INSIGHT: Nigeria’s Finance Act 2019—Applications of Interest Expense Limiting Provision

One of the new provisions of the Finance Act, 2019 is the introduction of the Base Erosion and Profit Shifting project Action 4 recommendations by the Organization for Economic Co-operation and Development. Essentially, Action 4 recommendations aim to limit the impact of base erosion involving excessive interest expense deductions and other financial payments on related-party or third-party (but guaranteed by related party) debt.

Thus, according to Section 24 and the Seventh Schedule to the Companies Income Tax Act, as amended by the Finance Act, the deductibility of interest and similar expenses incurred by a Nigerian company, in respect of debt issued by a foreign connected person, will be limited to 30% of the Nigerian company’s earnings before interest, tax, depreciation and amortization (EBITDA) (the Finance Act exempts a Nigerian subsidiary of a foreign company which is engaged in the business of banking or insurance from the provision) in a particular accounting year. Interest expense in excess of this cap will be disallowed in the current year but can be carried forward and treated as tax-deductible for a maximum of five years.

Related-party loans are a common financing arrangement with multinational enterprises (MNEs). These loans are typically advanced by parent companies to their local subsidiaries to fund their operations, lever performance and overall profitability, etc. However, related-party loan arrangements could be open to abuse, in that they could be used as a means of shifting profits from one jurisdiction to another. Typically, MNEs may exploit the use of interest payments on related-party loans advanced by an entity in a low-tax jurisdiction to shift profits through excessive interest income derived from its related entity operating in a high-tax jurisdiction.

Therefore, to counter the negative impacts of interest expense on loan on tax revenues, a number of countries have introduced measures to ensure that related-party interest payments by companies operating in their jurisdictions stay within “reasonable limits” and do not erode the tax base. It is in this connection that the provision of the Finance Act on interest expense deductibility was birthed.

It is instructive to note that the Seventh Schedule does not clearly specify the manner in which the excess interest expense (disallowed in prior years) should be deducted in subsequent tax years. Given this apparent gap, it is useful to examine how this new tax rule will be applied and the implications for affected businesses. This article looks at these issues and gives recommendations on ways to manage unintended impacts of the rule.

Breaking Down the Issues

Consider the following six-year (2020–2025) financial projection of a Nigerian subsidiary company (NigeCo) of an MNE (GlobeCo) operating in the fast-moving consumer goods industry.

NigeCo has a 10-year loan financing agreement with GlobeCo, which was concluded towards the end of 2019, and will become effective from 2020. How would NigeCo apply the new provisions of the Finance Act as contained in the Seventh Schedule?

There are two possible approaches. The first is that NigeCo will be required to carry forward excess interest amount in a given year (say Year 1) to another year (say Year 2) where the company’s 30% of EBITDA will be more than interest expense due in that Year 2, such that the excess interest carried forward from Year 1 will be relieved/claimed in Year 2, after Year 2’s interest expense has been fully deducted. For ease of description, we will term this the “last in, first out” (LIFO) approach.

In the second approach, NigeCo will be required to recover the carried forward interest first, before considering the interest amount for the current year (i.e. Year 2). We will call this the “first in, first out” (FIFO) approach. As will be seen in the analysis that follows, the FIFO approach is preferred over the LIFO approach because it minimizes a company’s risk of forfeiting the excess interest after the five-year limit.

From the data in Table 1, the following analysis, using the FIFO, method can be made:

• Year 1: 2020

NigeCo’s interest payments due to GlobeCo will be 550 million Nigerian naira ($1.4 million). However, in preparing its income tax computations for 2020, NigeCo will be required to limit the interest expense to 30% of its EBITDA for the year; i.e. 300 million naira, and disallow the excess; i.e. 250 million naira, which will be carried forward.

It is useful to note that the implication of disallowing any excess interest expense is that such disallowed amount will be added back to taxable income and assessed to tax, accordingly.

• Year 2: 2021

Here, the total tax-deductible interest amount will be 450 million naira (i.e. 30% of EBITDA). To give effect to the FIFO rule, the 550 million naira interest accrued will be disallowed first in the income tax computations; thereafter, the 250 million naira excess interest (brought forward from Year 1) and 200 million naira out of the current year’s 550 million naira will be treated as tax deductible.

Note that NigeCo will now have a total excess interest amount of 350 million naira (i.e. from Year 2). This will be carried forward accordingly.

