• 15 Marks

ATAX – May 2023 – L3 – Q6 – Tax Impact of Financing Decisions

Discuss thin capitalisation concepts, related rules under the Finance Act 2019, and non-tax factors affecting corporate location decisions.

Tax planning is a right that taxpayers must exercise to reduce tax liability and improve profitability while fully complying with existing tax legislations to avoid penalties and further risks. Thin capitalisation and non-tax factors are important fiscal policy issues that corporate players and governments in different tax jurisdictions should not undermine.

Required:

  1. (a) Explain the concept of thin capitalisation and the problems it may create for both creditors and tax authorities. (5 Marks)
  2. (b) Discuss the thin capitalisation rules put in place by the Federal Government via the provisions of the Finance Act 2019. (4 Marks)
  3. (c) Explain briefly, six important non-tax factors that may affect the choice of location of a corporate entity by a holding company in another tax jurisdiction. (6 Marks)

(a) Concept of Thin Capitalisation (5 Marks)

Thin capitalisation occurs when a company is financed with a significantly higher proportion of debt compared to equity, resulting in high leverage or gearing.

Problems Created by Thin Capitalisation:

  1. For Creditors:
    • Increased solvency risk as the company is obligated to repay substantial debt with interest, potentially reducing financial stability.
  2. For Tax Authorities:
    • Risk of abuse through excessive interest deductions that reduce taxable profits, leading to lower tax revenues.

(b) Thin Capitalisation Rules under Finance Act 2019 (4 Marks)

  1. Introduction of Specific Rules:
    • Prior to the Finance Act 2019, Nigeria lacked formal thin capitalisation rules, leading to arbitrary disallowances of excessive interest by the FIRS.
  2. EBITDA Benchmark:
    • The Act introduced a limit where deductible interest expenses cannot exceed 30% of Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) for loans from foreign-connected persons.
  3. Disallowable Excess Interest:
    • Any excess interest exceeding the 30% benchmark is disallowed for deduction in the current year.
  4. Carryforward of Unutilised Interest:
    • Excess interest can be carried forward and claimed within five years, after which it expires.
  5. Exemptions:
    • The rule does not apply to Nigerian subsidiaries of foreign companies engaged in banking or insurance operations.

(c) Six Important Non-Tax Factors Affecting Corporate Location Decisions (6 Marks)

  1. Economic and Political Stability:
    • A stable economy and political environment attract investors and ensure smooth business operations.
  2. Infrastructure Availability:
    • Adequate business, accounting, and legal infrastructure support efficient operations and compliance.
  3. Bureaucratic Efficiency:
    • Minimal bureaucratic bottlenecks improve investor confidence and ease of doing business.
  4. Communication Channels:
    • Reliable communication systems, such as telecommunication and secure data transmission, are critical for effective operations.
  5. Effective Dispute Resolution Mechanism:
    • A functional legal framework and alternative dispute resolution systems enhance investor confidence.
  6. Skilled Workforce Availability:
    • Access to professionals in law, finance, accounting, and related fields is vital for efficient management and operations.
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