MPs back plan to tax infrastructure, green bonds

MPs have backed the Treasury’s proposal to start taxing infrastructure and green bonds, even as financial experts warn that bond tax exemptions granted to large institutional investors will limit the benefit of the new levy to the Exchequer.

The Finance Bill 2024 has called for the introduction of a five percent withholding tax for residents and 15 percent for non-residents on infrastructure and green bonds that have a maturity of at least three years and that are issued after June 1, 2024.

The National Assembly Finance and Planning Committee in its report on the Finance Bill, has backed the proposal, despite multiple public submissions opposing the levy on account that it will discourage local and external investments in these bonds.

Finance experts are warning that the government’s collection from the proposed withholding tax on infrastructure bonds is unlikely to offset the likely cost of higher interest if investors raise their rate demands to compensate for the tax.

This is partly due to the existing exemptions enjoyed by pension funds and insurance companies from paying tax on bond interest earnings, with some banks also enjoying this advantage through their insurance arms.

The exemptions effectively mean that only a small percentage of infrastructure bond buyers from the retail segment, where foreigners and small corporates are also grouped, will end up paying the tax anyway.

“…they can simply load the added tax cost on the interest rate they demand from the borrower (government),” said a Treasury official.

“For foreign investors looking to buy long-dated bonds, it will make sense to go for ordinary bonds compared to Infrastructure bonds, due to the lower tax of 10 percent compared to the proposed 15 percent on the IFB.”

Infrastructure bonds (IFBs), which were first issued in 2009, are exempted from withholding tax, making them an attractive option for investors. Other regular Treasury bonds are subject to a withholding tax of 15 percent for papers maturing within five years, and 10 percent for those with a tenor longer than five years.

Pension funds and insurance companies together hold 33.4 percent of the government’s domestic debt, which stood at Sh5.37 trillion as at June 12, 2024. Banks hold a share of 45.47 percent, retail investors hold 12.94 percent, and the remaining 5.15 percent is in the hands of parastatals.

The fund manager also warned of the potential distortion of the secondary market for infrastructure bonds once the tax on new issuances is approved by Parliament.

Demand for existing infrastructure bonds which are being shielded from the tax is set to go up, raising prices as holders are unlikely to let go of tax-free paper that they cannot replace in new primary issuances—and in turn, lowering the yield on the papers.

On the other hand, the new taxed bonds being issued after June are likely to see investors asking for higher rates, which diverge from the prevailing yields on tax-free options even when there is a match in tenor.