How thin capitalisation rule impacts deductibility of interest

The thin capitalisation rule is a tax rule designed to curb excessive debt financing in corporations, especially when substantial ownership of the corporation is held by non-resident entities or person. In Tanzania, the essence of the rule is to restrict the deduction of interest expense on debts of a corporation that exceed a debt-to-equity ratio of 7 to 3. This ratio serves as a safeguard against companies with excessive debt financing arrangements which habitually reduces taxable profits of the paying entity.

In Tanzania, the rule applies to exempt-controlled entities with a substantial stake held by either a non-resident entity, charitable organisations, and other such shareholders. In accordance to the Tanzania Income Tax Act (“ITA”), an entity qualifies as an exempt-controlled resident entity if it is a resident entity, and at any point during the year of income (financial year) or if twenty five percent or more of its ultimate shareholding is held by entities, such as, approved retirement funds, charitable organisations, non-resident persons, or associates of such entities or person.

For purposes of testing the rule, there are two key considerations: debt and equity.

The ITA has defined debt as all debt obligations, except for non-interest-bearing debt obligations, debt obligations owed to resident financial institutions, and debt obligations owed to non-resident banks or financial institution on whose interest tax is subject to withholding in the United Republic of Tanzania. Consequently, any other debts, including intercompany debts, are part of the debts for purposes of testing the thin capitalisation rule.

On the other hand, the definition of equity was modified in 2022 thereby affecting the determination of the deductible interest expenses for businesses.

Before the changes were passed in the Finance Act of 2022, the definition of equity in thin capitalisation rule context was broad and included all items of equity as determined in accordance with Generally Accepted Accounting Principles (GAAP). Equity comprised three key components which were paid-up share capital; paid-up share premium; and retained earnings on an unconsolidated basis as determined in accordance with GAAP.

Following this change, the definition of equity was narrowed, and limited to the paid-up share capital of the entity at the end of the year of income.

Notably, this change disregarded the paid-up share premium and retained earnings of the company.

This modification affected calculation of the deductible interest expense for corporations falling under the purview of the thin capitalisation rule.

This is because, by narrowing the equity component to only paid-up share capital, businesses may find it more challenging to meet the required debt-to-equity ratio threshold.

As a result, interest expense on excessive debt beyond the prescribed ratio may be disallowed as a tax deduction, leading to higher taxable profits which will be subjected to corporate income tax.

Given the significance of the thin capitalisation rule on interest expense deductions, affected entities must be proactive in their financing strategies and careful consideration of the debt-to-equity ratio is crucial to ensure compliance with the updated equity definition. Consequently, proper apportionment of the amounts of debts and equity during the thin capitalisation rule test is essential.

It is therefore paramount that entities with considerable non-resident ownership and charitable organisations remain vigilant in their financing arrangements to avoid adverse effects on their tax liabilities.

Happiness Tarimo ([email protected]), a tax supervisor at KPMG East Africa in Tanzania. The views expressed here are the author’s and do not necessarily represent the views and opinions of KPMG