How Capital Gains Tax Applies To Your Inheritance

Where a beneficiary sells inherited property to an independent third party, the gain on the sale will be calculated as the transfer value (sale price) less the acquisition cost. The acquisition cost in this case is the market value of the property at the time of inheritance.

Context

Income derived from the transfer of property (land, buildings, and shares) in Kenya is subject to income tax under the provisions of the Income Tax Act, Cap 470, Laws of Kenya (the ITA). If the property is deemed to have been acquired and held for investment purposes, the gain from selling the property is treated as a capital gain, subject to CGT at 15% on the excess of the property’s transfer value over its cost of acquisition.

The ITA defines a transfer as "where property is sold, exchanged, conveyed, or otherwise disposed of in any manner, including by way of gift, whether or not for consideration."

Therefore, the transfer of property as a gift qualifies as a gain subject to CGT. However, the ITA provides certain exemptions from CGT, including but not limited to:

1. Property transferred or sold for the purpose of administering an estate, provided the transfer or sale is completed within 2 years of the death;

2. Vesting of property in the personal representatives of a deceased person by operation of law;

3. Transfers from personal representatives to legatees during the administration of the estate of a deceased person.

Issue

When a beneficiary inherits property and later decides to sell or dispose of it to a third party, what is the applicable cost of acquisition for CGT purposes? Should the cost of acquisition be:

School of Thought 1: Having inherited/acquired the property without any monetary consideration, CGT should be based on the entire sale proceeds, as the gain represents the total amount "received."

School of Thought 2: The property’s value is rebased upon its transfer to the beneficiary. Therefore, the acquisition cost for any subsequent sale is the market value of the property at the time the gift was received.

In Commissioner of Domestic Taxes v. Shah & 2 others (Income Tax Appeal E054 of 2023) the Tax Appeals Tribunal addressed this issue. The Tribunal’s judgment, delivered on 17th March 2023, was subsequently appealed by the KRA to the High Court, which upheld the Tribunal’s ruling on 24th June 2024. This judgment establishes a precedent supporting the second school of thought.

Facts of the Case

The Appellants, siblings inherited two parcels of land and had them independently valued by Knight Frank in 2015. The total market value was determined to be Kshs. 389,619,600. In 2020, the Appellants sold the properties to Risun Development Company (RDC) for Kshs. 305,584,000.

The KRA issued an assessment notice for CGT.

Parties Submissions

The KRA argued that the Appellants did not incur the purchase cost of Kshs 389,619,600 when they inherited the properties, as the transfer was exempt from capital gains tax. Therefore, the KRA applied CGT on the entire sale amount of Kshs 305,584,000.

The Appellants contended that the adjusted cost should be based on the market value of the properties at the time of inheritance.

The Appellants claimed adjusted costs, resulting in a loss of Kshs 99,485,087. They argued that this loss exempted them from any chargeable gain, as per the provisions of the tax laws.

Tribunal’s Ruling

The Tribunal examined Paragraph 9 of the Eighth Schedule to the ITA which provides that where property is acquired or transferred:

a. Otherwise than by way of a bargain made at arm’s length;

b. By way of a gift, in whole or in part;

c. For a consideration that cannot be valued;

d. As the result of a transaction between persons who are related,

The amount of consideration for the transfer or acquisition of the property is deemed to be equal to the market value of the property at the time of the transfer or acquisition or the amount of the consideration used to compute stamp duty payable on the transfer by which the property was acquired, whichever is lesser.

Thus, property automatically rebases to the market value as of the date the transfer occurs. When the property is transferred to a third party, the CGT will be based on a smaller gain due to the use of the rebased value.

The Tribunal ruled in favor of the Appellants stating that they were justified in using the fair market value determined by Knight Frank in 2015 as the cost basis for adjusting costs and calculating the CGT payable.

Therefore, where a beneficiary chooses to sell inherited property to an independent third party, the gain on the sale will be calculated as the transfer value (sale price) minus the acquisition cost. The acquisition cost will be the market value of the property at the time of inheritance.

Anti-Avoidance Provisions

The Finance Act 2023 introduced an anti-avoidance provision by adding Paragraph 4A to the Eighth Schedule. This provision states that where property is transferred in a transaction not subject to CGT, and the property is subsequently transferred in a taxable transaction within five years, the adjusted cost in the subsequent transfer shall be based on the original adjusted cost as determined in the first transfer.

This means that, for the transfer to qualify for the calculation of CGT on the rebased value, there is a five-year waiting period before a subsequent taxable transaction can occur.

How We Can Assist

At CM Advocates, our tax advisory services are designed to minimize your tax liabilities, maximize tax saving opportunities, advise on tax implications of transactions and reduce the time spent on managing tax compliance. Therefore, besides rendering tax advice and opinions to our clients on their day–to-day transactions, we routinely advise clients on the most tax efficient models to achieve their commercial objectives. Moreover, we regularly help clients

analyse the potential tax liability of commercial transactions, especially dealing in property, to ensure transaction prices realistically incorporate future operating costs related to tax. For any inquiries, please contact law@cmadvocates.com