Michael Ngunjiri and Ochieng Rateng have decided to go into business together. They are not certain as to the legal form their business should take and have approached you for tax advice. Specifically, they are uncertain whether they should form a partnership or a company.

All the estimated figures below exclude value added tax (VAT). The business manufacturing for both local customers and export and it does not qualify for the benefits of an EPZ company. Initially, they have 20 million Kenya shillings each to invest in the business in whatever form necessary. The turnover in the first year is expected to be 30 million Kenya shillings but there will be significant capital outlay in the first year in terms of equipment required for the manufacturing process costing Ksh. 300,000, a further Ksh. 1,000,000 to acquire office equipment and Ksh. 1,750,000 to acquire the raw materials from various suppliers. They also intend to install a standby generator Ksh. 200,000 to run the manufacturing equipment in the event of any power failures to prevent any loss of orders. Closing inventory at the end of the first year (2020) of assessment is estimated to be Ksh. 230,000.

The net profits before tax for accounting purposes in the first year (2020) has been estimated as Ksh. 1,166,667.

Michael and Ochieng each already have separate, unincorporated, businesses in their personal capacities which each generate turnover of more than 5 million and are, therefore, registered for VAT. They have agreed that, if a partnership structure is used, they will share the profits in the ratio 50:50. If a company is formed, they will each hold 50% of the equity shares and the company will pay to them the maximum (100%) dividend. They are also considering the possibility of introducing money by way of loans as well as equity if a company structure is used. They are fairly sure that they wish to use a company structure due to the legal advantages of limited liability over a partnership. However, in order to enable them to make their final choice, they have approached you and asked you to undertake the following work for them:

1. Loan financing company

Explain the tax advantage of Michael and Ochieng introducing the majority of their capital into the business by way of loan finance (debt) rather than equity. (3 Marks)