Innodis granted loans to five wholly-owned subsidiaries between 2002 and 2004. The loans were unsecured, interest-free and had a grace period of one year. The subsidiaries to which the loans were granted were either start-up companies with no assets or companies in financial difficulties. The tax authorities (MRA) had carried out an assessment of the tax liability of Innodis Ltd in respect of the assessment years 2002 – 2003 and 2003 – 2004. In the course of the exercise, a number of items were added to the taxable income, including income from interest-free loans to subsidiaries and overseas passage allowances to eligible employees, which had been earmarked but not paid. The tax authorities were of the opinion that the grant of the interest-free loans was not on arm’s length terms in accordance with section 75 of the Income Tax Act 1995 (ITA) and was clearly preferential treatment of the subsidiaries. An assumed interest rate of 13% was applied to the loans, based on the market rate for loans made to Innodis for other purposes around the same time. Innodis Ltd appealed against the decision of the tax authorities to the Assessment Review Committee where all issues raised in the appeal were settled by agreement between the parties except those relating to the items of interest-free loans to subsidiaries and overseas passage allowances to employees. Innodis Ltd subsequently appealed to the Supreme Court. Judgement of the Supreme Court The Court dismissed the appeal of Innodis and upheld the decision of the Assessment Review Committee. Excerpt “With regard to the complaint of the appellant that the ARC wrongly accepted the application of “deemed interest” to assess the liability to tax as such notion has no legal basis, we note that the ARC clearly explained the expression “deemed interest” and its application. In that respect, the ARC observed that “deemed interest” is an expression commonly used in practice by the tax authorities and accountants to denote interest which a party should have claimed from another party if there had been no relationship between them. It also explained that the use of the expression of “deemed interest” was relevant since in the present case, in effect, the Appellant has been assessed on interest income, which it should have derived if it had been at arm’s length with its subsidiaries regarding the loans. It further observed that it is not correct to say that the assessment has no legal basis because it has always been the case for the MRA that this assessment is based on section 75 Income Tax Act 1995 and the term “deemed interest” was used in the heading to designate the nature of the amount assessed under section 75. We find no fault in the above reasoning of the ARC. As a matter of fact, we agree that, as found by the ARC, the assessment itself had a legal basis by virtue section 75, which empowers the Director General to do so if he is of the opinion that the transaction in question was not at “arm’s length.” Once this is done, it was necessary for the Director General to designate by an appropriate term the income that would have been derived if the transactions had been at “arm’s length.” Since the transactions targeted were loans, which in practice generate interests as income, there can be no wrong in designating the income that the applicant ought to have derived from them as “deemed interest”. Furthermore, as observed by the ARC, the concept of “deemed interest” is neither one invented by it or the respondent nor blatantly inappropriate since it is an expression used by the tax authorities and accountants to denote interest which a party should have claimed from another party if there had been no relationship between them. With regard to the application of the provisions under Part Vll of the Income Tax Act, particularly those under section 90, we note that in brushing aside the contentions of the appellant in that respect, the ARC made the following observations, with which we agree. Part VII concerns anti-avoidance provisions and section 90 relates to transactions designed to avoid liability to Income Tax. The MRA had decided to base its case on section 75 or the Income Tax Act as it was entitled to and to the extent that section 75 imposes on domestic companies an obligation to deal with subsidiaries at arm’s length, it is irrelevant whether section 90 could also have been applicable. It is therefore correct to say, as the ARC observed, that even if section 90 would have been applicable, it does not mean that the Director General was bound to apply section 90 or that section 75 was wrongly relied upon. Therefore, there is no substance in the appellant’s contention that the ARC was wrong to have discarded and failed to properly address its mind to the application of section 90 of the Income Tax Act 1995 and the arm’s length principle which is enunciated therein. For all the above reasons, the present appeal cannot succeed. We accordingly dismiss it with costs.” Click here for other translation ...

