The Income Tax Act Amendment: Deductibility of interest to be limited to 30% of Earnings

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.

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INCOME TAX ACT AMENDMENT: TAXPAYERS TO AGREE PRICES WITH BURS IN ADVANCE

What are Advanced Pricing Agreements?

The introduction of Transfer Pricing (TP) legislation in Botswana brings with it what is known as Advanced Pricing Agreements (APAs). Transfer pricing concerns itself with the prices at which goods or services are traded between and among related parties as BURS usually loses in taxes since the relationship of the parties involved allows them to manipulate the prices. For example, a business in Botswana may sell goods to its subsidiary in Zambia at P10m when it sells to independent parties at P15m, which reduces BURS’ tax collections.

The Income Tax Act (The Act) states that a taxpayer may apply to the Commissioner General (CG) for an APA and that the CG shall specify the appropriate criteria for the application of an APA including period of time, eligibility criteria, compliance procedures and revocation conditions. An APA is an arrangement whereby a taxpayer and a tax authority get into an agreement on the applicable transfer pricing method relating to specific transactions of the taxpayer; put simply, they agree on the pricing to be applied on goods/services by the taxpayer. These are normally entered into to avoid future TP disputes.

There are two types of APAs, being multilateral APAs and unilateral APAs. Multilateral APAs normally cover more than one tax jurisdiction and will normally be among countries that already have Double Taxation Avoidance agreements (DTAs). Bilateral APAs (agreements covering two jurisdictions) are the most common multilateral APAs. The emphasis on transparency by the Organization of Economic Cooperation and Development (OECD) Base Erosion and Profit Shifting (BEPS) framework and action plans may lead to BURS and taxpayers adopting the use of bilateral APAs for Multi-National Enterprises (MNEs).

The multilateral APAs are usually entered into through Mutual Agreement Procedure (MAP) articles in states’ respective DTAs. For instance where MNEs in South Africa may want to initiate a bilateral APA for operations in Botswana, they may invoke article 24 of the DTA between Botswana and South Africa. Unilateral APAs relate only to a specific tax jurisdiction and in the Botswana case it is more likely to be used by group companies that operate in Botswana only. Under unilateral APAs, a taxpayer only agrees the pricing of goods/services with BURS.

Benefits of Advanced Pricing Agreements

APAs are beneficial to both taxpayers and tax authorities because they are time and cost effective. As stated above, they are a certain way of preventing TP disputes and therefore saves both the taxpayer and authority time spent in trying to resolve the disputes. TP disputes can stretch over several tax years and resources that are channeled towards this in terms of industry experts, consultants, and legal experts can be a financial strain. Therefore, it is advisable for all those that are eligible to have APAs to apply for them. Though they may seem costly at the beginning as taxpayers will need experts for their drafting, the benefits derived from having APAs are far greater than the cost involved in settling TP disputes.

The multilateral APAs go further to not only avoid disputes between taxpayers and tax authorities but between tax authorities in different jurisdictions. TP audits often result in tax increase adjustments by tax authorities and where there is no multi-lateral APA, disputes can arise on who is entitled to a share of the additional liability that arises.

Under a multi-lateral APA, all tax authorities involved will be aware of set prices, it’ll help in lowering chances of double taxation by the tax jurisdictions involved. Furthermore where transfer pricing methods and prices have been agreed in advance, the taxpayer and tax authority both have certainty on the tax liability that is due and payable.

Though Mutual Agreement Procedure provisions may still be used where there are no multi-lateral APAs, APAs remain the quicker and cheaper option as they are pro-active. In other jurisdictions, the use of unilateral APAs may deny taxpayers to use Mutual Agreement Procedure provisions in resolving TP disputes, taxpayers will only be aware if this is available in Botswana once the detailed regulations are issued.

THE NEW INCOME TAX ACT AMENDMENT: WHAT ARE THE IMPLICATIONS?

On the 12th of December 2018, Parliament passed some Income Tax Act amendments that are aimed at maximising domestic revenue collection in the country.  The main change to the law is the introduction of what are known as Transfer Pricing (“TP”) provisions. TP concerns itself with ensuring that transactions that happen between and among related entities are not affected by their relationship i.e. are arm’s length. In general, related companies tend to have relaxed dealings such as interest-free loans, provision of goods at reduced prices or at no cost etc. This eventually affects the revenue that the Botswana Unified Revenue (“BURS”) collects, hence the introduction of the TP rules.

