OPINION: The Finance Bill should protect small businesses in new tax proposals


OPINION: The Finance Bill should protect small businesses in new tax proposals
File image of Gikomba market in Nairobi. PHOTO| COURTESY

By Everlyn Muendo and Leonard Wanyama

Considering the ongoing effects of COVID-19 pandemic, this year’s Finance Bill 2021 for the budget of FY2021/22 is undergoing a great deal of scrutiny.

This is because the public is keen to know how these proposals will affect the common citizen, Wanjiku, as well as the budget’s impact on small businesses. The Finance Bill 2021 has introduced several progressive tax measures that are in line with international standards.

These measures aim to reduce the tax avoidance activities of multinational companies which have been estimated to cost Kenya USD565.8 million as reported in the recent Tax Justice Network (TJN) study on the State of Tax Justice.

Significantly, these tax measures include the introduction of a new definition of permanent establishments, that is, rules determining creation of a fixed place of business for foreign companies.

Secondly, the bill introduced a broader definition of what is ‘control’, that is how proprietorship of a company is recognized. This widens understanding of how enterprises are associated with multinational companies based on degrees of ownership. Thirdly, is the requirement for multinational companies to file group financial statements amongst other proposals.

While these efforts are highly commendable, a careful reading of these suggestions, is worrying because in an attempt to capture multinational companies, some of these measures are extremely harmful to small and medium enterprises (SMEs) in these difficult times.

Current Thin Capitalisation Rules

A good example is the introduction of new thin capitalisation rules. These are anti-tax avoidance rules that prevent companies from reducing their tax obligations. Generally, a person can deduct interest payments when calculating their tax liability.

However, corporations especially, multinational companies misuse this by structuring the financing of their activities using debt instead of equity. This is to increase their interest deductions thereby allowing them to avoid paying their fair share of taxes.

Current Kenyan law aims to curb this by limiting the amount of interest, foreign controlled companies can deduct using a ratio method. This provides that when the debt-to-equity ratio reaches the stipulated legal threshold then interest deductions cannot be made beyond that point.

This approach is limited to enterprises associated to foreign companies. This implies that only parent-subsidiary companies would be subject to deductions based on the stipulated legal threshold of the debt-to-equity ratio.

This restriction entails only parent-subsidiary companies, in which the parent company was a foreign entity, are prevented from making excessive interest deductions. Therefore, domestic enterprises would be not liable unless they were caught up in such arrangements of foreign association.

The New Rules

Rather than apply the debt-to-equity ratio, the new rules will cap interest deductions if the interest payments go beyond 30 percent of earnings. This new method has been widely adopted in various European countries as well as the United States and Canada.

It offers the advantage of closing tax avoidance loopholes previously misused under the debt-to-equity ratio method, such as the use of hybrid instruments incorporating both debt and equity to increase interest deductions unfairly. Further, it offers a broader scope for tax collection. This is because it not only applies to foreign controlled companies but also domestic enterprises.

The Risk Posed to Small Business

By coming under the purview of these new tax rules, local enterprises, especially SMEs face additional hurdles and costs of doing business.

A study by Financial Sector Deepening (FSD) Kenya in 2016, showed that SMEs prefer using debt financing as opposed to equity investments to bankroll their activities. Many SMEs are in the habit of multi banking, with some of them having been reported to be indebted with up to 8 banks.

Considering, the COVID19 pandemic, this reliance on debt has increased further, resulting in more businesses facing cash flow disruptions due to the pandemic. Therefore, reducing their ability to make interest deductions especially in light of unwavering interest rates will do more damage to their already weakened state.

Other countries such as the US and Canada have recognised the potential damage thin capitalisation rules have on small businesses considering the disruptive economic impact of COVID19. In Canada small businesses are exempted from limitations on interest deduction measures if they had less than USD 12 Million in gross receipts.

Meanwhile in the US, under the Coronavirus Aid, Relief, and Economic Security (CARES) Act similar measures are provided to increase the liquidity of small businesses in the wake of COVID19. This approach should be adopted in Kenya. The government must, therefore, be careful to ensure that even as they increase their tax base, they do not do so at the expense of small businesses.

Everlyn Muendo and Leonard Wanyama work for East African Tax and Governance Network (EATGN). Email: [email protected]

For Citizen TV updates
Join @citizentvke Telegram channel



Video Of The Day: CAS Rachel Shebesh and athlete Asbel Kiprop share their mental health journeys

Avatar
Story By Guest Writer
More by this author