By Arthur
In this analysis, Mark Ruhindi‘s primary objective is to assist prospective equity investors in evaluating the tax risk level in relation to the impending Airtel IPO. This evaluation is underpinned by my thorough examination of the information furnished in the IPO’s prospectus. The scope of this analysis is limited to tax risk in light of Airtel’s capital structure as revealed in the prospectus, and with particular attention to the balance sheet liabilities item and its transfer pricing framework with related parties.
Mark Ruhindi, a a tax lawyer and commercial advisor
Recently, there was debate online, particularly on X, in regards to the company’s loan liabilities which form a substantial portion of the capital structure of the business and so i felt i needed to address this before moving on to the main focus of my commentary, which is tax risk.
One commentator remarked, “Airtel Uganda in the last 5 years has borrowed a whooping UGX 1.5 Trillion and paid Dividends to its Parent company a whopping close 1.4 Trillion. Someone “might” conclude all the money they borrowed was paid out as Dividends.”
This observation points to one crucial factor which deserves consideration for those who will be investing in this IPO; that is, the company’s generous dividend policy. This therefore will be the other main focus of my evaluation in this commentary.
Airtel Uganda’s loan liabilities vis-a-vis its dividend policy;
It must be emphasised at this point that corporate borrowing forms part of normal commercial and financial management routine for large business and there is absolutely no way a business of the size and turnover of Airtel can do business without borrowing, as this carries with it immense commercial advantages including but not limited to ability to make capital Investments that generate revenue, management of liquidity, tax Benefits, risk diversification among many others.
It’s also important to note at the onset that a generous dividend policy like this may limit a company’s ability to make capital re-investments for further growth and scale or to pursue other long-term strategic initiatives, especially when the policy in place is that dividends must be paid even if it always means that they are paid with borrowed funds. But ultimately, the balancing act here is that, the choice between dividends and reinvestment should always align with the company’s long-term strategic goals.
With that out of the way, It is my opinion that for income-oriented investors, such as retirees and institutional investors with constant cash-flow demands, Airtel might be the right IPO, since;
- A generous dividend policy means regular dividend payments which provide a steady income stream in addition to capital gains on the investment.
- It implies reduced risk since dividend payments provide a cushion against market volatility. That is, even if the share price fluctuates or stagnates, investors still receive dividends, which helps offset losses or the capital gains stagnation and thereby translating into reduced risk.
Debt to equity ratio;
The debt to equity ratio measures a company’s financial leverage. The higher the ratio, the higher the likelihood that it will have a favourable commercial effect on the business for purposes of ascertaining;
- Tax liabilities,
- Retained earnings eventually available for dividend payouts.
- Interest deduction:
When a company has a higher debt load, it often also has to pay a substantial amount of interest on that debt. Interest payments are tax-deductible expenses. This means that a company with more debt can reduce its taxable income by deducting interest expenses, potentially lowering its overall tax bill. And it matters not that this debt is denominated in foreign currency because forex exchange losses incurred during the repayment of debt is equally a deductible expense, as long as the loss is one that attaches to a revenue loan and therefore of a revenue nature or rather one which adds to the revenue structure as opposed to the capital structure of the business.
- Retained earnings:
The amount of net income a company retains after accounting for tax is known as retained earnings. If a company has lower taxes due to higher interest deductions, it may have more retained earnings available for distribution to shareholders in the form of dividends.
However, this must be weighed against the interest deduction caps imposed by tax law. Many tax jurisdictions including Uganda have implemented such caps to limit the amount of interest expenses a company can deduct from its gross income in a single year of income, but with a deferral permitted for deduction in subsequent years.
This however does not negate the tax benefits which Airtel’s kind of capital structure carries (i.e, a capital structure with just the right amount of debt). For investors in this IPO, the key consideration here is the confidence that Airtel’s debt is not so excessive so as to affect the company’s overall financial health and its ability to meet its obligations to creditors as and when they fall due.
Transfer pricing;
Transfer pricing, in essence, revolves around the mechanics of related-party transactions within corporate groups. It’s a practice aimed at ensuring that companies within a group transact with each other at prices akin to what unrelated entities would employ in open market conditions.
The Ugandan tax laws, much like the others in numerous jurisdictions, imposes a stringent obligation on entities within a group to adhere to arm’s length pricing standards. Any deviation from this norm can potentially be construed as tax avoidance. Under Ugandan tax law, the Commissioner General possesses an arsenal of tools to counter such attempts. These tools encompass the re-characterization of transactions and the recalibration of profits to reflect true open market values, and are all designed to thwart tax avoidance schemes. This is done through extensive post reporting transfer pricing audits, which then brings the question of unascertained tax risk into purview.
