SBM Bank Kenya Limited v Commissioner of Legal Services and Board Coordination
Can a bank’s default interest be taxed as excise duty?
This question recently came before the Tax Appeals Tribunal in SBM Bank Kenya Limited v Commissioner of Legal Services and Board Coordination.
The Tribunal’s answer provides important clarity for banks and financial institutions operating in Kenya: additional interest charged for late repayment remains interest for tax purposes and therefore falls outside the scope of excise duty.
At a time when tax authorities are increasingly scrutinizing financial services income streams, the ruling offers critical guidance on how contractual loan charges should be characterized for tax purposes.
Background
Like most lenders, SBM Bank includes a default interest clause in its loan agreements. Under these provisions, where a borrower fails to repay a facility on time, the outstanding amount attracts additional interest at 1.25% per month above the prevailing contractual rate.
During a tax audit, the Kenya Revenue Authority (KRA) took the position that this additional charge did not constitute interest, but rather a penalty or fine imposed for late payment.
On that basis, KRA issued an assessment demanding excise duty at 20%, together with penalties and interest, arguing that the charge fell within the category of “other fees” charged by financial institutions under the Excise Duty Act.
SBM Bank disputed the assessment, and the matter ultimately proceeded to the Tax Appeals Tribunal.
The Core Legal Question
The entire dispute hinged on one question: is default interest charged by a bank to a borrower for late repayment a ‘fee’ subject to excise duty, or is it ‘interest’ excluded from excise duty?
The Excise Duty Act imposes a 20% excise duty on ‘other fees’ charged by financial institutions. The First Schedule defines ‘other fees’ as any fees, charges, or commissions charged by financial institutions relating to their licensed activities. The definition expressly excludes interest on loans and returns on loans from its scope.
KRA’s argument was straightforward: the default charge is a penalty for non-performance, not compensation for the use of money, and therefore falls outside the interest exclusion and into the taxable ‘fees’ category. SBM Bank’s position was equally straightforward: the letters of offer call it interest, it functions as interest, and the law excludes it from excise duty.
What the Law Says
The Tribunal approached the dispute as a matter of statutory interpretation.
The Excise Duty Act imposes excise duty on “other fees” charged by financial institutions, defined in the First Schedule as fees, charges, or commissions relating to licensed financial activities. However, the same provision expressly excludes interest on loans and returns on loans from the definition of taxable fees.
Because the Excise Duty Act does not define the term “interest,” the Tribunal relied on the definition contained in the Income Tax Act, which broadly describes interest as:
“amounts payable in any manner in respect of a loan, deposit, debt, claim, or other right or obligation.”
Applying this definition, the Tribunal held that additional interest triggered by late repayment remains interest in substance, because it represents compensation to the lender for the continued use of money beyond the agreed repayment date.
KRA’s Argument Failed
KRA’s central submission was that default interest is a penalty, not interest, because it arises from a failure to perform a contractual obligation. KRA argued that a penalty and interest are ‘completely different and independent of each other’ and that the bank’s use of the word ‘interest’ in its letters of offer was designed to mislead.
The Tribunal rejected this framing. The characterization of a charge is determined by its economic substance and the clear wording of the contract, not by KRA’s preferred taxonomy. SBM Bank’s letters of offer expressly stated that the borrower would ‘pay the bank interest at the rate of 1.25% per month over and above the then subsisting rate of interest.’ The charge is additional interest compensating the lender for being kept out of its money beyond the agreed date.
KRA’s attempt to reclassify the charge as a penalty or fine had no basis in the contractual documents, no support in the statutory definitions and ran directly contrary to established case law. The Tribunal declined to follow KRA’s argument.
The Time-Barred Period
SBM Bank raised a limitation period argument that the assessment issued covered periods exceeding the statutory timeframe. Under Section 31(4)(b) of the Tax Procedures Act, KRA’s power to amend an assessment is restricted to five years from the date the relevant self-assessment return was filed.
SBM bank argued that assessments falling outside the statutory period should be entirely vacated. KRA did not raise the willful neglect exception, which is the only statutory ground for going beyond five years. The time-barred portion of the assessment had no legal foundation.
The Finance Act 2019 Window
The Finance Act, 2019 temporarily expanded the exclusion from excise duty by removing all fees and commissions earned in respect of a loan from the definition of ‘other fees.’ This amendment was effective from November 2019 and remained in place until it was reversed by the Finance Act, 2021, which came into force in July 2021.
During that window, all fees and commissions connected to loan facilities were outside the scope of excise duty. The bank argued that any charge assessed for the period November 2019 to July 2021 fell within this broader exclusion and should be vacated on that independent basis as well.
Outcome
The Tribunal allowed the appeal in full setting aside KRA’s objection decision invalidating the entire assessment.
| Key Holding:
Additional interest charged on late payment remains interest and is therefore excluded from excise duty. |
The Tribunal found that KRA had erred in law and in fact by assessing excise duty on amounts that are not subject to excise duty under the Excise Duty Act.
The ruling aligns with earlier decisions by both the Tribunal and the High Court in Commissioner of Domestic Taxes v Key Microfinance Bank Limited.
Why This Decision Matters
The Tribunal’s decision has broader implications for financial institutions operating in Kenya:
- Clarification of the excise duty base – The ruling confirms that interest whether ordinary or default interest remains outside the scope of excise duty.
- Limits on tax authority recharacterization – Tax authorities cannot simply relabel contractual interest as a “penalty” to bring it within the excise duty net.
- Importance of contractual drafting – The case highlights the value of clearly describing loan charges in facility agreements.
- Audit defense precedent – Financial institutions facing similar excise duty assessments may rely on this reasoning in objections or appeals.
Practical Impact for Financial Institutions
Financial institutions should take note of several practical lessons emerging from this decision:
- Default interest remains interest where contractual documentation clearly characterizes the charge as interest;
- KRA cannot recharacterize contractual income streams purely to expand the excise duty base;
- Time limitation rules under the Tax Procedures Act remain a powerful defense where assessments extend beyond the statutory five-year window; and
- Clear loan documentation reduces audit risk, particularly where additional charges are triggered by late repayment.
The decision reinforces a fundamental principle of Kenyan tax law: a taxpayer is not liable to pay tax unless the charging provision unambiguously imposes it. Where the statute expressly excludes a category of income from the tax base, KRA cannot override that exclusion through audit reclassification.
How Intelpoint Consulting Can Help
Excise duty assessments in the financial services sector are becoming increasingly complex, particularly where tax authorities attempt to recharacterize revenue streams arising from loan arrangements.
At Intelpoint Consulting, we advise banks, microfinance institutions, and financial service providers on managing tax authority audits, defending excise duty assessments, and structuring financial products in a manner that is both commercially effective and legally defensible.
If your institution has received a tax assessment or requires assistance reviewing the tax treatment of financial service charges, our team would be pleased to assist