short-term loans to the Appellant's sister power companies under KTDA power.

28. The Respondent stated that upon further review of the Appellant's returns revealed substantial interest expense. According to the Respondent, the Appellant had explained that the income interest relates to interest charge on intercompany borrowing and that the loans were taken to support power generation business when it has cash flow problems and hence should be claimed against the business and not exclusively incurred in the generation of interest income only.

29. Consequently, the Respondent issued an assessment order. It was the Respondent’s case that it apportioned the interest expense between business and interest income proportionally.

30. The Respondent issued an assessment of additional taxes which the Appellant objected to on the ground that whereas it agreed with the Respondent's position in regards to apportionment, it noted that the Respondent only considered the apportioning of interest as opposed to apportioning of all expenses using the apportionment ratio.

31. The Respondent alleged that it requested the Appellant to provide an analysis of the income and expenses for the periods under review. From the documents provided the Respondent found as follows:a.The Appellant incurred interest expense as a result of borrowing funds for supporting the power generation business when it experienced cash flow problems. Therefore, the expense ought to be claimed against the business income; andb.The interest income earned related to intercompany lending of the Appellant’s surplus funds.

32. According to the Respondent, it did not find a correlation between the interest income and interest expenses as the funds borrowed were not directly invested to earn interest income. The interest expense was incurred to earn business income and therefore ought to be deducted from business income.

33. The Respondent averred that it confirmed general administrative expenses and apportioned in the ratio of interest income to total income and allowed them meaning that the objection applications were partly disallowed and the additional assessments issued by the Respondent were partly confirmed. The Appellant being dissatisfied with the decision of the Respondent lodged this Appeal.

34. In response to the memorandum of appeal, the Respondent stated that the Appellant carried out business and is therefore expected to pay taxes based on Section 3(1) and (2) (b) of the ITA which provides as follows:“3. (1)Subject to, and in accordance with, this Act, a tax to be known as income tax shall be charged for each year of income upon all the income of a person, whether resident or non-resident, which accrued in or was derived from Kenya(2)Subject to this Act, income upon which tax is chargeable under this Act is income in respect of-(b)Dividends or interest”

35. The Respondent contended that review of the Appellant's income returns revealed that the Appellant had both business income and interest income. The business income related to the sale of power to the tea factories and KPLC whilst interest income was generated from short term loans to sister power companies under KTDA power.

36. The Respondent cited the provisions of Section 2 of the ITA which defines interest as follows: "interest" (other than interest charged on tax) means interest payable in any manner in respect of a loan, deposit, debt, claim or other right or obligation, and includes a premium or discount by way of interest and commitment or service fee paid in respect of any loan or credit or an Islamic finance return.

37. The Respondent also relied on Section 10 of the ITA which makes the following provisions pursuant to Sub-section 1 (c) as follows:“… for the purposes of this Act, where a resident person or a person having a permanent establishment in Kenya makes a payment to any other person in respect of-c.Interest and deemed interest.the amount thereof shall be deemed to be income which accrued in or was derived from Kenya:’

38. According to the Respondent, a further review revealed a substantial interest income in which the Appellant explained that they received interest income from intercompany lending of the Appellant's surplus funds. The Respondent further noted that interest expense was incurred as a result of borrowing funds for supporting power generation business when the Appellant experienced cash flow problems.

39. The Respondent contended that the expense ought to be claimed against business income and not interest income.

40. The Respondent averred that it could not find a nexus between the interest income and interest expenses and that the interest expense was incurred to earn business income and therefore ought to be deducted from business income.

41. It is the Respondent’s case that the assessment was based on the available information provided by the Appellant and the best judgement by the Respondent. It relied on the provisions of Section 59 of the Tax Procedures Act, CAP 469B Laws of Kenya, (hereinafter “TPA”), which according to the Respondent, empowers it to require production of necessary documents in determination of tax liability.

42. The Respondent maintained that the Appellant is misguided in lodging this Appeal since the objection decision was given after review of the supporting documents provided by the Appellant. The Respondent further averred that the allegations of the Appellant as laid out in its Memorandum of Appeal and Statement of Facts unless where in agreement by the Respondent were unfounded in law and not supported by evidence.

43. In further opposition of the appeal, the Respondent relied on its written submissions dated 11th April,2024 and filed on 15th April,2024. The Respondent identified single issue for determination which was whether it erred in law and fact by disallowing interest expenses claim against interest income.

44. The Respondent relied on Section 24 (2) of the TPA to submit that it is not bound by the returns of a Taxpayer, and that the law allows the Respondent to use the information within its reach to compute the tax liability of taxpayers pursuant to the provisions of Section 31 of the TPA.

