Introduction
Contracts are the foundation of business relationships. They define the rights and obligations of the parties involved and ensure transactions are carried out as agreed. Yet, beyond their legal and commercial purpose, contracts also carry important tax implications that affect both compliance and financial outcomes.
It would be treacherous for an organisation not to consider carefully the terms of each contract they enter into, or worse still to enter into a gentleman’s agreement in cases where a contract is necessary, since this may result in unforeseen or vague contractual obligations, restricted rights, misalignment with company goals, unintended legal consequences, major financial losses as well as endless dispute cycles. These are just a few of the consequences of failure to take note of contractual terms.
In this article, we shall discuss the importance of contracts, the various types of contracts, with a focus on commercial contracts, and highlight the tax and legal aspects that are critical for small and medium-sized businesses to consider prior to entering into such contracts.
Importance of Contracts
We certainly cannot over-emphasize the importance of having properly executed contracts as a standard business practice. For all verbal agreements entered into, it is best practice to follow up with a written agreement outlining the terms as agreed by the parties. Finally, such an agreement MUST be executed for it to be enforceable. This is underpinned in section 3(1) of the Law of Contracts Act (CAP23).
For instance, in the case of Rhoda Kibunja t/a Docuquest Enterprises v Next Technologies Limited [2020] eKLR, the plaintiff’s claim was that the parties entered a joint venture agreement which was drafted but not executed. As such, the plaintiff brought before the court a claim for breach of contract. The court could not rely on the provisions of the agreement, as it was not executed. The learned judge held that the intention to enter a legal agreement does not in itself constitute an agreement between parties. Such intention must be consummated. The lack of a written agreement between the parties made it extremely difficult to prove or provide evidence in support of the plaintiff’s case. As a result, the suit was dismissed with costs.
LEGAL ASPECTS
Standard Contractual Terms
Types of Contracts
There are various types of contracts recognised under Kenyan law. The Law of Contracts Act (CAP 23) does not expressly provide for types of contracts. However, various types of contracts have been set forth in caselaw and common law. These include express (written or verbal), implied (inferred from actions), unilateral, and bilateral contracts. Commercial contracts can be categorised as either express, implied, bilateral, or unilateral, as they are business contracts that can broadly be classified and are subject to the principles of contract law.
Employment contracts
Matters of employment are primarily governed by the Employment Act of Kenya (CAP 226); “the Employment Act”. Other pieces of legislation that should be considered when drafting employment contracts include the Labour Relations Act, 2007, the Work Injury Benefits Act, 2007, Occupational Safety & Health Act, 2007, among others.
The Employment Act refers to employment contracts as contracts of service. A contract of service must adhere to the provisions of the Employment Act. A contract of service whose period is more than three months must be in writing. For these types of contracts, there must be a clause on work arrangements or duties of the employee, compensation, and termination.
Section 10 of the Employment Act provides that the employer must provide details of the place of work, working hours, the duties and responsibilities of the employee, and, where necessary, any probationary period. Without clear clauses on these issues, it may be difficult to establish the scope of work required to be carried out by the employee in the event of disputes or claims of unfair dismissal. It may also be difficult to establish any claims of misconduct or poor performance. Furthermore, these provisions ensure adherence to the basic minimum provisions of employment as provided under section 26 of the Employment Act, as read together with Part V of the same act.
A reading of section 10 of the act further provides that details on remuneration, the scale of remuneration, and its calculation must be provided in the contract of service. Moreover, the employer must also indicate the benefits the employee is entitled to under such clauses. The compensation clause should clearly state the amount of salary to be paid, the frequency of payment, and any deductions therein. The legal risk of failing to adhere to this provision is that there are penalties attached to going below the statutory minimums.
A termination clause is also essential in all employment contracts. Section 35-40 of the Employment Act provides that a comprehensive termination clause should contain the notice period, the basis for dismissal, disciplinary proceedings, terminal dues, restitution of company assets and provisions covering redundancy. The issue of procedural fairness with regard to termination arises a lot in employment matters. As a result, failure to properly draft or adhere to the termination clause in an employment matter could lead to claims of wrongful termination, financial liability on the part of the employer, or even orders for reinstatement by courts.
Supplier Contracts
These are primarily governed by the Sale of Goods Act (CAP 31). For this category of Contracts, clearly defining payment terms will save a business from loss. The payment clause should clarify the currency, exact amounts in question, any taxes, discounts, or delivery costs. Failure to include the aforementioned elements presents difficulty in enforcing payment or supply. Although section 29 of the Sale of Goods Act recommends that, in such cases, the principle of reasonable time be applied, reasonable time varies from case to case, and can be disputed in a court of law. There may also be hidden costs attached to a vague payment clause. This may lead to unexpected additional charges and financial loss on the part of the purchaser.
It is also important to include a clause on the merchantable quality of goods to be delivered and expectations of both parties during delivery. This is buttressed by section 16(b) of the Sale of Goods Act, which provides that goods bought by description shall be of a merchantable quality. This ensures goods delivered are not defective and prevents disputes arising over the same. In addition to this, proving that goods are not of merchantable quality can be difficult, especially when the terms of the contract are not express.
A termination clause is also key in this type of contract, as it makes it easy for both parties to know when they can end the contract and how disputes will be handled. This will save both parties time and costs in the event any dispute arises.
Customer contracts
For customer contracts, it is important for parties to agree on the scope of work. This ensures the client understands what they are paying for, and the merchant/ supplier is also held accountable since the contract will clearly state their product description.
