Interest expense deductions: Why banks should be exempt

Capital flight through excessive interest expense deductions for companies has long been and is still a concern for developing countries. Capital flight occurs when money made in a developing country moves from that country to a developed country.
In order to restrict capital flight through excessive interest expense deductions, countries such as Kenya, Rwanda and Tanzania have restricted the amount of interest that a foreign controlled company that is not a financial institution, can claim as a deduction. Where the debt of a company exceeds its equity, the interest expense claim of such a company is restricted based on the ratio by which debt exceeds equity.
Prior to July 2018, the tax laws in Uganda restricted the amount of interest that a foreign-controlled company can claim as a deduction based on the debt to equity ratio of the company.
This restriction did not apply to interest paid to banks and was widely seen as an attempt to curb capital flight through interest payments by companies that are heavily indebted. This was in addition to a 15 per cent tax on branch profits over and above the 30 per cent tax on profits generally paid by companies in Uganda.
However, effective July 1, 2018 the above interest expense restriction was removed and replaced with a restriction based on the tax earnings. The amount of interest that can be claimed as an expense by a company that is a part of a group is now restricted to 30 per cent of the tax earnings before interest.
This restriction applies to both foreign -controlled companies and Ugandan companies; banks inclusive.
The limiting of interest expense deductibility based on a company’s tax earnings was drawn from a recommendation by the Organisation for Economic Cooperation and Development (OECD), an intergovernmental economic organisation with more than 36 member countries, founded in 1961 to stimulate economic progress and world trade.
In its recommendations, the OECD noted that limiting of interest expense deductibility should not be applied to financial institutions such as banks because of the specific features of the industry. Banks mainly use depositors’ money to earn income and as such, the interest paid to the depositors is their biggest operating cost. Capping this cost may significantly affect the operations of the banks.
In addition, access to finance remains one of the biggest challenges for small and medium enterprises. This is mainly due to the high cost of finance. Restricting the tax deductibility of interest paid to a bank will only increase the already high cost of finance in Uganda. As such, the interest paid to banks by borrowers should also be exempted from this restriction.
One of the growth accelerators in Uganda’s National Development Plan II, is increasing the stock and quality of strategic infrastructure to accelerate the country’s competitiveness. Infrastructure projects such as the oil refinery, oil pipeline and roads, among others, typically require huge capital investments. Companies involved in these projects access this capital through loans, which are interest bearing.
Restricting the interest expense that such companies can claim as a deduction in their corporation tax returns will discourage them from investing in Uganda and this will ultimately impact the implementation of National Development Plan II.
As such, companies involved in huge infrastructure projects should also be exempted from the restriction on deductibility of interest expense.
Capital flight has serious consequences for economic performance and well-being. However, the measures put in place to curb capital flight should not discourage investment in critical sectors of the economy. Banks and their borrowers should be exempted from capping of interest expense deductibility.

Mr Niwamanya is a tax consultant at KPMG, The views expressed here are his own.