Introduced in the Finance Act of 2010, deemed interest refers to the notional interest assumed to be payable by a resident person on any interest-free loan provided by a non-resident person.
Essentially, it operates as a penalising provision, imposing a tax on non-existent interest. This provision is particularly controversial because the deemed interest is not deductible for income tax purposes, forcing taxpayers to pay taxes on ‘phantom’ income without the benefit of a tax deduction.
This raises a fundamental question: Is it time to reconsider, or even end, deemed interest?
Tax authorities always aim to limit excessive interest deductions to prevent tax erosion. However, in the case of deemed interest, the reverse happens whereby the Kenya Revenue Authority (KRA) imposes a penalty for non-deduction of interest.
This punitive approach places taxpayers in a disadvantageous position, forcing them to pay taxes on income they did not earn.
Deemed interest might be justified as a measure to prevent tax avoidance in specific scenarios, such as when related parties engage in interest-free financing where the lender recoups the foregone interest through a price discount on goods or services provided in the return leg by the borrower.
In this discounting mechanism, the financier effectively earns a return on the loan through a reduced sale price, which could be considered income and thus subject to withholding tax.
However, as it stands, the broad application of deemed interest targets all interest-free loans, regardless of whether there is an actual financial gain.
This creates artificial interest income and demands tax on imaginary earnings.
The specific scenario above also does not justify the non-deduction of the notional deemed interest. Section 3 of the Kenya Income Tax Act is clear: income tax can only be levied on actual income, that is income accrued in or derived from Kenya.
Deemed interest, by its nature, does not represent real income; it is a notional concept created by tax authorities. There are ‘deeming’ provisions in the Income Tax Act in respect of deeming whether income is of ‘Kenyan origin’, the accrual points of income and around payment dates.
But there are no provisions (other than the deemed interest provision) that deems into existence non-existent income.
This raises legal and one may say constitutional concerns. How can one tax imaginary income?
This provision could be seen as an unconstitutional deprivation of property. Taxes are typically paid out of actual income, but in the case of deemed interest, taxpayers are forced to pay taxes on income they never received.
The consequences of the deemed interest provision become even more apparent when one makes a comparison between discounting mechanisms and a ‘vanilla’ interest-free loan.
In the former, there is actual income in the financier’s hands due to the reduced sale price as alluded to earlier, which could arguably justify such a ‘penalty’ tax.
However, in the latter example, in the case of a simple interest-free loan, no income is generated.
Unfortunately, the latter tends to be most cases where interest-free loans arise. Despite this, the taxpayer is still required to pay withholding tax on this non-existent income.
This results in a profoundly unfair situation where individuals and businesses are paying taxes without having earned any corresponding income.
It is difficult to reconcile this outcome with principles of fairness and justice that are supposed to underpin tax law.
The idea of deemed interest, as it exists now, results in a situation where taxpayers are punished for earnings they never truly obtained.
Although it might have been designed as a measure to address tax avoidance in particular circumstances, its wide-ranging use has resulted in unforeseen, far reaching, and unfair outcomes, especially for foreign investors in high-risk sectors such as oil and gas exploration.
These companies frequently depend on interest-free loans from their non-resident related entities to fund their initial investments, and imposing taxes on these loans before any income has been earned raises the cost of operating in Kenya.
If Kenya is to establish itself as an attractive investment destination, the government must reconsider the application of deemed interest.
Providing clarity on this provision or removing it altogether would not only align tax policy with the principle that taxes should only be levied on actual income (or instances where there has been a circumvention of payment of withholding tax through a subsequent discounted sale) but would also make the country a more attractive destination for long-term investment.
Given the legal and practical issues at stake, it may well be time to end the concept of deemed interest.
The writer is a senior manager within PwC Kenya’s Tax Consulting Solutions business unit
