The Purpose for Thin Capitalization Rules

Thin capitalization rules have usually been implemented to limit tax avoidance by companies. It limits engagement in tax planning by way of debt shifting.

The thin capitalization rules disallow interest expense where the debt-to-equity ratio is 3:1, for tax purposes.

However, for companies in the extractive sector (i.e. mining, geothermal, petroleum), the disallowed interest expense applied to the debt-to-equity ratio of 2:1.

(“Debt” comprises all types of financial indebtedness).
(“Equity” comprises all classes of share capital including redeemable preference shares).

Ingredients for Thin Capitalisation

Under Clauses 8(2)(d) and 8(3) of the VAT Act and Clause 16 of the VAT DMS Regulations, the following services are subject to VAT, as long as they are supplied by a non-resident digital service provider to a consumer based in Kenya.

  1. A company incorporated in Kenya and is controlled by a non-resident whether alone or together with less than four persons. (A company is considered to be “controlled by a non-resident” where the non-resident holds at least 25% or more of the issued share capital in the company); and
  2. The interest charged exceeds the company’s more than three times the revenue reserves (including accumulated losses) and the issued and paid-up capital, at any time during the year.

Of Note:

  1. Thin capitalization does not apply to banks or financial institutions;
  2. Branches are also not subject to thin capitalization restrictions. However, subsidiaries are; and
  3. Thin capitalization rules apply to companies’ borrowing whether locally or internationally. They apply whether the financing is from a financial institution or its associated body (parent company).
  4. Foreign exchange losses in respect of loans (whether realized or unrealized) are postponed until the Kenyan company ceases to be thinly capitalized (they are not tax deductible).
  5. Deemed interest rates on interest-free loans from non-resident-associated bodies are not deductible. It, therefore, attracts withholding tax at the prevailing rate. (Deemed interest rate each quarter is based on the average 91-day treasury bill rate).

Please note that this legal article is for information purposes only and should not be relied upon without legal consultation. Should you have any questions, please feel free to contact us.