Recent ruling on tax treatment of bad debts written off could negatively impact the cost of credit

A recent decision by Kenya’s Tax Appeals Tribunal (TAT) in the case pitting a credit-only microfinance institution vs Commissioner for Domestic Taxes has sent ripples through the country’s financial services sector. At the heart of the dispute was whether a microfinance institution could claim a tax deduction for the principal amounts of loans —the original sum lent out—that had become irrecoverable and was written off as bad debt.

The TAT agreed with the Kenya Revenue Authority (KRA) and ruled that under paragraph 4 of Guidelines on Allowability of Bad Debts and the provisions of the Income Tax Act (ITA), the principal element of a loan is capital in nature and therefore not deductible in arriving at the tax payable. According to the TAT, only the interest, fees, and penalties components of loans, which are revenue in nature, can potentially be deducted if they meet the bad debt guidelines. In short, if a lender is unable to recover a loan and must write it off, the lender is not allowed to claim, as a legitimate business expense, the principal element of the loan and thus effectively pays corporate income tax on the principal loan written off.  

How is this different from other countries?

In many Commonwealth countries, such as the Malta, Australia, and South Africa, the rules are different. While tax laws generally do not allow the deduction of capital losses, for those in the business of lending money, the principal amount lent out is treated as “stock in trade” and not capital —just like goods in a shop. Imagine a car dealer who sells cars on credit. If a customer fails to pay, the dealer can deduct the cost of the car from their taxable profit. Similarly, a manufacturer that sells products on credit can deduct the cost of those products if the customer defaults. The same logic applies to lenders: the money they lend out is their “stock,” and if it cannot be recovered, it should be treated as a business loss, incurred in the ordinary course of their business.

By contrast, the TAT’s decision in Kenya appears to have overlooked this fundamental reality. The principal advanced by lenders is not merely capital in the abstract sense, but the very lifeblood of their business model. To deny tax relief on irrecoverable principal amounts is to ignore the nature of lending as a commercial/ trading activity. This approach not only deviates from international best practice but also creates uncertainty in the financial sector which could impact its competitiveness.

What are the risks?

The implications of this ruling are significant and, if left unchallenged, could be damaging to the industry and the broader economy. First and foremost, lenders—especially those serving high-risk and underserved segments—may face increased tax liabilities when loans go bad. This additional burden may force some institutions to tighten their lending criteria, reduce their exposure to riskier borrowers, or even exit certain market segments altogether.

Secondly, the ruling could lead to a rise in the cost of credit, as lenders seek to price in the increased risk and tax burden associated with bad debts. For micro, small, and medium-sized enterprises (MSMEs) and individuals who rely on access to credit, this could translate into higher interest rates and reduced availability of finance. In a country where financial inclusion remains a key policy objective, such outcomes would be deeply regrettable.

Thirdly, there is also a risk of capital flight, as investors and financial institutions reconsider their exposure to the Kenyan market in light of the less favorable tax treatment of bad debts. Potential job losses in the financial sector and related industries cannot be ruled out, as institutions adjust to the new reality. The cumulative effect of these developments could be to stifle innovation, reduce competitiveness, and slow the pace of economic growth.

What should happen next?

Given the far-reaching potential impact of this ruling, it is recommended that the taxpayer considers appealing the decision at the High Court considering a number of factors including existing judicial precedent. In my view, there is a strong case to be made that the principal element of a loan, for those engaged in the business of lending, should be treated as circulating capital akin to stock in trade and not as fixed capital, in which case losses arising from unrecoverable loans are of a revenue nature. This position is not only consistent with international best practice but also with the economic and commercial realities of the lending business. On a positive note, this view has recently been upheld by the TAT in two other cases with similar circumstances, although it begs the question why the current ruling diverged from this position.

In parallel and as a matter of urgency, it is crucial for industry stakeholders to come together and advocate for a change in the law to ensure that this treatment is not only forestalled but it is made abundantly clear that for financial institutions involved in lending business, loss arising from unrecoverable principal element of a loan is revenue in nature and not capital. This could be achieved through the upcoming Tax Laws Amendment bill 2026 or the Finance Bill 2026, providing a timely opportunity for industry to present a united front and push for much-needed reform.

In conclusion, the ruling has created uncertainty in the financial sector which could have negative economic and social implications. Allowing lenders to deduct bad debts supports financial inclusion and economic growth, especially for those who need credit the most.

Fredrick Kimotho is an Associate Director and the Tax Policy Lead at Deloitte East Africa. The views presented are his own and do not necessarily represent those of Deloitte. He can be reached at Fkimotho@deloitte.co.ke and here LinkedIn.

This article was originially published on Business Daily here.