Simbarashe Hamudi
COMPANIES usually finance their operations either by debt or equity. Where a company is financed primarily by debt, it is deemed to be thinly capitalised. Thus, thin capitalisation can be described as the use of high proportions of loan to equity capital to gain tax advantages.
The Income Tax Act discourages thin capitalisation by limiting interest deductible for income tax purposes. The provision was introduced in 2001 initially to restrict thin capitalisation in the mining sector and extended to cover other sectors of the economy in 2003. In 2018 the Finance Act 2018 has amended it once again. Thus, with effect from the year of assessment beginning on January 1, 2018, any expenditure incurred by a local branch or subsidiary of a foreign company, or by a local company or subsidiary of a local company, in servicing any debt or debts contracted in connection with the production of income to the extent that such debt or debts cause the person to exceed a debt to equity ratio of three to one (for the purpose of this paragraph, “equity” means issued and paid-up capital, unappropriated profits, reserves, realised reserves and interest-free loans from shareholders.
Thin capitalisation rules do not apply if the debt or debts in question are contracted by a local company or subsidiary of a local company with a locally domiciled, registered or incorporated financial institution or other person ordinarily resident in Zimbabwe; and the contracting parties are not associated with each other, and have not colluded for the purpose of avoiding tax.
This means that interest or other related expenditure incurred on a debt contracted in connection with production of income which is in excess of 3:1 debt to equity ratio is disallowed.
However, where the debts are contracted by a local company or subsidiary of a local company with a locally registered financial institution or other person ordinarily resident in Zimbabwe, they shall be income tax deductible as long as the contracting parties are not associated with each other and have not made relations or collided for the purpose of tax avoidance.
Thus in computing the debt for purposes of the above ratio local debt from non-related parties (from financial institution or any other person) is excluded unless where there is a collusion with a related party. This means that debt from non-resident (foreign debt) whether from a related or non-related party is included in the computation of the ratio.
Associates are defined in section 2A as persons excluding an employee and his/her employer who act according to each other’s instructions, directions, requests, suggestions or wishes no matter the persons are in a business relationship or not. It covers a person and his/her near relative or a person and his/her partnership unless the Commissioner is satisfied that neither person acts in accordance with the directions, requests, suggestions or wishes of the other. Companies that are under the same control are deemed associates and, so are shareholders and the companies to which they are members.
The term “expenditure” is wide and looks at all costs associated with the debt, i.e. interest, foreign exchange loss on a foreign currency denominated loan, loan raising fees, administration fee etc. If the ratio of 3:1 is exceeded, any interest or related expenditure incurred on the excess debt is disallowed.
This applies to debt incurred in the production of income of a local branch or subsidiary of a foreign company, a local company (whether local or foreign borrowings) and a subsidiary of a local company. The restriction does not apply to a partnership, local or like authority, deceased or insolvent estate and a private trust.
In the scenario of thin capitalisation that is, debt in excess of equity, the excess debt is then reclassified as equity and the interest or other related expenditure on the reclassified debt is treated as dividend distribution by the company to its shareholders. These dividends are however subject to 15 percent Non-Resident Shareholder’s Tax when such interest is paid to a non-resident. Such interest does not however qualify for benefits envisaged in tax treaties.
In an international context, the difference between debt and equity may be a significant concern to the tax authorities, especially in relation to multinational companies for which finance planning is a tax-planning concern in any major corporate acquisition. There is however no significant definition of debt or equity for tax purposes. Some companies tend to get involved in thin capitalization schemes namely hidden capitalisation and back-to-back loans. Thin capitalisation can also be effected by channelling inter-company loans through international banks and other financial intermediaries, this is referred to as back-to-back loans, an example is where two related companies (X and Y) resident in different countries want to avoid thin capitalisation rules, company X resident in country A may lend money to an unrelated bank, then the bank lends the money to company Y in country B. The loan from the unrelated bank to company Y will not be subject to thin capitalisation rules of country B because it appears to be at arm’s length.
These thin capitalisation schemes have been an issue of concern to tax authorities and so the OECD has come up with ways to curb thin capitalisation namely the arm’s length approach and the fixed ratio approach (Base Erosion and Profit Shifting Action 4). The arm’s length approach provided for in the Income Tax Act mainly used for curbing transfer pricing risk can also be applied to curb thin capitalisation.
Under the fixed ratio approach, if the debtor company’s debts exceed a certain proportion of its equity capital, then the interest on the loan or the interest on the excess of the loan over the approved proportion is automatically disallowed or treated as a dividend.
The old thin capitalisation rules placed limit on non-related parties’ debt and locally contracted debt in addition to the related party debts. Thus it disallowed “any expenditure incurred by a local branch or subsidiary of a foreign company, or by a local company or subsidiary of a local company, in servicing any debt or debts contracted in connection with the production of income to the extent that such debt or debts cause the person to exceed a debt to equity ratio of 3 to 1. The revised thin capitalisation rules to exclude from limitation of deduction of interest and other related expenditure on debt to equity ratio exceeding 3:1 if the ratio is exceeded by reason of a debt contracted through a government credit facility by a public entity as defined in the Public Entities Corporate Governance Act.
l Hamudi is Tax Partner at Baker Tilly Central Africa, based in Harare, Zimbabwe. He can be contacted at +263 775 399 536 or simbarashe. hamudi@bakertilly.co.zw