The High Court has overturned the decision of the Tax Appeals Tribunal on deemed interest

The High Court has overturned a decision of the Tax Appeals Tribunal delivered in February 2020 where 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 a debt arrangement between the parties which provides that interest does not apply or would apply at a future date.

The taxpayer in this case is a company engaged in the business of sales, distribution, and installation of generators in Kenya which are supplied by its holding company based in South Africa. The KRA carried out a verification audit on the taxpayer for the years 2014 to 2017 and it was established that the taxpayer had 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 grounds that the trade balances were simply transactional balances which did not constitute a loan for tax purposes. The question for determination by the Tribunal was whether the outstanding amounts due to the holding company constituted ‘loans’ for tax purposes.

The Tribunal ruled in favor 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. It was the Tribunal’s view that absence of any interest, premium or financial charge excluded the debts owed by the taxpayer from classification as ‘loans’ and therefore rendering the KRA’s assessment erroneous.

The KRA would have made its case if it was able to demonstrate from the existing statutes that the term ‘loan’ included trade debts or any other form of indebtedness which is interest free or in respect of which no financial charge, discount or premium is paid. The Tribunal further stated that until there is legislation that defines ‘loans’ to include interest free loans, the benefit of such a lacuna must be given to the taxpayer.

The KRA appealed to the High Court and argued 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 judgment 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.

The implication of this decision is 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. Consequently, documentation relating to these dealings should be drafted carefully to avoid unintended tax obligations.