In today’s global economy, the way companies are capitalised—whether through equity or debt—can have significant tax consequences. In Nigeria, the balance between debt and equity financing is closely monitored, particularly for multinational corporations. This article delves into the concept of thin capitalisation, the associated tax regulations, and the treatment of debt conversion programmes under Nigerian tax law.

What is Thin Capitalisation?

Thin capitalisation occurs when a company—especially a subsidiary of a multinational corporation—is financed primarily through debt rather than equity, often sourced from related parties, such as a foreign parent company. This strategy enables companies to shift profits by using interest payments, which are tax-deductible, thus reducing taxable income in Nigeria.

According to Section 24(a) of the Companies Income Tax Act (CITA), interest on loans is deductible, making debt financing an appealing tool for tax planning. However, to curb potential abuse, Nigeria has implemented restrictions on such deductions.

Features of Thin Capitalisation

• Thinly capitalised companies benefit from tax relief on interest payments, unlike dividend payments, since interest is deductible before calculating taxable profit.
• Debt financing is often more attractive to related companies aiming to shift profits across borders for tax avoidance purposes.

Nigeria’s Thin Capitalisation Rules

Nigeria has set rules that limit how much debt a company can use to finance itself, especially when the debt originates from related parties, like a parent company. These rules are intended to prevent base erosion and profit shifting (BEPS), where companies load subsidiaries with excessive debt to reduce taxable income by claiming high interest deductions.

In Nigeria, interest on related-party debt is tax-deductible only up to 30% of earnings before interest, taxes, depreciation, and amortisation (EBITDA). Additionally, Section 10 of the Finance Act 2019 amended Section 24(a) of CITA and introduced the 7th Schedule, stipulating that interest on debt issued by a foreign connected person (excluding Nigerian subsidiaries involved in banking or insurance) is deductible only to a certain extent. Any excess interest paid beyond the 30% EBITDA limit is disallowed and can be carried forward for up to five years. After that period, the unclaimed deductions are forfeited.

Failure to comply with these rules results in a penalty of 10% on the excess interest, along with additional interest calculated using the Central Bank of Nigeria’s monetary policy rate plus a spread set by the Minister of Finance.

Debt Conversion Programmes: Options and Tax Treatments

Debt conversion programmes are common tools for corporate restructuring and can take various forms:

• Debt-for-Cash: A company repays part or all of its loan with cash, sometimes at a discount. This does not retroactively address a thin capitalisation issue, and any forgiven debt may be treated as taxable income. For instance, if a debt of ₦100M is partially waived by ₦30M, that ₦30M could be considered taxable income.
• Debt-for-Debt Swap: This occurs when a company exchanges its existing debt for a new debt instrument, usually with different terms (e.g., lower interest rates, extended maturity). While this doesn’t automatically fix a thin capitalisation problem, it may help improve the company’s financial sustainability without affecting tax-deductibility rules.
• Debt-for-Export Swap: A company or country may use goods or commodities (often exports) instead of cash to settle a debt. In Nigeria, this has been seen in arrangements where crude oil exports are used to settle or secure foreign loans.
• Debt-for-Equity Swap: A creditor converts debt into equity (shares) in the debtor company. This is often used to address excessive leverage and can resolve thin capitalisation issues by reducing taxable interest expenses. Such swaps can occur between a multinational corporation and its subsidiary, even in countries with strict thin capitalisation regulations.

Regulatory and Tax Considerations for Debt-for-Equity Swaps

Debt-for-equity swaps come with specific tax, transfer pricing, and regulatory considerations:

• Tax Compliance: Only interest paid up to the point of conversion and within the 30% EBITDA limit is deductible. Any shares issued in exchange may be subject to stamp duty.
• Transfer Pricing: Both the original loan and its conversion must reflect arm’s length terms, and proper documentation is required in transfer pricing files.
• Regulatory Oversight: If foreign exchange is involved, the loan must be backed by a Certificate of Capital Importation (CCI). The Central Bank of Nigeria (CBN) and the Corporate Affairs Commission (CAC) must be notified of the conversion. Non-compliance could affect future profit repatriation and lead to regulatory penalties.

Conclusion

Nigeria’s thin capitalisation rules and treatment of debt conversion programmes are part of a broader effort to prevent base erosion and profit shifting while ensuring fair taxation. While debt remains an essential financing tool, companies engaging in related-party debt transactions must comply with thin capitalisation rules, transfer pricing guidelines, and statutory reporting requirements to avoid penalties and disallowed interest deductions.

For professional advice on Accountancy, Transfer Pricing, Tax, Assurance, Outsourcing, online accounting support, Company Registration, and CAC matters, please contact Inner Konsult Ltd at www.innerkonsult.com at Lagos, Ogun state Nigeria offices. You can also reach us via WhatsApp at +2348038460036.