Back duty and in-depth investigations

The obligation to declare all incomes for tax purposes rests with the taxpayer whether or
not he has been specifically told to do so by the Domestic Taxes Department. Back-duty
refers to collection of all kinds of tax in arrears. The Income Tax Act requires every person
assessable to tax to notify his liability within four months after the end of the year of
income. Return forms/materials will be sent to taxpayers in the Domestic Taxes
Department records though the Department is not obliged to issue necessary
returns/materials.
Where the income tax authorities have reason to suspect that a resident individual subject
to taxation has not made complete and accurate return of income for taxation purposes,
they may require an investigation to determine the correct position. This investigation is
ordinarily called a back duty investigation. Tax arrears normally arise due to the
following conditions;
 Under declaration of income (incomplete and incorrect returns)
 Non declaration of income
 Tax payer claims expenses, allowances, reliefs that he is not entitled to
An offence will have been committed by a taxpayer under the above mentioned
circumstances and his affairs will be dealt with as a back-duty case i.e. back-duty
investigation will be instituted into the affairs of the taxpayer. Penalties may be charged
including interest charges. Where the above circumstances are due to:
 Gross or wilful negligence on the part of the taxpayer and his accountant, or;
 Fraud on the part of the taxpayer
Sources of information resulting to back-duty will be from: -
 Taxpayer himself - Informers
 Public media - Income tax departments
 Farming organisations
 Registrar General’s office
 Licensing Department offices etc.

Determination of income through back-duty cases

a) The taxpayer can declare income acceptable to the department supported by
accounts and other relevant documentation.
b) A capital statement may be prepared as sufficient estimation of growth in assets
and therefore estimate income for such taxpayer if there are no reliable
records/accounts. A capital statement consists of details of assets and liabilities as
at a given date or period. This would show changes in total worth of a taxpayer
 between two or more periods. The capital statement also considers capital losses
or gains, living expenses, income tax paid etc.
Where the capital statement covers more than one year, the resultant figures will be
divided by number of years involved giving rise to a uniform figure as estimate measure
per year. Capital statements must appear reasonable to be acceptable by the Income Tax
Department.

The victim is required to appoint his own accountant to carry out the investigation at his
own cost. The appointment has to be approved by the income tax department. A
statement known as a capital statement is usually the form in which the results of this
investigation are summarised. The purpose of the statement is to attempt a reconciliation
of net worth at the opening and at the close of the period respectively by reference to
known and estimated sources of income and expenditure. The final discrepancy that is
revealed is the closest possible approximation of the undisclosed income which gave rise
to the investigation in the first place.
The following procedural points should be noted:
 The investigation relates to the income and expenditure of the tax payer in his
private as well as business capacity. The enquiries must therefore extend to his
wife and children and other dependants.
 All sources of potential information must be tapped such as: bank statement,
deposit receipts, brokers’ notes, insurance policies, interest and dividend
counterfoils etc. Receipts and payments have to be traced to source and destination
respectively.
 Do not ignore small items since they may indicate the existence of assets
previously undisclosed.
 The amount of insurance covered should be ascertained since it may indicate the
approximate value of the underlying assets.
The final report should refer to the deficiencies in the information provided as well as the
assumptions and estimates which it has therefore been necessary to make.

Special points which arise in this investigation are:

 the period to be covered which could be many years,
 the apparent cash available for living compared with the tax payers actual
standard of living,
 the accumulation of capital compared with known sources of such accumulation,
 the existence of other sources of income and capital must be investigated. This will
include: gambling wins, gifts and legacies.
The result of the investigation may be that undeclared income comes to life. This will
involve the payment of tax on the income, interest thereon, and a negotiated penalty in
some cases strangely very rare, the tax payer may be jailed.

The following steps are followed in determination of income;

i) Add all assets (both tangible and intangible) for a given period. Deduct all
liabilities (personal and business) used to finance the assets. The resulting
figure will represent net assets.
ii) Calculate the growth or loss in net assets for each time period by comparing
net assets of the period with those of previous period. This represents
additional assets that the tax payer acquired/disposed.
iii) Deduct any non-taxable income that was used to finance the above growth in
net assets e.g. gifts, money from friends etc.
iv) To compute the undeclared business profits taxable, deduct any non-trading
business income from growth in net assets.
v) Add living expenses e.g. water, power, income tax paid, interest on loans,
premium on insurance, rent and rates and personal expenses for example food,
cash stolen etc.
vi) If capital assets are sold at a loss, add the loss. If sold at a profit, deduct the
profit.
vii) Deduct any income declared during the year to get the undeclared income
which is the basis of the back duty.

