Banks win against state in currency swaps tax battle

Kenyans banks have won a major tax battle against government after the High Court declared last year’s law on financial derivatives null and void.

The Treasury, through Income Tax (Financial Derivatives) Regulations, 2023, required banks and Kenyans to pay Kenya Revenue Authority (KRA) at least 15 per cent of each transaction.

Financial derivative contracts are used to trade in financial market through ‘financial bets’ whereby the value of the derivative is determined either by the value placed on the contract (the derivative itself) or the price of the real or financial things that the derivatives are based on (the price of the actual item).

The most common financial derivative that banks deal with is currency swaps - a transaction in which two parties exchange an equivalent amount of money with each other but in different currencies.

They have a contract to re-pay the amounts at a specific date and exchange rate. The reason for the swap is for speculative purposes or to reduce the cost of borrowing foreign currency.

Justice John Chigiti found that it was impossible to implement the regulations as provided by the government.

He declared that the law is vague on how the tax will be computed as it deems that after exchange, the amount by the other person especially non residents is an income.

The Judge said that without clarity, on how the tax will be computed, then the scales of justice tilt to the banks.

“In the absence of a deeming provision under Section 10 of the ITA, the entire premise of the regulations fails as the “gains from financial derivatives” of a non-resident person cannot be deemed to be income which accrued in or was derived from Kenya, for tax purposes and I so hold,” said Justice Chigiti.

“ It is against this background, it is my considered view that the Regulations are ultra vires, null and void and incapable of being implemented,” he added..

The case was filed by Kenya Bankers Association (KBA).

KBA told Justice John Chigiti that the new law would lead to massive losses as one will be required to calculate a 15 per cent withholding tax based on speculation. According to the bank's lobby, Parliament gave the Cabinet Secretary the green light to roll out the new law without giving them a chance to explain its impact.

KBA explained that the contracts are such that any tax charges  are passed on to the resident. The association asserts that Njuguna's move amounts to double taxation adding that financial derivatives cannot be treated as separate income. 

"The regulations impose a further unfair tax burden on the resident person by characterising the gains from a financial derivative as a separate income. This characterisation imposes an onerous burden on the resident person particularly KBA's members whose core function is trading in financial derivatives. In such a case it will be unduly difficult to separate the source of the gain from the financial derivative," KBA argued in its case. 

Financial derivatives trade is a relatively new concept. For example, Nairobi Securities Exchange launched the derivative market in 2019. The sole reason for this was to trade in futures contracts on the Kenyan market. 

The new tax on the other hand was meant to ensure that both residents and non-residents who derive gains accrued in Kenya pay taxes. However, KBA argued treasury was jumping the gun as it gazetted the regulations even before the legislative process was completed.

KBA Chief Executive Habil Olaka in his supporting affidavit told the court that on March 13, 2024 the National Assembly's clerk called stakeholders to submit their views on the regulations. 

He said KBA then wrote to former Treasury Cabinet Secretary Njuguna Ndung'u seeking to have him brief them. However, the former CS informed KBA that the regulations had actually come into force on January 27 last year. . 

Olaka said the regulations are vague and do not provide how KBA members should compute the tax. 

In their reply, KRA, Treasury and National Assembly argued that the regulations were meant to seal loopholes by ensuring non-resident companies do not evade paying taxes from gains derived in Kenya. They also argued that they were simply spreading the tax burden and that they had complied with the law.