45. It submitted that it reviewed the Appellant's returns, which revealed that the Appellant had both business income and interest income. The business income related to sale of power to tea factories and KPLC while interest income was generated from short-term loans to sister power Companies under KTDA power. The Respondent submitted that it is empowered to amend a return based on available information therefore, it proceeded to issue additional assessments for the period 2018- 2021 to charge interest income.

46. The Respondent argued that the Appellant in its objection proposed apportionment of all expenses against interest income and business income but the Respondent did not agree with the proposed apportionment as the expenses in question were incurred in the generation of the business income and not exclusively incurred in the generation of the taxable interest income.

47. It cited the case of GreenroadKenya Limited vs Commissioner of Domestic Taxes TAT Appeal No. 538 Of 2021 where the Tribunal at paragraph 52 and 53 held as follows:‘‘The Tribunal's considered view is that the failure by the Appellant to avail the documents requested granted the Respondent the power to use its best judgement as provided for under Section 31(1) of TPA Which provides that:- "subject to this section, the Commissioner may amend an assessment (referred to in this section as the "original assessment") by making alterations or additions, from the available information, and to the best of the Commissioner's judgement, to the original assessment of a taxpayer for a reporting period."

48. The Respondent relied on Section 3(1) and (2) (b) of the ITA to submit that review of the Appellant's income returns revealed that the Appellant had both business income and interest income. The business income related to the sale of power to the tea factories and KPLC while interest income was generated from short term loans to sister power companies under KTDA power.

49. The Respondent urged the Tribunal to examine section 2 and section 10 of the ITA with regards to the meaning of ‘interest” and cited the provisions of Section 30 of the Tax Appeals Tribunal Act, CAP 469A of the Laws of Kenya (hereinafter “TATA”) to submit that the Appellant failed to discharge its burden of proof.

50. The Respondent cited the case of Pearson of Belcher CH.M Inspector of Taxes) Tax Cases Volume 38 referred to by Justice D.S. Majanja in PZ Cussons East Africa Limited V Kenya Revenue Authority (2013) eKLR to the following extent:“Where there is an assessment made by the Additional Commissioner upon the Appellant: it is perfectly settled by cases such as Norman Vs. Galder 267C 293, that the onus is upon the Appellant to show that the assessment made upon him is excessive and incorrect and of course he has completely failed to do. That is sufficient to dispose of the appeal, which I accordingly dismiss with costs."57. ...the Appellant in the present appeal has manifestly failed to discharge such an onerous burden of proof placed squarely on it...."

51. The Respondent submitted that the Appellant had not disputed that it had excess cash, which it lends to other regional power companies hence generation interest income.

52. The Respondent cited the case of Afya X-ray Centre limited v Commissioner of Domestic Taxes TAT No. 70 of 2017 to submit that the Respondent cannot be faulted for relying on the available documents. Therefore, the Respondent maintained that the Appellant failed to discharge its burden of proof.

Respondents Prayers 53. Based on the above grounds, the Respondent prayed that the Tribunal be pleased to uphold the its decision dated 7th August 2023 and dismiss the Appeal with costs to it.

Issues for Determination 54. The Tribunal having considered the parties’ pleadings documentation and submissions, is of the view that there are two issues for determination:i.Whether the Respondent erred in apportioning the Appellant’s expenses proportionally between business and interest income.ii.Whether the Respondent’s resultant assessment from the apportionment of the expenses proportionally between business and interest income was justified.

Analysis and Findings 55. The Tribunal wishes to analyse the issues as hereinunder.

i. Whether the Respondent erred in apportioning the Appellant’s expenses proportionally between business income and interest income. 56. The Appellant argued that the Respondent erred in law and fact by disallowing the interest expenses claim against interest income. It asserted that when filing annual returns, it offset the interest expense against the interest income.

57. On the other hand, the Respondent’s case was that the Appellant’s income was from business income and interest income. The Respondent stated that the business income relates to sale of power to Matara tea factory, Ngerere tea factory and to KPLC while interest income was generated from short-term loans to Appellant’s sister companies under KTDA power. Further, the Respondent argued that it could not find a correlation between the interest income and interest expenses as funds borrowed were not directly invested to earn interest income. The Respondent further alleged that the Appellant did not provide documents to support its case and to guide the Respondent to arrive at a different outcome.

58. The Tribunal examined the pleadings and documentary evidence on record and notes that the parties agree on the nature of business and transactions carried on by the Appellant; that the Appellant is in the business of power generation, and also had interest income from loans issued.It was also not in dispute that the Appellant obtained multiple loans. The Appellant adduced loan agreements, resolutions to borrow funds and letters addressed to Co-operative Bank undertaking to repay the loans. The Respondent did not challenge this position.