Section 36 on tax avoidance has been amended by deleting section 36 (2) and by removing the phrase or is entered into or carried out otherwise than as a transaction between independent persons dealing at arm’s length” in subsection one. The two will be replaced with section 36A that introduces Transfer Pricing (TP) regulations that detail conditions that are consistent with the arm’s length transactions. The new subsection will focus on avoidance of tax and leave the arm’s length principle to TP regulations. The Income Tax Act (The Act) states that such rules on arm’s length transactions will be prescribed by the Minister of Finance and Economic Development (“The Minister”). The Arm’s length principle states that transactions between parties should be on a commercial basis with the involved parties being independent from each other and cannot control or influence over the other party.

It is expected that the Minister will provide taxpayers with options of either using the United Nations (“UN”) or the Organisation of Economic Cooperation and Development (“OECD”) models in preparing their TP documentation. It should be noted that the regulations will apply to related parties (persons who have control or influence over each other) regardless of whether the other entities are resident or non-resident for tax purposes. The Act also introduces a provision for Advance Pricing Agreement (“APA”) where taxpayers will be able to get into fixed price agreements with BURS. These are normally put in place to avoid TP disputes between taxpayers and revenue authorities during TP audits.

Though the Act does not prescribe how long the APA will be valid, however the international best practice is normally 5 years. The Minister is expected to issue eligibility criteria for application for an APA. Further, the deductibility of interest for tax purposes will now be capped at 30% of Earnings before Interest, Tax, Depreciation and Amortization across all sectors save for banking and insurance companies. This provision will also apply to mining operations and the 3:1 ratio for mining entities will no longer be applicable.

Non-compliance with the transfer pricing regulations comes with some penalties that will hit hard on both multi-nationals and local group companies. Penalties for failure to produce TP documentation will range between P250, 000 and P500, 000. Additionally where an entity had failed to comply with ensuring that they transact at market rates as if dealing with third parties, they will be liable a to 200% penalty on the tax that was lost due to a tax avoidance scheme or transaction. The legislation will not only be useful to BURS but to taxpayers as they will be able to do their tax planning using the recommended procedures. The legislation will come into effect after Presidential assent.

 

Other amendments are in relation to International Financial Service Centre Companies (“IFSCs”). This is in response to worries by the Forum on Harmful Tax Practices (“FHTP”) that the country’s IFSC regime has potentially harmful features.  “Intellectual property exploitation” and “development and supply of computer software for use in the provision of other approved financial operations” will no longer be considered as approved financial operations.

Therefore any entities that were exclusively offering such services will no longer be considered IFSC companies and will now be taxed at 22% instead of the 15% that is currently applicable. Furthermore an IFSC company is now defined as “a company incorporated in Botswana to provide any of the approved financial operations under section 138(7) to its associated or related parties”. Initially there was no clear definition of IFSC Company but there was a list of the approved financial operations mainly tailored towards dealing exclusively with non-residents and other IFSC companies.

TRANSFER DUTY AMENDMENT BILL: CONSIDERATION OF MARKET CONSTRAINTS OR FORCED SALES VALUE (SECTION 15)

The acquisition of property in Botswana can be quite expensive as market values are usually too high for most buyers to afford. The proposed amendment seeks to use the market value instead of the purchase value in determining the duty payable. While it may not necessarily be a bad idea for immoveable property bought in an open market, the use of market value in all circumstances is not ideal. Auctions are normally an alternative to buying property in the open market as the properties at an auction are normally bought at a bargain and significantly lower than the market value, the price reduction normally ranges between 20% and 50%.  The old section 15 appreciated that property can be bought through an auction where the property being sold are through a sale in execution of a court order. Currently properties bought through an auction are not subjected to the “proper valuation test” as the market forces in a sale in execution of a court order are very much different compared to an open market sale.

It is not only the Act that appreciates this fact, property valuers usually provide two values when issuing a valuation report, being the fair market value and the forced sales value, therefore it is necessary for the proposed amendments to also consider the same. The International Valuation Standards Council (IVSC) defines market value as “The estimated amount for which a property should exchange on the date of valuation between a willing buyer and willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion.”  On the contrary, a forced sale value is normally made under unfavorable conditions for the seller and conditions of market value are not met. Though IVSC and other property institutions worldwide are moving away from the use of “forced sale value” and prefer use of phrases such as “market constraints”, the bottom line is property sold in a sale in execution of a court order do not meet the definition of market value, especially the without compulsion and willing seller aspects. Therefore it is important that the proposed section 15 take this into consideration.

