David Tarimo: Why it’s time we reconsidered our options on taxing retained earnings

Currently, Tanzania’s income taxation basis for a company and its shareholders is corporate income tax (at 30 percent of taxable profit) and withholding tax on dividend payments to shareholders (at 10 percent). So, a company with profit of 100 bears income tax of 30 and remains with profit after tax of 70, which as and when paid as a dividend triggers withholding tax of 7; accordingly, the effective tax rate on distributed profits is 37 percent.

The recent budget speech and Finance Bill proposed a 10 percent withholding tax on retained earnings after six months from the date of filing income tax returns.  The practical effect is to deem a company to distribute earnings not paid out as dividend within twelve months of the end of an accounting period.  The private sector has articulated various concerns with this proposal.

The implicit message of the change seems to be that dividend declaration practice should be to immediately pay out 100 percent of profits for a year.  However, such a distribution policy is not normal practice - some funds are normally retained whether to cover ongoing business activities including further investment; or out of prudence to deal with uncertain future cash flows - for example, a business dependent on commodity prices, or unsure of debtor repayment timelines; or to comply with regulatory requirements. 

Accrual basis accounting does mean that retained earnings do not necessarily match equivalent distributable cash.  For example, a company may have significant investment that is being written off over a long period of time for accounting purposes but which has already been paid for.   A 100 percent payout approach might mean the need to resort to increased borrowing (and consequent interest costs) for the company; increased debt could also result in increased liquidity challenges during an economic downturn.  Even if in practice the tax change does not change corporate dividend policy, the need to fund the tax on retained earnings will still deplete cash reserves or increase borrowings.

If enacted there are areas that will require clarification.  Firstly, it is assumed that this tax is not retrospective; in other words, it will apply to future profits and not cover historic retained earnings.  Secondly, so as to avoid double taxation it is assumed that a dividend withholding tax account will be kept to match withholding tax on deemed dividends with future actual dividend payments (resulting in increased administrative cost and complexity).  While this should deal with the local double taxation risk, further review may be required to confirm that overseas shareholders in receipt of dividends will not have practical difficulties in claiming credit for the attributable tax on retained earnings. 

In practical terms this change (to automatically tax retained earnings) can be seen to remove (for tax purposes) the corporate veil between a company and its shareholders as there is no longer an effective distinction between corporate income tax and dividend withholding tax.  If so, why not increase the corporate income tax rate and remove dividend withholding tax?  This would also avoid the administrative complication of monitoring deemed dividends with actual dividends. 

However, the disadvantage of such a system (higher corporate income tax, and no dividend withholding tax) would be to have a higher headline corporate income tax rate than the region, and to buck the global trend for reduced corporate income tax rates.  In addition, it might reduce tax credits available to overseas shareholders when taxed in their home jurisdictions on dividends paid out of Tanzania (unless there is a mechanism to treat a component of the corporate income tax as an advance payment of dividend withholding tax to be credited as and when dividend withholding tax becomes due). 

So, what other options are there?  Well, we could consider an approach adopted in certain other jurisdictions that apply a tax on retained earnings, which is to limit this tax to specific scenarios involving benefit to a shareholder other than by way of receipt of a dividend - for example, loan to a shareholder, payment on behalf of or benefit availed to a shareholder, transaction at undervalue with shareholder (share buyback, debt forgiveness, asset transfer) - in essence what may be described as a “disguised dividend”.  This narrow scope is what applies in India, Kenya, and South Africa and may be what we should consider in Tanzania. 

Ultimately, the pathway to increased receipts from withholding tax on dividends is an increased pool of retained earnings from which dividends can be paid, which is achievable with further improvement of the business and investment environment, including addressing any issues currently detracting or delaying investment.

David Tarimo is Chairman of The CEO Roundtable of Tanzania. These comments are personal views and not attributable to any particular organisation