The Finance Act 2026 has delivered one of the most significant tax reforms for Kenya’s banking sector in recent years. In a move that has long been advocated by the banking industry, Parliament amended the Income Tax Act to allow financial institutions to deduct the principal component of qualifying bad debts for income tax purposes.
Although the amendment may appear technical, it represents an important recognition of the unique nature of the lending business.
Under the previous law, the principal amount of a loan was regarded as capital in nature. As a general principle of income tax, capital losses are not deductible when computing taxable income. Consequently, where a borrower defaulted on a loan, a financial institution was required to absorb the loss of the principal without any corresponding tax relief.
The banking industry consistently argued that this treatment overlooked a fundamental characteristic of financial institutions. Unlike most businesses, the capital deployed by banks and other financial institutions is not a long-term capital investment; it is the very commodity or stock-in-trade from which they generate income. Therefore, when a customer fails to repay a loan, the institution does not merely lose an investment; it loses part of the stock it relies on to earn its income.
Following engagement between the Kenya Bankers Association, other industry stakeholders, the National Treasury and Parliament, this commercial reality was ultimately acknowledged.
Parliament accepted that denying a deduction for the principal component of irrecoverable loans imposed an unnecessary tax burden on financial institutions by requiring them to bear both the commercial loss arising from the default and the resulting tax cost. The Finance Act 2026 was therefore enacted to address this anomaly by allowing the principal component of qualifying bad debts to be deducted for tax purposes.
This amendment is undoubtedly a significant victory for the banking industry. The change is also likely to improve the sector’s profitability by ensuring that taxable income more accurately reflects its genuine economic performance.
Tax Relief Only Applies to Financial Institutions
However, the amendment should not be interpreted as changing the general tax treatment of bad debts across all sectors. The relief is specifically confined to persons carrying on a money lending business, banks or financial institutions licensed under the Banking Act, the Microfinance Act or the Central Bank of Kenya Act, because of the unique nature of their business.
Other taxpayers remain subject to the long-standing principle that losses of a capital nature are not deductible unless the law expressly provides otherwise.
This distinction is particularly relevant where businesses lend money outside the ordinary course of a lending business. For example, if one company advances a loan to a related party and that loan subsequently becomes irrecoverable, the lender cannot rely on the Finance Act 2026 amendment to claim a deduction for the unpaid principal. Since the lender is not carrying on the business of lending money as a financial institution, the principal amount remains capital in nature and the loss will generally not qualify as a deductible expense.
Recognising Industry-Specific Commercial Realities
Overall, this amendment is a positive development because it recognises that different industries operate under distinct commercial realities and that tax legislation should be designed with those differences in mind to promote fairness and equity.
By recognising that money advanced by financial institutions constitutes their trading stock rather than a capital investment, Parliament has commendably addressed a long-standing inequity in the taxation of the banking sector.
As Kenya continues to modernise its tax system, policymakers should adopt a similarly sector-sensitive approach, ensuring that tax laws reflect the economic characteristics of each industry. Doing so will not only create a more equitable tax system but also support investment, enhance competitiveness and contribute to stronger long-term economic growth.
If you require further information or clarification on this matter, please do not hesitate to contact CMC Advocates.
