Misclassifying expenses as disbursements causes tax issues for your business. Learn what between expenses and disbursements is taxable in Kenya.
Whenever you move value out of your company, you must know your tax obligations. It is a general rule that you are only taxed when you have earned an income from selling goods or services.
The tax on goods and services is known as income tax, a tax on business profits. So, income tax would not ordinarily apply to expenses. A tax that might apply is the value-added tax (VAT).
However, there is another way you can move money out of your business: when you make disbursements. So, more important than how you move money out of your business is why you move it.
We know that expenses - a cash outflow - are subject to VAT. What about disbursements? Do you add or claim VAT on disbursements? Are disbursements taxable in Kenya?
Let’s tackle that question today.
Understanding disbursements. What are they?
Disbursements are payments you make on behalf of your clients. An example is when a real estate agent pays land tax to complete an ownership transfer for a commercial property you are buying. In this instance, they are indeed an ‘agent’ making a payment on your behalf.
Disbursements also include payments you make from a dedicated fund. Examples include:
- dividend payments to your shareholders,
- salary payments for your workers,
- social grant payments, and
- loan deliveries to borrowers.
Disbursements do not constitute an income for your business. Neither are they an expense to you. You will recharge the customer to recover the money spent, So it is your customer’s expense, not yours.
This brings us back to our question;
Are disbursements taxable in Kenya?
Disbursements are not taxable in Kenya. The reason for that is disbursements do not constitute an income. You cannot profit from them since you cannot put a markup on them when you recharge the third party you made them for.
That said, only genuine disbursements are exempted from tax. You cannot disguise your own expenses as disbursements to avoid tax. But avoid which tax exactly?
Income tax technically does not apply to disbursements because they are payments made on behalf of a third party. Let’s say this third party is your customer. You can only recharge the customer the exact amount you paid on their behalf. In that case, there’s no profit for the KRA to tax.
VAT does not apply to disbursements either. As a principle, VAT is charged on products you have added value. It is a tax levied on consumption, which means it is paid by the final consumer.
Since disbursements are not your expense, they don’t add any value to the product or service you sell. You are, therefore, not obliged to add VAT to disbursements. Neither should you add VAT when you recharge the third party on whose behalf you made the disbursement.
Are your disbursements genuine?
Misclassifying expenses as disbursements can be interpreted as tax avoidance or deliberately not charging VAT where it lawfully applies. You will be penalised if caught, and the VAT will still be due.
All expenses you incur in the normal course of business, which you will pass on to your customers, are subject to VAT. You have to add VAT to your invoices.
Not charging VAT to give the appearance of lower prices and avoid the administrative burden, a business might pass off their own expenses as disbursements or expenses they covered on behalf of the customer.
As this would rob the KRA of VAT on the value added to your product or service, disbursements must meet strict criteria. Disbursements must satisfy the following conditions:
- You acted as your customer’s agent and had their permission when you made the said disbursement,
- The customer used and benefited from the product or service you paid for on their behalf,
- It was the customer’s responsibility to pay for the expense,
- You itemise the expenses on the invoice you send the customer, and you don’t claim more than you paid for them,
- The goods and services you paid for are, in addition, not part of your services to them.
If what you claim as disbursements does not meet these conditions, it is likely your own expense to which you should add VAT when you invoice the customer.
Are disbursements subject to VAT in Kenya?
Section 13(5) of the VAT Act stipulates that VAT disbursements to third parties should not be included in taxable income. Since VAT is only charged on the ‘value added’ it does not apply to disbursements or recharges. Disbursements are neither an earned income or value added.
VAT is a general tax that applies to all commercial activities. It is levied at every stage of the production or distribution chain.
Every VAT-registered business acts as an agent of the KRA. You must collect VAT on its behalf by adding the gazetted VAT component to your invoices.
The VAT you add to your invoices is the tax on the value you have added to the raw materials, utilities, and services you used to produce your goods or services.
To avoid double taxation and ensure VAT is levied only on the value added, you have to deduct the VAT you paid for the inputs you bought and expenses you paid for at your stage of the production chain.
While VAT is not a charge on the business, it can make your prices appear cheaper and more competitive. However, this can only harm your business as the KRA will still demand the VAT when you submit your returns. Not only that, but you may also pay a fine.
There are also harsh penalties for businesses that charge VAT on their invoices when they are not VAT-registered.
Disbursements are outside the scope of VAT
VAT is a tax that is charged when you supply goods and services. But when you make a disbursement, whether it is rent, salaries, or loans, what you are supplying is money, which is neither a good or service.
Disbursements, therefore, fall outside the scope of VAT. You are not obliged to charge VAT on the disbursements you make or on their repayments if you made them on behalf of a customer.
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