For early-stage and growth companies in Rwanda, securing financing is a critical step, often involving a mix of debt and equity. While shareholder loans can offer flexible funding, understanding Rwanda's tax legal framework, particularly its thin capitalisation rules, is key for both companies and investors to ensure tax-efficient arrangements and manage financial risks with confidence.

This article demystifies the 4:1 thin capitalisation ratio and its implications for the deductibility of shareholder loans.

Rwanda’s Law nº 027/2022 of 20/10/2022 establishing taxes on income (the "Income Tax Act”) as amended to date, includes specific provisions designed to address thin capitalisation, a situation where a company is excessively financed by debt rather than equity, potentially leading to tax avoidance through excessive interest deductions.

Article 25(10°) of the Income Tax Act precisely provides that interest arising from loans between related persons is considered a non-deductible expense if the total loans exceed four (4) times the amount of the company’s paid-up equity.

For the purpose of this central calculation, paid-up equity overtly excludes provisions, reserves, and retained earnings. This strict definition denotes the importance of initial capital contributions over accumulated profits when assessing compliance.

The concept of related persons is far-reaching. According to Article 3(1°) of the Income Tax Act, related persons include individuals or entities that directly or indirectly participate in the management, control, or capital of another entity.

This definition is further elaborated upon in the Ministerial Order nº 003/20/10/TC of 11/12/2020 establishing general rules on transfer pricing (the "Ministerial Order on TP Rules”), which applies to controlled transactions between related persons. This extensive definition captures all intertwined relationships under thin capitalisation rules, which exclude banks, insurers, and other financial institutions.

When the 4:1 debt-to-equity ratio is exceeded for loans between related persons, the tax implication is clear: the interest corresponding to the excess debt is non-deductible from the company’s taxable income. This elucidates that while the company may still incur and pay the interest, it cannot reduce its taxable profit by that amount, effectively increasing its corporate income tax liability.

Besides, realised foreign exchange losses arising from total loans between related persons that exceed this 4:1 ratio are also non-deductible (Article 25(11°) of the Income Tax Act).

The effect of non-deductibility is to treat that portion of the financing as if it were not a pure debt instrument for tax purposes, thereby increasing the company’s taxable profits, which are currently taxed at a rate of 28%. This insinuates that every non-deductible Rwandan Franc of interest or foreign exchange loss directly adds to the company’s tax burden.

One significant area of legal uncertainty arises with the tax treatment of hybrid financing instruments, such as convertible notes. These instruments typically possess characteristics of both debt (e.g., fixed interest payments, repayment obligations) and equity (e.g., convertibility into shares).

The Rwandan tax laws do not offer explicit guidance on how instruments like convertible notes should be classified for thin capitalisation purposes or for general tax treatment (as debt or equity). This lack of clarity creates a challenge for startups, which often use convertible notes as a flexible way to defer valuation discussions and simplify early-stage fundraising, and for their investors.

The classification of such an instrument as debt or equity has profound tax implications. For instance, if classified as debt, it would be subject to the 4:1 thin capitalisation ratio, affecting interest deductibility. Interest income from such instruments is usually subject to a 15% withholding tax, or potentially 5% if listed on the capital market (Article 60 of the Income Tax Act).

If classified as equity, the interest payments might be treated as dividends, which are subject to a 15% withholding tax, or 5% for listed securities if the beneficiary is a Rwandan or EAC resident taxpayer.

Notably, the Law n° 006/2021 of 05/02/2021 on investment promotion and facilitation (the "Investment Code”) exempts withholding tax on up to five dividend issuances by a start-up to angel investors, provided conditions such as a maximum investment of USD 500,000 are met.

This incentive could be beneficial if convertible notes are treated as equity at conversion or if their payments are construed as dividends from the outset. Likewise, dividends and interest from financial services are exempted from VAT.

Without clear statutory or regulatory guidance on hybrid instruments, their tax classification remains a matter of interpretation, posing potential risks for both companies and investors.

Given the applicable rules and ambiguities, early-stage companies and investors structuring financing in Rwanda should, before entering into any related-party loan arrangements, carefully assess their existing paid-up equity and model the potential impact of the 4:1 ratio on the deductibility of interest expenses.

To mitigate these challenges and explore alternatives, for angel investors and qualifying start-ups, the Investment Code offers substantial incentives for equity financing. These include an exemption from capital gains tax on the sale of shares (for primary equity issuance) and an exemption from withholding tax on the first five dividend distributions.

Beyond specific ratios and incentives, all related-party transactions, including loans, should be thoroughly documented. This documentation should align with the arm's length principle, demonstrating that the terms and conditions of the loan are comparable to those that would be agreed upon between independent parties.

In particular, concerning hybrid instruments such as convertible notes, parties should seek clarity from RRA or strive to structure such instruments in a way that aligns as closely as possible with existing definitions of debt or equity. This approach fortifies minimising ambiguity and potential challenges in tax treatment. While the 4:1 debt-to-equity ratio for related-party loans is clearly defined, the absence of guidance on hybrid instruments poses challenges, especially for early-stage financing.

Ultimately, to ensure tax efficiency and compliance, early-stage companies, founders, and investors should consult legal and financial advisors with expertise in Rwandan tax law to structure financing effectually, manage perils, and focus on growth with assurance.

The writer is a Corporate and Legal Services Lead at Andersen in Rwanda