Introduction
It comes as no surprise that Nigerian entities are net recipients of intercompany loans from their related parties in other jurisdictions. Nigerian entities enter such financial arrangements for several reasons including to fund acquisition of equipment from original equipment manufacturers located outside Nigeria, purchase of raw materials that cannot be sourced locally and payment of service fees due to foreign service providers. Foreign intercompany loans have become an increasingly more attractive source of funding due to the difficulty of obtaining forex from domestic sources encountered by companies in recent years.
These intercompany loan transactions are scrutinized by the Federal Inland Revenue Services (FIRS or the tax authority) during Transfer Pricing (TP) audits particularly where the terms of such arrangements require the payment of interest as such interest payments qualify as deductible expenses thereby reducing the taxable profits of the Nigerian borrowers. Loan arrangements are also considered to be one of the means of extracting value from Nigeria by foreign investors seeking to bring funds into the country through the application of interest rates that the tax authority may deem inappropriate. The subsequent sections of this article highlight some key areas of interest which could create potential additional tax exposure for the recipients of such loans.
- Debt Capacity of the Borrower
The first question asked by many taxpayers seeking to enter intercompany loan arrangements with their foreign related parties is whether the interest rate applicable to such intercompany loan arrangements satisfies the arm's length standard. Interestingly, more often than not, this is one of the last points considered by the tax authority while reviewing such arrangements during a TP audit exercise, the first being whether the borrower has the capacity to access and take on such debt.
Although Nigeria does not have thin capitalization rules and has only fairly recently introduced interest deductibility rules, this does not preclude the tax authority from seeking to assess whether it is defensible for companies with low equity to seek to raise funds through debt and whether such intercompany debt qualifies to be treated as bona fide debt or as some other form of financing on which interest should not apply. Where a taxpayer is unable to convince the FIRS that its financial arrangement with a foreign related party should be treated as a debt and not be characterized as equity, the tax authority may seek to disallow a portion, or the entire interest expense recognized in the books of the taxpayer and assess the amount to tax.
In order to address this question, taxpayers should consider putting together an analysis of a combination of both qualitative and quantitative factors which highlight the facts and circumstances of the intercompany loan arrangement. The quantitative analysis could include determining certain key financial matrices such as debt-to-equity, debt-to-capital and interest coverage ratios which are typically considered by various rating and commercial lending institutions and, if possible, demonstrating how this compares with other independent parties who have been able to access similar loans from independent lenders. Qualitative factors to consider include the presence of an intercompany agreement and the terms and conditions documented in such an agreement including how such terms and conditions align with the group's lending policies, if available, the presence of an explicit guarantee as well as an assessment of the commercial alternatives reasonably available to the borrower.
- Ability to Repay
Intricately linked to the debt capacity of the borrower is the ability to repay the said debt. Taxpayers would also need to clearly demonstrate their ability to repay any intercompany debt as the tax authority can expressly conclude that any independent lender would be unwilling to extend a loan to any business that is unable to demonstrate the ability to repay such debt. Hence, such intercompany transactions cannot be considered by the tax authority to be bona fide loans and the resulting interest charges may be disallowed for tax purposes.
Taxpayers can address this potential issue by preparing robust financial projections to demonstrate their ability to repay both the interest and principal when they fall due.
- Application of an Arm's Length Interest Rate
Once, the borrower's ability to borrow the intended amounts has been well established, the next consideration would be ensuring that the interest rate applied on the loan is consistent with the arm's length principle. This would again require the conduct of an interest rate benchmarking analysis which considers such factors as the credit rating of the borrower, the currency and tenor of the loan amongst others. This interest rate benchmarking analysis would provide information about the interest rate charged by independent lenders on debt issued to independent borrowers in similar circumstances (i.e, the arm's length range of interest rates). The expectation of the tax authority is that the rates charged by the related party lender involved in an intercompany transaction would fall within the arm's length range of interest rates. Where the interest rate charged on an intercompany loan is above the arm's length rate, the tax authority may seek to adjust the rate and thereby assess any excess interest expense to additional tax.
- Presence of Adequate Documentation
In addition, the borrower will need to maintain adequate documentation regarding its intercompany loan transaction. This documentation includes the executed intercompany loan agreement, evidence of receipt of the borrowed funds (this could include the bank statement into which the funds were paid and the Certificate of Capital Importation), interest computation and repayment schedules.
Further, if the funds are first expected to be brought into Nigeria before it is used for its intended purpose, it is important to ensure that the Certificate of Capital Importation issued for such funds does not carry a wrong description (for example, it is clearly described as a loan rather than an equity contribution).
- Compliance with Extant Tax Laws
The tax authority would also be keen to establish that the borrower has fully complied with its obligation to withhold tax on the interest paid to its foreign related party and remitted same to the tax authority in the currency of the transaction.
In addition, it is also important for taxpayers to ensure that the interest deductibility rule which was introduced by Finance Act, 2019, is complied with. This rule restricts the interest which can be treated as a deductible expense for foreign related party loans in a given tax year to thirty percent of earnings before interest, taxes, depreciation, and amortization (EBITDA). Companies can however roll over any interest charges in excess of this limit and claim such as an allowable deduction against the EBITDA of subsequent years for a period of up to five years.
Conclusion
It is apparent that taxpayers can no longer use "artificial" foreign intercompany loan arrangements as a tax planning measure as the tax authority has moved beyond just scrutinizing the arm's length nature of the interest rate to challenging the characterization of such loans as bona fide debt. Thus, it is essential for taxpayers to proactively review any intended loan arrangements from the perspective of the tax authority prior to concluding such loan arrangements to ensure that they can provide objective responses to the potential queries that the tax authority is likely to raise in respect of these arrangements.
The opinion expressed in this article is solely personal and does not represent the views of any organization or association to which the authors belong.