 

EXTEND TRANSFER DUTY EXEMPTION EXEMPTIONS TO DONATIONS TAX

The recently published Transfer Duty Amendment Bill 2018 proposes to exempt eligible beneficiaries that receive immoveable property donations through programs such as the National Housing Appeal and RADP to be exempt from payment of duty. Though in practice the beneficiaries have not been requested to pay the duty, this is a good move that will protect the beneficiaries from committing tax evasion while they are not aware that they have been evading tax. The eligible beneficiaries who usually receive such donations are the less privileged who due to their economic status are unable to acquire or build such property for themselves. Therefore imposing such a tax on them might seem like an unfair move by the legislature.

Though this move is highly appreciated, it should be noted that Transfer Duty is not the only tax that is triggered by the donation of property to the kind of individuals or beneficiaries stated above. Donations Tax (also known as Capital Transfer Tax (CTT)) is also applicable to such property and based on the type of immoveable property that are normally donated to these beneficiaries, they can be liable to pay 2% to 5% of the value of the donation received. Though it may be argued that in practice BURS does not enforce the tax, it is advisable to also ensure that the exemption is explicitly stated and in writing. This will avoid situations where the beneficiaries may lose such property because of unpaid taxes and interest.

It has been decided in the courts of law (Lord Halsbury LC) that “If the person sought to be taxed comes within the letter of the law, he must be taxed however great the hardship may appear”. Therefore based on this and the ever growing pressure on revenue authorities to ensure domestic resource mobilisation is maximised, it is advisable to extend exemption of tax for such beneficiaries to CTT. Furthermore the donors of such immoveable property should also be exempt from Capital Gains Tax (CGT) as an incentive for them to continue making the donations. It appears unfair to tax someone for their philanthropic gesture.

 

TRANSFER DUTY AMENDMENT ACT: THERE IS A NEED TO DEFINE A PERSON

Tax Acts are normally drafted in such a way that they are efficient and able to cover a wide range of taxpayers. Case law teaches us that there are ordinary and legal meanings of almost every word. Words such as ‘person’ and ‘charity’ may not necessarily mean the same thing to the ordinary man on the street and a judge at courts of law. Therefore in whatever context we use, there is need to define such words, especially when we are dealing with matters of law. The Transfer Duty Act stipulates that all persons who acquire property whether through donation, purchase or other means shall be subject to Transfer Duty. Unlike the Income Tax Act, Value Added Tax Act and Capital Transfer Act, the Transfer Duty Act does not define what a person is.

A standard definition of a person for tax purposes will include among others, an individual, a body corporate and non-corporate bodies such as religious organisations, political parties, employee unions and other non-governmental organisations. Such definitions are normally included to avoid any doubt of who may be subject to tax or have any other obligations within such tax Act.  There is need to define a person for Transfer Duty purposes to avoid any confusion that may arise as to who is chargeable to tax or not. This will further avoid unnecessary disputes that may arise between buyers of property, Registrar of Deeds/Land Boards and Botswana Unified Revenue Service as most of the time these organisations are of the opinion that they are all tax exempt while there is nothing that expressly states that.

The Act has two rates that are applicable on the acquisition of property, 5% for citizens and 30% for non-citizens. The Act further clarifies that a citizen shall include a company that is 100% owned by a citizen(s) of Botswana. Organisations such as religious institutions, community trusts and other charitable organisations are not owned by individuals and belong to the public. Hence when it comes to such we do not talk of shareholding but rather trusteeship, therefore we suggest that the definition of citizen be expanded to also include such organisations that are registered in Botswana. Admittedly it may be argued that the use of the phrase “includes” in a description means that the listed items are not exhaustive. But it is advisable to make it clear for taxpayers by expanding the list of whom is regarded as “citizen”.

Otherwise, in case of a dispute in court, the contra fiscum rule may apply and taxpayers may easily win the case which may result in a loss to the fiscus. The contra fiscum rule is a common law principle stipulating that should a taxing statutory provision reveal an ambiguity, the ambiguous provision must be interpreted in a manner that favours a taxpayer. It will be in the interest of Botswana Unified Revenue Service to define a person and further elaborate on whom is a citizen or non-citizen.

The Article first appeared on the Sunday Standard (25/11/2018 edition).

THE PROPOSED TRANSFER DUTY ACT AMENDMENTS: WHAT IS THE IMPACT ON THE TAXPAYER, WHAT OTHER OPTIONS ARE AVAILABLE?

ADMINISTRATIVE ISSUES

Among the proposed amendments includes the Transfer Duty collection being moved from the office of the Registrar of Deeds (Registrar) to the Botswana Unified Revenue Service (BURS). This amendment attempts to optimise tax revenue collection and ensure that the duty is collected by the Revenue Authority. This is a step in the right direction as there has been complaints in the past in relation to levies that are administered by different departments or ministries. BURS should ensure that they have capacity to administer this and that there are measures in place to ensure smooth transition and clients are adequately assisted.

