Thin Capitalisation Norms in Tanzania

Thin Capitalisation in Tanzania

Introduction

Thin capitalisation refers to the situation where a company is financed through a relatively high level of debt compared to equity. 

Generally, interest expense incurred by an entity on funds borrowed for use in generating business income is an allowable tax deduction under Section 11(2) and Section 12(1) of The Income Tax Act, 2004. However, Section 12(2) imposes restrictions on the deductibility of interest expense incurred by an exempt-controlled resident entity where the debt-to-equity ratio of 7 to 3 exceeds the provided limits.

Section 12(4) of The Income Tax Act, 2004 states that where there is a change of the amount of debt or equity, the amount of equity or debt shall be the average of balances of amount of debt or equity at the end of each period.

Key Definitions 

“Interest expense”

1. Interest incurred by a person during a year of income under a debt obligation shall be treated as incurred wholly and exclusively in the production of income from a business if the debt obligation was incurred in borrowing money employed in the business or to acquire an asset that is employed during the year of income in the production of the income. In any other case, the debt obligation was incurred wholly and exclusively in the production of the business income.
2. The total amount of interest that an exempt-controlled resident entity may deduct for a year of income shall not exceed the sum of interest equivalent to debt-to-equity ratio of 7 to 3. 

“Exempt-controlled resident entity” is an entity which is resident during the year of income and at any time during the year of income 25 percent or more of the underlying ownership of the entity is held by entities exempt under the Second Schedule, approved retirement funds, charitable organisations, non-resident persons or associates of such entities or persons. 

‘’Debt’’ defined under the income tax act as any obligation excluding a non- interest-bearing debt obligation; a debt obligation owed to a resident financial institution; a debt obligation owed to a non-resident bank or financial institution on whose interest tax is withheld in the United Republic.

“Equity’’ means paid up share capital at the end of the year of income (as per The Finance Act, 2022 which substituted the earlier definition of equity which was made up of paid up share capital, paid up share premium and retained earnings on an unconsolidated basis in accordance with generally accepted accounting principles as per The Income Tax Act, 2004).

“Period” means a month or a part of month. 

Need for Thin Capitalisation Provisions

Thin capitalization provisions are in place as an anti-avoidance measure to ensure that a cross-border transaction is based on “arms-length” principle to avoid a profit shift and protect a country’s tax base. The result of such a profit shift is that the profits can be shifted to a low-tax jurisdiction, and/or an interest deductibility permitted in the other tax jurisdiction, with the result that the taxable income of such a party is reduced and less tax is collected and payable in the other tax jurisdiction.

Overview

The level of debt in the capital mix of a company is a crucial managerial decision since it affects the shareholders' return and risk. 

On the one hand, debt or loan as a finance source is considered cheaper than equity because the debt option improves dividend payable to shareholders. Apart from the dilution of earnings, there is also the question of ownership and control associated with the issue of shares. 

On the other hand, there is a problem of an increased cost of capital, reduction in firm value, and bankruptcy cost due to financial distress associated with high financial leverage.

The general assumption on the link between financial leverage and financial distress or failure is that highly geared firms have a higher degree of risks because of the potential of default in effecting payment of interest expense leading to bankruptcy or liquidation.