Thin capitalization

Consider a comparison between a company that secures an interest-bearing loan locally and one that sources a loan from abroad. For tax purposes, the two sources of financing have distinct implications under the thin-capitalization rules. Thin capitalization refers to the situation in which a company is financed through a relatively high level of debt compared to capital injection by shareholders’ equity.

Even though businesses have the right to decide on their financing arrangements, those financing arrangements impact the amount of profit reported, hence the tax payable to the tax authorities. This is why laws provide for restrictions with respect to the financing of companies to halt tax base erosion resulting from tax-adverse financing schemes that companies may adopt. In certain instances, investors may use debt financing as a tax loophole, considering that the interest is an allowable expense for income tax purposes.

However, deductibility of interest expense depends on sections 11 and 12 of the Income Tax Act Cap 332 [R.E 2023] (the “ITA”). The sections provide that the borrowed money must be employed wholly and exclusively in income generation or used in acquiring an asset to be used in income generation. Further, the ITA requires that a corporation's financing arrangement not exceed a debt-to-equity ratio of 7:3. This implies that in Tanzania, for tax purposes, businesses are allowed to operate in such a way that 70% of the finance is sourced externally, being more than 2 times the equity. For the above, the equity is defined as a paid-up share capital and positive retained earnings only, and debt as any debt obligation, excluding, among other things, “debt obligation owed to a resident financial institution”.

The introduction of these provisions of the ITA aimed at protecting Tanzania’s tax base by reducing the shifting of profit to overseas jurisdictions. The Tanzania Revenue Authority (“TRA”) has no right to tax the interest paid to foreign lenders except through a withholding tax mechanism. However, the TRA has the taxing right to interest paid to local lenders, i.e., resident financial institutions.

In recent tax audits, we have seen the TRA restricting interest on loans obtained from local financial institutions for establishing the allowable interest expense. The contention here is that the law excludes debt obligations from resident financial institutions but does not explicitly exclude the corresponding interest expense. It is an obvious, severe interpretation of the law. This interpretation does not serve the intentions of the provisions in the sections above. One would imagine that the restriction intends to limit deductibility of excess interest, and especially discourage the use of foreign debt financing to ensure no base erosion and profit shifting. The interest expense paid outside Tanzania is an income repatriated to other jurisdictions.

However, for loans sourced from local financial institutions, the interest income earned by these institutions is taxed at a rate of 30%, and there is no profit shifting. Thus, restricting deductions on interest incurred on loans from local banks is contrary to the law's objective. The intention of excluding debts owed to local financial institutions was to promote local financing, ensure no profit shifting, as interest income is taxed in Tanzania. In substance, the TRA position results in double taxation, bearing in mind that both the borrower and lender are resident persons, where the TRA has tax rights to both.

The restriction based on the debt-to-equity ratio makes more sense to be applied to overseas debt financing rather than local financing. It is important that local funding is encouraged, so that more profit is generated within the country and is taxed within Tanzania. For clarity, we may consider an amendment to section 12 to exclude interest expense from local banks for restriction testing, as it has excluded debt owed to these banks. It will increase access to local loans and maximize profits in the finance sector, which has witnessed some tremendous growth in recent times.  

Yusuph Jackson is a Senior Tax Consultant with Deloitte Consulting Limited. The views presented are his own, not necessarily those of Deloitte. He can be reached at yujackson@deloitte.co.tz.