Budget should ease tax burden on microfinance firms

By Ibrahim Khalif

According to Standard & Poors, a US-based financial services company, micro-finance institutions have two unique characteristics.

The first is the provisions of loans and financial services to the low income and financially underserved populace.

The second characteristic is that they are financial institutions with a double bottom-line goal of achieving a defined social mission and financial viability.

In my view, the defined social mission of most micro-finance institutions in Kenya is to reduce poverty through enhancing access to credit. This is because without access to credit, economic development would be curtailed.

It is common knowledge that in the last few years, micro-finance institutions have played a significant role in the economic development of our country by providing access to credit to poor households that would not otherwise qualify for credit from conventional banks.

Loan portfolio

They also make significant contributions to the Vision 2030 goal of economic development through financial inclusion.

Statistics by the Central Bank of Kenya (CBK) at the beginning of this year showed that as at November last year, Deposit-Taking Microfinance institutions (DTMs) mobilised deposits of Sh7.9 billion and had a loan portfolio of Sh17 billion.

It is in recognition of their critical contribution to the economy that policymakers saw the need to regulate the industry.

Treasury enacted the Microfinance Act in 2006 even though it did not come into operation until 2008.

Under this Act, CBK started licensing DTMs. So far, CBK has licensed five DTMs and more than 30 applications were under consideration by last month.

It is, however, sad to note that the policy makers addressed only the regulatory issues of these institutions but failed to consider tax matters affecting them under their new operating environment.

Deposit-Taking Micro-Finance institutions compete with other financial institutions such as banks, building societies, and co-operatives for deposits and loans.

In line with the cardinal taxation principle of equity, it is only fair that the tax regimes that apply to banks and other financial institutions are also applied to micro-finance institutions.

Logistical nightmare

Interest paid to resident banks and other financial institutions specified in the Income Tax Act are not subject to withholding tax.

The rationale for exempting such interest from the withholding tax requirement is that borrowers are technically not in a position to withhold tax as the financial institutions recover the interest due on the loans directly from the accounts of such borrowers.

Without such exemption, there would be an administrative nightmare considering the number of borrowers involved.

The other rationale for exempting interest income of resident banks from withholding tax is that interest is their main source of income. The requirement to withhold tax on such interest would have meant that most of the institutions’ tax would be paid at source and in advance thus creating cash flow challenges for the affected taxpayers.

The cash flow situation would be worse for those institutions making losses or with low profit levels.

Such institutions would invariably find themselves in a tax-recoverable position that would aggravate their cash flow headaches given the fact that it is becoming increasingly difficult to obtain refunds from the tax authority.

However, the current tax legislation does not exempt interest paid to micro-finance institutions from withholding tax requirement. Treasury has a duty to level the playing field by exempting interest paid to micro-finance institutions from the withholding tax requirement. It should do this by including micro-finance institutions in the list of specified financial institutions under the fourth schedule to the Income Tax Act.

Secondly, the Income Tax Act states that interest income received by resident individuals from specified financial institutions such as CBK, banks licensed under the Banking Act and housing bonds is "qualifying interest".

What this means is that the withholding tax deducted from such income is final tax. The current rate of withholding tax on interest payments is 15 per cent of the gross amount payable.

However, interest income earned from micro-finance entities is not treated as qualifying interest. I would think the reason for the preferential tax treatment of the qualifying interest is to encourage savings as well as home ownership.

In view of this, interest earned from savings with micro-finance institutions should also be treated as qualifying interest to encourage low-income savers to save without a high tax burden. This will also bring tax treatment of savings with micro-finance institutions at par with those of banks and building societies.

Finally, there is a concept known as "thin-capitalisation" in our income tax legislation. This is where a company with foreign control uses debt instead of equity to finance its operations. In such situations, the tax authority is empowered to protect its revenue base by restricting the amount of interest expense that such a thinly capitalised company can deduct.

Capitalisation rules

However, the Kenyan thin capitalisation rules do not apply to banks licensed under the Banking Act due to the nature of their business. Since micro-finance institutions are in similar business as that of banks, the thin capitalisation rules should be changed to accommodate them as well.

Policymakers entrusted with the preparation of the first budget under the new Constitution should incorporate the widest views possible, and give attention to the micro-finance sector that is playing a significant role in empowering the low income Kenyans.

—Ibrahim Khalif is a Tax Senior Manager, Deloitte Kenya.

The views expressed in this article are the author’s and not necessarily those of Deloitte Kenya.