This is called equity (or equity financing). Another way is getting money from lenders in the form of long-term loans.
Generally, there are two broad ways a business can be financed on along-term basis. One is a contribution from the owners (or shareholders) of the business. This is called equity (or equity financing). Another way is getting money from lenders in the form of long-term loans. This is a debt financing. Some hybrid forms of financing mix characteristics of debt and equity but usually can be classified as mainly debt or equity in nature.
In practice, most of the businesses are financed by both equity and debt but the ratio of the two would vary from one business to another depending on various factors – both internal and external to the business.But, whether it is an equity financing, a debt financing or both, there are tax consequences that need to be taken into account.
Ignoring tax implications in financing decision-making canimpact the business profitability and in some cases, the impact can be severe.
Debt is tax advantageous
A debt is contractual and must be repaid within a pre-agreed time. In addition to repaying the debt, interest is, normally, also payable. Interest on debt financing is a business expense and generally, a deduction is allowable for tax purposes. Equity, on the other hand, is generally not repayable to business owners.
The owners expect to receive the distribution (or dividend) from the business profits. For tax purposes, no deduction is allowable for distribution or dividend made by the business to its owners. Therefore, debt financing tends to minimize income tax liability whilst equity financing does not.
Tax avoidance possibility
It follows that, if other factors are disregarded in business financing decisions and income tax minimization is taken as the only determining factor, a rational decision would entail financing a business with debt as much as possible and by equity as low as possible. This phenomenon is called “thin capitalization”.
Business owners or shareholders may hence decide to loan their business rather than contributing to equity just to get the tax advantage. Thin capitalization is one of the devices that can be used for tax avoidance and shifting of profits from one jurisdiction to another. It can also be used within the same jurisdiction if interest income to the owner-lender is taxed less than his business or not taxed at all in the period(s) of the loan.
Anti-avoidance and safe harbour
Cognizant of the possible tax planning opportunities around the debt or equity financing, the income tax law in Tanzania (The Income Tax Act, Cap. 332) has in place an anti-avoidance provision in respect of interest. The law restricts interest deduction of an exempt - controlled resident entity. An “exempt-controlled resident entity” is a resident entity owned 25 percent or more by non-resident persons, pension funds, charitable organizations or their associates.
For income tax purposes, the maximum amount of interest expense such a business can deduct is restricted an amount equivalent to a debt-to-equity ratio of seven to three (7:3). This essentially means that, for such an entity to claim the fulldeduction of interest expense, their debt should not exceed 2.3 times its equity in a particular year of income (“safe harbour”). The debt, in this case, exclude non-interest-bearing debts and debts from financial institutions.
So, it is imperative for these kinds of businesses to manage their debt-to-equity ratio within the safe harbour as otherwise, the restricted interest deduction will negatively hit their bottom line.
Mr Maurus is a partner with Auditax International