Kenya’s previously tax-free infrastructure bonds, hailed for their role in financing critical development projects, are set to lose their tax-exempt status following plans by the National Treasury to reintroduce withholding tax on gains from these bonds. This move, part of broader fiscal reforms outlined in the reintroduced Finance Bill 2024, signals a significant policy shift aimed at shoring up government revenue but risks discouraging investment in a critical area of economic growth.

Background of Infrastructure Bonds in Kenya

Since their inception in 2009, infrastructure bonds (IFBs) have been a linchpin for Kenya’s public finance strategy, offering investors the dual benefit of attractive returns and tax-free status on interest income. These bonds have been used to fund large-scale infrastructure projects, including road networks, power generation, water supply, and other key public utilities. Their appeal has been particularly strong among institutional investors, high-net-worth individuals, and investment funds, drawn by the security of government backing and tax advantages.

The proposal to tax IFBs marks a stark reversal of a policy designed to attract long-term investments and promote economic growth. The move has sparked widespread debate among financial analysts, policymakers, and investors over its potential impacts on both investor sentiment and the government’s ability to finance infrastructure development.

Details of the Proposal

The National Treasury’s plan stipulates that gains from infrastructure bonds with a tenure of at least three years will be subject to a 5% withholding tax. This tax aligns with the existing rate on certain fixed-income instruments but represents a departure from the longstanding tax-free status of IFBs. Treasury Bills, which are generally shorter-term and considered less attractive to long-term investors, already face a 15% withholding tax on returns.

This new policy, if enacted, will see infrastructure bonds join a suite of financial instruments under the tax net, a measure the government argues is necessary for increasing domestic revenue collection.

Historical Context: The Finance Bill 2024 Controversy

The current push to tax infrastructure bonds revisits a provision from the Finance Bill 2024, which initially stirred considerable public unrest earlier this year. The proposal to tax IFB returns was among a series of fiscal measures that led to widespread protests in June, resulting in confrontations between civilians and law enforcement, injuries, and significant disruption to the economy.

The original Finance Bill 2024 included a dual taxation model: a 5% tax on domestic investors and an implied 15% rate for foreign investors. Tax analysts, including Mbiki Karanja, a tax manager at Grant Thornton, highlighted the ambiguity surrounding the rate applicable to non-residents, which was not explicitly stated but inferred to be the standard 15%.

“While the rate for domestic investors was set at 5%, the absence of a specified reduced rate for non-residents indicated that the standard 15% withholding tax would apply,” Karanja explained during an interview with Bloomberg.

Current Market Performance and Investor Gains

Despite the uncertain regulatory environment, 2024 has been a lucrative year for infrastructure bond investors. In February, an IFB issuance attracted a record-high return rate of 18.4607%, underlining the strong demand for such financial instruments. These high returns were especially attractive given the backdrop of global economic uncertainties, including fluctuating commodity prices and foreign exchange volatility.

The success of infrastructure bonds has been pivotal in financing Kenya’s infrastructure, with projects such as the Nairobi Expressway, the Lamu Port-South Sudan-Ethiopia Transport (LAPSSET) Corridor, and renewable energy ventures like geothermal power plants benefiting from this funding model.

Potential Impacts of the Proposed Taxation

1. Investor Sentiment and Market Behavior

The reintroduction of a withholding tax on infrastructure bond gains could alter the landscape of the fixed-income market in Kenya. Historically, the tax-free nature of IFBs has attracted investors who prioritize stable, long-term returns. Taxing these bonds may lead investors to seek alternative instruments that offer comparable returns without the tax burden, potentially impacting the inflow of capital into infrastructure projects.

“Taxing infrastructure bond returns could dampen investor enthusiasm and reduce demand,” said Peter Ndegwa, an investment strategist based in Nairobi. “Investors might look to diversify into other areas such as real estate investment trusts (REITs) or equities, which, although riskier, may offer tax-optimized gains.”

