According to the Organization for Economic Co-operation and Development (OECD) thin capitalization refers to the situation in which a company is financed through a relatively high level of debt compared to equity.
The Kenya Finance Act 2021 introduced new provisions governing interest payments that are not deductible for corporation tax purposes. The Act, provides for non-deductibility of interest expenses exceeding 30% of earnings before interest, taxes, depreciation and amortization (EBITDA), to related and non-related parties. This approach of restricting deductibility of interest to 30% of EBITDA is also referred as “Earnings Stripping Approach”. This restriction as per the Act applies to:
- Interest on all loans
- Expenses incurred in connection with raising finance
- Payments that are economically equivalent to interest
- 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 capitalization restrictions, to the extent that the coupon is treated as an expense in the books of the company.
The thin capitalization restrictions however do not apply to the following institutions:
- Banks or financial institutions licensed under the Banking Act
- Micro and Small enterprises registered under the Micro and Small Enterprise Act
Previously, thin capitalization restriction was based on a debt-to-equity ratio of 3 to 1. The disadvantage with this method was that it did not necessarily reflect economic reality and that it distorted behavior by group affiliates. According to research conducted by OECD, a fixed ratio approach most of the time, does not always take into account specific market situations or industries, and may result in inconsistent treatment of members of multinational enterprises in comparisons to independent companies.
Why Thin Capitalization?
Multinational groups are often able to structure their financing arrangements to maximize these benefits of thin capitalization. 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.
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.
Impact Of The Thin Capitalization Policy Change
From a policy perspective, failure to tackle excessive interest payments to associated enterprises gives Multinational Enterprises (MNEs) an advantage over purely domestic businesses which are unable to gain such tax advantages.
Under the new Act, currently, interest payments are disallowed proportionately if the sum of all loans are more than three times the aggregate of positive revenue reserves and share capital. This therefore implies that; highly leveraged entities will be adversely affected by the changes envisaged due to the low threshold (30%) for disallowing interest expenses; hence increasing their taxable income.
Author: Eddie Opiyo