The Government’s recent decision to change the Value Added Tax (VAT) status of ordinary bread from exempt to zero-rate was received with jubilation by the Kenyan public. However, despite this welcome move, the Government has, based on the other proposed changes contained in the Finance Bill, 2017, displayed a continued tendency to lean towards exemption as a means of incentivizing various industries.
This trend can be traced back to the repeal of the Value Added Tax Act, Cap 476(repealed VAT Act) with a less voluminous VAT Act, 2013 with effect from 2 September 2013. The VAT Act, 2013 significantly reduced the number of items that were either zero-rated or exempt as per the repealed VAT Act. Further, the number of public bodies, privileged persons and institutions entitled to zero-rated supplies were significantly reduced. Since the enactment of the new Act, the Government has continued to exempt supplies, sometimes in response to lobbies for zero-rating, with the latest examples being the VAT exemption of liquefied petroleum gas (LPG), commonly used by households and the VAT exemption of inputs for the manufacture of pesticides.
In my view, exemption as an incentive carries hidden costs which eventually undermine the noble intentions of the Government in trying to grow industries which are integral to Kenya’s economy. Take for instance the loaf of bread which is now zero-rated. An average-sized ordinary loaf of bread retails at KES 50. For purposes of this illustration, let us assume that it costs the bakery (assuming the bakery is the retailer) KES 40 (exclusive of VAT) to bake one loaf of bread.
When ordinary bread was VAT exempt, the bakery was not entitled to input tax credits in relation to VAT incurred on inputs acquired in the course of producing the bread. This meant that while the bakery was charged 16% on KES 40(KES 6.40) on purchase of its inputs, it was not able to offset the VAT incurred against VAT charged since the supply of ordinary bread was VAT exempt.
Therefore, the bakery would either absorb the VAT costs and suffer a corresponding decrease in its profit margins (which is often the case where contracts have already been negotiated) or recoup the tax cost by factoring it in its retail price such that the non-recoverable VAT burden is ultimately borne by the consumer (which is the sensible business decision to make).Therefore, the retail price of KES 50 has a cost component of KES 46.40, with KES 6.40 being the non-recoverable input tax.
Based on this illustration, it can be seen that neither the consumer nor the bakery benefits from VAT exemption because exemption of the final supply of goods and/or services as an incentive ignores the cascading effect of non-recoverable VAT in the entire supply chain. On the flip side, zero-rating (as is now the case for bread) means the bakery is entitled to claim input tax credits in relation to the VAT incurred on the purchase of its inputs hence the KES 6.40VAT in the illustration above would be recoverable by the bakery thereby eliminating the need to pass on the cost to the consumer. Therefore, the bakery can reduce the retail price of bread while maintaining its profit margins which is the reasonable expectation of the Government and its citizenry.
The Government has acknowledged the futility of exemption as an incentive, which is why it has now overturned the exemption on ordinary bread in favour of zero-rating in order to obtain the desired effect of relieving the cost of living burden for the mwananchi. Whilst the trimming down of the VAT legislation in enacting the VAT Act, 2013 simplified the law, it is my view that the current legislation should retain enough flexibility to allow for the provision of zero-rating as an incentive for the growth of key industries as the country aims to achieve its Vision 2030 aspirations.
I therefore urge the Government to rethink its reliance on VAT exemption and consider adopting zero-rating especially where the intention of granting VAT exemption is to alleviate cost to the citizenry or to stimulate growth in a specific sector. That said, I take cognizance of the VAT refund challenges associated with zero rating – the Kenya Revenue Authority and the National Treasury have in the past cited lack of funds to service the numerous applications by taxpayers for refunds.
However, in my view, the money refunded to taxpayers should not be a cost or loss to Government but rather a reimbursement of taxes that should not have been paid to the exchequer in the first instance. Perhaps, the National Treasury should consider setting aside a portion of the VAT paid by taxpayers in a fund to finance refunds before allocating the tax collections to its many competing priorities. Ultimately, VAT refunds are part and parcel of any VAT regime hence the Government should not miss out on the benefits of zero-rating by throwing the baby out with the bath water!
Corazon Ongoro is a Senior Associate with PwC Kenya’s Indirect Tax Team