The new tax laws – assented into law by retired president Uhuru Kenyatta in 2021 – were perhaps meant to shore up revenue collections.
Officially known as Finance Act 2021, the law will see to it that businesses and companies pay more taxes by denying them tax deductions on excess interests paid on debt acquired for organisational operations.
The Act amended some tax laws such as the Income Tax Act, The Value Added Tax Act, of 2013, the Excise Duty Act, the Tax Procedures Act, of 2015, and the Miscellaneous Fees and Levies Act.
At face value, it is a robust piece of legislation.
The Act adopted OECD (Organization for Economic Cooperation and Development) guidelines, and specifically Base Erosion on Profit Shifting (BEPS) Action 4; introducing a fixed ratio rule to replace the previous thin capitalization rules.
Previously, interest expense restriction was limited to thinly capitalised companies: companies controlled by non-residents (except banks or financial institutions or those involved in affordable housing schemes).
The maximum Debt to Equity ratio allowed was 3:1 and 2:1 for extractive industries.
Now, allowable interest expense has been capped at 30 per cent of Earnings before Tax, Interest, Depreciation and Amortization (EBITDA).
This officially took effect on January 1, 2022. In determining EBITDA, exempt income is excluded.
The immediate impact of the new rules is significant tax liabilities for companies with a significant debt financing component.
You see, companies are typically financed through debt (loan) or equity financing (acquisition of shares).
From a tax perspective, debt financing is often preferred because the interest expense paid on the debt is allowable for tax.
Return on equity financing is a dividend paid from post-tax profits and gives no tax benefit. In any case, a further 5 per cent to 15 per cent is levied depending on tax residency.
For instance, if company X takes a loan to buy a property to enable it to conduct business, and ends the year with a rental income of Sh1.7 million while utilising Sh0.8 million on administration expenses, its EBITDA would be Sh0.9 million.
It would look like the company has made a profit; until you get to learn that it has finance costs (including interests on the loan) of Sh1 million that it has to honour.
In normal circumstances, it wouldn’t be paying any taxes because its finances (after paying interest on debts) are in the negative.
The new laws will force the company to pay tax – which is extra expenditure – on 70 per cent of EBITDA; leading to even further losses.
In plain English, companies use interest expense to reduce the total profit that should be subjected to tax.
In, Kenya this translates to 30 per cent in tax savings: which in the long run is good for the business and allows shareholders to maximise their wealth.
Now interest costs exceeding 30 per cent of EBITDA shall be disallowed and there are no provisions to defer such excess to be utilized in future tax periods – as is the case in other countries.
As tax advisors and auditors, we have done our best to send circulars to our clients – letting them know that a storm is coming.
Some haven’t quite understood what these new laws mean and how they will affect their operations, growth prospects and of course profitability.
Many will wake up to the new reality with shocked faces in April next year when the auditor writes to them to say, “You can’t claim this much interest expense on the loan you are servicing,” even though it is a legitimate cost of doing business.
Everybody – big companies and small businesses alike – urgently need to go back to the drawing board and try to restructure their companies.
They have to change all the tax planning the company has done so far and that was pegged on debt financing.
Now that we are on this topic, I think the new tax laws need to be rethought.
I would urge His Excellency the president and his team to give this a second look.
The new tax laws won’t augur well with our economy. Most OECD countries have low-interest rates: some as low as 1 per cent.
Our interest rate is 13 per cent. Companies using debt to further operations are poised to make incredible losses due to the loans they are servicing.
If nothing is done, companies will gradually shy away from taking credit facilities meant for further development as this option is no longer an obvious tax planning tool.
This will hurt companies’ cash flows and profitability. Over time – with companies lacking tax-protective financing to innovate and stay competitive – we shall see them fizzling out or moving to countries with accommodative tax laws.
Who wants to take a loan to finance a business operation and make losses on account of high interest and unfavourable tax laws?
It’s not just the companies that will be affected. Employees too: when companies fail or ship out, it leads to direct job losses.
Banks too will see their profitability go down over the years as companies and businesses will stop taking credit facilities.
Decreased profitability in the banking sector will result in decreased corporate tax contribution to the economy from this sector.
Kenya’s pride as a regional hub may also be eroded. Investors wanting to set base in Nairobi may opt for less capital-intensive operations like liaison offices as opposed to capital-intensive manufacturing or research centres, shifting such investments to tax-friendly jurisdictions.
I understand that the new laws are pushing Kenya towards international best tax practices. However, we must be cognizant of our economic environment.
I also know that the government has given itself higher revenue collection targets as the country seeks to overcome pressure from mounting public debt.
This government, I believe, is pro-business: it is pro-entrepreneurship. I mean, this is a ‘hustler’ government. So, I wouldn’t be overstretching my optimism to say the president wants businesses to thrive and grow.
We could use other laws to net more revenue.
But this one will kill the geese laying golden eggs. In the long run, the effect will be that there will be fewer corporate companies and businesses, fewer taxpayers, and less tax for the exchequer.
The writer is the partner at tax advisory and audit firm, Thakrar Financial Consultants based in Nairobi.