The Finance Bill 2021 proposes to introduce a restriction on interest expense allowable for tax purposes to 30 per cent of your business earnings before interest, tax, depreciation and amortisation (EBITDA).
Currently, interest restrictions apply only to thinly capitalised companies. Let’s take a step back to explore why this is an issue in the first place.
Companies are typically financed through debt and/or equity financing. The decision on whether to use debt or equity depends on a number of factors such as the liquidity of the investor, type of project, business life cycle, exit strategy, among others.
From a tax perspective, the main advantage of debt over equity is the tax deductibility of the interest expense. In monetary terms and ignoring the impact of other taxes such as withholding tax, the use of debt over equity financing results in a corporation tax saving equivalent to 30 percent of the interest expense.
An investor wishing to maximise returns would out rightly favour debt over equity financing. To curb the misuse of interest deductibility through excessive loans, thin capitalisation rules were introduced. In a nut-shell, thre rules only apply to companies controlled by a non-resident where the total debt exceeds three times the total equity (including reserves). There are some exceptions to this such as companies in the extractive sector where the debt threshold is two times the total equity. Also, financial institutions and affordable housing developers that build over 100 units annually are exempt.
The Finance Bill 2021 proposes to replace the thin capitalization rules with a fixed ratio rule whereby, interest will be restricted to a maximum of 30 percent of EBITDA. Unfortunately, this will apply to both local companies and foreign-controlled companies unlike the thin capitalisation rules.
This fixed ratio rule has been adopted from internationally recognised guidelines and in particular, Action 4 of the domestic tax Base Erosion Profit Shifting (BEPS), a project undertaken by the Organisation for Economic Co-operation and Development (OECD) and the G20 that was released in final in December 2016. BEPS Action 4 focuses on limiting base erosion involving interest deductions and other financial payments and gives guidance on various rules that may be adopted by revenue authorities to counteract excessive interest deductions.
The introduction of an interest restriction of 30 percent of EBITDA in Kenya will greatly impact existing companies and potential future investment. Although investors are mainly driven by business opportunity, taxation plays a key role in evaluating whether or even where to invest and what business model to use.
At the onset, companies that are loss-making and those with low margins that require heavy borrowing would be denied any interest deduction and consequently, will bear a higher tax burden despite such loans being commercially justifiable. Also, start-ups that are yet to break-even would equally be punished.
Both local and foreign investors evaluating what business model to use - how to invest - may opt to set up non-capital-intensive operations in Kenya such as representative offices, branch/liaison office or shared services centre, and on the other hand, set up capital intensive operations, for instance manufacturing, research and development in more ‘tax favourable’ jurisdictions.
This would deny Kenya the opportunity for critical skills transfer and further, decelerate the Big Four agenda (Manufacturing, Affordable Housing, Healthcare, Food Security) which are pre-dominantly capital intensive. For example, affordable housing developers are currently exempt from thin capitalisation rules but under the Finance Bill 2021, interest deductions will now be restricted thus deterring investment.
A quick solution to this would be to bite the bitter pill and get rid of the interest restriction of 30 percent of EBITDA in favour of the tried-and-tested thin capitalisation rules to mitigate the adverse effects that it would have on existing companies and future investment. BEPS Action 4 recognises that not all countries are in the same position and therefore, gives flexibility to revenue authorities to use what tools are favourable to them.
The government may also choose to adopt other alternative tools provided for under BEPS Action 4 such as the De Minimis Rule ( restricting interest once it exceeds a certain fixed amount), Targeted Rules (for instance by limiting the interest restriction to only related party loans), Specific Rules, for example, excluding industries such as financial services), Group Ratio Rules (by allowing use of group ratios rather than local company ratios to protect loss-making entities with debt that is justified on commercial grounds), among others.
There is need for the government to evaluate the impact of the adoption of international best practise on the economic environment so as not to adopt policies that would negatively impact investments as well as the competitiveness of local industries in Kenya.
In summary and in the words of Lawrence Summers, an American Economist, “All taxes discourage something. Why not discourage bad things like pollution rather than good things like working or investment?"
Kenneth Kahora is a tax manager at PKF Kenya. Email: [email protected]