Are the tax obligations of deemed interest fair?
Globalisation has brought the market to the rest of the world. Kenya is one of such market. Before investing in Kenya, multinational enterprises consider several factors. Key among these factors is the mode of financing the investment.
Given the time that these investments take before the capital invested generates returns, most investors opt for a mix of equity and debt. Compared to equity, debt is easier to mobilise.
The most conventional source for debt is usually financial institutions. However, few banks in Kenya would be willing to finance newly established companies. Those that are willing end up charging relatively higher interest rates. Owing to the challenges of accessing affordable financing, some companies may opt to obtain financing from their foreign parent companies. It is reasonable that some parent companies, save for transfer pricing considerations, would issue loans free of interest to their Kenyan subsidiaries. This draws the financing arrangement into the ambit of deemed interest provisions of the Income Tax Act (the Act).
The deemed interest provisions were introduced by the Finance Act of 2010 and became effective from 11 June 2010. It was however not until 2012 when the law prescribed how to compute withholding tax on deemed interest.
The Act defines deemed interest as an amount of interest equal to the average ninety-one day Treasury Bill rate. It is 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. The Act also empowers the Commissioner of Domestic Taxes (the Commissioner) to prescribe the form and manner in which the deemed interest shall be computed and the period for which it shall be applicable. The Commissioner, by publishing the applicable deemed interest rate every quarter, carries out this duty diligently.
Under the provisions of the Act, where a resident person makes a payment to any other person in respect of, amongst other things, interest and deemed interest, the amount thereof shall be deemed to be income which accrued in or was derived from Kenya.
It further provides that upon making such payment to a non-resident person, the person making the payment will deduct therefrom tax at the appropriate non-resident rate. The current non-resident rate for withholding tax on deemed interest is 15%.
The Act also provides that an amount of deemed interest computed by a company, other than a bank, is not an allowable deduction for purposes of computing corporation tax. Two questions arise in this regard. Firstly, whether deemed interest is actually “paid” interest for purposes of withholding tax, and secondly, whether this deemed interest should be a non-deductible expense for corporation tax purposes.
Regarding the first question, the Act defines “paid” to include “distributed, credited, dealt with or deemed to have been paid in the interest or on behalf of a person”.
This issue of “payment” was adjudicated in the judicial review filed by Fintel Limited against a tax demand by the Kenya Revenue Authority (Miscellaneous Application No. 1768 of 2004). The decision was issued in October 2012. In the Fintel Case, the Court noted that the words “include” in the definition is merely illustrative of the kinds of activities that constitute payment.
The learned judge also noted that payment implies, “delivery of money or some other valuable thing.” He went ahead to state that to pay means “to give (a sum of money) thus owed” as defined in the Concise Oxford English Dictionary, 2011. Consequently, “distributed, credited, dealt with or deemed to have been paid” should be interpreted as being the same kind in nature and character with the word paid.
This view is reinforced by the withholding tax provisions of the Act. These provisions require that a person making the payment should deduct tax therefrom at an appropriate rate. Deduction, as noted by the learned judge, implies subtracting from what is due and being paid to another person. The Court therefore noted that these provisions negate any intention by the legislature to ascribe a meaning other than the “plain and obvious meaning to paid and upon payment.”
If the above is applied to withholding tax on deemed interest, it is difficult to see how withholding tax can be deducted from, an amount that, firstly, does not exist and secondly, has not been paid. In addition, no interest has been credited to the parent company or anything of value transferred to the parent company, even on consolidation of the accounts. Basically, there is no “expense” reflected in the income statement of any entity.
Therefore, to force a company, which by virtue of the returns from its operations opted to obtain a cheaper debt (even at zero percent interest) to account for withholding tax on deemed interest should be deemed illegal. In any case, most of these companies have cash flow issues and that is why they opt for an interest-free loan.
Secondly, to then disallow the non-existent expense when determining the taxable income negates the need by the government to create an enabling environment to attract foreign investment. Strictly speaking, there is no actual income that is derived from Kenya and therefore nothing should be subjected to any form of taxation in Kenya.
As for the subsidiary in Kenya, it is understood that the accounting profit is the beginning point for determining the taxable income. Therefore, changes in the basis of determining accounting profit have a direct bearing on the taxable income. Deemed interest does not affect the accounting profit in any way as it is not an “actual” expense. Why then must it be disallowed when determining the taxable income?
While the Government may argue that it is losing tax from “possible interest payments” to either local or international companies, the economic benefits and the multiplier effect of a profitable company far outweighs the revenue collection targets expected from charging tax on income (to the parent company) and disallowing expenses (from the subsidiary in Kenya) that do not exist in the first place.
It is therefore necessary for the Government to review these provisions. If Kenya wants to attract foreign investment, it must create an enabling business environment. Increasing the costs of operations is definitely not the way to go about it.
Hopefully, Treasury will consider this matter in the upcoming budget process. In the meantime, until the ruling in the Fintel case is reversed (it is now four years and counting), withholding tax should not be charged on deemed interest.
Senior Advisor – Tax & Regulatory
The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG.