Understanding Thin Capitalisation and Debt Conversion Programmes in Nigeria’s Tax Jurisdiction
In today’s globalised economy, the manner in which companies are capitalised—either through equity finance or debt finance—has significant tax implications. In Nigeria, the balance between debt and equity is closely monitored, particularly in cases involving multinational corporations. This article explores the concept of thin capitalisation, related tax rules, and how debt conversion programmes are treated under Nigerian tax law.
What is Thin Capitalisation?
Thin capitalisation occurs when a company—especially a subsidiary of a multinational—is financed with a disproportionate amount of debt relative to equity, often from a related party such as a foreign parent company. This strategy allows companies to shift profits via interest payments, which are tax-deductible, thereby reducing taxable income in Nigeria.
Under Section 24(a) of the Companies Income Tax Act (CITA), interest on loans is deductible, making debt financing an attractive tool for tax planning. However, to curb abuse, Nigeria has implemented rules to restrict such deductions.
Features of Thin Capitalisation
- Thinly capitalised enterprises enjoy tax relief on interest charges, unlike dividends.
- This is because interest is tax-deductible and paid before the calculation of taxable profit.
- Debt financing is often more attractive for associated companies aiming to shift profits between jurisdictions for tax avoidance purposes.
Nigeria’s Thin Capitalisation Rules
These rules limit the amount of debt a company can use to finance itself—especially when the debt comes from related parties, like a parent company. The goal is to prevent base erosion and profit shifting (BEPS), where companies load up subsidiaries with debt to deduct interest and reduce taxable income. Thin capitalisation rules prevent companies (especially subsidiaries of multinationals) from being overfunded with debt, particularly related-party debt.
In Nigeria, interest on related-party debt is only tax-deductible up to 30% of earnings before interest, taxes, depreciation, and amortization. Also, Section 10 of the Finance Act 2019 amended Section 24(a) of CITA and introduced the 7th Schedule to the effect that where a Nigerian company, or a fixed base of a foreign company in Nigeria (other than a Nigerian subsidiary engaged in banking or insurance), incurs interest on debt issued by a foreign connected person, the excess interest thereon shall be a disallowable deduction in the assessment year for which the excess interest expenditure was first computed.
Excess interest is the amount of total interest paid or payable by the company in excess of 30% of EBITDA in the relevant accounting period. Thus, any excess interest beyond this cap is disallowed and can be carried forward for up to five assessment years. After this period, any unclaimed deductions are forfeited.
Non-compliance attracts a penalty of 10% of the excess interest and additional interest calculated using the Central Bank of Nigeria’s monetary policy rate plus a spread set by the Minister of Finance on any adjustments made by the Service relating to excess interest charged in any year.
Debt Conversion Programmes: Options and Tax Treatments
Debt conversion programmes are common corporate restructuring tools. They come in several forms:
- Debt-for-Cash: A company repays part or all of its loan with cash, sometimes at a discount. However, this does not retroactively correct a thin capitalisation breach. Any forgiven debt may be treated as taxable income. The FIRS focuses on interest deductibility, not repayment of principal. If a debt is partially waived (e.g., ₦70M paid on ₦100M), the ₦30M may be treated as taxable income, even in thin cap situations.
- Debt-for-Debt Swap: This occurs when an existing debt is exchanged for a new debt instrument, typically under different terms—such as a lower interest rate, extended maturity date, different currency, or secured instead of unsecured (or vice versa). It is often done to restructure a company’s debt in a way that makes it more manageable or attractive to investors/lenders. Such swaps do not automatically resolve thin capitalisation issues but may improve financial sustainability. However, they do not directly affect tax deductibility rules.
- Debt-for-Export Swap: This is a restructuring arrangement where a country or company pays off its debt by delivering goods or commodities (usually exports) instead of cash. It’s a barter-style settlement. This type of arrangement has been reported where Nigeria used crude oil exports to settle or secure foreign loans.
- Debt-for-Equity Swap: A creditor converts debt into shares in the debtor company, often used to address over-leveraging. This can correct thin capitalisation issues and reduce taxable interest expenses. A debt-for-equity swap can take place between a multinational company (MNC) and its foreign subsidiary, even in a country that enforces thin capitalisation rules. This is often a remedy when the subsidiary is over-leveraged and risks breaching those rules.
Regulatory and Tax Considerations for Debt-for-Equity Swaps
These swaps have tax, transfer pricing, and regulatory implications:
- Tax Compliance: Only interest up to the point of conversion, and within the 30% EBITDA limit, is deductible. Share allotments may attract stamp duty.
- Transfer Pricing: The original loan and subsequent conversion must reflect arm’s length terms and be properly documented in transfer pricing files.
- Regulatory Oversight: Where foreign exchange was involved, the loan must be supported by a Certificate of Capital Importation (CCI), and both the Central Bank of Nigeria (CBN) and the Corporate Affairs Commission (CAC) must be notified of the conversion.
Failure to comply with these requirements could affect future profit repatriation and result in regulatory penalties.
Conclusion
Nigeria’s thin capitalisation rules and tax treatment of debt conversion programmes reflect a broader effort to prevent base erosion and ensure tax fairness. While debt remains a vital financing tool, companies engaging in related-party debt transactions must ensure compliance with thin capitalisation rules, transfer pricing regulations, and statutory reporting to avoid penalties and disallowance of interest deductions.
PREPARED BY JACOB DIPO FAMODIMU- LLM, ABR, GCTI, ACTI and Notary Public
PROFESSIONAL CREDENTIALS
Jacob Dipo Famodimu holds a Master’s degree in Law and is a Notary Public of the Supreme Court of Nigeria. He is a graduate and Associate of both the Chartered Institute of Taxation of Nigeria (ACTI) and the Business Recovery and Insolvency Practitioners Association of Nigeria (ABR). In addition, he serves as an ICAN students’ tutor at Topclass Tutors Ltd.
