Court of Appeal Clarifies on Deductibility of Foreign Exchange Losses

Introduction and Background

Delmonte Kenya Limited (the Respondent) obtained unsecured, interest-free loans denominated in foreign currency from a related party, Delmonte International Incorporation (DII) incorporated in Panama. These loans, obtained since 2001, financed ordinary business operations such as supplier and salary payments and procurement of raw materials. As per legal obligations, the Respondent prepared financial statements in Kenya Shillings (KES) which fluctuated against the foreign currency loans resulting to foreign exchange losses or gains. However, since the loans remained unpaid between 2001 and 2008, these foreign exchange differences were treated as unrealised and excluded from tax computations.

In 2009, DII assigned the foreign currency denominated loans to Delmonte Kenya Holdings (DKH). In the same year, the Respondent extinguished the DKH loans partly by offsetting intercompany receivables and by issuing 41,625 ordinary shares to DKH. This debt-to-equity conversion crystalized an unrealized foreign exchange loss of KES 401,261,996, which the Respondent claimed as a tax deduction in its 2009 tax computation. Following an audit covering 2009–2011, the Commissioner of Domestic Taxes (the Appellant) disallowed the deduction, raising additional assessments of over KES 222 million.

The Case at the Tribunal

Aggrieved by the audit and the additional assessments of over KES 222 million, the Respondent objected to the assessment and appealed to the Tax Appeals Tribunal (the Tribunal) arguing that it accounted for unrealized exchange rate differences resulting from the re-evaluation of the loan balances every year end until the liability was fully settled. It adjusted its entries in its tax computation for the year of income in 2009, recognizing the prior years’ foreign exchange losses that were now realized upon settlement of the loan. The Tribunal sided partly with the Appellant holding that the portion of the loss converted into shares was capital and non-deductible.

The Tribunal determined that the full debt was amortized against receivables and the balance converted into equity. In the absence of evidence demonstrating that the debt-to-equity conversion constituted an independent transaction, the Tribunal held that it could not be treated as a tax-deductible expense. The Tribunal took the view that a loss did occur as the Respondent was required to surrender more shares for the same currency value at the date of conversion than it would have if the conversion occurred on the date the loan’s issuance. However, the Tribunal concluded that such an expense could only be treated in tandem with the underlying equity; it is fundamentally a capital expense and is therefore non-deductible pursuant to Section16 (1)(b) of the Income Tax Act (the Act) which provides that deductions are not to be allowed in respect of any capital expenditure, or any loss, diminution or exhaustion of capital.

The Appeal at the High Court

The Respondent preferred an appeal to the High Court against the Tribunal’s decision. The High Court reversed the Tribunal's findings, ruling instead that the entire loss was revenue in nature and therefore tax-deductible. The Court set aside the portion of the Tribunal’s decision which had disallowed the foreign currency losses and held that the Appellant was not entitled to deduct the losses incurred on the part of the loan extinguished through debt-to-equity conversion.

The High Court held that settling the loans through conversion to receivables and share capital constituted a realization event of a foreign exchange loss of a revenue nature. The Judge further observed that it would in fact have been preposterous to treat the loan portion retired by receivables as revenue loss while treating the portion retired by the share issue as a capital loss given that the repayment was of a debt of a single nature. The Court emphasized that such a segregation would be both artificial and unjustified clarifying that the true character of a loss depends strictly on the utilisation of the loan and not the method of repayment. Because the loans were utilised for working capital, the resulting losses were fundamentally revenue in nature.

The Appeal at the Court of Appeal

The Appellant aggrieved by the High Court’s judgement appealed to the Court of Appeal. It contended that the issuance of shares in satisfaction of the debt constituted a capital transaction and accordingly, any resulting loss fell within the ambit of Section 16 (1) (b) of the Act and was therefore non-deductible. Furthermore, it argued that the High Court failed to interpret the statute holistically. It asserted that Section 4A of the Act which provides for income from businesses where foreign exchange loss or gain is realized and which the High Court had interpreted in its finding that Section 4A is not a stand-alone provision and must be read alongside Sections 3 (2)(a)(i), 15 and 16 of the Act. Section 3 (2)(a)(i) provides for income upon which tax is chargeable in respect of gains or profits from any business, for whatever period of time carried on while Sections 15 and 16 delineate permissible and prohibited deductions.

In response the Respondent argued that it had properly deducted the foreign exchange losses pursuant to Section 4A of the Act. It asserted that because the foreign currency loans were used to finance day-to-day business expenditure (revenue expenditure) there was harmony in the joint application of Sections 3 (2)(a)(i), 4A, 15 and 16 of the Act. The net effect of these provisions, the Respondent submitted, was that all expenses incurred wholly and exclusively in the production of taxable income are tax deductible.

The Court of Appeal while applying the strict construction principle of tax statutes by focusing on the literal meaning of the statutes rejected the Appellant’s claim that the loss incurred in converting the debt-to-equity was capital in nature. This is because Section 4A of the Act makes no reference to the capital or revenue nature of the foreign exchange loss or gain. This informed the decision of the Court of Appeal as foreign exchange losses were allowable as deductible as per the wordings of Section 4A of the Act and the method of realization was immaterial.

Conclusion

This judgment firmly crystallizes the "utilization test" in Kenyan tax jurisprudence. It establishes that foreign exchange losses realized from financing ordinary, day-to-day business operations, such as settling supplier invoices, purchasing raw materials, and meeting payroll obligations, retain their revenue character even upon a debt-to-equity conversion, rendering them fully tax-deductible.

During economic downturns or foreign exchange crunches, many Kenyan companies face severe dollar-denominated debt burdens. Converting this debt to equity is a common restructuring tool to improve a company's leverage ratio without draining cash reserves. This judgment provides immense comfort to corporate lenders and distressed borrowers by ensuring that such restructurings do not trigger unexpected, punitive tax liabilities or cause them to forfeit valuable realized forex deductions.

While the decision is overwhelmingly favourable to taxpayers, it underscores a critical operational burden: documentation. To benefit from this precedent, companies must maintain a meticulous paper trail proving exactly where and how the borrowed foreign currency was deployed. If a taxpayer cannot conclusively trace the loan proceeds directly to working capital (such as supplier invoices, import bills, or payroll records), the Kenya Revenue Authority may still successfully argue that the loan was capital in nature.