Judgement Appeal Number 292 Of 2021- Aquavita Kenya Limited Vs. Commissioner Domestic Taxes

Redeemable preference shares, redeemable at an option of the holder, establish a debt obligation for accounting and tax purposes due to the expectation of future repayment. Moreover, when issued to non-residents, these shares are subject to deemed interest provisions despite not constituting traditional debt instruments. 

Background  

Aquavita Kenya Limited (Aquavita KE) is a company incorporated in Kenya, primarily engaged in providing eco-friendly, point-of-use water services within the country. It is a subsidiary of Aquavita II UK Limited (Aquavita UK). 

Aquavita KE issued redeemable preference shares to its parent company. the Kenya Revenue Authority (KRA) conducted an assessment asserting that these redeemable preference shares constituted interest-free loans extended by nonresidents thus falling under deemed interest provisions as per the Income Tax Act (ITA). Consequently, the KRA levied withholding tax at 15% on the deemed interest. 

Aquavita Kenya Submissions  

Aquavita KE highlighted that companies have various options for financing through equity, including ordinary shares, preference shares, and shares that may be redeemed at the option of the company or the shareholder.  

Aquavita KE further submitted that the Companies Act allows a limited company to issue redeemable shares that are to be redeemed or are liable to be redeemed at the option of  the company or the shareholder. The shares remain part of the equity of the company and dividends made in respect of the shares cannot be treated as interest. 

Aquavita KE argued that the KRA made an incorrect assessment by categorizing redeemable preference shares as an interest-free loan and a financial liability rather than capital. The KRA's basis for this classification was the shares' redeemability at the shareholder's discretion.  

Aquavita KE relying on the definition of loan under the ITA submitted that the preference shares comprise part of the share capital of the company and therefore cannot be treated as debt since there is no debt arrangement between Aquavita KE and Aquavita UK.  

KRA’s Submissions  

The KRA argued that redeemable preference shares should be treated as loans for income tax purposes, primarily due to their redeemable nature which implies a commitment to repay.  According to the KRA, this characteristic aligns more closely with the features of a loan rather than traditional equity.  

It emphasized that for income tax purposes, it is essential to examine the entirety of the transaction and consider its inherent economic substance beyond its legal form. This approach aims to ensure that the tax treatment accurately reflects the economic reality and financial implications of the transaction, irrespective of its legal classification. 

To buttress its position, the KRA submitted that a review of Aquavita KE’s instruments revealed that whereas disguised as equity, the primary indicator  for the transaction were in their own nature a debt in favor of Aquavita KE. The KRA relied on IAS 32 which requires that redeemable preference shares, redeemable at a future date or at an option of the holder be classified as a financial liability as there is expected future outflow of cash or another financial asset from the issuer or the holder.  

The KRA submitted that the terms of the redeemable preference shares  revealed a creditor-debtor relationship because the critical feature in differentiating a financial liability from an equity  instrument is the existence of a contractual obligation of the issuer either to deliver cash  or another financial asset. 

The KRA concluded by stating that Aquavita KE’ assertions that issuance of redeemable preference shares automatically amounts to equity was itself misleading when viewed from an accounting and tax  perspective. 

Issue for Determination  

Whether the redeemable preference shares are equity hence exempt from tax or whether they constituted an  interest free loans subject to  withholding tax. 

Tribunal’s Analysis and Findings  

The tribunal looked at the definition of interest as per the Income Tax Act  which provides that  

“ interest (other than interest charged on tax) means interest payable in any manner in respect of a loan, deposit, debt, claim or other right and obligation  and includes a premium or discount by way of interest and commitment or service fee paid in respect of any loan or credit or an Islamic finance return.  

Based on the arguments presented, the court held that the question to be answered in this case was whether  redeemable preference shares  amount to a loan or a debt, noting that the preference shares were redeemable at the option of the shareholder and there was no option for the amount not to be repaid. Thus, the court affirmed that interest is payable on such indebtedness, aligning with its understanding that the redeemable preference shares arrangement created a debtor-creditor relationship between Aquavita KE and Aquavita UK. 

The court quoted IAS 32.18 (a) which states that  

“a preference share  that provides for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date, or gives the holder the right to require the issuer to redeem the instrument at or after a particular date for a fixed or determinable amount is a financial liability” 

The Tribunal noted that Aquavita KE’s redeemable preference shares gave the holder the option to redeem the shares at a future date  upon issuance of a seven-day notice . The Tribunal therefore held that  a debt obligation arose by virtue of the fact that the holder of a preference share expects  to be paid or repaid  at some point in the future.  

The court concluded that since the preference shares were considered a financial obligation or debt, issued by a non-resident entity without any interest charged on them, they fell under the deemed interest provisions. 

How we can assist  

Navigating the nuances of tax law, especially in cross-border transactions requires specialized knowledge and strategic foresight. Our tax advisory services offer solutions to manage and mitigate risks associated with financial transactions. We provide tax planning strategies that align with regulatory requirements, helping you understand and implement the implications of such transactions effectively. We offer proactive guidance to address potential tax implications early, ensuring your business is well-prepared and positioned to make informed decisions. For this and any other tax questions please contact Tabitha at tmuchiri@cmadvocates.com