Interest expenditure is normally deductible to the extent the borrower has used the debt to derive business income. However, the deductibility of interest expenditure may be limited or disallowed under 3 different sets of rules.

Firstly, interest paid be a person is deductible only to the extent the rate applied does not exceed the rate used between the National Bank and commercial banks as increased by 2 percentage points. This limitation does not apply to interest paid to (a) a financial institution recognized by the National Bank, or (b) a foreign bank permitted to grant loans in Ethiopia (in which case the borrower must submit a copy of the authorization granted by the National Bank to the lender).

Secondly, interest paid by a taxpayer to a resident related person is not deductible except if the interest is included in the resident related person’s Schedule “D” income (see Sec. 5.1.)

Thirdly, under the thin-capitalization rules, interest paid by a foreign controlled resident entity is not deductible to the extent the debtor’s debt/equity ratio exceeds 2:1 during the relevant year. In that case the deduction of excess interest as determined in accordance with the following formulae is disallowed:

AxB/C

Where:

A is the debtor’s total amount of payable interest for the year

B is the debtor’s excess debt for the year

C is the debtor’s average debt for the year

For the purposes of the thin-capitalization rules, a foreign-controlled resident entity means a resident entity in which more than 50% of the membership interests are held by a non-resident, either alone or together with a related person or persons.

The thin-capitalization rules do not apply in the following two situations:

the debtor is a resident financial institution; or
the average debt does not exceed the arm’s length debt amount, defined as the amount of debt a financial institution would be prepared to lend in an arm’s length transaction having regard to all circumstances of the borrower.

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