Excise Duty and treatment of bad debts

Is it time to rethink Excise Duty and treatment of bad debts for fifinancial institutions in EAC?

In any conversation around the taxes affecting financial institutions within the East Africa region, excise duty and deductibility of loan provisions is likely to feature. 

Starting with Excise Duty, what was initially known as a “sin tax “has now morphed into somewhat a mainstream transaction tax increasing revenue collection for governments across the region!

In the process, financial institutions have not been spared and currently “other fees” charged by financial institutions are now subject to Excise Duty at a steep rate of twenty percent (20%). But what exactly constitutes financial institutions in this context and what is “other fees” that is subject to Excise Duty? This article clarifies some of these terms and weighs in on the tax treatment of Excise duty on “other fees” across the region.

For Excise Duty purposes, a financial institution refers to a person licensed under the Banking Act, the Insurance Act, the Central Bank of Kenya Act, or the MicroFinance Act, 2006 and a Sacco society registered under the Sacco Societies Act. With the exception of interest on loans, share of profits, insurance premiums or premium based or related commissions, any other fees levied by these institutions relating to their licensed activities attracts 20% Excise Duty. The Excise Duty is payable at the time of supply of these services which is often when a charge is made to the customer.

From the Total Tax Contribution of the Kenya Banking Sector - 2022 report, a study by PwC Kenya and the Kenya Bankers Association ("KBA"), it was reported that the banking sector contributed KES 22.9 bn in Excise Duty in 2022, as compared to KES 14.3 bn in the previous year representing a 60.13% growth year on year. These statistics buttress the fact that Excise Duty is increasingly being considered as a mainstream transactional tax and a key source of revenue for governments across the region just like Value Added Tax (“VAT”).

We have however seen a decrease in the Excise Duty fees charged for money transfer services by banks, money transfer agencies and other financial service providers from 20% to 15% in the Finance Act 2023. This reduces the cost of these services which is a positive step towards achieving access to financial services for Kenyans.

Across the borders in Tanzania, Excise Duty applies at the rate of 10% on charges or fees payable by a person to a financial institution for services provided by such institution. This is in addition to VAT applicable on financial services. In Uganda, Local Excise Duty (“LED”) of 15% is levied on ledger fees, ATM fees, withdrawal fees on periodic charges and other transaction and non-transaction charges excluding loan related charges by financial institutions.

Whilst it appears to be very clear on what transactions or activities attract Excise Duty, this has been a subject of tax controversy and numerous tax disputes across the region. For instance, in Uganda the question has been what comprises loan related charges that qualify for exemption from LED.

In Kenya, whilst the definition of the term “other fees” has in the recent past been clarified by Parliament, it is still unclear on the extent of licensed activities that fit in the realm of Excise Duty. The KRA has in the past sought to levy Excise Duty on other fees earned by financial institutions related to their licensed activities, however the nature of the fees is often the subject of dispute with taxpayers arguing that some of the income earned does not fall within the definition of “other fees” as contained in the law.

It is clear that the Revenue Authorities in the region are keen to grow tax revenue on financial services. However, there needs to be a balanced approach towards this to ensure that the Excise Duty regime does not lead to numerous tax disputes and that the cost of the taxes does not act as a deterrent towards access to the financial services by making banking products more expensive.

Turning to the issue of deductibility of loan provisions, in Kenya, financial institutions registered under the Banking Act and regulated by the Central Bank of Kenya (“CBK”) are required to comply with three regulations when ascertaining Non-Performing Loans (“NPLs”) for tax purposes. These are Section 15(2)(a) of the Income Tax Act as read together with Legal Notice 37/2011, CBK Prudential Guidelines and International Financial Reporting Standard (“IFRS”) 9.

Loan loss provisions under IFRS 9 are not allowable for tax purposes. As per the 2022 Total Tax Contribution study by KBA and PwC Kenya, for every KES 100 of profit made by the 39 banks who participated in that study, KES 43.09 bn was paid to the Government in form of taxes. This is significantly higher than the 30% statutory corporation tax rate. One of the main contributions to this high rate of 43% was attributable to fewer tax incentives available for the banking sector and misalignment of the treatment of Non-Performing Loan (“NPL”) provisions as per the tax legislation on one hand, and IFRS 9 together with CBK Prudential Guidelines on the other hand.

Given that the core mandate of banks is to act as credit intermediators to allocate credit to sectors of the economy in order to spur economic growth, it is interesting that the core expense (bad loans) incurred by banks in executing their core mandate has overly stringent rules for deductibility which leads to a sharp divergence between the statutory corporate tax rate (30%) and the total tax rate (48.5%) in Kenya.

In addition, it is administratively cumbersome to comply with three regulatory requirements given that banks must comply with tax, accounting, and regulatory requirements when computing NPLs. In Tanzania, the Bank of Tanzania (“BOT”) has issued regulations governing the banking sector (“BOT Regulations”) that all banks are required to adhere to in respect to accounting for bad debt provisions.

The BOT Regulations require a bank to write off a debt after 365 days of the loan entering the “loss making” category. For tax purposes, where a financial institution wants to claim a tax deduction on a bad debt, one of the requirements is to demonstrate to the revenue authority the “reasonable steps” that it took to pursue the debt. Given that “reasonable steps” are not defined in the law, this is usually an area of contention with the Revenue Authority as it is at the discretion of the taxman to verify whether reasonable steps were followed in pursuing the debt. This lack of clarity on what are the “reasonable steps” has made it difficult for banks to manage their liquidity.

In Uganda, similar to Tanzania, bad debts are deductible where reasonable steps for recovery have been undertaken and there’s reasonable grounds to demonstrate that the debt will not be recovered.

From the analysis above, it is clear that the tax treatment of impairments has a signifificant impact on the tax liabilities of the banks and it is an area of continued concern. A review of the local tax laws in light of international standards such as IFRS 9 and best practices may be a welcome move. Additionally, where there is ambiguity in the tax legislation, the legislators should consider the relevant amendments necessary to provide certainty and foster compliance by both the taxpayers and the taxman.