Thin Capitalization and Deemed Interest– Revisit proposed changes in Kenya Income Tax Bill (2018)

Thin Capitalization and Deemed Interest 

Revisit proposed changes in Kenya Income Tax Bill (2018)

Background

What is a thin capitalisation?

A company is can be financed (or capitalized) through a mixture of debt and equity. Thin capitalisation refers to the situation in which a company is financed through a relatively high level of debt compared to equity. Thinly capitalized companies are sometimes referred to as highly leveraged or highly geared.

Why is thin capitalisation significant?

The way a company is capitalized does have a significant impact on the amount of profit it reports for tax purposes. Country tax rules typically allow a deduction for interest paid or payable in arriving at the tax measure of profit. The higher the level of debt in a company, the higher the amount of interest it pays and the lower will be its taxable profit. For this reason, debt is often a more tax efficient method of finance than equity.

Transfer Pricing

Multinational groups are often able to structure their financing arrangements to maximise their group after tax profits. Not only are they able to establish a tax-efficient mixture of debt and equity in borrowing countries, they are also able to influence the tax treatment of the lender which receives the interest – for example, the arrangements may be structured in a way that allows the interest to be received in a jurisdiction that either does not tax the interest income, or which subjects such interest to a low tax rate and a higher interest rate in high tax jurisdiction, even when the rate at which is borrows is low.  This results in Profit Shifting and base erosion. Like in the Chevron case in Australia

https://www.taxinstitute.com.au/news/chevron-case-ato-wins-landmark-transfer-pricing-case

What are thin capitalisation” rules?

As the manner in which a company is capitalised can have a significant effect on the amount of profit it reports, and thus the amount of tax it pays. For this reason, country tax administrations often introduce rules that place a limit on the amount of interest that can be deducted in calculating the measure of a company’s profit for tax purposes. Such rules are designed to counter cross-border shifting of profit through excessive debt, and thus aim to protect a country’s tax base.

From a policy perspective, failure to tackle excessive interest payments to associated enterprises gives MNEs an unfair advantage over purely domestic businesses which are unable to gain such tax advantages.

Thin capitalisation rules typically operate by means of either one of two approaches:

  1. a) determining a maximum amount of debt on which deductible interest payments are available; and
  2. b) determining a maximum amount of interest that may be deducted by reference to the ratio of interest (paid or payable) to another variable.
  3. a) Limiting the amount of debt on which deductible interest payments may be made

Thin capitalisation rules often operate by limiting, for the purposes of calculating taxable profit, the amount of debt that can give rise to deductible interest expenses. The interest on any amount of debt above that limit (excessive debt‖) will not be deductible for tax purposes.

Countries take different approaches to determining the maximum amount of debt that can give rise to deductible interest payments, but there are generally two broad approaches:

  1. The “arm’s length” approach: Under this approach, the maximum amount of allowable debt is the amount of debt that an independent lender would be willing to lend to the company i.e. the amount of debt that a borrower could borrow from an arm’s length lender. The arm’s length approach typically considers the specific attributes of the company in determining its borrowing capacity‖ (that is, the amount of debt that company would be able to obtain from independent lenders).

 

The arm’s length‖ approach can also encompass a determination of the amount of debt that a borrower would have borrowed if the lender had been an independent enterprise acting at arm’s length. This “would have” approach is subjective.

 

  1. The “ratio” approach: Under this approach, the maximum amount of debt on which interest may be deducted for tax purposes is established by a pre-determined ratio, such as the ratio of debt to equity. The ratio or ratios used may or may not be intended to reflect an arm’s length position. This ratio may be considered arbitrary, but it’s advantage of using a ratio is that it provides a great deal of certainty and reduces compliance costs to companies and taxing authorities. The rule is simple to implement. Kenya uses this approach for Thin Capitalisation.

