COLUMN: WEEKLY INVESTMENT TALK. Retained earnings and efficient asset allocation

THE 2025/26 National Budget introduced a withholding tax of 10 per cent on companies’ retained earnings, which sent panic waves across all the country raising concerns on various issues including double taxation and a limitation of growth for corporates.

Previously, the tax was to be levied on a six-months basis, however, following discussions with stakeholders, the timeline was extended to twelve months after the close of the financial year, giving room to companies to put their affairs in order.

What are Retained Earnings and Rationale for the Tax Retained earnings are the accumulated profits a company has kept from previous financial reporting periods, rather than distributing them to investors as dividends. They indicate the company’s financial health and can be used for expansion or growth of the business.

A company with positive accumulated retained earnings is obviously more profitable and has a strong balance sheet and is more capable of riding against economic headwinds than a company with none.

The rate at which annual net income is converted into retained earnings depends on a few factors including the company’s dividend policy, capital regulatory requirements for businesses such as commercial banks and management decisions.

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Most tax authorities including US Internal Revenue Service justify taxing retained earnings for the reason that corporates avoid income taxes for their shareholders by not paying out dividends. Therefore, the authorities’ tax any amount of retained earnings they deem excessive.

This decision by the government follows suit of other countries that already have this tax in place. The introduced rate of 10 per cent pales in comparison to other jurisdictions like the United States, where the rate is 20 per cent.

Investor’s Perspective Most listed companies have clear dividend policies, however, sometimes senior management applies discretion on which rate to pay, attracting either applause from investors if the rate is higher or disdain, if it is lower.

When announced dividends are below the rate allowed by the policy, it begs questions about the efficiency of senior management in allocating company’s assets.

It pushes investors to evaluate company’s records and see how previous retained earnings were deployed in furthering business’s interests. If most projects had subpar outcomes, it’s clear that the money spent was better off paid out as dividends than invested in the mediocre projects.

Vivid example of this is Tanga Cement PLC, which used to pay dividends until it could not in 2017 as projects to expand production plant yielded poor results, which rocked the whole company’s dynamics leaving it in poor financial health.

Another clear example is TOL Gases, which was not paying dividends, but annual company’s growth was lingering close to 10 per cent for years pushing investors to demand justification for not paying dividends. The management finally capitulated and started to issue dividends for the first time in 2019.

On a final note A company has to retain some of its annual earnings for future use, including investing in new projects and to create a buffer against business cycle fluctuations. Senior management has a fiduciary duty to allocate retained earnings into projects that have a higher rate of returns to justify not.