Interesting question on interest rates & how to avoid VAT

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

20 January 2008

Irungu Thiongo who works in a bank asks an interesting question: “A bank client wants to make a fixed deposit of Sh50,000 over a period of one year. The customer has two options; to deposit the amount at an interest rate of 4.5 percent for the whole 12 months, or to invest the amount at 4.25 percent in intervals of three months such that the whole amount becomes the new principal. Between the two which is more favourable to him (assuming the rates don’t change)?”

If the bank applies simple interest calculation, the first option yields Sh2,250.00. To find out the result for the second option, we start by dividing the rate by 4. This gives the rate to be applied every three months – remember, three months are equal to a quarter of a year. The result is 1.0625 percent.

Thus at the end of the first three months, he will earn Sh531.25. This amount is then added to the principal (to make Sh50,531.25) and the total invested back. On the sixth month, the interest earned will be Sh536.90 and the total will now be Sh51,068.15.

When these calculations are repeated on the third and fourth periods, the result at the end of a year is an interest of Sh2,159.10. Comparing this to the Sh2,250.00 obtained earlier, it is clear that the first option is preferable.

Perhaps Thiongo would like to know what rate of the second option would yield the same interest as the first method. The answer to that is 4.426 percent.

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Starting this month, rent for commercial premises will attract Value Added Tax (VAT). Many traders have complained that this will increase their business expenses. But that need not be the case – especially for businesses that are already registered for VAT.

Suppose the business has a monthly turnover (before VAT) of Sh500,000 and pays rent of Sh20,000. The VAT collected from customers comes to Sh80,000 and that payable on the rent is Sh3,200. But before paying this to the tax man, the trader must deduct the “input VAT” paid for expenses incurred in direct operations.

Rent is a direct expense and the VAT paid qualifies for deduction. Thus the trader will subtract the Sh3,200 from the Sh80,000 and pay the difference (Sh76,800) to the revenue authorities.

Interestingly, for cases where the trader is registered for VAT, the tax man will not get any additional revenue. As the above example shows, the total tax collected is Sh80,000 (without VAT on the rent) and Sh76,800 + Sh3,200 = Sh80,000 (with VAT on rent).

So, why would the government want to complicate matters by introducing VAT on commercial properties? Well, there will be some additional tax collected in cases where traders are not registered. But, the greatest advantage will be that the landlords who have not been declaring rental income will now be exposed!