Executive summary

On 19 March 2024, the High Court of Kenya issued a ruling in favour of the Kenya Revenue Authority (KRA) affirming the applicability of withholding tax on deemed interest. Deemed interest applies where no interest is charged on loans from nonresident persons.

The High Court found that the Tax Appeals Tribunal (TAT) erred in its interpretation of the term "all loans" and deemed interest as per the Income Tax Act (ITA). Further, the High Court held the TAT erred in concluding that there should be a fixed charge, interest, discount or premium for an indebtedness to qualify as a loan.

The decision reaffirms the applicability of deemed interest and withholding tax on that deemed interest for interest-free loans provided by nonresident persons.

Detailed discussion

Background

The KRA conducted an audit on Socabelec East Africa Limited (Respondent) and concluded that the Respondent had interest-free borrowings from nonresident entities. As such, the KRA assessed withholding tax on deemed interest on these borrowings.

The Respondent appealed at the TAT and won the appeal on the basis that the debts owed by the Respondent did not qualify as "loans" under the ITA due to the absence of a financial charge, interest, discount or premium. The KRA appealed to the High Court.

Appellant's arguments

The KRA (Appellant) argued that the TAT misinterpreted the definition of "all loans" by restricting it to Section 16(2) and 16(3) of the ITA and failing to recognize that deemed interest applies to interest-free loans provided by nonresident persons.

The Appellant argued that the TAT's strict interpretation of Section 16(3) caused the debts to not be classified as loans. The Appellant emphasized that the ordinary principles of statutory construction should apply and that the TAT should have applied the ordinary meaning of "loan" rather than a restrictive interpretation that there has to be a fixed charge, interest, discount or premium for an indebtedness to qualify as a loan.

Further, the Appellant referred to the Respondent's financial statements, which classified the amounts as borrowings, being proof of indebtedness.

Respondent's arguments

The Respondent argued that the borrowings were transactional supplier balances and not loans as defined under the ITA.

The Respondent further argued that Section 16(3) of the ITA imposes deemed interest if there is interest, premium or financial charge on the supplier balances, which was not the case under the instant facts.

High Court determination

The High Court, having considered the appeal, determined that the TAT erred in its interpretation of the term "all loans" and the application of deemed interest.

The High Court determined that the TAT's strict interpretation was not in accordance with the ordinary meaning of a loan and that the absence of a fixed charge, interest, discount or premium does not exclude the Respondent's debts from being classified as loans.

The High Court held that withholding tax applies to any indebtedness to a nonresident entity, regardless of whether interest is payable. The Court clarified that if no interest is payable, deemed interest applies at the 91-day Treasury bill rate as provided in the ITA.

Implications

The High Court's decision affirms the application of withholding tax on interest-free loans from nonresident entities. It establishes that such loans are subject to deemed interest and that financial statements classifying amounts as "borrowings" can serve as proof of indebtedness.