Chapter 1

Part A: Income tax

Taxation concepts and regulations

Last updated November 202619 sectionsabout 14 min read

Key takeaways

A tax is a compulsory charge imposed by government to fund public expenditure, not paid in direct exchange for a specific service.
Direct taxes such as income tax and capital gains tax fall on the person meant to carry them; indirect taxes such as VAT, excise and customs duty are charged on a transaction and can be passed on through the price.
Impact is where a tax first lands, on the party legally liable to pay it; incidence is where it finally rests after shifting, and the more inelastic demand is compared with supply, the more a seller can shift forward to the buyer.
Evasion is illegal; avoidance is the lawful arrangement of one's affairs, but a scheme with no commercial purpose beyond the tax advantage can be disregarded under general anti-avoidance rules.
Kenya taxes income on a source basis by default and also charges a resident on certain income earned abroad, so residence has to be settled before a person's full tax position is known.

Four statutes carry the weight of Kenya's tax system, the Income Tax Act, the VAT Act, the Tax Procedures Act and the East African Community Customs Management Act, all administered under one roof by the Kenya Revenue Authority. Before working through any actual computation, this opening chapter settles the vocabulary and the underlying principles the rest of the paper is going to lean on repeatedly.

Which rates to apply

The tax rates, bands, reliefs and thresholds used throughout this material are the general ones, and they are given so that each computation can be worked through end to end. They apply unless the exam paper states otherwise. Where the question, or the tax tables supplied with it, indicates different rates, those are the rates to apply. Finance Acts change rates from year to year, but the method does not change, and the method is what earns the marks.

Tax

A tax is a compulsory financial charge imposed by government on persons or entities, not given in direct exchange for a specific service, used to fund public expenditure.

Income tax

Charged under the Income Tax Act on income accruing in or derived from Kenya, plus, for a resident, certain income earned even outside the country, a direct tax paid by the person who earns the income itself.

Value Added Tax

An indirect tax collected in stages across the supply chain, each stage taxed only on the value it adds, and ultimately paid by the final consumer, the subject the chapter on value added tax develops fully.

Excise duty

Charged on a named list of goods and services, whether locally manufactured or imported, alcohol, tobacco and fuel among the classic examples, regardless of whether the item itself is essential.

Customs duty

Levied on goods crossing the border into Kenya, or in certain cases out of it, and on movement across the wider East African Community customs territory.

Advance tax

Paid up front by an operator of certain public-service or commercial vehicles before their licence is even issued, then set off against whatever the final assessment actually turns out to be.

Instalment tax

Income tax paid across the year in staged instalments ahead of the final self-assessment, based on the taxpayer's own estimate or the previous year's liability.

Capital gains tax

Charged on the gain made when qualifying property, land, a building, or shares in an unlisted company among the categories, is transferred for more than its adjusted cost.

Purposes of taxation

Raising the revenue government actually spends on infrastructure, security, health and education
Redistributing income and wealth between citizens, through a progressive rate structure and targeted relief
Steering economic behaviour, discouraging a demerit good through excise duty, or encouraging a preferred activity through relief
Shielding local industry from cheaper foreign competition, by making an import relatively more expensive through duty
Correcting for an externality, making an activity's price reflect a cost it otherwise imposes on society beyond what its producer or consumer pays directly
Supporting price stability, working alongside monetary policy to manage overall demand in the economy

Statutory deductions

Pay As You Earn (PAYE)

The income tax an employer withholds directly from an employee's own taxable pay, computed against the graduated bands currently in force and remitted straight to KRA.

NSSF

A mandatory retirement contribution to the National Social Security Fund, split between employer and employee; a compulsory deduction, but not itself a tax.

NHIF

The name the syllabus still uses for the statutory health-cover deduction, which now takes the form of a Social Health Insurance Fund (SHIF) contribution, currently 2.75% of gross pay, under the Social Health Insurance Act.

Affordable Housing Levy

A fourth deduction the syllabus's own list of three omits, but one that has appeared on every Kenyan payslip since 2024 regardless: 1.5% of gross pay from the employee, matched by a further 1.5% from the employer, under the Affordable Housing Act, 2024, taken off pay in the same step as NSSF and SHIF, before PAYE is worked out.

