Interest Limitation, EBITDA Base and a Related-Party Pricing Question
Zawadi Manufacturing Ltd is a Kenyan resident company with a 31 December year end. Accounting profit before tax for 2025 is KES 180 million, after charging: finance costs of KES 130 million, of which KES 90 million is interest at 15% on a KES 600 million loan from its Mauritian parent (10% withholding tax was correctly deducted and remitted), and KES 40 million to a local bank; depreciation of KES 70 million; and KES 8 million of fines and penalties. It also received KES 40 million of exempt dividend income. Capital allowances equal depreciation for the year. Under the Income Tax Act, interest deductible is limited to 30% of EBITDA, with any excess carried forward for five years. The company's equity is KES 900 million. Comparable third-party borrowing by Kenyan manufacturers of similar credit standing is priced at 9%.
1. Compute the interest limitation, the amount of interest disallowed and the 2025 tax liability on the mechanical (statutory) EBITDA basis.
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Step 1 - EBITDA on the mechanical basis. PBT + interest + tax + depreciation + amortisation, with no further adjustment:
| KES m | |
|---|---|
| Profit before tax | 180.0 |
| Add back: finance costs | 130.0 |
| Add back: depreciation | 70.0 |
| EBITDA (mechanical) | 380.0 |
Step 2 - Cap. 30% x 380.0 = KES 114.0m. Tax EBITDA is computed before the interest deduction itself; netting interest against earnings first would double-count. Depreciation is added back even though it is also given as capital allowances, because the cap is defined on EBITDA, not on taxable income.
Step 3 - Disallowance. Deductible interest = 130.0 − 114.0 = KES 16.0m disallowed, carried forward for up to five years and set against future interest capacity.
Step 4 - Taxable income.
| KES m | |
|---|---|
| Profit before tax | 180.0 |
| Add: fines and penalties (not deductible, s.16) | 8.0 |
| Less: exempt dividend income | (40.0) |
| Add: disallowed interest | 16.0 |
| Taxable income | 164.0 |
| Tax at 30% | KES 49.2m |
Checks. WHT was correctly deducted, so no s.16 disallowance of the related-party interest arises on that ground. Debt:equity is 600:900 = 0.67:1, so no thin capitalisation issue. Capital allowances equal depreciation, so no balancing adjustment.
2. The tax manager argues that the EBITDA base should exclude exempt income and add back non-deductible fines, giving a materially different result. Evaluate both bases, quantify the difference and recommend a position.
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The alternative base:
| KES m | |
|---|---|
| Mechanical EBITDA | 380.0 |
| Add back: fines (charged in arriving at PBT) | 8.0 |
| Less: exempt dividend income (not 'earnings' from operations) | (40.0) |
| Adjusted EBITDA | 348.0 |
30% x 348.0 = KES 104.4m → disallowed interest = 130.0 − 104.4 = KES 25.6m, i.e. KES 9.6m more than the mechanical basis, and additional tax of KES 2.88m.
Evaluating the arguments:
- For adjusting (tax manager): the purpose of the rule is to cap the deductibility of financing costs against operating earnings. Exempt dividend income has no tax capacity to absorb interest; including it funds a deduction with income that is never taxed. Fines are non-deductible, so allowing them to reduce the base gives relief the Act denies elsewhere.
- For not adjusting (mechanical): the statute defines the measure by reference to accounting earnings before interest, tax, depreciation and amortisation. It does not import the deductibility tests of s.15 or s.16. 'Depreciation and amortisation' is expressly added back, but exempt income and disallowable expenses are not expressly excluded - and a court will not read in words the legislature omitted.
Recommendation. Adopt the mechanical basis of KES 16.0m as the filing position because it follows the statutory wording, but:
- Disclose the alternative computation in the tax working papers and in the tax provision note to management.
- Recognise the KES 2.88m as a potential exposure in the tax-risk register, not as a liability - an uncertain tax treatment under IFRIC 23 is assessed on whether the revenue authority is more likely than not to accept it.
- Do not 'split the difference'. A filed position must be one you can defend in full.
The judgement the examiner is testing is that a technical argument in the client's favour is not automatically the correct position, and that the documented alternative is what protects the company and the adviser.
3. The 15% rate on the parent loan is 6 percentage points above the 9% third-party benchmark. Advise on the transfer pricing exposure, its interaction with the interest limitation, and the documentation the company must have.
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The exposure. Under Kenya's transfer pricing rules, a transaction with a non-resident related party must be priced on an arm's-length basis. The loan is a related-party financing transaction and 15% is 600 basis points above comparable third-party borrowing.
- Interest actually charged: 600m x 15% = KES 90.0m
- Arm's-length interest: 600m x 9% = KES 54.0m
- Excess: KES 36.0m, which the Commissioner may disallow
Order of application matters. The arm's-length adjustment is applied first, because the interest limitation can only cap what is deductible in the first place.
| KES m | |
|---|---|
| Arm's-length interest | 54.0 |
| 30% EBITDA cap | 114.0 |
| Interest allowed (lower of the two) | 54.0 |
| Additional disallowance vs. the KES 114.0m previously allowed | 36.0 |
| Additional tax at 30% | KES 10.8m |
The interest limitation therefore becomes irrelevant once the pricing adjustment is made - a trap for anyone who computes the cap first.
Secondary consequences:
- The arm's-length adjustment is a deemed dividend or a recharacterisation; the company should confirm the WHT treatment of any adjustment (the 10% already remitted on the 90m may need revisiting).
- Corresponding adjustment in Mauritius should be sought under the treaty's mutual agreement procedure to avoid double taxation.
Documentation required: a transfer pricing study covering the loan - a benchmarking search for comparable unsecured (or secured, as the case may be) third-party loans, credit-rating analysis, tenor and currency, the group's financing policy, and the choice of the comparable uncontrolled price method. Kenya applies a documentation threshold and a master file/local file structure; the file must be contemporaneous, because it is worth nothing if prepared after the audit notice.
Recommendation: reprice the loan prospectively and consider whether an advance pricing arrangement or a voluntary disclosure of prior years is preferable to an assessment with penalties and interest.