The amendment of the Income Tax Act in relation to deductibility of interest extends what is normally referred to as thin capitalisation to other industries other than mining and IFSC companies, only banking and insurance industries will escape these rules. The Organization for Economic and Cooperation Development (OECD) defines thin capitalisation as an instance in which a company is financed through a relatively high level of debt compared to equity. Traditionally, in the world of corporate finance, there are normally two forms of financing the first one being equity which is the capital injected into the company by investors or entrepreneurs. The expected return for investors is normally in the form of dividends which are outright not tax deductible.
The other traditional form of finance comes in the form of debt the return for which is interest paid to the lender. Interest is an allowable expense for tax purposes and reduces one’s tax liability when computing tax payable for the year. Terms such as “highly leveraged” or “highly geared” are often used to describe companies that have a higher ratio of debt to equity. Though the international practice for application of these rules is normally limited to transactions between connected persons, that is, entities that are related and have influence over each other, the new Botswana thin capitalisation rules apply to all interest transactions regardless of whether they are between connected persons or third parties.
The OECD advises that there are generally two approaches that are used to implement thin capitalisation rules, the first by determining a maximum amount of debt on which deductible interest payments are available. The other approach is to determine a maximum amount of interest that may be deducted by reference to the ratio of interest (paid or payable) to another variable. The first approach may limit interest deductibility through a pre-determined equity to debt ratio such as 1:3 that was applicable to mining industry and IFSC companies and 1:12 for banks. Banks and IFSC companies will retain the use of this approach.
Apart from the use of a ratio, the first approach may also use the arm’s length principle to limit interest deductible. That is, it’ll compare the loan conditions to that of an independent lender such as a bank and whatever excess interest that the connected person earns over and above what independent banks earn would be added back. The second approach mentioned above would normally compare interest to variables such as taxable income, profit before tax, or EBITDA. This is the approach that has been adopted by Botswana in the limitation of deductible interest for tax purposes.
The deductibility of interest for all companies save for banks, insurance and IFSCs will now be capped at 30% of the Tax EBITDA, EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortization. This shall be arrived at by calculating the taxable income as it is normally computed and adding the net interest expense, depreciation and amortisation to the same. The net interest expense shall be calculated by deducting interest earned from interest incurred, that is, interest charged by lenders less interest received from other entities. Interest expense in this case shall apply to all types of debts such as profit participating loans, finance lease payments and Islamic finance.
All this means is that the old provisions that allowed interest deductions are no longer applicable and the introduced section 41A will be the applicable provision for purposes of deducting interest in determining taxable income.
For the avoidance of doubt, this limitation only applies to companies, a term defined in the Act as including a society, an association, a charitable or religious organisation as well as trusts of a public character. This, in principle, is a welcome development for the country as it will save revenue that was lost in the past through highly leveraged foreign companies that have huge debts as a way of escaping tax. However, the development impacts hybrid corporate finance structures (quasi equity structures where equity capital is modelled with features of traditional debt financing) used to mitigate investors risks in relatively risky investments in the country and may deter some foreign (and local) investors. Also, this may result in the local companies that are highly leveraged for true business purposes being punished for trying to develop their companies where they are unable to attract equity investors.