Debt vs. Equity Financing: Tax Benefits Analysis

Equity Financing

• Returns: Shareholders receive dividends (Section 133, Income Tax Act, 2015 (Act 896)).
• Tax Treatment:
  • Dividends are not deductible for tax purposes in the company’s books (Section 130(4), Act 896).
  • Dividends paid are subject to 8% withholding tax (Section 115, First Schedule, Act 896).
  • Exemption: Dividends paid to a resident company controlling at least 25% of the paying company’s voting power are tax-exempt (Section 59(3), Act 896).
• Anti-Avoidance: If a closely held company (controlled by ≤5 persons) retains unreasonable profits, the Commissioner-General may treat profits as dividends, subject to business needs (Section 59(8) & (9), Act 896).

Debt Financing

• Returns: Lenders receive interest (Section 133, Act 896).
• Tax Treatment:
  • Interest paid on debt used in business or for asset acquisition is generally deductible, reducing taxable income (Section 10, Act 896).
  • Withholding Tax:
    • Interest paid to individuals (except from resident financial institutions or government bonds) is subject to 1% withholding tax (Section 115, First Schedule, Act 896).
    • Interest paid to non-individuals is subject to 8% withholding tax.
• Restrictions:
  • Transfer Pricing: Related-party loans must comply with arm’s length rules (Act 896).
  • Thin Capitalization: Interest deductions may be limited if the lender is an exempt person and the borrower is a resident non-financial institution (Act 896).

Analysis

Debt financing appears more tax-advantageous because interest is deductible, reducing the company’s taxable income, unlike non-deductible dividends. However, debt financing risks transfer pricing scrutiny and thin capitalization restrictions, which may limit interest deductions.

Conclusion

The assertion that debt financing provides more tax benefits is generally accurate due to interest deductibility, but companies must navigate anti-avoidance rules to ensure compliance.