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Why tax changes may power down green energy investments

In order to realise Kenya’s Vision 2030 goals for sustainable and affordable energy, the government has been offering incentives to encourage investment in the renewable energy space.  One of the most effective incentives in the government’s toolbox is the provision of tax exemptions which have the dual advantage of encouraging investment and possibly lowering electricity tariffs payable by consumers. 

Investors in the energy sector enjoy various incentives including a zero rate of import duty and VAT exemption on renewable energy equipment; exemption from tax on interest paid on loans from foreign sources; exemption from payment of stamp duty in respect of certain instruments; and exemption from withholding tax on payments made to a non-resident for specific services rendered under a power purchase agreement.

In the wake of the Covid-19 pandemic, the government proffered a stimulus package which included concessionary tax rates.  It was the hope of many that this stimulus package would help affected businesses ride the storm and the energy sector players were among those waiting to partake of the government’s liberality.

On 31 March 2020, the Tax Laws Amendment Bill, 2020 (“the Bill”) was circulated for stakeholder comments.  Surprisingly, in addition to the tax reliefs which had earlier been announced by the government, the Bill also contained tax measures unrelated to Covid-19 which were geared towards reversing tax exemptions, including some specific to the energy sector.  The intention of such an approach was likely two-fold: firstly to limit the losses of tax revenue by counter-balancing the Covid-19 tax reliefs with higher tax revenue emanating from the withdrawal of other incentives; and secondly, to implement the removal of tax exemptions at a time when the Bill would  face less resistance on account of urgency.

As luck would have it, when the Bill was assented to by the President on 25 April 2020, most of the changes affecting the energy sector had been removed.  One change that survived the cut in the final Act was the application of VAT at 14% for taxable supplies imported or purchased locally for direct and exclusive use in the construction of a power generating plant.  Previously such supplies were VAT exempt.

Another ground shifting change was the deletion of the tax exemption for compensating tax accruing to a power producer under a power purchase agreement.  The exemption had enabled investors in the power sector to extract profits without incurring a penalizing tax which effectively claws back the tax savings generated from the other incentives granted.  Ironically, for existing energy producers who have robust ‘change in tax’ provisions in their contracts, they may come out of this with a whole skin as the government or offtaker would be required to cushion them from the additional tax costs.

The compensating tax exemption took effect on 1 July 2018 so there may only be a handful of taxpayers who have so far enjoyed the benefit that the exemption intended to confer.  This brings up another pain point on tax incentives which is that, in a stable tax regime, incentives, especially those geared towards long term investments, should be preserved for several tax years so that the investors who were motivated by those incentives are able to realise their benefits. Chopping and changing incentives from one annual budget cycle to the next will only make taxpayers wary of them and they will eventually lose their appeal and efficacy as a fiscal device.

Players in the power sector will also be impacted by the other incentives which have been reduced by the Act.  For example, the 150% investment deduction will now apply at 100% and a smaller proportion of capital allowances will be claimable in the first year of use of buildings and machinery.

Strangely, some of the changes contained in the Bill which were left out of the Act have made a comeback in the Finance Bill 2020.  It is well understood that in the throes of the economic storm created by the pandemic, the Government is focused on generating additional revenue.  However, some of the tax proposals feel like a further siege on an embattled energy sector.

In particular, the Finance Bill proposes to shift some energy related inputs from the VAT exempt category to the standard rated category including specialised equipment for the development and generation of solar and wind energy.  This is bound to have a drastic impact on projects that are about to embark on their construction phase because the cost of such equipment will now be higher than what the project companies had projected in their budget.  The ensuing financing gap will likely force them to borrow more funds at a cost of capital that is quite high since project financiers have to price in the high risk.  The higher project development costs could cause the project to stall and where the offtaker compensates the developer for the extra costs, then these may trickle down to the consumer in the form of higher electricity charges.

The overall effect of the recent tax changes and those proposed in the Finance Bill is to dampen investor appetite in the energy space.  There is a view that the government is no longer as interested in incentivising the renewable energy sector as it previously was, due to the current oversupply of electrical power.  However, providing incentives for renewable energy projects is still advisable because they enable the country to exploit its endowment of resources such as terrain that is optimal for wind and solar energy production.  In addition, renewable energy projects have the distinct advantage of providing cheaper and cleaner energy which is more beneficial economically and environmentally. 

Furthermore, renewable energy projects can help to address the disparity in access to electrical power as there are remote parts of the country with sparse connectivity to the national grid and renewable energy projects can be used to plug this gap by providing localised power solutions.  Another key point is that power projects take a long time to complete.  The country’s demand for power is expected to grow as the Eastern Africa countries integrate and operationalise the Eastern Africa power pool, and as the government actualises its Big 4 Agenda and Vision 2030 and joins the rest of the world in its decarbonisation agenda by switching to electric powered vehicles, buses and trains. Re-introducing incentives at that point would not address the power deficit quickly enough. 

The removal of the tax incentives has been greeted with disappointment by energy investors and it is to be hoped that they seized the opportunity to voice their concerns during the public participation consultations on the Finance Bill.  They should also consider their options and the remedies available to them, where the tax incentives ultimately end up being withdrawn.

The article was published in the Business Daily on 16 June 2020 and can be accessed here

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