Airtel’s unascertained tax risk.
This is in reference to potential tax liabilities or uncertainties that Airtel may face, but which have not yet been fully identified, quantified, or resolved. These risks can arise due to various factors, including complex tax regulations, tax audits such as the transfer pricing audits alluded to above, or if and when unresolved tax disputes are decided against it.
A critical facet here is that a taxpayer can shield themselves from post-transaction re-characterizations by seeking private rulings and securing the commissioner’s endorsement concerning specific related-party transactions. Importantly, these private rulings are legally binding upon the commissioner and once a private ruling is handed down, the commissioner may not subsequently alter his position through the invocation of transfer pricing mechanisms aimed reopening up a transaction to which the private ruling relates, save for exceptional circumstances such as if fraud was to be uncovered.
Equity investments at primary level(IPOs) are predicated on the financial standing of the business as of the prospectus issuance date, with liabilities and EBITDA figures being pivotal. And so for equity investors eyeing an IPO, it’s paramount to ascertain that such risks have been prudently addressed.
This is because unanticipated liabilities can profoundly alter the financial landscape taken into consideration during the investment decision-making process, since they necessitate the re-allocation of funds initially earmarked for shareholder dividends, to payment of these unanticipated tax liabilities. The crux of this risk factor therefore lies in the potential emergence of unanticipated liabilities during future tax audits.
I do note from the prospectus that, Airtel Uganda has taken commendable steps in securing such private rulings pertaining to a significant portion of its inter-party transactions. In my assessment, this proactive measure effectively mitigates a significant risk factor, particularly regarding the prospect of the Uganda Revenue Authority (URA) raising any future unanticipated tax liabilities against the business in respect of these transactions.
Whereas the prospectus reveals a tax liability of Ugx 17.6Billion shillings which is currently the subject of tax litigation at the Tax Appeals Tribunal, this already forms part of the company’s ascertained liabilities as at the date of issuance of the prospectus, and although not de minimis, it ought not unsettle investors, taking into account all the other positives and bearing in mind that the liability stands to be set aside in case of successful litigation.
For potential investors, focus on the other aspects of the company’s financial structure, including a rich capital assets portfolio, robust revenue performance from voice, data segments, market share size and its generous dividend policy may be more relevant here.
Airtel Uganda Credit exposure to related parties:
The prospectus discloses that a substantial portion of the company’s debt is unsecured. This disclosure naturally beckons the question: what assets are available for distribution to shareholders in the unfortunate event of business insolvency?
The prospectus also highlights that the bulk of Airtel’s debt emanates not from the parent company but from several banks. The credit exposure Airtel Uganda has with the parent company is limited to extensive guarantees the parent company has given for this debt. From a taxation perspective, this arrangement effectively eliminates the transfer pricing audit risks alluded to earlier, as these transactions do not fall under the classification of related-party dealings in tax terms.
The Advantage of Airtel Uganda’s unsecured debt:
Unsecured debt, as mentioned in the prospectus, is a noteworthy characteristic of Airtel Uganda’s financial structure. This form of debt is one where creditors do not have a specific locked down claim on the company’s assets identified and given in as security at transaction stage, with charges such as mortgages and debentures created upon such assets.
Most crucially to note here is that none of Airtel Uganda’s key capital assets identified from the prospectus is at risk of mortgage or debenture realisation processes for credit default against any of the banks who hold most of its debt. All this risk is shouldered by the shareholders of airtel’s mother ship which has guaranteed the bulk of this debt.
Why is this important for equity investors?
Unsecured debt can be seen as advantageous for shareholders in cases of insolvency. When a company faces financial distress or insolvency, secured creditors have the primary claim on the company’s assets through enforcement of charges created upon those assets. They are entitled to recover their debt before other stakeholders. Unsecured debt holders, on the other hand, are secondary in line, and shareholders often come next.
In essence, unsecured debt can put shareholders in a better position than if the debt was secured when a company encounters financial trouble. While creditors may recover a portion or all of their debts, shareholders still have the potential to retain some value from their equity holdings, which is a significant advantage.
NOTE: This analysis is not to be misconstrued as investment advice from me to my audience or anyone to whose attention bits of this opinion may be drawn. It is intended solely for purposes of general knowledge consumption. For comprehensive, tailored investment guidance, it is imperative to seek investment advisory services of a duly remunerated investment advisor, well-versed in the nuances of equity investments and taxation i have written about and for guidance in broader detail.
Source – Mark Ruhindi