Rates as at 1 July 2025

SHIF is 2.75% of gross pay with a KES 300 minimum under the Social Health Insurance Act, 2023, from October 2024; the Affordable Housing Levy is 1.5% from the employee and 1.5% from the employer under the Affordable Housing Act, 2024; NSSF follows the NSSF Act, 2013 tiers in force from February 2025, 6% of pay up to KES 8,000 (tier I) and 6% of pay between 8,000 and 72,000 (tier II), employer matching. Finance Acts revise these figures: use the rates a question supplies.

Classification by rate

Progressive

Climbs as the taxable amount climbs, so someone earning more hands over a bigger slice of it, the shape Kenya's individual PAYE bands follow.

Digressive

Climbs with income too, but the climb flattens out past a certain point, effectively progressive only up to that threshold and behaving close to a flat rate beyond it.

Regressive

Falls as the taxable amount rises, so it actually costs a lower earner a bigger share of their income, the effect a flat charge on a daily necessity has once measured against income.

Proportional

Stays fixed at one rate no matter how large the amount taxed, the shape Kenya's standard corporate tax rate takes.

Classification by effect

Tax effect

The broad economic footprint a tax leaves, on prices charged, on behaviour, and on how income ends up distributed across the population.

Tax impact

Where the tax first lands, on whichever party is legally obligated to hand it over to the authority in the first place.

Tax incidence

Where the tax actually ends up resting once any shifting (see Tax shifting, below) has run its course; it only coincides with impact when the tax genuinely cannot be passed on.

Direct taxes

Charged straight on the income or wealth of the person meant to carry it, with no route to pass the burden on elsewhere, income tax and capital gains tax both work this way.

Indirect taxes

Charged on a transaction rather than on income directly, which is exactly what lets it be passed on, wholly or in part, to someone else via the price, the pattern VAT, excise and customs duty all follow.

Tax shifting

Forward shifting

The party first liable pushes the cost of the tax onward to the buyer, folded into a higher price.

Backward shifting

The party first liable pushes the cost backward instead, squeezing a lower price out of their own supplier.

Factors that determine the tax shifting

Comes down mainly to the relative price elasticity of demand and supply for the good involved: the more inelastic demand is compared with supply, the more of the tax a seller can push forward onto the buyer, and the relationship reverses the other way round.

Principles of taxation

A good tax is judged against a set of classical canons going back to Adam Smith, extended by later writers into the fuller list below.

Equity

Taxpayers facing similar circumstances should carry a similar load (the horizontal strand), and someone with more capacity to pay should be asked to carry more (the vertical strand).

Economy

Whatever it costs government to actually collect a tax should stay small next to what that tax brings in.

Convenience

Paying should fit naturally into the taxpayer's own routine, PAYE taken straight off pay at source is exactly this principle built into the system's design.

Certainty

How much is owed, and when, and how it must be paid, should be spelled out clearly rather than left open to arbitrary interpretation.

Simplicity

An ordinary taxpayer should be able to understand and follow the rule without needing specialist help just to comply.

Elasticity

Revenue should grow naturally as the wider economy grows, without Parliament having to legislate a brand-new tax every time.

Flexibility

The system needs to be adjustable at reasonably short notice as economic conditions shift.

Productivity

The revenue a tax brings in should be worth the administrative effort of actually collecting it.

Diversity

Government is better served drawing revenue from several different sources than leaning too heavily on any single one.

Tax evasion

Ways of tax evasion

The deliberately illegal end of reducing a tax bill: understating income earned, inflating claimed expenses, simply not registering or filing at all, smuggling goods across the border, and issuing invoices that do not reflect a genuine transaction.

Measures the government can put in place to prevent tax evasion

A stronger audit and investigation capacity, cross-checking a taxpayer's declared figures against third-party data, making ordinary compliance simpler, raising penalties, investing in taxpayer education, and deploying technology, iTax and the Electronic Tax Register (see the chapter on administration of income tax) among them, that leaves a transaction with far less room to hide.

