The Income Tax Act (ITA), CAP 470 provides for payment of corporate tax chargeable from the profits of a corporation and payment of Capital Gains Tax (CGT) as levied on gains made from the transfer of a property acquired on or before January 2015. This leaves real estate developers with the question on whether they shall be responsible to pay both corporate tax and capital gains tax. Notably, the ITA provides that where net gain from a transfer of a property is subject to CGT then such net gain shall not be subject to further taxation. Therefore, a developer is responsible to either pay corporate tax or CGT, ultimately, the nature of business of a developer is a key determinant in addressing the query whether it will pay either CGT or corporate tax.
To ease the way out in determination of whether a developer’s nature of business exposes them to corporate tax or CGT, the Commissioner of Domestic Taxes and the Tax Appeals Tribunal apply the “Badges of Trade” test, the test contains various factors of trade that together establish whether the nature of business of a developer is that of a trading activity or pure investment. Where it is established that the developer’s business is a trading activity attracting profit, then the developer is responsible to pay corporate tax.
In the case of Ruaraka Diversified Investments Limited (Appellant) vs. Commissioner of Domestic Taxes (Respondent), Tax Appeal No. 86 of 2019, the Tax Appeal Tribunal ruled that where a transaction effected by a real estate company was for purpose of realizing profit then the proceeds from the sale were subject to corporate tax and not capital gains tax.
Therefore, the key question that developers ought to ask is, is my nature of business that of trading or pure investment, if the former corporate tax will apply.
Below is a brief highlight of the Badges of Trade Test which developers can use to self-assess whether based on the nature of their business the income from the business will be subject to corporate tax or capital gains tax.
The Badges of Trade Test
In the case of Zulekha Samji vs Commissioner of Domestic Taxes (Appeal No. 5 of 2017), the Tax Appeals Tribunal set out the Badges of Trade to include: profit seeking motive, frequency or number of similar transactions by the same person, the nature of assets, connection with existing trade, change of assets, the way the sale was carried out, the source of finance, length of ownership and method of acquisition of the asset.
Following below is a brief analysis of the above mentioned badges.
Profit seeking motive
It has been established that where the sole objective of acquiring an asset is to resell it with the intention of making a profit and without an intention of holding it as an investment then that points out to the carrying out of a trade, implying that corporate tax will attract to the income realized from the trade and not capital gains tax.
Frequency of similar transactions
In the case of Zulekha Samji vs Commissioner of Domestic Taxes (Appeal No. 5 of 2017) the Tax Appeals Tribunal adopted the decision in the case of CIR v Fraser (1942) 24 TC 498 by restating thatwhere there are systematic and repeated transactions or where there is a track record of similar transaction then the developer can be said to be engaging in a trading activity and thus the income from the trade is subject to corporate tax and not capital gains tax.
Modification of an asset
It lays out that where an asset is modified in order to make it more attractive or saleable and realize greater profit, then the developer can be said to be engaging in a trading activity and the income realized is subject to corporate tax.
Source of financing
Where money is borrowed in financing the acquiring of an asset and then the asset is later resold and the reselling is linked to repayment of the loan it indicates an intention to resell the asset with a profit motive or a trading motive and thus the income attracts corporate tax.
Length of ownership of an asset
The longer an asset is held, the more likely it is to be considered that the acquiring of the asset is a pure investment rather than an indicator of trading activity. Thus, in the case of Zulekha Samji vs Commissioner of Domestic Taxes (Appeal No. 5 of 2017), where the interval of times between when the appellant (Zulekha) acquired an asset and resold it were not long, the tax appeals tribunal ruled that the nature of conduct of the appellant was that of a trade and thus the income from selling the asset was subject to corporate tax.
However, the acquiring of an asset and later reselling it within a short period of time does not always constitute a trading activity, the motive matters, for instance in the case of Taylor v Good – CA 1974, 49 TC 277;  STC 148;  1 WLR 556;  1 All ER 1137, a taxpayer bought a house to be used as a family home, however, the house was not alluring to the taxpayer’s partner which inclined the taxpayer to sell it, though the time period between the acquiring of the house and selling was not long, it was held that this did not constitute a trade as the original motive of the taxpayer was not to trade.
Method of acquisition of an asset
Although not always the case, where an asset is acquired through inheritance or gift, it could be said that it is not acquired for trade. On the other hand, an asset acquired through market it can be presumed to be acquired with the intention to trade or make an investment. Therefore, though not always conclusive on its own, the method of acquisition of an asset pre-determines whether a person has the intention to engage in a trading activity or just investment.
The nature of asset
The key feature in this factor is whether the acquired asset is of a type or amount that can be said to have been acquired for the advantage of trading. For instance, though not always conclusive determinant on its own, someone who acquires assets in bulk can be presumed to be acquiring them not for pride in possession but to trade and realize profit and thus income realized is subject to corporate tax.
The way the sale was carried out
Assets sold in the ordinary nature of business of the seller can be said to imply trade, on the other hand, where assets are not sold in the ordinary nature of the business of the seller for instance when someone sells an asset to cover for an emergency then the latter may not be construed trade.
In conclusion, where on application of the above badges of trade, it is established that the developer nature of business is that of a trading activity then the income realized is subject to corporate tax. It is crucial to note that the application of the above badges is subjective on a case to case basis and the badges are considered together, in other words, the application of just one badges of trade may not be conclusive evidence on whether the activities of a developer constitute a trade or an investment.
This article is for informational purposes only and should not be taken to be or construed as a legal opinion. For more insights, please do not hesitate to contact Jane Makena Kirimi (firstname.lastname@example.org) b or Faith Karanja (email@example.com)