Debt and equity financing are the mainstay of raising capital for any business. Debt financing is sometimes a more attractive financing option particularly where one can minimise the businesses overall tax liability. The main attraction being that in certain jurisdictions, the interest payable by the corporation to the lender is a deductible expense when calculating the corporation’s profitability; ultimately, reducing the corporation’s tax liability.
Thin capitalisation refers to a situation where a corporation has more debt compared to its equity financing. To combat excessive tax avoidance as well as ensure financial stability of corporations, some jurisdictions have enacted thin capitalisation rules that restrict deductibility when the debt-to-equity ratio (DER) exceeds a certain threshold thus encouraging equity financing. Kenya, is one such country.
The existing thin capitalisation rules apply to both corporations borrowing locally and internationally irrespective of whether the debt financing is from a financial institution or an associated entity e.g. a parent companies, based in another jurisdiction.
The Thin Capitalisation Regime
Specifically, section 16 (2)(j) of the Income Tax Act (Chapter 470 of the laws of Kenya) (the Act) disallows deductions on interest payments where ‘the highest amount of all loans held by the company at any time during the year of income’ exceeds the sum of three times the revenue reserves (including accumulated losses) and the issued and paid up share capital of all classes of shares of the company. Moreover, where the company is controlled by a non-resident person or is controlled by four or fewer persons and the company is not a bank or a financial institution, a company is not allowed to deduct the amount of deemed interest which would ordinarily have been charged.
In the case of a partnership, control is present where the foreign partner(s) has the right to a share of more than one-half of the assets or of more than one-half of the income of the partnership.
From the foregoing the permissible DER in Kenya for a corporation is 3:1, although for the extractives sector, the applicable DER is 2:1.
The result of a Kenyan company being thinly capitalised is that:
- it cannot claim a deduction on the interest incurred by the company in excess of the prescribed DER;
- any foreign exchange loss on any shareholder loans is deferred for tax purposes until the company ceases to be thinly capitalised; and
- deemed interest on interest-free loans from the non-resident related parties is not deductible and attracts a withholding tax at the prevailing rate.
The Proposed Thin Capitalisation Regime
The Income Tax Bill 2018 (the “Bill”) intends to dramatically change the thin capitalisation regime in Kenya. In particular, section 24 (11) (j) of the Bill proposes to reduce:
- the prescribed DER to 2:1; and
- the threshold of non-resident control for purposes of the Bill to 20%.
These proposed changes, if enacted, will have various effects on corporations and firms operating in Kenya.
- First, many currently compliant companies may find themselves to be thinly capitalised.
- Second, companies will have to pursue other tax minimisation strategies that may be available to them.
- Third, a reduced DER may result in lower bankruptcy risk for companies since more assets will be available for distribution upon liquidation.
Local and multinational companies operating in Kenya must keep an eye on the progress on the Bill and look into the implications the proposed changes would have to their individual business should the Bill come to pass.
1Under paragraph 32(1) of the Second Schedule to the Act, control is defined in relation to a party having the ability to direct the conduct of the affairs of a company, and unless otherwise provided in its constitutional documents, a company with at least 25% non-resident shareholding shall be deemed to be controlled by a non-resident.
2Section 2 of the Income Tax Bill 2018.
Should you have any enquiries regarding this article or any general queries on the subject matter, kindly contact Waringa Njonjo, Partner Linda Ondimu, Associate and Kenneth Likoko, Lawyer, MMAN Advocates.
Disclaimer: This article has been prepared for informational purposes only and is not legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Nothing on this article is intended to guaranty, warranty, or predict the outcome of a particular case and should not be construed as such a guaranty, warranty, or prediction. The authors are not responsible for any actions (or lack thereof) taken as a result of relying on or in any way using information contained in this article and in no event shall be liable for any damages resulting from reliance on or use of this information. Readers should take specific advice from a qualified professional when dealing with specific situations