i. Total assets –liabilities = Net assets of a period

ii. Net asset of period n2 – Net assets of period n1 = growth or loss in assets
Illustration 1
Mr. Kikwai, a retail trader, does not maintain proper books of account. You are provided
with the following information:

i) His profit for the years ended 31 December 2008 to 2013 were as follows:
Year Profit (Sh.)
2008 735,000
2009 740,000
2010 787,000
2011 1,375,000
2012 1,214,000
2013 926,000
ii) The creditors, debtors, cash and stock as at 31 December 2008 and 31 December 2013 were
as follows:
31 December 2008 31 December 2013
Sh. Sh.
Creditors 732,000 840,000
Debtors 145,000 592,000
Cash 947,000 1,945,000
Stock 542,000 674,000
iii) Kikwai owed his brother Sh.400,000 on 31 December 2007. This was repaid on 15 February
2011. Kikwai lent his brother Sh.300,000 on 1 January 2013.
iv) Over the years, Kikwai has purchased the following assets:
Year Item Amount (Sh)
2007 House 2,000,000
2008 Car 450,000
2011 Sh. 1,000,000 26% Treasury bond 1,050,000
2009 In 2010, Sh.300, 000 in cash was stolen from his house.
2010 His living expenses are estimated as follows:
2008 Sh.500, 000;
2009 Sh.550, 000;
2010 Sh.650, 000;
2011, 2012 and 2013 Sh.700,000 per annum.
2011 He received a legacy of Sh.125, 000 in August 2009 from the estate of his
father.
Required:
i) A statement showing the growth of capital between 2008 and 2013 for tax purposes. [7 Marks]
ii) Comment on the tax treatment of such increase in capital on Kikwai’s tax liability [3 Marks]
SOLUTION
Capital statement for the year 2013
Assets Computation: Growth or Capital Between 2008 – 2013
NET ASSETS
31.12.2008 31.12.2013
ASSET SH ‘000’ SH ‘000’
Debtors 145 592
Cash 947 1,945
Stock 542 674
Creditors (732) (840)
House 2,000 2,000
Loan creditor (400) -
Treasury bonds - 1,050
Car - 450
Other debtors (loan) - _ 300
NET ASSETS 2,502 6,171

Growth in Net Assets over period 31.12.2008 to 31.12.2013 (Sh.6,171,000 – 2,502,000) =3,669,000
Sh ‘000’ Sh ‘000’
3,669
Add: Cash stolen in 2010 300
Living expenses (500 + 550 + 650 + (700 x 3 yrs) 3,800 4,100
7,769
Deduct: Legacy in 2009 (125)
7,644
Profits reported for 2008 – 2013 (Sh.735 + 740 + 787 + 1,375 + 1,214 + 926) = Sh. 5,777
 Undeclared income over the period = (Sh. 7,644 – 5,777)
= Sh 1,867,000
 1,867,000 
Average undeclared income over the period = Sh.   Sh.311.167 p.a.
 6 years 
An increase in capital is taken to represent estimate growth in capital over the period under
consideration which is then adjusted for allowable expenses, non-taxable incomes and non-
allowable expenses. The adjusted growth in capital will be income accruing evenly over the years
2008 to 2013 and taxed as such set-off tax.
Any undeclared income is brought to tax hence increased liability.
Wear and tear allowance is not granted since information relating to the extent of usage of the
car for business and private purpose is not given
Illustration 2
Mr Okumu is a citizen of Malawi but has been residing and conducting business in Kenya since
2015. However he was not aware of the requirements to maintain proper accounting records and
submitting regular assessments to the Revenue authority. An inspection conducted by revenue
authority on his business and personal transactions over the four years revealed the following
Assets and liabilities (business and personal) as at
1 Jan 2015 31 Dec 31 Dec 31 Dec 31 Dec
2015 2016 2017 2018
Shs 000 Shs 000 Shs 000 Shs 000 Shs 000
Household 300 350 280 360 440
property
Office cabinets 70 68 82 82 90
Property and 1400 1300 1200 1100 1000
plant
Residential house 2000 1950 1900 1850 1800
Staff 800 1100 980 1020 1040
quarters(business)
Motor vehicles- 1600 1400 1200 1000 800
private
Motor vehicle 2400 3600 4000 3600 2800
business
Office premises 3000 2940 2880 2820 2760
Computer 110 130 180 120 230
hardware
Computer 30 40 40 60 70
software
Books-home 50 50 50 50 50
liability
Inheritance 0 0 150 0 0
Land asset 2000 2800 3200 3700 4000
Personal clothes 100 160 160 180 180
Farm implements 64 45 32 30 30
Liabilities-private 80 110 90 70 100
Liabilities 450 510 590 310 600
business
Bank account (120) 720 (360) 180 120

Additional information
 Assets were stated on net realisable value basis where relevant
 His expenses for each of the four years were as follows
Year ended 31st December
2015 2016 2017 2018
Business expenses 900,000 1,350,000 1,300,000 1,500,000
Living expenses 310,000 460,000 610,000 720,000
Ignore capital allowance

Required:
a) Estimate the taxable income or loss of Mr Okumu for each of the four years ended 31 st
December 2018 (10 marks)