Payment terms are also crucial. Section 29 of the Sale of Goods Act provides that payment must be made in exchange for the goods. The buyer must be willing to make payment in exchange for the goods, whereas the seller must also be willing to allow the buyer to gain possession of the goods in exchange for the price. Consequently, details of the price, payment period, ownership transfer, and interest, where applicable, should be included in this clause.
A limitation of liability clause is also essential when it comes to customer contracts. It acts as a safety net against excessive claims by customers for allegations of poor performance, loss, or damage. It also shields the supplier against liability for indirect losses such as loss of reputation or profits. The supplier can also cap their liability to the value of the contract. Courts have endorsed contracts where limitation of liability is expressly provided for. For instance, in the case of National Bank of Kenya Ltd v Pipeplastic Samkolit (K) Ltd [2001] eKLR, the learned judge stated that courts cannot rewrite contract terms when they’re clearly stated in the contract. Accordingly, contractual terms on limitation of liability bind the parties therein.
TAX ASPECTS
The way a contract is written can determine whether a transaction attracts Value Added Tax (VAT), Withholding Tax (WHT), Pay-As-You-Earn (PAYE), or other statutory deductions. Understanding these implications is essential for good tax planning, managing risks, and avoiding costly disputes with the Kenya Revenue Authority (KRA). Poorly drafted contracts can lead to penalties, interest charges, or unexpected tax liabilities.
This section highlights key tax considerations in customer, employment, and supplier contracts, and explains how businesses can structure agreements to remain compliant and financially efficient.
- Customer Contracts
Customer contracts, which govern the sale of goods or services, often attract VAT at the standard rate of 16%, unless the supply is exempt or zero-rated under the VAT Act, 2013. To avoid confusion, contracts should clearly state whether the prices quoted are VAT-inclusive or VAT-exclusive.
VAT-registered businesses must also issue electronic tax invoices (eTIMS) for all taxable supplies. Without a valid eTIMS invoice, a customer cannot claim input VAT, making proper invoicing and documentation essential.
Timing is another important factor. Under VAT rules, tax becomes due at the earlier of issuing an invoice or receiving payment. This means that advance payments can trigger VAT even before goods are delivered or services are completed. Unclear contract terms on timing may therefore lead to premature tax obligations or cash flow issues.
In addition, payments for services such as management, consultancy, or professional work may attract Withholding Tax (WHT) at prescribed rates. Contracts should specify who is responsible for deducting and remitting WHT to KRA.
Ultimately, clear and well-structured customer contracts support proper VAT and WHT compliance, promote transparency, and help avoid disputes during tax audits.
- Employment Contracts
Employment contracts have direct tax consequences under the Income Tax Act, particularly regarding Pay As You Earn (PAYE). Employers are required to deduct PAYE from all employee earnings, including salaries, bonuses, and taxable benefits, and remit it to KRA.
Clauses that define employee benefits such as housing, transport, medical cover, or club memberships influence how those benefits are taxed. Unless proven to be wholly for business purposes, such benefits are taxable.
Similarly, termination benefits, gratuities, or performance bonuses should be clearly addressed, as some may qualify for tax exemption while others do not. For individuals engaged on temporary or consultancy terms, payments may instead attract Withholding Tax rather than PAYE.
Employment contracts should also provide for statutory deductions such as NSSF and Social Health Insurance Fund (SHIF) contributions. Non-compliance can result in penalties and reputational damage.
In short, employment contracts are vital tools for managing tax compliance. When drafted correctly, they ensure that PAYE, benefits, and terminal dues are taxed properly and reported accurately.
- Supplier Contracts
Supplier contracts regulate procurement and service delivery arrangements, making them key in determining Withholding Tax (WHT) and Value Added Tax (VAT) obligations. Payments for professional, management, agency, or contractual services attract WHT at rates prescribed under the Income Tax Act.
Contracts should clearly specify the nature of services provided and the residency status of the supplier, as these determine the applicable WHT rate and any relief available under double taxation treaties.
Special attention should also be paid to reimbursement and cost recovery clauses. If reimbursements are not properly documented, KRA may treat them as taxable income. Proper recordkeeping and clear wording are therefore, critical.
A notable example is the case of Techsavanna Company Limited v Commissioner of Domestic Taxes [2025] eKLR, where the High Court upheld KRA’s position that VAT was due on payments received by Techsavanna for seconding software developers to clients. The Court ruled that although the company claimed to act merely as an intermediary, it actually provided taxable administrative services. The decision highlighted that KRA focuses on the substance of the transaction, not just its form, reinforcing the importance of accurately drafted supplier contracts.
Well-drafted supplier contracts thus ensure proper tax compliance and minimize tax risks for both local and foreign parties.
CONCLUSION
From the foregoing, we can come to the distinct conclusion that clauses in contracts should never be treated as routine. Each contract must reflect the real nature of the transaction and clearly allocate legal and tax responsibility. Wording such as “prices are inclusive/exclusive of all applicable taxes” should be used carefully to avoid disputes.
Furthermore, it is quite evident that the financial arrangements, the work plan, and individual parties’ obligations, as well as the dispute resolution clause, are indispensable elements of a commercial contract. Overlooking these elements has proven to result in serious financial and reputational losses.
Additionally, contracts should anticipate changes in tax laws, allowing for adjustments to pricing or terms where necessary. Including tax indemnity clauses provides added protection if one party’s non-compliance leads to unexpected tax assessments.
Finally, it is crucial that contract terms align with a business’s tax reporting systems, including invoicing, withholding, and payroll records.
In Kenya’s evolving tax landscape, businesses should seek professional tax advice when drafting or reviewing contracts. Proactive tax consideration not only ensures compliance with the applicable taxes but also enhances financial predictability, transparency, and overall efficiency.
