Should you accept an interest-free loan?
Anyone who is in the business of lending, would not consider providing interest-free loans because they would quickly put them out of business.
Would any other individual / company that is not in the lending business provide interest free loans? Well, most times, they would provide interest-free loans if they have an interest in the company. So this means, companies are most likely to receive interest free loans from parties they are related to or parties that have an interest in their business.
Going back to our question, but now with related parties in context – should one accept an interest free loan from a related party?
Before answering the question, let us define a related party. A related party, from an entity perspective, is a company that may benefit from 25% or more of the rights to income, capital or voting power of another company. Irrespective of the percentage, a company may also be considered a related party if the Commissioner General of the TRA is convinced that it has influence in another company.
Interest fee loans from related parties are quite common. Most times, an entity in Tanzania is on the receiving end, where it would receive a loan from its parent company or sister companies located overseas. Interest free loans are usually issued especially when the company is in a start-up phase or when it is not performing well financially. Therefore, the related party jumps in to support with an interest free loan for capital expenditure or working capital purposes, until the company is financially stable. This is logical, since companies from the same group work towards a similar goal and therefore, supporting one another in various aspects, not just financially, is part and parcel of their strategy.
You would wonder, what is wrong with not being charged interest? In fact, it is beneficial to Tanzania since there is no flow of income outside the country. You are right! There is no flow of income outside Tanzania and so, the tax man should not make a big fuss out of it. But is it acceptable from a legal perspective?
The Tax Administration (Transfer Pricing) Regulations, 2018, require all transactions between related parties, with or without consideration, to be conducted at arm’s length. Arm’s length means, the price charged by related parties should be similar to the price charged by third parties under similar circumstances. Hence, not charging interest is against the tax laws in the first place. This exposes the company to transfer pricing adjustments which may result to penalties and additional tax liabilities.
Secondly, interest charged on related party loans is subject to withholding tax at the rate of 10%. Therefore, interest free loans may be considered as a means to avoid withholding tax. This is considered an avoidance mechanism especially if the loan recipient is in a loss making position – which is usually the case. Consequently, it exposes the company to future tax liabilities.
Therefore, as good as interest free related party loans are to the business, companies should avoid accepting such non-arm’s length terms in order to avoid future tax liabilities. It is important to establish an arm’s length interest rate where tax would be withheld upon payment of the interest to related parties. If it is not feasible for the company to repay the loan plus interest, then the related party may consider financing the company through other means such as equity.