COMMISSIONER OF DOMESTIC TAXES V THAARA LIMITED (HIGH COURT INCOME TAX APPEAL No. E133 OF 2023) (2024)

In December 2024, the High Court of Kenya in Commissioner of Domestic Taxes vs Thaara Limited (2024) was tasked with making a determination as to whether Thaara Limited (Thaara) ought to have paid Withholding Tax on interest for the period 2019 to 2020 wherein the same had been deferred.

A. Brief Facts of the Case
In 2018, Thaara received a term loan from a private equity fund, Vantage Mezzanine III Pan African Sub Fund Partnership. According to the Principal Loan Agreement, the loan was to be paid in full, including interest, within 7 years from the date of signing of the loan Agreement. Interest was chargeable at the Libor rate.

The Loan Agreement was subsequently amended on 20th October 2020 by both parties vide an Addendum to the effect that interest payment, as well as accrual of the expense and interest, would be deferred, with effect from 1st January 2019. This was due to the financial constraints faced by Thaara.

The Kenya Revenue Authority (KRA) undertook a tax verification on Thaara for the periods 2017 to 2019. Following the audit, the KRA issued a tax assessment demanding the sum of Kshs. 18,011,425/- from Thaara in respect of withholding taxes on deemed interest for the years 2019 and 2020. As per the KRA, the Addendum to the Principal Loan Agreement altered the loan terms to an interest-free loan and, as a consequence, withholding tax on deemed income was applicable on the loan under Section 2 of the Income Tax Act (ITA).

As per Thaara though, it was its submission that the Addendum did not change the nature of the loan to be interest-free as it did not alter the terms of the Principal Loan Agreement. It also submitted that the Addendum only deferred the interest payment to a future date before the expiry of the term of the loan in 2025. Lastly, it contended that deemed interest could only arise when the loan was not interest free.

B. Analysis of the Legal Basis of the judgment of the Court

In arriving at its judgment, the High Court considered three factors, that is: –

1) Whether the loan facility obtained by Thaara was subject to deemed interest as per Section 2 of the Income Tax Act (ITA) due to deferral of interest for periods 2019 to 2020?

In respect of the above issue, the High Court made reference to the provisions of Section 2 and Section 35(1) of the ITA which provides as follows –

Section 2 of the ITA :-

“deemed interest” means an amount of interest equal to the average ninety-one day Treasury Bill rate, deemed to be payable by a resident person in respect of any outstanding loan provided or secured by the non-resident, where such loan is provided free of interest;”

Section 35(1) of the ITA: –
1) A person shall, upon payment of an amount to a non-resident person not having a permanent establishment in Kenya in respect of –

(e) interest and deemed interest, including interest and deemed interest arising from a discount upon final redemption of a bond, loan, claim, obligation or other evidence of indebtedness measured as the original issue discount;”

Based on the above provisions of the ITA and after reviewing the Principal Loan Facility Agreement together with the Addendum, it was the Court’s finding that the Principal Loan Facility Agreement provided for the interest rate as the Libor rate plus the margin, accruing and compounding quarterly in arrears.

As for the Addendum, the same only amended the facility agreement to increase the capital amount and deferral of the accrual of interest and payment thereof. That did not mean that the Loan thus was interest free during the period of deferral of the interest. Consequently, the Court held that the loan facility was not interest-free and therefore not subject to deemed interest.

2) Whether the interest on the funds borrowed by Thaara pursuant to the Loan facility attracted Withholding tax?

In its further analysis, it was the Court’s finding that though it had determined that the deemed interest provisions were not applicable, the same did not mean that the interest on the funds borrowed was not subject to Withholding Tax (WHT). The court noted that WHT on the interest was due upon payment or accrual of the interest.

To support the above finding, the Court made reliance to the case of Commissioner of Domestic Taxes v Dominion Petroleum Kenya Limited (Tax Appeal E093 of 2020) wherein the Court observed that the main factor of consideration was whether there was any interest provided for in the financing agreements amounted to a loan; if there was no interest, then WHT on deemed interest would apply at the 91 day Treasury Bill rate; if there was interest, WHT would still apply at the rate provided for in the Third Schedule of the ITA. That what should be noted was that whichever the case, WHT would still apply.

3) Whether with the finding that WHT was payable on interest, the same was due from Thaara having deferred the same for periods 2019 and 2020?

In order to decipher the above issue, the Court noted that as per Section 35(1) as read together with 35(3) of the ITA, WHT was deducted upon payment of the interest which was chargeable to tax or accrued (recorded as a liability). Consequently, the Court sought to determine whether the deferred interest had actually been paid for tax purposes to warrant the withholding and remitting of WHT by Thaara.

To respond to the above, the High Court made reference to the definition of “paid” as per Section 2 of the ITA. The same provides as follows: –

“paid” includes distributed, credited, dealt with or deemed to have been paid in the interest or on behalf of a person”

Further, the court relied on the Court of Appeal case in Kenya Revenue Authority v Republic (Exparte Fintel Ltd) [2019] eKLR (Fintel Case) where the Court clarified that the word paid included amounts accrued as stipulated under Sections 3 and 10 of the ITA, noting that the Kenyan income tax regime was based on an accrual system.

In moving away from the findings in the Fintel Case, the Court observed that unlike the Fintel Case, in the subject case, Thaara had explicitly agreed to defer the interest accrual through the Addendum. Thaara thus had not benefited from the deduction of interest expense from its taxable profit. As such, it was the Court’s finding that WHT was not due where the same had been deferred and not accrued (recorded as a liability in its books) and hence KRA had erred in demanding for WHT for the periods 2019 to 2020 where the interest had been deferred.

C. Implication of the judgment
Based on the above findings, both the Tax Appeals Tribunal and High Court, have confirmed in the subject case that where there is deferral of interest accrual, the same will not be subject to WHT until such interest is paid at a future date since the Taxpayer who would have deferred the interest accrual would not have benefited from its deduction from its taxable profit.