Dominion Petroleum Dkenya’s principal activity was exploration of oil and gas. The tax authorities carried out an in-depth audit of Dominion’s operations and tax affairs for the years of income 2011 to 2016, which resulted in the following taxes being raised: Withholding Income Tax (WHT) on imported services – KES 114,993,666.00; WHT on deemed interest – KES 504,643,172.00 and; Reverse Value Added Tax(VAT) on imported services– KES 714,258,472.00 all totaling KES 1,333,895,311.00. An appeal was filed by Dominion with the Tax Appeals Tribunal where, in a judgment dated 24th July 2020, the Tribunal set aside the Commissioner’s Objection decision on Reverse VAT and WHT on Deemed Interest to the extent of the period prior to 1st January 2014. Further, it upheld the Commissioner’s Objection Decision on WHT on local services on condition that the amount of KES 656,892,892.00 paid by Dominion Petroleum to Apache Kenya Limited for seismic data be excluded from the assessment as it was not subject to WHT. In addition, it directed Dominion Petroleum to provide the Commissioner with documentation in support of the errors occasioned by the migration from its Pronto to SUN systems within thirty (30) days of the Tribunal’s ruling to facilitate computation of the WHT payable. The tax authorities was not satisfied with the decision in regards to VAT and withholding tax on deemed interest and filed an appeal with the High Court. Judgement of the High Court The High Court decided partially in favour of the tax authorities and partially in favour of Dominion Petroleum. Excerpts “WHT on deemed interest 23. WHT is a method of tax collection whereby the payer is responsible for deducting tax at source from payments due to the payee and remitting the tax so deducted to the Commissioner. Under section 10(1) of the ITA, the resident company paying interest and deemed interest is required to pay WHT to the Commissioner as follows: 10. Income from management or professional fees, royalties, interest and rents (1) For the purposes of this Act, where a resident person or a person having a permanent establishment in Kenya makes a payment to any other person in respect of- (c) interest and deemed interest 24. Under section 16(3) of the ITA “Deemed Interest” is defined as “….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 loans have been provided free of interest.” In essence, it is applicable on interest free borrowing and loans received from foreign-controlled entities in Kenya. Further by section 35(1) of the ITA, a person upon payment of a non-resident person not having a permanent establishment in Kenya in respect of interest which is chargeable to tax is required to deduct withholding tax at the appropriate non-resident rate which is provided for in the Third Schedule to the ITA. 25. Resolution of this issue involves around the nature of financial agreements entered into by the Respondent and its affiliate companies. The Commissioner contends that the agreement between the Respondent and its related companies were interest free outright loan agreements and any payments made to them by the Respondent thereunder fell within the definition of “Deemed Interest”. It observes that all of the Respondent’s related party lenders disclosed in their audited financial statements that the loans were interest free and that the Respondent attempted to introduce a 0.1% rate on one of the loans with Dominion Petroleum Acquisition Limited through contracts dated 5th February 2015 and 10th February 2015 respectively which were backdated to an effective date of 1st January 2014. The Commissioner thus accuses the Respondent of attempting to circumvent provisions of the ITA regarding treatment of interest free loans. 26. The Commissioner faults the Tribunal for holding that the “inter-company loans” do not fit the description of a loan as defined under section 16(3) of the ITA when the parties themselves had decided to call those arrangements ‘loans’ and that there is no such thing as “quasi-equity” from the definition in section 16(3) aforesaid which provides that, ‘’“all loans” means loans, overdrafts, ordinary trade debts, overdrawn current accounts or any other form of indebtedness for which the company is paying a financial charge, interest, discount or premium.” The Commissioner urges the court to take cognizance of the fact that this very chicanery called tax planning is the reason we have an entire body of practice called Transfer Pricing to ensure that related-parties transact at arm’s length as though they are related. (…) 34. I hold that the main factor of consideration is 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. What should be noted is that whichever the case, WHT would still apply. 35. In its judgment, at para. 110, the Tribunal observed that the said agreements were “…all unsecured, interest-free and have no definitive repayment plan…”. Further, at Para. 115, the Tribunal noted that the agreements in question dated 28th March and 24th September 2014 both provided for an earlier effective date and had no interest clause. These agreements were later amended by the contracts dated 5th February 2015 and 10th February 2015 respectively to include an interest clause at the rate of 0.1% with an effective date of 1st January 2014. 36. I am in agreement with the Tribunal that in the absence of any demonstrable fraud or illegality, the parties are free to make amendments to their agreements. I also note that the parties may make an agreement that includes equity and borrowing. In this case, there was clearly a lending transaction and the inclusion of the 0.1% interest rate means that “Deemed Interest” could no longer apply at least from 1st January 2014. However, ...