On July 26, 2019, the Minister of Finance & Economic Development published the much-anticipated relaxation of the Income Tax Act provisions which restricted 100% deductions of interest expenses for companies, much to the amusement of the corporate world.
The proposed amendment, published through Income Tax Amendment Bill 2019, comes after rigorous lobbying by business for the amendment of the recently introduced thin capitalisation law which was enacted on December 31, 2018.
The effect of the December 2018 law was to effectively limit interest expenses incurred by corporates as from July 1, 2019 as tax deductions. Previously, every company could claim 100% of its interest expense but the law limited it to 30% of what is known as Tax EBITDA, effectively increasing corporate tax.
This is one of the fiercely opposed tax laws in the past decade, which businesses argued would dampen the investment mood, constrain economic growth, hamper infrastructural development, restrict employment creation and lead to a spike in taxes. The recent proposed amendment is a clear sign that the tax authorities treated the concerns and fears of business regarding the negative effects of the law seriously.
The recent proposed amendment seeks to exempt variable rate loan stock companies (huge corporates which usually build malls) and micro, small or medium enterprises (SMEs) from the provisions of the interest deduction limiting law. Banks and insurance companies were the only entities exempt from this law. SMEs are defined in the new bill as any company which does not belong to a group. A company is regarded as belonging to a group if it owns more than 20% shareholding in another company or when another company owns at least 20% of its shareholding.
Technically, any company which belongs to a group will still have its interest deduction for tax limited and will most likely suffer heavier tax bills.
Presenting the 2019/2020 budget on February 4, 2019, the Dr K Matambo stated that, ‘The amendment to the Income Tax Act also introduced … Thin Capitalisation provisions. Thin Capitalisation is when a company is financed through a high level of debt compared to equity. The Thin Capitalisation provisions seek to restrict the amount of interest on debt, which would reduce a company’s profits and thereby reduce its tax payable.’ Whilst thin capitalisation laws are acceptable practices internationally, business felt that the December 2018 law was rather too stringent and would have negative effects on the economy in general.
The Income Tax Act was amended in December 2018 to limit the interest expense for all companies (including associations, societies and public trusts) to 30% of what is referred to as tax EBITDA. Effectively, what this meant is that before the stated December 2018 amendment, companies could deduct 100% of their interest expenses, without having to worry about any limitations. The limitation meant that interest expenses, including that payable to banks, shareholders and other financiers would no longer automatically qualify as a tax deduction. The effect of that is to increase the amount that would be subjected to company tax, thereby leading to a spike in taxes. As an example, if a company was supposed to have taxable income of say P8m (on which corporate tax of P1.76m would be payable), the interest deduction limit could result in an additional adjustment raising taxable income to say P10m, therefore increasing tax bill to P2.2m.
Most affected businesses
Business argued that the problem with the December 2018 law is that it technically frowns at businesses which bear interest genuinely borne in running their businesses such as financing expansion into a new area or expanding operations. This is the reason why business felt that the law would reduce
The entities which were severely affected by this law were property development companies, particularly Variable Rate Loan Stock companies which develop massive malls such as Game City, Riverwalk and Airport Junction. The capital structure of these entities is divided into linked units, which comprise equity and debt, and the debt generates massive interest expenses. Variable Rate Loan Stock Companies are the preferred property investment vehicles into property by pension funds as the returns are high and the interest expense was always not limited for tax purposes.
Following the removal of the publication of the proposed interest limitation on these entities, there is likely to be more appetite in investment into the property sector, as was previously the case. In fact, the tax treatment of these entities has just been restored to what it was before December 31, 2018, i.e. they could deduct 100% of their interest expenses.
Other property developers who are not variable rate loan stock companies have however not been exempted from the law, which means that their tax costs will spike.
Mines have also been left in the cold as they were not catered for by the recent Bill. It is common knowledge that mines need hundreds of millions in loans in order to finance their operations. The limitation of their interest expense would certainly lead to less expansion of the critical economic sector and reduce employment creation. It is also possible that prospective mining projects that were to be established in the country may be directed to other countries, causing a deep in FDI.
Further profitable miners are taxed at a minimum of 22% and a maximum of 55%, depending on their profitability. The more profitable the mine, the high the tax rate. The interest limitation for tax purposes exacerbates the miners’ tax situation by increasing the tax bills of these already highly taxed enterprises.
Lastly, any capital-intensive business will also need to get used to higher tax bills as they have not been considered for the exemption. It was expected that manufacturing enterprises will also be exempt from the interest limitation, given their critical significance in the economy. Chain stores also require a lot of financing to restock and expand their operations but they also did not make it to the list of exempt entities.
Since SMEs are no longer affected by the law and any company which holds at least 20% shares in another or which has any other company holding more than 20% of its shares will still be required to limit interest deductions, the law is likely to see corporates reconsidering their group arrangements, if the tax bills bite.
Some may have to sell off their shareholding to qualify as SMEs so that their tax bills remain in check. The new amendment, whilst welcome, may mean that within the same group, some group entities will have their interest expenses limited whilst some will not, depending on the shareholding structure. This calls for careful consideration of the laws by business.
It is also possible that those industries which feel that they have a strong case for not having their interest expenses limited will continue to lobby the tax authorities for exemption from the interest deduction for tax purposes.
*Jonathan Hore is a managing consultant with Auprecon Tax Specialists