What is EBITDA?

EBITDA refers to “Earnings Before Interest, Tax, Depreciation and Amortization”. EBITDA is applicable in financial situations in which a company is funded primarily through debt rather than equity.

Debt financing is often used as a tax strategy, as interest payments on debt are typically tax-deductible. This allows companies to reduce their taxable income by shifting profits to deductible interest, lowering their overall tax liability. As a result, companies may be incentivized to take on more debt, sometimes beyond prudent business levels.

While debt financing can offer significant tax benefits, it is often subject to scrutiny by tax authorities. When a company borrows excessive amounts of capital from its shareholders or related parties, it can result in a higher debt-to-equity ratio than what is considered reasonable for its industry or operations.

Regulatory Framework

Many countries have introduced specific regulations to curb abusive practices. These rules limit the amount of debt that can be used for tax-deduction purposes by setting thresholds for the debt-to-equity ratio or by restricting the deductibility of interest payments on excessive debt.

The intention behind such rules is to prevent companies from exploiting debt financing solely for tax advantages. Tax authorities are particularly concerned when the debt is provided by related parties, as this can lead to potential tax avoidance schemes. To counter this, many jurisdictions require that the debt-to-equity ratio be maintained within reasonable limits, often based on the company’s industry standards or capital structure norms.

In Kenya, Section 16 (2) (j) of the Income Tax Act (ITA) outlines guidelines for interest deductions. It stipulates that interest payments to non-residents cannot exceed 30% of the borrower’s EBITDA for any given financial year. If the interest exceeds this threshold, the excess may be carried forward and deducted in the following three years, provided the total interest on loans from non-resident entities does not surpass the 30% limit. Additionally, any exempt income must be excluded from the EBITDA calculation when determining the allowable interest deduction.

Case Law:

Car and General (Trading) Limited v Commissioner of Legal Services and Board Coordination (Appeal E667 of 2023) [2024] KETAT 1235 (KLR) (23 August 2024) (Judgment)

Background

The case revolves around the Appellant’s challenge of the KRA’s assessment regarding the exclusion of share profits from its associate company (Watu Credit Limited) and joint venture (Cummins C&G Joint Venture) in determining EBITDA, arguing both procedural errors in the assessment process and substantive issues regarding the correct interpretation of tax law.

Appellant’s Case

• The Appellant argued that the Assessment Order was vague, preventing identification of the specific adjustments leading to the additional tax assessment and hindering the ability to file a valid objection.
• The Appellant argued that profits from its associate company and joint venture should be included in EBITDA for calculating deductible interest expenses, as per International Accounting Standards (IAS) and IFRS, and should not be excluded as exempt income.
• The Appellant highlighted the lack of clear definitions for “EBITDA” and “exempt income” under the ITA, suggesting that in cases of ambiguity, the law should favor the taxpayer.
• The Appellant referred to an amendment in the Finance Act 2023 to Section 16 (2) (j) of the ITA, which clarifies the EBITDA rule, arguing that it underscores the ambiguity in the original provisions and should not apply retroactively to their case.

Respondent’s Case

• Before filing its tax returns, the Appellant sought advice and was advised through a private ruling, that according to Section 16 (2) (j) of the ITA and OECD guidelines, non-taxable income, such as branch profits or dividend income benefiting from participation exemption, should not be included in the EBITDA calculation.
• Despite advice from the private ruling, the Appellant included the share of profits from its associates and joint venture in the EBITDA calculation for interest expense restrictions.
• The Respondent issued an assessment on 6th June 2023, based on the Appellant’s failure to follow the guidance. The Appellant lodged an objection on 5th July 2023, which the respondent rejected, confirming the assessment on 23rd August 2023, totaling KShs. 49,566,383, including penalties and interest.
• The Respondent argued that the assessment was based on the Appellant’s non-compliance with the private ruling and tax law, and not the amendment brought about by the Finance Act, 2023.

Issues for Determination

• Whether the respondent’s income tax additional assessment was justified.

Court’s Determination and Verdict

• The Tribunal affirmed that the Appellant had received a private ruling from the Respondent, which advised that profits from associates and joint ventures should not be included in EBITDA calculations for interest expense deductions, in accordance with Section 16 (2) (j) of the Income Tax Act.
• The Tribunal further concluded that such profits were not considered taxable income under Kenyan tax law and that the Income Tax Act does not recognize group or consolidated tax accounting, thereby reinforcing the exclusion of these profits from the Appellant’s EBITDA calculation.
• The tribunal found that the respondent’s income tax additional assessment was justified.

Implications of the Ruling

• Strict Interpretation of Tax Laws: Tax laws must be applied based on their clear and ordinary meaning.
• Binding Nature of Private Rulings: Private rulings from the KRA are binding, and non-compliance can lead to additional assessments and penalties.
• Exclusion of Non-Taxable Income in EBITDA: Profits from associates and joint ventures benefiting from participation exemption are not taxable income and should not be included in EBITDA for interest expense deductions.
• No Group or Consolidated Tax Accounting: Kenyan tax law does not support group or consolidated tax accounting, meaning profits from associates and joint ventures cannot be included in the parent company’s taxable income.
• Impact on Tax Compliance: Taxpayers must prove compliance with tax laws and private rulings, as failure to do so can result in additional assessments and penalties.
• Handling of Legal Ambiguities: Tax laws are not automatically interpreted in favor of the taxpayer when terms are ambiguous; legal clarity is prioritized.
• Finance Act Amendments: Amendments to Section 16 (2) (j) in the Finance Act 2023 do not apply retroactively, emphasizing adherence to existing tax law.

This ruling sets a clear precedent on tax law application, the importance of compliance with KRA guidance, and the treatment of certain income types in tax calculations.

Conclusion

To ensure compliance with tax regulations and avoid potential legal and financial risks, it is crucial for businesses to carefully manage their debt financing strategies. Companies should regularly review their debt-to-equity ratios and interest deductions to stay within the limits set by tax authorities, such as the 30% EBITDA threshold in Kenya.

Maintaining a balanced approach to debt financing ensures businesses maximize tax efficiency without crossing into tax avoidance practices. We encourage companies to consult with tax advisors to navigate these complex rules effectively and ensure that their financing strategies are both compliant and optimized for long-term growth.

This material is intended solely for informational purposes and should not be relied upon without seeking specific professional advice on the matter. Should you have any questions regarding this topic, please feel free to contact our team at info@ke.andersen.com or +254 20 5100263.

Contributors & Contact Persons

Irene Masecko

Tax Associate

irene.masecko@ke.andersen.com

Marco Manyenze

Associate Director

marco.manyenze@ke.andersen.com