Is your company adequately capitalised?

“Is your company adequately capitalised?” is a question asked not just by the shareholder and lenders to a company, but also by revenue authorities. In the context of tax, this is often addressed by thin capitalisation rules which look at the ratio between debt and equity - something that also applies in Tanzania. Not included in this year’s Budget speech, or Finance Bill, but then appearing in the Finance Act 2022 (FA 2022) was an amendment to the definition of “equity” for thin capitalisation purposes.

So, what is the issue? Well, a company is normally financed through either, or a combination of, debt and equity (capital). The way a company is capitalised can have a significant impact on its profit it reports for tax purposes; in particular, the higher the level of debt, the higher the amount of interest and consequently the lower profit (than if this funding were provided by way of equity).

While tax administrations accept the choice of a company to resort to borrowing, their concern is that such borrowing (particularly from related parties) should be supportable from a commercial perspective rather than a motive of tax efficiency. In particular, if you go to a third party bank and ask for a loan to your business, they will normally insist that you also put some degree of capital in. Similarly, if you seek a mortgage to buy a house, you will not get a 100 percent loan.

Tax legislation frequently also includes such a limit by way of a debt equity ratio. In the case of Tanzania’s Income Tax Act 2004 (“ITA 2004”), specifically section 12(2) ITA 2004, restricts the deductibility of interest expenses incurred by an entity based on a debt to equity ratio of 7 to 3 (i.e. 2.33). The restriction does not apply to any entity, but rather to what is termed “an exempt-controlled resident entity”, and in practice this tends to be of most relevance to companies in which non-residents have an underlying ownership interest of 25 percent or more.

The term “debt” is defined for thin capitalisation purposes to include any debt obligation except a non-interest bearing debt obligation and a debt obligation owed to a resident or a non-resident bank or financial institution on whose interest tax is withheld in Tanzania.

Before July 1, 2022, the term “equity” was defined to include: “paid up share capital, paid up share premium and retained earnings on an unconsolidated basis determined in accordance with generally accepted accounting principles”. This definition of equity benefitted profit making companies by inclusion of the retained earnings as equity; conversely, it disadvantaged loss making companies with negative retained earnings, who were then more at risk of being thinly capitalised.

Following the enactment of the FA 2022, the definition of equity for thin capitalisation purposes has been limited to only refer to paid up share capital. Whilst the purpose of the change is not clear, the impact of removal of express reference to “retained earnings” is clear. Less clear is the impact if any of the removal of express reference to “share premium” as this would in any case seem to fall within the “paid up share capital” (being the element of paid up share capital in excess of the nominal value of the shares).

In any case as the change is here to stay, any company with affected borrowings (”debt” as defined) should reassess its financing structure to evaluate the exposure towards non deductibility of the interest costs. On a case by case basis, the options could be increasing the paid up share capital through issuance of new shares, conversion of the intercompany debt/ loan to equity or repayment of intercompany loans and replacing them with debts from banks or other financial institutions.

On the other hand, this could be a relief to loss making companies as the exclusion of accumulated losses would increase “equity” (as compared to previously) and therefore improve the debt to equity ratio for thin capitalisation purposes. As such there may be companies that previously could not claim (partially or fully) their interest costs for tax purposes which may now be able to do so.

The change could also be good news to financial institutions as it may act as a reminder to companies that no deductibility restriction applies to borrowings from such institutions in contrast to borrowings from related parties or other non-financial institutions.

So, what actions do companies need to take? Well first of all they should consider whether they are affected by the thin capitalisation change. If so, they should consider whether there is a need to change the capital structure. In addition, they should consider whether they need to revise their instalment tax estimate (provisional tax) upwards or downwards. This is perhaps most urgent for companies with December year ends as their final opportunity to revise their estimated tax for 2022 is 31 December 2022, so just round the corner. Interesting times!

Neema Henry Nyandoa is an experienced senior associate, Tax Services with PwC Tanzania, Arusha office.