In a landmark ruling, SBM Bank Kenya won a Sh176.44 million tax dispute against the Kenya Revenue Authority (KRA). This case set a significant precedent for the taxation of penal interest on loans. The central issue was whether additional charges on late loan repayments—penal interest—should attract excise duty.
The Tax Appeals Tribunal ruled in favor of SBM Bank. It determined that penal interest is an extension of regular interest and should not be taxed under the Excise Duty Act, 2015. This decision will impact Kenya’s banking industry, offering tax clarity and relief for financial institutions facing similar disputes.
Understanding Penal Interest
Penal interest, also called default or late payment interest, is a charge imposed on borrowers who miss scheduled loan repayments. It serves multiple purposes:
- Deterrence: Encourages borrowers to make timely payments.
- Compensation: Covers potential lender losses from late payments.
- Risk Management: Mitigates risks linked to non-performing loans.
Unlike processing fees or service charges, penal interest is directly tied to a loan’s interest rate. It is a risk management tool rather than a separate fee.
SBM Bank vs. KRA: The Tax Dispute
Background of the Case
A KRA tax assessment from September 2018 to September 2023 led to the dispute. KRA claimed SBM Bank failed to remit excise duty on penal interest charged to customers. As a result, KRA assessed a tax liability of Sh176.44 million, including penalties and interest.
SBM Bank’s Defense
SBM Bank argued that penal interest is an extension of a loan’s standard interest rate. Since the Excise Duty Act excludes interest from excise duty, the bank maintained that the charge should not be taxed.
KRA’s Argument
KRA insisted that penal interest serves as a fine or fee rather than actual interest. Since lenders impose it on defaulting borrowers, KRA classified it as a fee, subject to a 20% excise duty.
The Tribunal’s Ruling
The Tax Appeals Tribunal ruled in SBM Bank’s favor. It found that KRA had misinterpreted the law. The Excise Duty Act explicitly excludes interest from excise duty, which includes penal interest. This ruling aligns with international accounting standards and Kenyan tax law.
Impact on Kenya’s Banking Sector
This ruling carries several important implications:
1. Clarification on Tax Obligations
Banks now have clear guidance on the tax treatment of penal interest. They can structure loan agreements with certainty, knowing penal interest will not attract excise duty.
2. Legal Precedent for Future Disputes
The ruling provides a strong legal precedent for other banks in similar disputes. Future tax assessments and appeals could reference this decision, potentially saving financial institutions millions.
3. Regulatory Compliance Adjustments
Banks must review their compliance frameworks to align with this ruling. Financial institutions that previously paid excise duty on penal interest may seek tax refunds.
Related Tax Disputes in Kenya’s Banking Industry
SBM Bank is not the only institution that has contested KRA’s tax claims. Other notable cases include:
- Stanbic Bank’s Tax Challenge: In November 2024, a tribunal ordered Stanbic Bank to pay Sh234 million in taxes related to payments made to foreign card companies. The tribunal ruled that these payments constituted royalties subject to withholding tax.
- SBM Bank’s Previous Tax Dispute: SBM Bank previously contested a Sh737 million tax penalty linked to an agency contract with KRA while operating as Fidelity Commercial Bank. The matter went to arbitration.
These cases highlight ongoing conflicts between financial institutions and KRA regarding tax liabilities.
How Borrowers Benefit from the Ruling
This decision impacts borrowers in several ways:
- Prevents Additional Costs: Since penal interest is not taxed, banks won’t pass excise duty costs onto customers.
- Greater Transparency: Borrowers now understand that penal interest is purely interest-based and not an administrative fee.
- Encourages Timely Repayments: While penal interest still acts as a deterrent, borrowers avoid extra taxation on late payment charges.
Global Perspectives on Taxation of Penal Interest
Tax treatment of penal interest varies worldwide:
- United States: Penal interest is considered standard interest income and taxed accordingly.
- United Kingdom: Similar to Kenya’s ruling, penal interest is treated as interest and not subject to VAT.
- Australia: Penal interest is classified as a fee and may attract Goods and Services Tax (GST).
These variations highlight the importance of jurisdiction-specific tax laws.
Recommendations for Banks
Following this ruling, banks should:
- Review Loan Agreements – Ensure that all penal interest charges are clearly categorized as interest.
- Adjust Compliance Measures – Align financial policies with this tribunal decision to avoid unnecessary tax liabilities.
- Engage with Tax Experts – Work with tax professionals to correctly interpret and implement tax laws.
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Conclusion
Furthermore, SBM Bank’s victory sets an essential precedent in Kenya’s banking sector. By confirming that penal interest is not subject to excise duty, the tribunal has provided clarity for financial institutions and borrowers. This ruling is expected to shape future tax disputes and prevent banks from being unfairly taxed on interest-related charges.
As Kenya’s financial industry navigates tax regulations, this decision reinforces the need for clear and consistent legal interpretations in tax matters.
