In the financial year 2022/23, Kenya government revenues are projected to increase to Ksh 2.4 trillion (17% of GDP), an increase from the Ksh 2.06 trillion (16.3 percent of GDP) collected in the year ended June 2022. This is slightly above the developing country’s average of 15% of GDP and way below the 40% collected by developed nations. 

For Kenya to achieve its economic goals as set out in various policy documents, it will require to broaden its tax base to capture more revenue without having to increase taxes to its residents. It is under these circumstances that The National Treasury and Planning Cabinet Secretary, Prof. Njuguna Ndung’u, recently published the draft Income Tax (Financial Derivatives) Regulations, 2022. The regulations are intended to take effect on January 1, 2023.  According to KRA, “the Finance Act, 2022 amended Section 3(2) of the Income Tax Act, Cap 470 to introduce income tax on gains accrued in or derived from Kenya by a non-resident person from financial derivatives”.

Following the release of the Capital Markets (Derivative Market) regulations Act in 2015, the Nairobi Securities Exchange launched the derivative market in mid 2019. The Income Tax Act Cap 470 defines financial derivatives as financial instruments whose value depends on its underlying asset. The outcome of derivatives are cash transactions settled at a future date. These underlying assets include bonds, commodities, currencies, interest rates, security, stock index, price indices, credit ratings or similar assets. The purpose of these derivatives is to hedge volatility of underlying assets and the resultant business risk. Financial derivatives under the regulations are call and put options, currency swaps, forward and future contracts, interest rate swaps and option contracts among others. 

The Income Tax (Financial Derivatives) Regulations, 2022 aims to broaden the tax base while shielding residents by imposing a gains tax earned by non-residents. The regulations seek to impose tax on gains from derivative contracts such as forward, future and swap contracts, put and call options including option premium accruing to a non-resident person without a permanent establishment in Kenya at 15 percent of the gains.

 Taxing financial derivatives is a complex and delicate matter with various issues likely to complicate the implementation of the regulation. For instance, issues of double taxation from various double tax agreements Kenya has entered with several nations are likely to play key roles in the effective implementation of proposed regulations. In order to promote growth of financial derivatives traded at the NSE, the regulations propose to exempt from imposition of the gains tax, a non-resident person who gains from financial derivatives traded at the exchange.

For realization of a gain, the regulation proposes that this shall be determined upon changing hands of the underlying asset, or on settlement of the contract, or on the payment of option premium, or on the expiry of the financial derivative contract. A loss accruing to a resident person shall be treated as a deduction from the gains accrued from the financial derivatives transactions. This cushions a resident person as one of the characteristics of financial derivatives is to hedge downside risk associated with these transactions. 

However, certain safeguards have been proposed by the regulations in terms of tax deductions. The resident person who suffers loss from the transaction cannot claim any deductions if they have not paid tax. The resident person is also prohibited from claiming a deduction in respect of a loss arising from the transaction if it enters into a substantially identical transaction within thirty days before or after the loss was realized.  

Proper record keeping of all contracts and financial transactions under financial derivative transactions is mandatory under the regulations. This provision is necessary for determination and ascertainment during tax computing.  It is an offense liable to penalty under the Income Tax Act for failure to keep transactional records. 

In conclusion, the regulations do not introduce anything new but are simply amplifying and enhancing the provisions introduced under the Finance Act, 2022. They offer detailed provisions on the legal framework for tax imposition on financial derivatives. 

Co-authored by: Mwaniki Mugo, Capital Markets Policy Analyst, Central Bank of Kenya