BY MARTINS AROGIE AND OLUWADAMILOLA DARAMOLA
There has been considerable private investment in the Nigerian power sector in recent years, encouraged by the government. However, Nigeria’s recently introduced thin capitalization rules have had an impact on the funding and tax arrangements of power companies.
Martins Arogie and Oluwadamilola Daramola of KPMG consider the effects of the rules and how some of the issues may be addressed.
Nigeria has an established infrastructure deficit. The Nigerian Vice President, Yemi Osinbajo, stated in December 2020 that the country needs about $3 trillion of investment over the next 30 years to bridge this gap. This is a very significant amount and it is debatable whether the federal government with its dwindling resources from oil and gas would be able to meet this demand without help from the private sector.
There is also the argument that even if the federal government had the resources to address this issue single handedly, would there not be other competing needs which these funds might better address? It therefore goes without saying that the federal government would need private investment to be able to bridge this gap.
The power sector in the country has not been spared from this deficit. However, there has been significant private investment in the sector over the past eight years since the launch of the government’s privatization program. A significant number of new players come into the sector annually, especially in the renewable energy space, where the Rural Electrification Agency of Nigeria, in conjunction with several multilateral financial institutions (MFIs) and private organizations, spearheads the setup of mini grids in under-served and unserved areas.
The federal government has also sought to incentivize the sector through the provision of pioneer incentives which grant investors an income tax holiday (pioneer period) for an initial period of three years, which may extend to up to five years. There have also been some duty waivers to encourage the importation of relevant equipment which may be difficult to source in-country.
However, as most players in the sector have argued, there is very little use for an income tax holiday if you do not anticipate that you would make profit in the initial period from commencement of business. A tax holiday is only useful where there are profits. Given the initial high cost of construction and set up of power plants and distribution system, it may be a while from commencement before a number of these companies derive real value from a tax holiday. Consequently, there is always focus on other possible ways the government can assist these entities.
It was against this backdrop that players in the sector received the news in 2020 that the government had, through the Finance Act, 2019, introduced thin capitalization rules into Nigeria’s tax lexicon. Prior to that time, Nigeria did not have any defined thin capitalization rules, which set it apart from other countries globally with clear rules. In fact, one question that potential investors into the country would ask tax practitioners was what the thin capitalization rules were in Nigeria: most investors were surprised to find out that there were none. That is no longer the case.
Thin capitalization primarily serves to mitigate instances of profit shifting where companies look to load up debt on related parties in certain jurisdictions to shift the profit from that jurisdiction to another. In response to this, countries introduced rules which limit the amount of debt with which an entity can be funded in relation to the amount of equity retained in the same entity. Companies which broke those rules ran the risk of having the excess interest not considered as an allowable deduction when determining their profits liable to tax for the relevant year of assessment.
Countries like Nigeria which did not have such rules prior to 2020 therefore stood at a disadvantage, as companies were likely to fund their business with debt as opposed to equity in order to ensure that they could take benefits above the line and not have to wait until profitability is achieved before recovering any value from their investments.
Nigeria’s Thin Capitalization Rules
Nigeria therefore sought to address this with its introduction of thin capitalization rules. Under the rules introduced, companies can only claim interest expense paid to a foreign connected person in any particular year that is limited to 30% of their earnings before interest, tax, depreciation and amortization (EBITDA). Any excess can be carried forward and utilized in the next year, for up to a maximum of five years.
The rules go further to define a “connected person” as:
any person controlled by or under common control, ownership or management;
any person who is not connected but receives an implicit or explicit guarantee or deposit for the provision of corresponding or matching debt; or
any related party as described under the Nigerian Transfer Pricing Regulations 2018.
Funding of Power Projects in Nigeria
This may sound fair and reasonable, but the real issue is—how does it impact our current realities?
Several power projects in the country are, as mentioned earlier, funded by MFIs. A number of these MFIs typically require some form of sovereign guarantee prior to advancing loans to the investors. These guarantees are primarily a reflection of the risk profile of the country and are mostly necessary for these kinds of projects to reach final investment decisions.
The thin capitalization rules consider these types of loans as connected party loans, which now have limited tax deductibility even though there is no common ownership, management or control between any of the parties involved in the transaction and it therefore cannot be argued that the intention of the loan is to shift profits from Nigeria to a friendlier jurisdiction. However, the broad description of what may constitute related party loans will impact the transaction.
There is also the instance of loans advanced by financial institutions offshore to projects driven by Nigerian incorporated entities in the country. These financial institutions, in reference to our country risk profile, also may insist that a related party offshore guarantees the loan before they can advance it to the Nigerian entity. It is possible in some instances to negotiate the loan without the provision of a guarantee, but in many of these instances the cost of the loan would typically increase.
This therefore leaves the parties, including the country, in a difficult situation under the rules. Provide the guarantee and you are restricted in the amount of interest you can deduct annually even though the beneficiary of the interest is not in fact a related party and the applicable rates are a reflection of current market realities, with no intention to shift profit. Refuse to provide the guarantee, and the rates go up and so does your interest payment whilst your profitability and the amount of tax payable to the government drops.
Clearly, this cannot be the intention of the drafters of the law? There are instances where, in a bid to avoid thin capitalization rules, related parties have advanced funds to a third party for the sole purpose of issuing out loans to their related party in another country.