2. Implications for Infrastructure Development

The impact on infrastructure development could be profound. The government has historically relied on the proceeds from these bonds to finance significant infrastructure projects that support economic growth and job creation. If investor interest wanes due to the reduced attractiveness of IFBs, it could slow the pace of infrastructure development and hinder progress in essential sectors.

Moreover, with reduced uptake of infrastructure bonds, the government may face higher borrowing costs if forced to offer higher interest rates to attract buyers. This, in turn, could exacerbate the fiscal deficit and strain public finances.

Comparisons with Other Countries

Kenya’s move to tax infrastructure bonds aligns with practices seen in other emerging markets, where governments often balance the need to attract investment with the imperative of raising revenue. For example, in Nigeria, interest income from government bonds is also taxed, though incentives exist for investments in specific strategic sectors. Similarly, South Africa subjects its government bond interest to taxation, albeit with a graduated system based on residency and type of investment.

However, some analysts argue that Kenya, as an economy still developing its financial depth, risks stifling a critical investment avenue by removing tax incentives on infrastructure bonds. “While it is understandable that the Treasury seeks to expand the tax base, there should be a measured approach to ensure that long-term capital formation is not adversely affected,” said Dr. Susan Kimani, a finance lecturer at Strathmore Business School.

Economic Context and Government Rationale

The decision to tax infrastructure bond gains comes as Kenya faces significant economic challenges, including rising debt levels, budget deficits, and inflationary pressures exacerbated by both domestic and global factors. The National Treasury, under Cabinet Secretary Njuguna Ndung’u, has been tasked with finding new revenue streams to finance development projects and service public debt, which stood at over KSh 10 trillion ($68 billion) as of October 2024.

The withholding tax on IFBs is projected to generate additional revenue that could help fund essential public services and reduce the government’s reliance on more expensive forms of debt, such as international bonds or commercial bank loans.

Public and Political Reactions

The proposed tax policy has been met with mixed reactions. Some economic policy advocates argue that it is a necessary measure to ensure sustainable government revenue in the long run. Others, including members of the opposition and financial lobby groups, have criticized it as regressive, fearing that it could deter investment and ultimately harm economic growth.

The Kenya Association of Manufacturers (KAM) and the Kenya Private Sector Alliance (KEPSA) have both voiced concerns, stating that taxing IFBs could disrupt financial market stability and reduce the flow of funds into sectors that are critical for growth and development.

Political leaders, including some members of Parliament, have also expressed reservations. “We understand the need for revenue, but we must be careful not to stifle investment,” said Minority Leader Opiyo Wandayi. “Our focus should be on broadening the tax base through innovative approaches that do not undermine the very mechanisms we rely on for development.”

Looking Ahead: The Path to Approval and Future Implications

The Finance Bill 2024, which includes this proposal, is set to be debated in Parliament in the coming weeks. The outcome will determine whether the government’s push to tax IFBs becomes law or faces amendments and delays.

Should the measure pass, it may prompt a re-evaluation of investment strategies among both institutional and individual investors. Analysts suggest that the government could consider phased implementation or exemptions for specific projects to mitigate potential negative impacts on investment sentiment.

Conclusion

The proposed taxation of infrastructure bonds in Kenya represents a pivotal shift in the government’s approach to balancing revenue generation with investment promotion. While the policy aims to bolster government coffers in the face of mounting economic pressures, it poses potential risks to investor confidence and the future of infrastructure development. Stakeholders will be watching closely as the proposal makes its way through legislative channels, with implications for the broader economic landscape hinging on its outcome.

Ready to take your career to the next level? Join our dynamic courses: ACCA, HESI A2, and ATI TEAS 7! 🌟 Dive into a world of opportunities and empower yourself for success. Explore more at Serrari Ed and start your exciting journey today! ✨

Photo source: Google

By: Montel Kamau

Serrari Financial Analyst

4th November, 2024