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The Finance Act, 2021 (the Act), which was assented into law by the President of Kenya on 29 June 2021, makes a raft of changes to Kenya’s tax regime including the Income Tax Act, the Value Added Tax Act, the Tax Procedures Act, the Miscellaneous Fees and Levies Act and the Excise Duty Act, among others.
The legislative changes have come amidst an increasingly stringent tax environment for businesses in an uncertain post-COVID-19 world. Businesses are witnessing lower liquidity levels and are becoming highly geared as they struggle to stay afloat in the current tough economic conditions.
In this flash alert, we highlight the key changes that the Act has introduced which will have an immense impact on businesses undertaking operations in Kenya.
1. Strict Rules on Deductibility of Interest for Tax Purposes
Effective Date: 1 January 2022
The Act has adopted the changes relating to thin capitalisation restrictions which were contained in the Finance Bill, 2021 (the Bill). Previously, thin capitalisation restriction was based on a debt-to-equity ratio of 3 to 1. Thin capitalisation will, from the effective date, be based on a percentage of earnings before interest, taxes, depreciation, and amortisation (EBITDA). The new thin capitalisation restrictions require that the gross interest paid or payable to related persons and third parties in excess of 30 percent of the EBITDA of a resident borrower in any financial year will not be deductible for tax purposes. Note however that, any income which is exempt from tax will be excluded from the calculation of EBITDA for the relevant entity. Further, banks or financial institutions licensed under the Banking Act and micro and small enterprises registered under the Micro and Small Enterprises Act have been exempted from the thin capitalisation restrictions.
In addition to the thin capitalisation restrictions applying to interest on all loans, the thin capitalisation restriction will now apply to payments that are economically equivalent to interest and expenses incurred in connection with raising the finance. For instance, where preference shares that are structured as debt have a fixed dividend/coupon obligation, the coupon may be deemed to be economically equivalent to interest and therefore subject to thin capitalisation restrictions, to the extent that the coupon is treated as an expense in the books of the company.
Since companies are currently structured to meet the thin capitalisations thresholds from a capital structure perspective (i.e. ratio of debt to equity), the debt burden and interest expense of the companies should be reconsidered to mitigate the impact of the thin capitalisation restriction being based on EBITDA. We also note that the new EBITDA test will now cover all companies including branches of non-resident companies which were not covered under the previous thin capitalization rules.
We point out that the new thin capitalisation rules will adversely impact Kenyan businesses who continue to be highly geared owing to the impact of Covid-19 on their cash flow. The gross interest amount in excess of 30 percent of the EBITDA of the companies will be disallowed for tax purposes, which further puts more financial pressure on the companies because the ‘excess’ interest will be subject to corporate tax, increasing the effective tax rate for such companies.
Since thin capitalisation is intended to avoid flight of capital from Kenyan companies by non-resident persons by way of interest, it would be expected that the thin capitalisation restrictions would only apply to companies that are under the control of a non-resident person as it was previously provided under the Income Tax Act.
2. Minimum Tax
Effective Date: 1 July 2021
The Act has introduced additional exemptions from the application of the minimum tax to include persons engaged in manufacturing businesses whose cumulative investment from 2017 to 2021 is at least Kenya Shillings 10 billion, persons engaged in distribution businesses whose income is wholly based on a commission and persons licensed under the Special Economic Zones Act. It is our view that there may be ambiguity arising as to the businesses that would be entitled to these exemptions, noting the broad drafting of the provision. It is also worth noting that the collection of the minimum tax is currently suspended pending the hearing and determination of Constitutional Petition Number E005 of 2021, Kitengela Bar Owners Association vs Commissioner General of the Kenya Revenue Authority & 2 Others. The Kenya Association of Manufacturers has also been enjoined in the case owing to the adverse impact on various manufacturing businesses operating in Kenya. Since inception, the minimum tax regime has now been amended twice, through legislative amendments set out in the Tax Laws (Amendment) No. 2 Act, 2020 and the Finance Act, 2021, to expand the exemptions from minimum tax. In addition, by way of a specific legal notice, the national carrier has recently been exempted from minimum tax. The number of amendments to this recently introduced regime may bolster an argument that greater consideration should have been given prior to the introduction of this regime in order to remove some of the uncertainties and ambiguities that are now being sought to be addressed.
The suspension of the collection of minimum tax has temporarily abated its far-reaching impact on businesses, noting that most businesses are currently in financial distress due to the adverse effects of the COVID-19 pandemic. Entities with high revenues but low margins would also have been adversely affected as they would have either paid a lower tax or not been in a tax-paying position from a corporate tax perspective. Further, entities in tax loss position arising out of reliance on various capital allowances would also have been required to pay the minimum tax thereby eroding any benefits realised from the capital allowances.
A comprehensive alert with our analysis on the various tax changes introduced by the Act will follow shortly.
Dennis Chiruba – Principal Associate
Abdullahi Ali – Trainee Lawyer