In Premier Credit Limited v Commissioner of Domestic Taxes (Tax Appeal No. E1149 of 2024), the Tax Appeals Tribunal (TAT) held that the principal amount of bad debts written off by lenders and credit institutions is not deductible for tax purposes.
The Tribunal emphasised the need to distinguish between the different components of a loan. It held that the principal amount is capital in nature, whereas the related interest, fees, and penalties constitute revenue items. As a result, only the revenue components may qualify for tax deduction at the point of write-off, while the principal amounts do not.
Background
Premier Credit Limited (the “Taxpayer” or “Appellant”) is a licensed credit microfinance company providing financial solutions to corporates, government institutions, and individual entrepreneurs.
The Kenya Revenue Authority (“KRA” or “Respondent”) conducted an audit of the Appellant’s accounts for the financial year 2018, which resulted in an additional assessment issued on 7 June 2024. The Appellant objected, and the Commissioner subsequently issued a revised assessment, reducing the total from KShs 138,438,726 to KShs 118,293,130.
Dissatisfied with the decision, the Appellant filed an appeal before the Tribunal. Part of the dispute was resolved through Alternative Dispute Resolution (ADR), with the unresolved principal taxes of KShs 30,132,515 referred back to the Tribunal for determination.
The key unresolved issue concerned the tax treatment of bad debts written off by the Appellant.
The Appellant’s Position
The Appellant challenged the legality of paragraph 4 of Legal Notice No. 37 of 2011, arguing that it is ultra vires and contrary to Section 15(2)(a) of the Income Tax Act (ITA). Paragraph 4, which formed the primary legal basis for KRA’s assessment, provides that bad debts which are capital in nature are not deductible for tax purposes.
Notwithstanding this, the Appellant submitted that the bad debts written off were incurred wholly and exclusively in the production of the company’s income and are therefore deductible under Section 15(2)(a) of the ITA.
The Appellant further contended that it had taken all reasonable steps to recover the debts before writing them off. These measures included offering debt restructuring arrangements, engaging professional debt collectors, and attempting to trace untraceable debtors.
Consequently, the Appellant only wrote off debts where it was uneconomic to collect, the debtor was deceased or untraceable, or the underlying collateral had been fully exhausted.
The Appellant asserted that it had met the statutory threshold for bad debt deductions under Paragraph 2 of Legal Notice No. 37 of 2011 and Section 16(2)(a) of the ITA and was therefore entitled to claim the expenses as deductible.
The Respondent’s Position
The Respondent submitted that, for tax purposes, a clear distinction must be drawn between the capital and revenue components of a loan. Paragraph 4 of Legal Notice No. 37 of 2011 prohibits the deduction of bad debts to the extent that they are capital in nature.
Accordingly, the Respondent argued that the principal amount forming part of the bad debts written off constitutes the capital component of the loan, while the interest, fees, and penalties constitute revenue.
On that basis, the revenue components qualified as deductible expenses, but the principal component remains capital in nature and was not deductible.
Regarding the validity of paragraph 4, the Respondent submitted that the provision constitutes guidelines issued by the Commissioner under powers conferred by Section 15(2)(a) of the ITA and should be interpreted alongside the other provisions of the Act.
The Tribunal’s Determination
The Tribunal identified the issues for determination as follows:
- Whether paragraph 4 of Legal Notice No. 37 of 2011 is ultra vires and contrary to Section 15(2)(a) of the ITA; and
- Whether the Respondent erred in finding that the principal loan amount is capital in nature, thereby disallowing the deduction of the said bad debts.
On the first issue, the Tribunal noted that it lacked jurisdiction to determine the validity of subsidiary legislation and was therefore constrained to down its tools.
On the second issue, the Tribunal observed that the principal amount of a loan constitutes a financial asset recorded on the balance sheet.
Being capital in nature, the Tribunal held that the principal component does not qualify for deduction when written off under paragraph 4 of Legal Notice No. 37 of 2011. However, the interest, fees, and penalties arising from the loan qualify for deduction when they become uncollectable.
Consequently, the Tribunal found that the Respondent did not err in disallowing the deduction of bad debts where the principal component had not been distinguished from interest, and other revenue elements.
Tax Implications for Lenders and Credit Institutions
This decision highlights the need to distinguish between the capital and revenue components of a loan when determining the deductibility of bad debts.
Lenders and credit institutions should therefore maintain detailed records identifying the various components of loans written off, including the principal amount, interest, fees, penalties, and any other related charges.
In light of the above, lenders should consider the following tax treatment when writing off bad debts:
- The principal amount, being capital in nature, should not be claimed as a deductible expense.
- Other components, such as interest, fees, and penalties, may be deductible if they satisfy the Commissioner’s threshold under Paragraph 2 of Legal Notice No. 37 of 2011, which requires that one of the following conditions be met:
- The creditor loses the contractual right to the debt through a court order;
- No form of security or collateral is realisable, whether partially or in full;
- The securities or collateral have been realised, but the proceeds fail to cover the debt in full;
- The debtor is adjudged insolvent or bankrupt by a court of law;
- The costs of recovering the debt exceed the debt itself; or
- Efforts to collect the debt are abandoned for another reasonable cause.
Overall, the decision affirms the distinction between capital and revenue items under Kenyan tax law and emphasises the importance of properly analysing the composition of bad debts to support any deductions in future audits or disputes.
If you require further information or clarification on this matter, please do not hesitate to contact CMC Advocates LLP.
