Kenya: lessons from Tax Appeals Tribunal setting aside KES 6.9 billion transfer pricing assessment on a carbon credit project

In a matter where Bowmans acted for the appellant (Service Provider), the Tax Appeals Tribunal (Tribunal) recently set aside a transfer pricing assessment of KES 6.9 billion relating to the Kasigau carbon credit project. The project was undertaken in Kenya by the Service Provider’s US parent entity (Project Developer).

The case reaffirms the importance of maintaining appropriate transfer pricing documentation for transactions between a Kenyan company and its non-Kenyan related companies. Similarly, it reiterates the requirement for the Kenya Revenue Authority (KRA) to consider all the documentary evidence presented to it before delivery of the Objection Decision.

Background

In this matter, the KRA reallocated most of the functions, assets, and risks in relation to the Project to the Service Provider, in disregard of the Group’s transfer pricing policy and, as a result, made transfer pricing adjustments on the income from sale of the carbon credits from the Project.

This was done on the premise that: (a) the functions performed by the Project Developer were comparable to the functions of a holding company (which would ordinarily be remunerated by way of after-tax dividends) and a service provider for the marketing services; (b) the Project Developer was the least complex party and therefore should have been the tested party in relation to the provision of intra group services; and (c) the most appropriate transfer pricing method with regard to intra-group service offered by the Project Developer would be cost plus, subject to proper documentation of the nature and extent of work done, costs incurred.

The KRA then assessed additional corporate income tax and withholding tax of KES 6.9 billion on the transfer pricing adjustments as follows:

• Corporate income tax: the Project Developer compensated the Service Provider by way of a cost-plus markup of 7.5% based on the transactional net margins method (TNMM). KRA considered this to be erroneous and contended that the Service Provider was entitled to all the income from the sale of carbon credits from the Project. Based on its reallocation of functions, assets and risks, the KRA considered the Service Provider to be responsible for undertaking the Project and therefore contended that corporate income tax from the sale of carbon credits should have been paid by the Service Provider.

• Withholding tax: the KRA assessed withholding tax on the transfer pricing adjustments as deemed dividends distributed to the Project Developer by the Service Provider

Further, the KRA sought dismissal of the Appeal on the allegation that the Service Provider did not discharge its burden of proof by failing to produce the relevant evidence and, even in instances where documentation was provided, the same was not competent or relevant.

The KRA disregarded the documentation provided at the Objection stage and issued its Objection Decision based on projected revenues from the Project.

Judgment

The Tribunal faulted the KRA for purporting that the Service Provider did not provide sufficient documentation to prove its case and satisfy the burden of proof. The Tribunal reviewed all the documentation which had been provided to the KRA and, as part of the Appeal, held that:

• the Service Provider discharged its burden of proof by providing sufficient and relevant documentary evidence, which the KRA ought to have considered;

• based on the documentation provided, it was clear that the Project was undertaken by the Project Developer and not by the Service Provider. The Project Developer performed significant functions and assumed significant risk with regard to the Project. In particular, the Project sourcing and design, funding, marketing, selling of credits, issuing of invoices, and reporting of carbon credit revenues were undertaken by the Project Developer that entered into the relevant agreements. Accordingly, the revenues from the carbon credit project were attributable to the Project Developer and not the Service Provider;

• the Service Provider was merely engaged by the Project Developer to provide support services in the running and management of the Project. This was evidenced by, among others, the contract between the Service Provider and the Project Developer, the transfer pricing policy of the Service Provider, and employment contracts and job descriptions of the employees and management team of the Service Provider;

• the transfer pricing policy, audited accounts, contracts, verification and validation report summaries, invoices and other documentary evidence submitted by the Service Provider were consistent with the economic substance of the services provided by the Service Provider to the Project Developer as per the functional analysis and sufficiently demonstrated that the fees from services provided by the Service Provider to the Project Developer were arm’s length and commercially rational; and

• the characterisation of the controlled transaction as provision of operational support services by the Service Provider to the Project Developer based on the functional analysis, the selection of the Service Provider as the tested party, and the selection of TNMM (with mark-up on total cost as the profit level indicator) as the most appropriate transfer pricing method in relation to the operational support services, was accurate.

Having determined that the KRA’s transfer pricing adjustments were erroneous, the Tribunal held that the withholding tax assessment on the transfer pricing adjustment was equally erroneous.

The KRA has filed an appeal on the matter at the High Court. However, no orders had been issued by the High Court at the time of writing.

Putting it into perspective

The Tribunal reaffirmed the significance of transfer pricing documentation in related party transactions. Further, there should be evidence that the arrangement as documented is applied in practice through supporting documents such as (where relevant) employment contracts, service agreements, job descriptions, loan agreements, marketing agreements, proof of travel, invoices, among others.

For carbon credit projects, the Tribunal upheld the position that the economic owner of the carbon credits, based on a functions, assets, and risk analysis, would be the person liable for income tax on the income from the carbon credits. 

Accordingly, a careful analysis should be undertaken by carbon credit project developers to correctly allocate functions, assets, and risks, determine benchmarks for the controlled transactions, and select the most appropriate transfer pricing method.

The Tribunal also reiterated to the KRA that all documentary evidence provided by a taxpayer before the delivery of the Objection Decision should be considered to arrive at the appropriate tax demand. Failure to consider the documentary evidence provides an erroneous assessment that lacks legality.