In February 2020, the Tax Appeals Tribunal delivered a decision that the High Court overturned. The Tribunal held that for any form of indebtedness to qualify as a loan for tax purposes, there must be a fixed charge, interest, discount, premium, or debt arrangement between the parties that provides that interest does not apply or would apply in the future.
In this case, the taxpayer is a company that sells, distributes, and installs generators in Kenya, a service it receives from its South African-based parent company.
The KRA conducted a verification audit on the taxpayer from 2014 to 2017, confirming the presence of trade balances with the holding company.
The KRA demanded withholding tax on deemed interest on the trade balances on the basis that they constituted interest-free loans.
The taxpayer lodged an appeal at the Tribunal on the grounds that the trade balances were simply transactional balances, which did not constitute a loan for tax purposes.
The Tribunal’s question was whether the outstanding amounts due to the holding company constituted ‘loans’ for tax purposes.
The Tribunal ruled in favour of the taxpayer and set aside the withholding tax assessment on the basis that there must be a fixed charge, interest, discount, or premium for any form of indebtedness to qualify as a loan based on the strict reading of Section 16(3) of the Income Tax Act.
The Tribunal’s view was that the absence of any interest, premium, or financial charge excluded the debts owed by the taxpayer from classification as ‘loans’, therefore rendering the KRA’s assessment erroneous.
If the KRA could have shown from the statutes that ‘loan’ included trade debts or other interest-free indebtedness without a financial charge, discount, or premium, it would have won out.
The Tribunal further stated that the taxpayer must benefit from such a lacuna until legislation redefines “loans” to include interest-free loans.
The KRA appealed to the High Court, arguing that the Tribunal erred by relying on the definition of ‘all loans’ instead of adopting the ordinary meaning of the term ‘loan’.
The High Court agreed with the KRA and overturned the Tribunal’s judgement on the basis that the Tribunal erred in concluding that there must be a fixed charge, interest, discount, or premium for any form of indebtedness to qualify as a loan.
The High Court further held that the Tribunal erred in failing to rely on the taxpayer’s financial statements, which classified amounts owed to the non-resident entity as “borrowings,” as proof of indebtedness.
The High Court held that if there is an indebtedness to a non-resident entity, withholding tax would apply whether there was interest payable or not; the only difference is that where there is no interest, deemed interest would apply.
This decision implies that trade balances or similar debt obligations resulting from transactions between a resident and a non-resident person may be considered interest-free debt, thereby triggering withholding tax on deemed interest.
Therefore, it’s important to carefully draft the documentation for these transactions to prevent unforeseen tax obligations.