National Treasury has revived plans to impose a 5% withholding tax on interest earned on infrastructure bonds with maturities of at least three years.
Infrastructure bonds (IFBs) have been tax-free since they were first issued in February 2009 – meaning they will be subject to tax for the first time if the proposal, which was previously in the controversial Finance Bill, 2024, is approved by Parliament.
“The Taxation Laws (Amendment) Bill, 2024 proposes to tax interest income from infrastructure bonds at a rate of five percent. This will apply to bonds to be issued from the effective date of this provision,” the National Treasury said on Friday.
IFBs are used by the government to finance the development or construction of specific infrastructure projects. The bonds have been very popular in the market due to their interest-free profile.
The 2024 draft finance law set the withholding tax on income from infrastructure bonds at 5% for residents and 15% for non-residents on papers with maturity periods of at least three years and issued after June 1, 2024.
However, the proposal faced backlash from financial experts during public engagement on the 2024 Finance Bill, who warned that taxing bonds would lead to investors demanding higher interest rates to cover returns lost due to taxes.
IFBs were first introduced in 2009 and have remained tax-exempt.
In contrast, regular Treasury bonds are subject to a withholding tax of 15 percent for notes maturing within five years and 10 percent for notes maturing more than five years.
Demand for existing infrastructure bonds is expected to rise if the reintroduced provision is implemented, as infrastructure bond holders are unlikely to give up tax-exempt notes.
The government has benefited from high demand for infrastructure bonds to meet its domestic borrowing needs, as other fixed income bonds struggle to garner the same level of interest from investors.
For example, the government mobilized Sh319.6 billion of infrastructure bonds in the fiscal year ending June 2024, with the bulk of the investors being commercial banks.
Lenders held Sh954.5 billion of the outstanding Sh1.7 trillion infrastructure bonds as of June, while non-banks held Sh758.6 billion worth of infrastructure bonds, including retail investors.
Meanwhile, non-residents partly hold Sh13.9 billion of outstanding IFBs.
Islamic banks accounted for just over a third of net domestic debt, or 35.41 percent, in the period under review.
Imposing a withholding tax on interest on Islamic banks may reduce their attractiveness to investors, although the rate remains relatively lower than that on ordinary government securities.
The appeal of IFBs remains high at present, with the February bonds, for example, fetching a premium of up to Sh112 per 100-shilling unit of paper in the secondary market at the end of last month.
National Treasury had previously proposed taxing green bonds at the same rate as international investment banks.