Double trouble: Why taxing retained profits could backfire

By Godfrey Mramba

To boost domestic revenue, the government has proposed a notable shift in income tax law: introducing a withholding tax on retained earnings — that is, on profits a company chooses not to distribute as dividends. Announced in the recent Budget Speech, the proposal has sparked debate among business leaders and lawmakers who worry that it may create unintended consequences for investment, cash flow, and long-term planning.

And understandably so. Because, while “retained earnings” sounds like cash stashed away under the CFO’s mattress, it often isn’t. Retained earnings are just an accounting entry - a record of cumulative profits not yet paid out as dividends. That money is frequently tied up in inventory, receivables, or equipment.  You cannot take it to the bank and ask to exchange it for shillings.

Under the new proposal, companies will have six months to pay dividends or face a 10 percent withholding tax after filing financial statements. This means that companies will be taxed 12 months after the end of their financial year, even if they haven’t distributed a single shilling in dividends.

To be clear, Tanzania is not alone in wanting more revenue. Governments around the world are grappling with that challenge. But how they do it matters.

Let’s take Australia, for example. They also tax corporate profits, but they use what’s called a “franking credit” system. This means that when the company pays dividends, shareholders get a credit for the corporate tax already paid. It’s a neat way to avoid double taxation, taxing the same money twice.

The US? Not so generous. Shareholders there don’t get any credit. Profits are taxed at the company level (21 percent), and then again at the shareholder level (up to 20 percent on dividends). Yes, they’ve made peace with double taxation, but at least it’s only when money is paid out.

Now, it’s true that corporations are separate legal entities — the law treats them like artificial people. But let’s not forget: they don’t exist for their amusement. Their profits ultimately belong to the shareholders, who are the real owners. So when the company pays corporate tax and then shareholders pay tax again on dividends, we’re effectively taxing the same income twice. That’s what I mean by double taxation.

In Tanzania, companies already pay 30 percent corporate income tax. While the proposed 10 percent withholding tax on retained earnings may be credited against future dividend tax, it effectively raises the tax burden in the year of dividend retention to 37 percent, even if the overall tax may remain the same over time. It accelerates taxation and sends a message that companies should ideally distribute all profits, a shift that could discourage reinvestment and prudent cash flow management.

This brings me to the season’s phrase: “premature dividend.” This concept sounds like a personal problem, but it is a tax one. Companies facing a looming 10 percent tax on undistributed profits may feel compelled to declare dividends sooner than they should, even when it’s not financially prudent.

That means:

* Paying dividends when there’s no cash could lead to borrowing to make the payout.

* Cancelling or delaying planned investments that create jobs and expand businesses.

* Making business decisions based not on commercial merit, but to avoid a tax trigger.

Economists call this: suboptimal outcomes — a fancy way of saying “bad decisions made under pressure.” Worse, it leads to the erosion of financial discipline. Businesses thrive on strategy, capital buffers, and smart reinvestment.

 The Minister for Finance, in his defence, says this is about broadening the tax base. But let’s be honest: it’s not broadening the base. It’s deepening the tap on the same base. We’re not taxing new income sources or bringing new taxpayers into the net. We’re taxing the same profits twice, first as income, then again as retained earnings.

And all this to raise Sh131 billion yearly, or roughly Sh11 billion monthly?

Now, I don’t want to sound unpatriotic. I know we need to raise revenue. But at what cost? If our monthly domestic revenue is already Sh2.8 trillion, we’re shaking up corporate finance for just 0.4 percent of collections.

That’s like selling your fridge to save on electricity, only to realize you have nowhere to keep your milk.

So what can be done?

If we want more dividends, let us focus on measures to encourage business and investment activity, and with that increase the pool of profits available for distribution as dividends     . Even in Australia, policymakers recognize that investment fuels growth more than tax penalties do.

Because if you start taxing companies for not paying dividends, don’t be surprised when they start doing so prematurely, even when they shouldn’t. And that’s when the fridge goes, and “the milk sours” or in Kiswahili “maziwa yanageuka mtindi.”

Godfrey Mramba is Managing Partner at Basil & Alred. The views expressed do not necessarily represent those of Basil & Alred. [email protected]