It is perplexing for me, as a tax lawyer having worked for close to 10 years on Ethiopian tax laws, to see how the investment and finance community in Ethiopia is not worrying enough about the tax on premiums “introduced” recently by the Ministry of Finance. It is perplexing because this “newly introduced” tax is unclear on many fronts, and anyone who has had any engagements with the Ethiopian Tax Authorities knows how the tax administration is beset by the problem of misapplication of even some of the well-articulated tax laws let alone those with uncertainties. The obscurity of the relevant law at issue is not only for the ordinary taxpayer, but also for the tax authority and, surprisingly enough, even to the Ministry of Finance (i.e. the very authority that “introduced” the tax) as will be shown below.
Initially, this tax on premiums first appeared under Article 11 of the Capital Gains Tax Directive no. 8/2011 (hereinafter “the Directive”) issued by the FDRE Ministry of Finance. The effective date of the Directive is beginning from the 7th of August 2019 and it is officially available only in the Amharic language. The ominous provision of Article 11 of this Directive (hereinafter the “Provision”) provides as follows:
11. Income of Companies on Sale of Shares
The income secured by companies from the sale of shares they issued at a price greater than their par value is taxable under Schedule ‘C’; the tax on gains on disposal of certain investment property shall not be applied on such gain in accordance with Article 64(1)a of the Proclamation. (Translation mine)
The Proclamation referred to in the Provision is the Federal Income Tax Proclamation No. 979/2016. The difference between the par value and the price at which shares are issued is known as a “Premium”. Schedule ‘C’ of the Income Tax Proclamation mentioned in the Provision is the schedule under which income from business is taxed. The rate of business income tax applicable to a body is 30%. Therefore, as one can clearly understand, what the above provision provides for is the taxation of premiums at the business income tax rate.
As any reader with an average knowledge of company law and taxation can already see from the reading of the above-reproduced Provision, the anomaly of the Provision begins from the start where it is depicted as though a premium is an income secured by the companies that issued the shares above the par value. This is simply not the case as there is no ‘gain’ to be made by the company from such an activity. The investment made by shareholders in terms of paying for newly issued shares are not properties or assets of the company, but in contrast, liabilities of the company towards shareholders. This is why the shareholders are paid dividends from the profits of the company or the proceeds after liquidation or even bankruptcy of the company.
Article 435 of the Commercial Code provides that the issue premiums can be transferred to a reserve fund and only persons who had been shareholders prior to the sale of the new shares may share in the distribution of such reserve. This shows two things. One, the owners of the issue premiums are the shareholders, and not the company. Two, until a decision is made for distribution to the respective shareholders, the premiums are placed in a reserve account. As such, issuance of new shares at a premium is not a sale of goods or services by a company and therefore there will be no profit or gain made by the company to be considered for taxation.
It is not also clear why the Provision addresses business income tax while it is part of a directive that is issued to govern the manner of capital gains taxation. Capital Gains Tax is a tax paid on disposal of certain investment property (i.e. immovable property, shares and bonds) under Schedule ‘D’ of the Income Tax Proclamation. For general information, Article 64(1)(a) of the Proclamation referenced in the above Provision provides that tax under Schedule ‘D’ shall not apply to an amount that is liable to tax under another Schedule.
On the other hand, although the Provision purports to tax premiums under Schedule ‘C’ or the business income taxation Schedule, it is interesting to note that such Schedule does not recognize premiums as business income. Article 21 of the Proclamation lists what business incomes are subject to business income taxation. Accordingly, it is only the items of (i) the gross proceeds from the disposal of trading stock and from provision of services, (ii) the gain on disposal of business assets and (iii) other amounts recognized as business income under the Proclamation which are business incomes that are subject to Schedule ‘C’ taxation. The Proclamation nowhere provides that premiums are to be considered as business income for the company. In such a manner, it can be said that the Ministry of Finance is introducing a new type of tax which is a power normally reserved for the Ethiopian Parliament under the Constitution. This calls into question whether the Provision adheres to the principle of Legality of Taxation.
In addition to the above, one general trait of the business income tax regime under Schedule ‘C’ of the Proclamation is net-basis taxation. This is the deduction of any expenditure to the extent necessarily incurred by the taxpayer during the year in deriving, securing, and maintaining amounts included in business income from the gross proceeds for the year. Under the “new” tax introduced by the Directive, it is not clear what expenses are meant to be deductible while the business income tax is applied. This shows that Schedule ‘C’ cannot accommodate the “newly introduced” tax on premiums.
What should worry the finance and investment community the most is not the anomalies and legal inconsistencies discussed above. Rather, it is the effect that such tax may have on the overall business activities and FDI inflow in to the country that is most concerning. As one form of financing (other than debt/loans), issuance of new shares by companies is aimed at increasing the capital of the company, as recognized as one of the main methods for doing so under Article 442 of the Commercial Code. Those companies which issue new shares at premiums do so because the valuation of the company has increased from the time it was established. The premium paid for the newly issued shares provides growth-capital which is usually used for expanding the business. This could consequently mean increased and diversified output, efficiency, job creation, profitability, etc., which are all beneficial for the country’s long-term development in terms of increased revenue collection and economic growth.
