By Benjamin Mutua, Associate - Tax
Section 16(2) (j) of The Income Tax Act (Cap. 470) provides for a limitation on the deductibility of interest expenses paid to non-resident lenders. This provision is designed to curb excessive debt financing from foreign sources, a practice often used by companies to reduce taxable income through high interest deductions.
By capping allowable interest deductions at 30% of Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA), the law ensures that businesses maintain a fair balance between debt and equity financing. It also provides clarity on the scope of application, exemptions for specific industries, and mechanisms such as the carry-forward rule to manage excess interest.
Main Rule
- Company paying interest to non-resident lenders can only deduct that interest expense up to 30% of its EBITDA.
- Any income that is exempt from tax is excluded when calculating EBITDA.
- This rule applies to;
- Interest on loans;
- Payments economically equivalent to interest;
- Expenses incurred in raising finance
Exempt Entities
These are entities that are not subject to the 30% EBITDA interest limitation. They include;
- Banks and licensed financial institutions (Banking Act, Cap. 488)
- Micro and small enterprises (Cap. 493C)
- Licensed microfinance institutions and non-deposit taking microfinance businesses (Cap. 493C)
- Hire purchase entities (Cap. 507)
- Non-deposit taking lending and leasing institutions
- Companies manufacturing human vaccines
- Holding companies regulated under the Capital Markets Act (Cap. 485A)
Carry-Forward Rule
If the interest expense exceeds the 30% cap, the excess is disallowed in that year, but the excess is not lost. Instead, the excess can be carried forward for up to 3 years.
In those later years, the carried-forward interest can be deducted only if the total interest deduction (current + carried forward) does not exceed the 30% EBITDA cap for that year.
After 3 years, any unused excess interest deduction expires permanently.
Impact on Businesses
The following are some of the implications of the rule for companies financed through non-resident lenders;
Higher tax liability: Companies with heavy foreign debt may face disallowed interest, increasing taxable income, translating to higher taxes.
Financing strategy shift: Firms may prefer local borrowing or equity financing to avoid hitting the cap.
Cash flow management: Carry-forward provides relief, but timing matters as companies need strong EBITDA in later years to utilize deductions.
Sectoral advantage: Exempt industries retain flexibility in foreign financing without restriction.
Conclusion
Kenya’s 30% EBITDA cap curbs excessive interest deductions, while the three‑year carry‑forward of the excess interest adds flexibility of the utilisation of the disallowed interest.
For firms paying interest to non‑residents, smart planning is necessary in balancing the debt and equity financing and also to ensure compliance while minimizing tax burdens.