Another administrative issue is the issuance of an exemption certificate to buyers of land where they are involved in a transaction that is exempted from Transfer Duty in terms of the Transfer Duty Act for instance instead of attaching a receipt (indicating proof of payment of the duty to the Commissioner General) to the application for transfer of the immoveable property the exemption certificate shall be attached as indication that the buyer is not subject to payment of the duty. Buyers of immoveable property have encountered difficulties in the past relating to duty exemption on properties that have been subject to Value Added Tax (VAT), especially zero rated transactions, and this provision will now ease transfer of such property.

In efforts to combat the under declaration of property values, a valuation certificate issued by a property valuer registered in accordance with Real Estate Professionals Act is to be submitted to BURS to determine Transfer Duty payable. This is to ensure that buyers do not evade tax by providing the Commissioner General with low values and paying no or less transfer duty. The Commissioner General will also be empowered to either accept the declaration made by the purchaser or to determine the market value of such property through independent valuers or such information that may be necessary to determine a market value.  The Commissioner General’s declared value may be subject to objection by the taxpayer and the two may settle for an agreed price within the confines of the Transfer Duty Act.

EXEMPTIONS

The exemption list has also been amended to include among others first-time home owners. This exemption though administratively efficient compared to the VAT exemption is inconsequential as the buyers would have still been exempt from transfer duty as they would have paid VAT on purchase of that property. The amendment as it is will only benefit buyers who acquire their immoveable property from individuals/businesses not registered for VAT, which will be an insignificant number of people.

A better alternative to this will be to allow the interest expense from mortgage or secured loans used for building or acquiring homes as a deduction for all first-time home owners when computing their taxable income. This will effectively reduce their income tax payable.

Currently only those in the business of renting out property for accommodation are allowed this as an expense. It might also be in the interest of BURS and the Deeds Registrar to have a clear definition of first-time home owner and maintain a proper registration system that will ensure that only first-time home owners benefit from this as intended by the Act. Notable inclusions that will be beneficial to buyers is the increase of exempted value from P200, 000 to P500, 000. This means that for any purchase of property less than P500, 000 a buyer will not be subjected to transfer duty and will only pay duty on the excess of P500, 000 for properties with values of over P500, 000. Divorcees getting property from distribution of their estate where they were married in community of property will also not be subject to Transfer Duty.

Exemption of duty for surviving spouses and dependants acquiring property from deceased spouses will now apply across all marriage regimes; currently exemption is only enjoyed by spouses who were married in community of property.

 TAX BASE

Currently sale of tribal land is not subject to Transfer Duty and many have been enjoying the exemption through sale of land in places like Tlokweng and Mmopane. If the bill passes through in parliament, tribal land will also be included among properties that are chargeable to Transfer Duty. This may be among efforts by the government to increase tax revenue base, among other amendments that will increase the tax base is the increase of rate from 5% to 30% for purchase of property by non-citizens. Currently only purchase of agricultural land by non-citizens was subject to 30% duty.

The transfer of shares where the company being sold has significant immoveable property and such transfer will result in change in beneficial ownership of such property; the transaction will be chargeable to Transfer Duty. The Act also seeks to change definition of citizen to include a company with a 100% citizen shareholding instead of just majority shareholding. Though a welcome development, the provision may not achieve its intended purpose as non-citizens may still benefit from a lower rate of 5% as they may be the ultimate beneficial owners of the company without necessarily being the shareholders of the company. This may be done through the use of quasi equity instruments and contracts that in effect mimic share ownership while no shares are owned. Therefore it is advisable for the Act to use the phrase beneficial ownership in fact rather than just in appearance (shareholding), this will not only help in achieving the intent of the legislation but will be consistent with provisions of the Income Tax Act where citizens (or residents) of Botswana can only benefit from certain tax concessions if they are the ultimate beneficial owners of the shareholding. Another amendment of interest is that mere registration of a lease or grant of lease/concession from the Land Board will attract payment of transfer duty; this may be targeting high value lands in the Chobe and Okavango areas reserved for tourism. The provision is less likely to affect individuals granted land for residential purposes as most of their values are likely to be less than P500, 000 exemption amount for citizens.

 

INTEREST AND PENALTIES

The 12% simple interest will be replaced a by P 20, 000 penalty plus additional interest of 1.5% compound interest on unpaid/uncollected duty, this are among efforts by BURS to encourage compliance among buyers of land.

The article first appeared in the WeekendPost and Sundays Standard editions of 17th and 18th November respectively.