It is therefore necessary that the rules introduced in Nigeria take this scenario into consideration. Where there is a guarantee which only serves to reduce the risk perception of the transaction and thus the interest rate payable, should we still seek to punish investors under this scenario? A number of countries would prefer that investments in critical sectors of their economy are made through equity rather than debt, so it is only fair that Nigeria also considers this in its rules, but does that take into consideration our current realities and our stated intention to attract private investors to shore up the significant infrastructure deficit in the country?
Impact of Power Project Development Phase
It is also important to consider the operational profiles of power companies in the country and whether the new rules may appear excessively punitive given the structure of their operations.
The average power plant would require between 6 and 24 months of construction before it is ready to go on stream. There is typically no operational income earned during this period, even though the loans for construction would have been put in place prior to commencement of the construction. Companies would therefore have significant interest exposure from day one whilst having no EBITDA for maybe the next two years.
At the end of the construction period, companies may have already accumulated significant interest expense with a few years gone on the number of years they can carry forward the amounts. They may therefore be in a position where they have to write off some of their interest expense because of the lead time between construction and revenue generation, a key feature of their business.
Would it be better for the entire industry if the rules were amended for new businesses, to allow for time for them to invest and recoup and thereafter convert any loans into equity, rather than the current scenario where the rules apply to everyone irrespective of the state of maturity of the business? This may be something the government might want to consider going forward.
Impact of Tax Holiday Incentive
Another scenario where the rules may create some confusion is in the application of tax holidays. As pointed out earlier, power companies are typically entitled to a three-year income tax holiday which may extend to five years. In practice, the tax holiday period is typically scheduled to commence on the date when the company commences a program of continuous sale of power. Therefore, the construction period would be considered as outside the tax holiday period. As described above, the company was already carrying forward interest from the construction period which it could not utilize due to the absence of any EBITDA.
The question then is what becomes of the interest post the five-year tax holiday? Will the interest be deemed to have elapsed at that time? Or does the company apply the interest cap during the pioneer period even though its profits are exempted from income tax during the period?
This issue is even more complicated by the fact that the laws guiding the operation of the tax holiday period expressly state that the company would be deemed to have commenced a new business on the day it exits the pioneer period. Losses incurred, if any, during the pioneer period would be deemed to have been incurred on the day immediately after the pioneer period elapses. Does this also apply to interest expense? Or would the interest lapse with the old business? It is important that we remember that a portion of the interest expense was generated prior to the pioneer period, so even if we say that those expenses incurred during that period can be carried forward then what happens to those incurred prior to the pioneer period?
The authors’ opinion is that interest incurred prior to the pioneer period would be packed and carried forward to after the pioneer period. There should be no restriction on the ability to claim any interest incurred during the pioneer period irrespective of the thin capitalization rules, as profits during that period are exempted from tax anyway. We therefore cannot use the thin capitalization rules as a basis to limit the amount of profit exempt from tax during the period.
The authors also believe that it is impracticable to treat the business commenced prior to the pioneer period as separate from that post-pioneer. The company cannot commence, cease solely for the purpose of starting a pioneer period, and thereafter commence a third business operation for tax purposes in the country. That cannot be the intention of the law.
It is obvious that the original drafters of the law did not contemplate a scenario where businesses could operate for that length of time, incur significant expense, before getting to a point where they begin to generate revenues in a consistent enough manner to commence the pioneer period. They most likely anticipated that the pioneer period would commence at about the same time the company commenced operations, but as we can see this is not the case for a power company. We therefore cannot punish these companies by writing off significant investments solely because the drafters of the law at the time it was envisioned did not contemplate the peculiarity of the situation of a power company.
Organization for Economic Co-operation and Development (OECD) Rules
Action 4 of the OECD/G-20 Base Erosion and Profit Shifting report on “Limiting Base Erosion Involving Interest Deductions and Other Financial Payments” itemizes various approaches that could be used to prevent base erosion, even though it suggests the fixed ratio rule as its preferred approach.
Countries such as the U.K. and India have also adopted this rule and set the applicable cap on interest claimable at 30% of EBITDA, like Nigeria.
The report also mentions that the disallowed interest expense can be carried forward for use in future years. It does not however stipulate the number of years. India has adopted an eight-year restriction while the U.K. has no restriction on the number of years the interest can be carried forward. This may suggest that Nigeria has taken a more conservative approach by deciding on a five-year limit.
Furthermore, the report also recognizes the fact that there can be exceptions to the interest deductibility rule. One of such suggested exceptions is an option to exclude certain public benefit projects from interest restrictions. Chapter 4 of the report identifies that some countries may have privately-owned public benefit assets which may be financed using a high proportion of debt. In such instances, even though the companies may be highly geared, there is a low risk of base erosion or profit shifting.
The report also mentions that to ensure that only tightly targeted projects are excluded from this rule, certain conditions should be stipulated which must be met by the companies. We believe that there is a case to be made for power and infrastructure projects to be exempted from this rule.
The introduction of thin capitalization rules in the country is laudable and long overdue. However, its application has to be carried out within the limits of our current realities as a nation. Our infrastructure deficit is real and must be addressed as a matter of urgent national importance. Indeed, the authors believe that the resolution of the infrastructure issue may serve as the foundation for sustainable growth and development in the country.
It is therefore important that we align our policies and action to support the growth of these sectors, especially the power sector which is critical to our long-term growth projections.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Martins Arogie is a Partner and Oluwadamilola Daramola is a Senior Adviser with KPMG in Nigeria.
The authors may be contacted at: firstname.lastname@example.org; email@example.com