59. The Tribunal notes that whereas the Appellant argued that it borrowed from other regional institutions to finance the deficit, the Appellant did not indicate the amount that it borrowed. Further, whereas the Appellant admitted that the surplus of the received funds was used to lend other regional power companies leading to generation of income, the Appellant did not specify the income it received from these transactions.

60. On ascertainment of income, Section 15 (7) of the ITA provides as follows:“Notwithstanding anything contained in this Act—(a)the gains or profits of a person derived from any one of the seven sources of income respectively specified in paragraph (e) of this subsection (and in this subsection called “specified sources”) shall be computed separately from the gains or profits of that person derived from any other of the specified sources and separately from any other income of that person;(b)where the computation of gains or profits of a person in a year of income derived from a specified source results in a loss, that loss may only be deducted from gains or profits of that person derived from the same specified source in the following year and, in so far as the loss has not already been so deducted, in subsequent years of income;(c)the subparagraphs of paragraph (e) of this section shall be construed so as to be mutually exclusive;(d)gains chargeable to tax under section 3(2)(f) of this Act and losses referred to in subsection (3)(f) of this section shall not be deemed income or losses derived or resulting from specified sources for the purposes of this subsection;(e)the specified sources of income are—(i)rights granted to other persons for the use or occupation of immovable property;(ii)employment (including former employment) of personal services for wages, salary, commissions or similar rewards (not under an independent contract of service), and a self-employed professional vocation;(iii)employment the gains or profits from which is wife’s employment income, profession the gains or profits from which is wife’s professional income and wife’s self-employment the gains or profits from which is wife’s self-employment income;(iv)agricultural, pastoral, horticultural, forestry or similar activities, not falling within subparagraphs (i) and (ii) of this paragraph;(iva)surplus funds withdrawn by or refunded to an employer in respect of registered pension or registered provident funds which are deemed to be the income of the employer under section 8(10);(ivb)income of a licensee from one licence area or a contractor from one contract area as determined in accordance with the Ninth Schedule; and(v)other sources of income chargeable to tax under section 3(2) (a), not falling within subparagraph (i), (ii), (iii) or (iv) of this paragraph.”

61. The Tribunal notes the following provisions of Section 3 (2) (a) of the ITA:“(2)Subject to this Act, income upon which tax is chargeable under this Act is income in respect of—(a)gains or profits from—(i)any business, for whatever period of time carried on;(ii)any employment or services rendered;(iii)any right granted to any other person for use or occupation of property;”

62. The Tribunal’s view is that pursuant to the provisions of section 15 (7) and 3(2)(a) of the ITA, dividends and interest are not included in the seven categories of income referred to as “specified sources of income”. The specified sources of income are, in conformity to the said provisions, to be computed separately from the gains or profits of a person derived from any other of the specified sources and separately from any other income of that person.

63. The Tribunal observes that the Appellant proposed apportionment of all expenses against interest income and business income in one way and the Respondent proposed separate apportionment of the expenses in another way. The Tribunal however notes that pursuant to section 15 (7) of the ITA, neither the expenses attributable to interest income nor those attributable to income from the power generation plant needed to be apportioned.

64. Accordingly, the finding of the Tribunal is that the Respondent erred in its attempt at apportioning the Appellant’s expenses proportionally between business income and interest income.

ii. Whether the Respondent’s resultant assessment from the apportionment of the expenses proportionally between business and interest income was justified. 65. Having determined that the Respondent ought not to have apportioned the expenses as it sought to do, it follows that the resulting assessment was erroneous and therefore unjustified.

66. The Tribunal notes and observes that the Appellant had also attempted to apportion its expenses across the revenue streams of its business. This too is unfounded in law.

67. Under the circumstances, the Tribunal finds that it is unable to determine whether or not the Respondent’s resultant assessment from the apportionment of the expenses proportionally between business and interest income was justified.

Final Decision 68. Based on the foregoing analysis and findings, the Tribunal makes the follows Orders:a.The Assessment issued and confirmed is hereby referred back to the Respondent for appropriate reassessment.b.Each party to bear its own cost.

69. It is so ordered.

DATED AND DELIVERED AT NAIROBI THIS 27TH DAY OF SEPTEMBER, 2024. CHRISTINE A. MUGA - CHAIRPERSONBONIFACE K. TERER - MEMBERELISHAH N. NJERU - MEMBEREUNICE N. NG’ANG’A - MEMBEROLOLCHIKE S. SPENCER - MEMBER