However, if such new investment, or capital is taxed before it is utilized in such a manner, the potential for the new investment to contribute to the company’s growth will be greatly diminished. This would obviously discourage every investor who wants to invest in companies having potentials for growth because no investor wants to be taxed at the rate of 30% just for investing into a company before making any profits. The proposed tax is as such a tax on capital and investment. It is tantamount to taking away certain limbs of a chicken kept for egg production and hatching many more chicks in the future.
While lack of access to capital affects most start-up companies in Ethiopia, the tax on premiums exacerbates this problem by further deterring available capital for growth. As companies that do not perform well do not normally issue shares at a premium, it can also be seen that the tax specially affects those companies that are doing well or have promising potential for growth. With the advent of capital markets to Ethiopia, such tax would also become volatile with frequently fluctuating values of companies.
The other fact which I think should alarm the investor community the most is the potential for assessment of huge tax liabilities following impromptu tax audits of the Tax Authority. As seen in practice, the Tax Authority usually conducts comprehensive tax audits against companies for the past five years from the time of the audit. This is practiced following the five years general limitation period for amending tax assessments. In this situation, it is common to observe taxpayers receiving tax assessment notifications with enormous amounts of liabilities in tax, interest and penalties which are beyond expectation. It is worth noting here that the rate of late payment interest under the tax laws is the highest commercial lending interest rate that prevailed in Ethiopia during the quarter immediately before the date the tax was due, increased by 15%.
The likelihood for such tax assessment being issued by the Tax Authority against relevant companies basing upon the above Provision is very high. And, the chances for avoiding the ensuing tax liability by presenting complaints through the tax dispute settlement procedures are slim. This is mainly because of the confusion surrounding the Provision as indicated at the beginning of this writing.
In a clarification guidance issued by the Ministry of Finance to the Ministry of Revenues on 24 December 2019 (i.e. less than 5 months from the effective date of the Directive), it was indicated that several companies repeatedly petitioned the Ministry of Finance stating that they are being asked to pay capital gains tax on the difference between the par value and the purchase price of newly issued shares (i.e. premiums). The guidance then proceeds to explain that capital gains tax is only paid when there is transfer of assets and a gain is derived therefrom, but that transfer of shares is not deemed to take place when a company issues new shares. In accordance with this logic, the guidance orders the Tax Authority to stop the practice of assessing capital gains tax in this instance by further reasoning that there is no law which authorizes assessment of capital gains tax when companies issue new shares to shareholders and such practice will adversely affect investment. Sadly enough though, the guidance concludes by stating that “the income obtained by companies by issuing a share above its value will be subject to tax under Schedule ‘C’, but it will not be subject to capital gains tax as indicated under Article 11 of the above mentioned Directive.” It opens a door for a further confusion by also stating that "for purposes of payment of the tax, the phrase ‘above the value of the share’ shall mean the price above the estimated market value of the share."
As anyone might expect, the above guidance could not address the concerns of companies that was referred in the guidance itself (because the issue was not in relation to capital gains tax but business income tax from the outset) and the Ministry of Finance was forced to make amendments to the Directive on 13 August 2020 to “further clarify the issue”. In the cover letter to the amendment addressed to the Ministry of Revenues, the Ministry of Finance stated that the amendment is necessitated by the need to further clarify the previous guidance issued to direct the Tax Authority not to apply capital gains tax on issuance of new shares beyond their par-value. But, again, in a very bizarre and sad manner, the amendment has not touched the very Provision of the Directive that is about taxation of issuance of new shares beyond their par value (i.e. Article 11). Rather, the amendment has modified two other provisions (i.e. Articles 3(1) and 6(1)) which are about the manner of calculation of ordinary capital gains tax.
Although it is not clear for anyone why both of these two communications by the Ministry of Finance on the Directive failed to address the elephant in the room, one thing is certain. They have the effect of solidifying the problematic Provision and diminishing any chance of success in an attempt to curb its application by relying on the inconsistences, principles and legal arguments detailed above in front of tax dispute settlement forums.
What makes this situation worse and extremely confusing is the fact that the Ministry of Finance has indicated in a recent explanatory note it issued on various controversial tax issues on 7 October 2021 (27 Meskerem 2014 E.C) that capital gains tax is applicable on issuance of new shares at a premium. Without the need for any explanation, this shows that it is high time to revisit and clarify the issue properly by all the concerned entities as soon as possible to avoid protracted disputes between taxpayers and the Tax Authority and prevent frustration of members of the investor community. If there is indeed a policy shift with the government in the direction of taxing issue premiums as business income, this policy needs to be legalized in an appropriate manner through the proper parliamentary legislative procedures.
Disclaimer: The views stated in this writing are solely those of the writer and are intended for the discussion of the subject dealt with. They do not reflect the views of any other individual or entity. The writing is not intended to be, and should not be used as, a substitute for taking legal advice in any specific situation.