 

Current Position

Kenyan Income Tax Act CAP 470 –  Thin Capitalisation and Deemed Interest

“Deductions not allowed. Section 16. (2) Notwithstanding any other provision of this Act, no deduction shall be allowed in respect of- (j) interest payments in proportion to the extent that the highest amount of all loans held by the company at any time during the year of income exceeds the greater of-

(i) three times the sum of the revenue reserves and the issued and paid up capital of all

classes of shares of the company; or

(ii) the sum of all loans acquired by the company prior to the 16th June, 1988 and still

outstanding in that year, or an amount of deemed interest where the company is in the control of a non-resident person alone or together with four or fewer other persons and where the company is not a bank or a financial institution licensed under the Banking Act; and for the purposes of this paragraph “control” shall have the meaning ascribed to it in paragraph 32 (1) of the Second Schedule;”

Provided that this paragraph shall also apply to loans advanced to the company by a non resident associate of the non-resident company controlling the resident company.

Application of Foreign exchange losses

4A. (1) A foreign exchange gain or loss realized on or after 1st January, 1989 in a business carried on in Kenya shall be taken into account as a trading receipt or deductible expenses in computing the gains and profits of that business for the year of income in which that gain or loss was realized:

Provided that:

(i) no foreign exchange gain or loss shall be taken into account to the extent that taking that foreign exchange gain or loss into account would duplicate the amounts of gain or loss accrued in any prior year of income; and

(ii) the foreign exchange loss shall be deferred (and not taken into account) –

(a) where the foreign exchange loss is realized by a company with respect to a loan from a person who, alone or together with four or fewer other persons, is in control of that company and the highest amount of all loans by that company outstanding at any time during the year of income is more than three times the sum of revenue reserves and the issued and paid up capital of all classes of shares of the company;

 Definition of control paragraph 32 (1) of the Second Schedule

32.(1) In this Schedule, unless the context otherwise requires –

“control”, in relation to a body corporate, means the power of a person to secure, by means of the holding of shares or the possession of voting power in or in relation to that or another body corporate, or by virtue of powers conferred by the articles of association or other document regulating that or another body corporate, that the affairs of the first mentioned body corporate are conducted in accordance with the wishes of that person; and in relation to a partnership, means 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;

 

Deemed Interest Section 16 (3) to (5)

(3) For the purposes of subsection (2), the expressions –

“all loans” means loans, overdrafts, ordinary trade debts, overdrawn current accounts or any other form of indebtedness for which the company is paying a financial charge, interest, discount or premium;

“deemed interest” means an amount of interest equal to the average ninety-one day Treasury Bill rate, deemed to be payable by a resident person in respect of any outstanding loan provided or secured by the non-resident, where such loans have been provided free of interest.

 

(4) For the avoidance of doubt, the expression “revenue reserves” under subsection (2) includes accumulated losses.

 

(5) The Commissioner shall prescribe the form and manner in which the deemed interest shall be computed and the period for which it shall be applicable.

 

Withholding tax on deemed Interest section 35 (1) e

 Interest and deemed interest, including interest and deemed interest arising from a discount upon final redemption of a bond, loan, claim, obligation or other evidence of indebtedness measured as the original issue discount;

 Future

Draft Income Tax Bill – Thin Capitalisation– Section 24 (11) J

Application on Interest

“(j) an amount of interest paid in proportion to the extent that the highest amount of all loans held by the company at any time during the year of income exceeds two times the sum of the revenue reserves and the issued and paid up capital of all classes of shares of the company where a non-resident person is in control of the company –

 

For the purpose of this subsection, the expression “revenue reserves” includes accumulated losses;

Provided that this paragraph shall –

(i) also apply to loans advanced to the company by a non-resident associate of the non-resident company controlling the resident company; and

(ii) not apply where the company is a bank or a financial institution licensed under the Banking Act or Microfinance Act; “

Application on Foreign exchange losses

  1. (1) A foreign exchange gain or loss realized in a business carried on in Kenya shall be taken into account as a trading receipt or deductible expenses in computing the gains and profits of that business for the year of income in which that gain or loss was realized.

