Tanzania in International Tax Law: How tax bias to debt finance hinders startups, innovation

One of the striking economic distortions in the Tanzanian economy created by the principal law relating to income tax, the Income Tax Act 2004, is that Tanzanian domestic firms and multinational companies often prefer debt financing over equity financing when constructing their capital structure for investments.
This is largely because of the tax advantage attached to the use of debt financing. In precise, interest incurred on loans is generally deductible for income tax purposes while equity returns (dividends or capital gains) are not.  
Let’s say that in one of Tanzania’s administrative regions, Tabora, there are two private limited companies, namely, ‘Swetu Invescorp’ and ‘Katukamoto Holdings’ looking to expand their business operations internationally.  
Swetu Invescorp obtains a loan from a commercial bank to finance its business expansion. In arriving at the tax measure of profits, the current tax law in Tanzania permits this company to deduct the interest payments it makes on the loan repayments.  
On the other hand, Katukamoto Holdings finances its business expansion by obtaining equity finance—that is, capital from investors in exchange for ownership stakes in the company.
When the equity-financed business expansion generates a profit, Katukamoto Holdings would have to pay to the Tanzania Revenue Authority withholding tax on gross dividend payments made by Katukamoto Holdings to investors, in addition to corporate income tax on its chargeable income. In short, Katukamoto Holdings is handicapped in its quest for business expansion with a second layer of taxation.  
Meanwhile, all other things being equal, Swetu Invescorp is accorded a better tax treatment than Katukamoto Holdings as regards the after-tax return on investment since the Tanzanian income tax law does not allow a deduction for Tanzanian corporate income tax in respect of dividend payments by a company.
SMEs and start-ups continue to struggle to obtain credit. With no credit rating, few assets to use on collateral for loans and no or little official track-record of accessing bank lending, it is tough for SMEs and start-ups to get debt finance from commercial banks.
More than 90 percent of the initial capital of SMEs and start-ups was obtained from principal owners and their family members, according to recent surveys of private sector businesses in Tanzania. This implies that many SMEs and start-ups are not able to access debt finance in the form of unsecured as well as secured loans. Instead, they face two levels of taxation imposed on earnings from equity-financed investments.
Research and development (R&D) and innovation is a major engine of economic growth and, ultimately, national development of a country. Yet, R&D and innovation start-ups must generally turn to equity financing, rather than debt financing, for investment.  The reason is that R&D projects are riskier and, thus, it is difficult for technology start-ups to raise funding for R&D from debt financing.
Investment in R&D hardly generates tangible assets that can be used as collateral and claimed by the lender if the project fails. And as outcomes are highly uncertain, bank lenders will want to charge outstandingly steep interest rates.
The inequitable tax treatment of debt financing and equity financing in Tanzania’s Income Tax Act, 2004 means that the SMEs and start-ups that make up nearly 90 percent of private sector businesses in Tanzania are subjected to a tax disadvantage.
So, what can tax policymakers in Tanzania do to remove this economic distortion stemming from the tax-induced bias in favour of debt financing instead of equity financing? One way is to either reduce the tax deductibility of interest. However, reducing interest deductibility does not extinguish the big bias towards debt financing completely, and it still leaves room for tax avoidance—using the tax law to gain a tax advantage not intended by the Parliament of Tanzania.
Another way is to introduce a deduction for the normal return on equity, equivalent to the rate of Treasury bonds (T-bonds). Beyond removing debt bias, economic experts say this deduction allowance would lead to more investment, increased wages and higher economic growth.
But this represents a cost on much-needed public revenues which, in the short run, could be minimised by restricting the allowance only to new investment. In the long run, however, the cost is expected to be much smaller as the favourable effects of the policy change would broaden the Tanzanian tax base.
International trade, investment and tax policy are intimately linked. As an important steering policy tool, tax policy may support Tanzanian domestic firms to directly invest in overseas territories, as outward investors, and ‘flying the national flag of Tanzania high’.  
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Paul Kibuuka ([email protected]), a tax and corporate lawyer and tax policy analyst, is the CEO of Isidora & Company and the Executive Director of the Taxation and Development Research Bureau.