Tax avoidance

Tax avoidance is the lawful arrangement of one's affairs to minimise tax liability, using provisions Parliament itself has enacted, rather than breaking the law as evasion does. KRA and the courts nonetheless treat avoidance schemes with no genuine commercial purpose beyond obtaining a tax advantage as abusive, and general anti-avoidance rules allow such arrangements to be disregarded for tax purposes even though no law was technically broken.

Sources of taxable income

Employment income
Running a business, trade, profession or vocation
Investing, dividends, interest, capital gains, rent and royalties among them
Farming
Any further gain or profit the Act does not specifically exempt

Rules for taxing income

Kenya's Income Tax Act taxes income on a source basis as its default rule: any income accrued in, or derived from, Kenya is taxable regardless of who earns it or where they are resident. Residents are, in addition, brought into charge on certain categories of income earned outside Kenya, which is why residence status (see Residence, below) has to be established before a person's full tax position can be determined.

Residence

Body corporates

A company is resident in Kenya if it is incorporated under Kenyan law, or if its management and control were exercised in Kenya in the year of income.

Individuals

Resident if they have a permanent home in Kenya and were present at any time during the year; or have no permanent home but were present for 183 days or more in the year; or were present for an average of more than 122 days a year in that year and each of the two preceding years.

Exam tip

Residence questions almost always give a set of facts (days present, where a permanent home is) and ask you to apply the individual residence tests directly. Work through all three in order rather than stopping at the first one that seems to apply.

Self-check

(a) An individual has no permanent home in Kenya but was present in Kenya for 190 days in the current year. Determine their residence status, with reasons. (4 marks)

(b) Distinguish between tax impact and tax incidence, using a scenario where a supplier passes a VAT increase entirely on to customers through a higher price. (5 marks)

(c) Distinguish between a progressive tax and a regressive tax, and classify Kenya's individual PAYE bands as one of the two. (4 marks)

(d) Distinguish between tax avoidance and tax evasion, and explain why KRA can still challenge an avoidance scheme even though no law was technically broken. (5 marks)

(e) State four of Adam Smith's classical canons of taxation, and explain what 'convenience' means using PAYE as an example. (5 marks)

Show worked answer

(a) The individual is resident. Under the residence tests for individuals, a person with no permanent home in Kenya is resident if present for 183 days or more in the year, 190 days satisfies this test directly, so residence is established without needing to consider the other two tests. (4 marks)

(b) Tax impact is the point at which a tax is initially levied, on whoever is legally liable to pay it to the authority in the first instance, here the supplier, who is legally liable to remit VAT. Tax incidence is the point at which the tax is finally borne, after any shifting has taken place, here the customer, since the supplier passed the VAT increase entirely on through a higher price. Impact and incidence differ in this scenario precisely because the tax was shifted forward from the legally liable party to the ultimate consumer. (5 marks)

(c) A progressive tax has a rate that rises as the taxable amount rises, so a higher earner pays a higher proportion of income in tax. A regressive tax has a rate that falls as the taxable amount rises, so a lower earner pays a higher proportion. Kenya's individual PAYE bands are progressive, the marginal rate rises through the graduated bands as taxable pay increases. (4 marks)

(d) Tax avoidance is the lawful arrangement of one's affairs to minimise tax liability, using provisions Parliament itself has enacted. Tax evasion is deliberately illegal, understating income, inflating expenses, or similar. KRA and the courts can still challenge an avoidance scheme with no genuine commercial purpose beyond obtaining a tax advantage because general anti-avoidance rules allow such arrangements to be disregarded for tax purposes even though no specific law was technically broken, the arrangement's lack of genuine commercial substance is itself the ground for disregarding it. (5 marks)

(e) Equity, taxpayers in similar circumstances bear a similar burden, and those with greater ability to pay bear more; economy, the cost of collecting a tax should be small relative to the revenue it raises; convenience, the manner and timing of payment should be convenient for the taxpayer; and certainty, the amount, timing and manner of payment should be clear and predictable (any four of the nine named). Convenience means PAYE is deducted directly from an employee's pay by the employer at the point of payment, the employee never has to separately set aside money or make a manual payment, the timing and manner of collection is built into a moment (payday) that is already convenient and routine for the taxpayer. (5 marks)