(2) Despite subsection (1), the foreign exchange loss shall not be allowed as a deduction where the foreign exchange loss is realized by a company with respect to a loan from a person who is in control of that company and the highest amount of all loans by that company outstanding at any time during the year of income is more than two times the sum of revenue reserves and the issued and paid up capital of all classes of shares of the company.

(3) For purposes of subsection (2), accumulated losses shall be taken into account in computing the amount of revenue reserves.

(4) The amount of foreign exchange gain or loss shall be the difference between (A times r2) and (A times r1)

Where –

A is the amount of foreign currency received or paid with respect to a foreign currency asset or liability in the transaction in which the foreign exchange gain or loss is realized;

r1 is the applicable rate of exchange for that foreign currency (“A”) at the date on which the foreign currency asset or liability was obtained or incurred .

Revised Definition’s of Control and Deemed interest

“control” shall be deemed to arise at any time during the year of income where –

(a) one person holds, directly or indirectly, shares carrying not less than twenty per cent of the voting power in the other person; or

 

(b) any person holds, directly or indirectly, shares carrying not less than twenty per cent of the voting power in each of such persons; or

(c) a loan advanced by one person to the other person constitutes not less than seventy per cent of the book value of the total assets of the other person excluding loans from financial institutions where the person and the financial institution are not associated; or

(d) a guarantee for any form of indebtedness by one person to the other person constitutes not less than seventy per cent of the total indebtedness of the other person excluding guarantee from financial institutions where the person and the financial institution are not associated; or

(e) more than half of the board of directors or members of the governing board, or one or more executive directors or executive members of the governing board of one person, are appointed by the other person; or

(f) more than half of the directors or members of the governing board, or one or more of the executive directors or members of the governing board, of each of the two persons are appointed by the same person or persons; or

(g) the manufacture or processing of goods or articles or business carried out by one person is wholly dependent on the use of know-how, patents, copyrights, trade-marks, licences, franchises or any other business or commercial rights of similar nature, of which the other person is the owner or in respect of which the other person has exclusive rights; or

 

(h) ninety per cent or more of the purchases by one person are supplied by the other person, or by persons specified by the other person, and the prices and other conditions relating to the supply are influenced by such other person; or

 

(i) ninety per cent or more of the sales by a person to the other person or to persons specified by the other person, and the prices and other conditions relating thereto are influenced by such other person; or

(j) any other form of control that the Commissioner may establish.

 “deemed interest” means the amount by which the interest payable at market interest rate in the country of non-resident of such a loan exceeds that which is paid by a resident person in respect of any outstanding loan provided or secured by a non-resident who exercises control on the resident company, where such a loan has been provided at interest rate that is lower than the market interest rate in the country of non-resident;

Summary and Conclusion

Kenya Income Tax law’s, both the current ITA CAP 470 and the revised Income tax Bill (2018), has taken the ratio approach to deal with Thin Capitalization, albeit that the debt: equity ratio has changed from 3:1 to 2:1 and although it still applies only to companies controlled by non-residents, the definition of control has been extended and definition of deemed interest made clear.

The changes will make the tax law relatively clear, however, the reduction in the debt to equity ratio may have an adverse effect on the Direct Foreign Investment by foreign controlled companies. It may have a positive effect on the exchange rate if Foreign investment is in form of Equity (higher amounts of Share Capital), which is perpetual in nature and the return on shares which is dividend, which is paid from after tax profits, compared to debt where both the principal may have to repaid (outflow of foreign currency) and is paid from before tax profit, resulting in higher level of retention of earnings of Multinational Corporations.

Online References for further reading – (accessed 20th July 2018)

https://www.taxinstitute.com.au/news/chevron-case-ato-wins-landmark-transfer-pricing-case

https://theconversation.com/thin-capitalisation-the-multinational-tax-avoidance-strategy-the-budget-forgot-58041

https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Thin-Capitalization-Rules-and-Multinational-Firm-Capital-Structure-41275

http://www.oecd.org/ctp/tax-global/5.%20thin_capitalization_background.pdf

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