Financing transactions often involve the capitalisation of interest, i.e. adding unpaid interest to the principal loan amount, which increases the principal amount on which interest subsequently accrues. This may, for instance, be the case in infrastructure project finance transactions where some time may lapse before the borrower reaches the commercial operations date (COD) and secures sufficient cash flow for servicing the loan. In this scenario, the project company is given a grace period whereby the payment of the principal amount is deferred for a pre-established period and the borrower may also negotiate to have interest capitalised during the grace period. Another instance may occur where a company has shareholder loans, but considers raising capital (senior debt) from external lenders, and the latter require that the repayment of existing shareholder loans and interest to be accrued thereon be subordinated to the senior debt and be paid only after full repayment of the senior debt. In this case the shareholders would typically request that interest on their loans be capitalised.
The capitalisation of interest raises, among others, one forthright tax issue, i.e. whether capitalised interest may be subjected to withholding tax. In addition, it is to be considered whether capitalised interest would be allowed as a deductible expense or is to increase the cost of the asset financed and, accordingly, the depreciation thereon, but this issue will not be discussed under this article.
The withholding tax implications of the capitalisation of interest is addressed under article 60 of the Income Tax Act (Law nº 016/2018 of 13/04/2018) which provides that:
“[a] withholding tax of fifteen percent (15%) of the total amount excluding Value Added Tax (VAT) where applicable is levied on payments or other methods of extinguishing an obligation made by resident individuals including tax-exempt entities, when such payments or other methods of extinguishing an obligation are made to a person not registered in the Rwandan tax administration or to a registered person who does not have recent income tax declaration.” [Emphasis added]
Under the same Act, “payment or other methods of extinguishing obligations” that are subject to withholding tax include financial interest, save for interest on deposits in financial institutions for at least a period of one year, interest on loans granted by foreign development financial institutions (DFIs) exempted from income tax under the laws applicable in their countries of origin and interest paid by banks operating in Rwanda to banks or other foreign financial institutions.
Unlike various other jurisdictions, in Rwanda an interest withholding tax liability is not incurred on a monthly basis when the interest accrues, but in terms of article 60 (3) of the Income Tax Act, accrued interest which remains unpaid for a period exceeding six months following the end of the income tax period in which such interest accrued, is deemed to be “paid” and the borrower will have the obligation to withhold and remit the relevant withholding tax at that stage.
A closer look at the provisions of article 60 of the Income Tax Act clearly indicates that the 15% withholding tax does not only apply to “payments” but also to “other methods of extinguishing obligations”. While the capitalisation of interest does not constitute a payment or deemed payment, it may be construed by the tax administration as a mode of “extinguishing obligations” as capitalized interest would become part of the principal amount due, cease to be due as “interest”, and therefore, be subject to the 15% withholding tax. This then suggests that when borrowers capitalise interest, especially on loans extended by non-residents, withholding tax must be remitted to the tax administration, if a deemed payment of such interest, as per article 60 (3) of the Income Tax Act, has not already occurred. The failure to do so would render them personally liable to pay the amount of tax which has not been withheld, including penalties and interest on arrears as per article 65 of the Income Tax Act.