INVESTMENT: Why tax law reform is key to boosting private equity

This is the third part of our ten-part article series on the market, legal and regulatory perspectives of private equity in Tanzania. In the second part, we discussed key regulatory issues in private equity fund formation. In this third part, we focus on some of the most pressing tax issues for private equity (PE) funds/investors. The hope is that the government will offer some relief to PE investors when Finance Minister Dr Philip Mpango presents his 2018/19 Budget Speech in Parliament on Thursday.

Tax is an important consideration for PE investors when making the decision to provide finance to targeted companies in exchange for equity (ownership) stakes in the companies.

The importance stems from the fact that private equity returns are obtained after tax. Under the current tax law (the Income Tax Act, Cap 332 (R.E.2008), all gains on disposal of investment assets, including shares, attract capital gains tax.

That is so even if PE investors acquire shares with the purpose of growing the target company to eventually realise growth on disposal, usually after a 3-7 year long-term investment period.

However, shares listed on the Dar es Salaam Stock Exchange and owned by a person who controls less than 25 percent of the controlling shares of the company are exempt from this tax.

Tanzania has different rates of capital gains tax (CGT) for individuals and companies. CGT is payable at the rate of 30 percent on disposals of investment assets by companies, 20 per cent in the case of non-resident individuals (but subject to any relevant double tax treaty), and 10 in the case of resident individuals.

The application of different rates for resident and non-resident individuals is arguably contrary to the EAC rules on free movement of labour and capital if the two individuals, viewed objectively, are not in a different situation to justify the difference in treatment.

Furthermore, Tanzania’s CGT rate for disposal of assets by companies is relatively high compared to some of its peers in the EAC and SADC regional economic blocs.

The rate is 5 percent in Kenya and 22.4 percent in South Africa. Zambia and Mauritius both don’t tax gains on disposals of investment assets.

If we look to the history of CGT in Tanzania, we find that the old tax law (the Income Tax Act, 1973) provided for a lower rate of 10 percent.

There’s a view that low rates on gains made by PE investors are offset by the income tax already paid at the portfolio company level and that such rates encourage risk-taking, entrepreneurship, investment and growth.

A reversion to the lower rate of 10 percent would be viewed by PE experts and investors as reasonable.

The other pressing tax issue for PE investors is that Tanzania does not index CGT brackets to inflation or devaluation.

There’s no indexation clause in the current tax law which would allow investors to adjust the acquisition (original) cost of shares and other investment assets to reflect either inflation or devaluation.

Thus, shares acquired by a PE investor five years ago are deemed to have the same TZS value for cost purposes today. Risk is inherent with investing, but, for foreign PE investors, the effect of not indexing is to tax their gain in the local currency arising as a result of depreciation of the currency.

Although the acquisition cost of the shares can be deducted in calculating the gain, the absence of indexation will hurt PE investors who contractually commit to a long-term investment period.

Finance Minister Dr Mpango is under pressure to cut spending while funding key government programmes, and plugging the Tsh14.3 billion ($6.3 million) revenue shortfall when he presents his 2018/19 Budget Speech.

The 30 percent CGT rate on gains from disposals of investment assets by a company; the application of different CGT rates for individuals and companies; and the absence of indexation to adjust the acquisition cost to reflect inflation/devaluation are pressing tax issues for PE investors.

Their Budget wish-list contains a clear statement by the Minister that the specific issues above will be remedied to enhance Tanzania’s attractiveness for private equity investments.