Leading financial institutions have found themselves embroiled in a legal battle with federal tax authorities over a contentious dividend tax issue.

A landmark ruling by the Federal Supreme against Tsehay Industries S.C. has opened the floodgates for a broader interpretation of tax laws, with consequential implications for the financial sector. The issue came to light after the acquisition of the former Quality Steel Industries by Tsehay Industries, a process that dates back over a decade.

The Tax Appellate Commission in the Mexico Square area has become the arena for this unfolding drama. Close to 10 private commercial banks, including Awash and Abyssinia, along with insurance giants like Nyala and Nib, have deployed their legal teams, mounting defenses against what they perceive as a direct threat to their liquidity.

Central to the controversy is how shareholders of Tsehay Industries used net profits of 48.9 million Br to increase their paid shares in the company to 439.5 million Br. The increase was made without the shareholders paying dividend taxes, a decision that stood unchallenged until a recent ruling by the Cassation Bench of the Supreme Court. The interpretation of Article 61 of the income tax proclamation, which stipulates that undistributed dividends not immediately reinvested are subject to taxation, remains at the core of the litigations.

In a recent hearing, federal tax authorities successfully argued this point before the Justices of the Cassation Bench, setting a precedent that has now alerted the entire financial sector. Banks and insurance companies are undergoing rigorous five-year audits, facing the prospect of paying billions in taxes.

Abere Asfaw, the legal directorate head at the Ministry of Revenues, has been aware of the contentious nature of dividend taxation for years. However, the Cassation Bench ruling against Tsehay Industries has acted as a catalyst, bringing this issue to the fore. Abere argued that while the income tax law allows for dividend taxation, the practical challenges of conducting extensive audits had previously led to a lax enforcement of this provision.

"Trade license should reflect the raised capital status," he told Fortune.

The shift in tax policy comes when the federal government is looking to significantly increase its tax revenue. This year, the tax collection target has expanded by 35 billion Br to 440 billion Br, a jump partly attributed to the government's reliance on tax revenues for about 60pc of its annual budget.

Mulugeta Ayalew, head of the Tax Appellate Commission, acknowledged the landmark nature of the Supreme Court ruling. He recalled several previous rulings on the payment of dividend taxes and noted that the requirements to present the recapitalised amount on trade licenses have historically been more relaxed. According to Mulugeta, renewals of these licenses often did not occur, leading to the current disputes.

"Renewals had not occurred immediately after capital growth," he told Fortune.

The situation has prompted intense debate among legal professionals and experts who closely examine the country's commercial and income tax laws.

Yohannes W. Gebriel, a legal expert, pointed out the critical need to distinguish between shareholders as individuals and as part of share companies.

"These are two entities," he said.

He argued that while the general assembly makes the decision to fulfil unpaid subscribed capital obligations, the responsibility ultimately rests with individual shareholders. He believes that the payment in cash of authorised capital should not be conflated with the capitalisation of a share company.