• Year 3: 2022

The total tax-deductible interest amount for the year will be 600 million naira (i.e. 30% of EBITDA). Again, the interest accrued of 550 million naira will be disallowed, then 350 million naira (excess interest brought forward from Year 2) and 250 million naira out of the current year’s 550 million naira will be treated as tax deductible. Hence, the excess interest amount from Year 3, carried forward to Year 4, will be 300 million naira.

• Year 4: 2023

The interest accrued of 550 million naira will be disallowed for income tax purposes. Total tax-deductible interest amount for the year will be 210 million naira (i.e. 30% of EBITDA for the year). Based on the FIFO approach, the entire 210 million naira to be recognized in the current year’s income tax computation would have to be taken from 300 million naira, which is the amount brought forward from Year 3, thus leaving a balance of 90 million naira. This amount, plus the entire 550 million naira due for the current year, making a total 640 million naira, will be carried forward to Year 5.

• Year 5: 2024

The interest accrued of 550 million naira will be disallowed. Tax deductible interest for the year will be 360 million naira (i.e. 30% of EBITDA for the year). Again, based on FIFO, the 90 million naira excess interest amount from Year 3 will be deducted first, thereafter, 270 million naira will be taken from the (550 million naira) excess interest amount brought forward from Year 4, thus leaving a balance of 280 million naira.

Based on the foregoing, total accumulated excess interest amount carried forward to Year 6 would be 830 million naira (comprising 280 million naira from Year 4, plus 550 million naira from the current year).

The interest accrued of 550 million naira will be disallowed. Tax deductible interest for the year will be 570 million naira (i.e. 30% of EBITDA for the year). This amount will be bifurcated as follows, based on FIFO: the sum of 280 million naira from Year 4 will be deducted first; thereafter, 290 million naira will be taken from the (550 million naira) excess interest amount brought forward from Year 5, thus leaving a balance of 260 million naira.

Total accumulated excess interest amount to be carried forward would be 810 million naira (comprising 260 million naira from Year 5, plus 550 million naira from the current year).

Therefore, based on the FIFO approach as established, it can be seen that interest carried forward will have to be deducted first in the subsequent year, before considering the interest amount for a current year. Using this approach minimizes the risk of losing interest amount from prior years after five years.

Unlike the FIFO, the LIFO considers interest due in a current year (for the purpose of tax deductibility), first, before considering prior year interest brought forward. The impact of using the LIFO is such that a company will keep carrying forward interest from prior years, subject a maximum of five years, until the company makes EBITDA that will be substantial enough to accommodate both the current year interest due, and prior year interest amounts (or at least a portion of it). This method effectively poses a huge risk to any company in terms of losing accumulated interest amounts after five years, where the company is unable to deduct it against profits.

What then should companies do, given the above analysis?

Planning Points

The Finance Act specifies that violation of the interest deductibility provision will attract penalty and interest charges on any adjustments made by the Federal Inland Revenue Service on the excess interest deducted in any tax year. This, therefore, demands that companies should ensure that they give necessary priority to this rule in order to stay compliant and avoid risk of tax sanctions.

To this end, companies are advised of the need to review the interest payable on their foreign related-party loan arrangements, on an annual basis, to ensure consistency with the new provision.

Further, companies are to ensure that they keep track of the year-on-year interest amount disallowed for tax purposes. To do this, they are advised to create a schedule of analysis that may be filed with the income tax returns, going forward. This will make for easy analysis and defense during tax audits. It will also ensure that they use up stock of accumulated interest amounts for the earlier years before those of the later years. This will ensure that, to a great extent, the amount that will be forfeited at the end of the five-year window stays within reasonable limits.

Conclusion

The new rule is a laudable attempt aimed at bringing Nigeria’s tax system to mirror what obtains in developed jurisdictions. It is therefore considered a welcome development, as it will bring about some level of clarity and certainty in the Nigerian tax system, while also addressing the challenges of profit shifting.

Although the rule restricts the carry forward of excess interest amount to five years, a case could also be made in subsequent Finance Acts to allow companies with spare interest capacity during a given year to be able to carry forward the interest capacity (not used up during that year) and use it as additional interest capacity in subsequent periods. Pending this being introduced in future Finance Acts, it is expedient that both taxpayers and tax authorities act in compliance with the provisions of the extant law. For the taxpayer, however, there is need for review and close monitoring of the interest payable on their foreign related-party loans to ensure compliance with the new rule.

Kenneth Mgbemena is a Tax Manager and Chiemeziem Ihejirika is a Senior Tax Adviser with KPMG Advisory Services, Lagos, Nigeria.

They can be contacted at kenneth.mgbemena@ng.kpmg.com and chiemeziem.ihejirika@ng.kpmg.com

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.