Deductibility of Interest Expense On Inter-Company Loans

THE RELEVANCE OF TRANSFER PRICING REGULATIONS[1]

Interest expense represents the cost incurred by a corporate entity on funds borrowed in carrying out its operations. It is the interest payable on borrowings which includes loans, bonds, letters of credit, etc.

In Nigeria, inter-company loans, that is, loans from a parent to a subsidiary and vice-versa are tax deductible if such loans are obtained in accordance with the prevailing market conditions; that is, the London Inter-Bank Offer Rate (LIBOR) and provided the funds are borrowed wholly, exclusively and necessarily for carrying out the operations of the borrowing affiliate. This position is in line with Section 24 of the Companies Income Tax Act (CITA) Cap C 21, Laws of the Federation of Nigeria (LFN) 2004 (as amended) and Section 10 (1) g of the Petroleum Profits Tax Act (PPTA) Cap P13, LFN, 2004.

In a ruling delivered on 18th September 2014, in the case of Nigeria Agip Oil Company Limited vs. Federal Inland Revenue Service (FIRS), the Tax Appeal Tribunal sitting in Lagos Nigeria provided guidance and clarity on the controversial issue of tax deductibility of interest arising from loans between affiliate companies. The ruling of the Tribunal was predicated on the interpretation of Section 10(1)g of the Petroleum Profits Tax Act (PPTA) which provides that interest on inter-company loans are tax deductible if obtained under prevailing market conditions, and Section 13 (2) of the same legislation which purports to disallow the tax deductibility of interest on loans between related entities.

The Tribunal, in its interpretation of these provisions of the PPTA (the guiding legislation for taxation of companies engaged in the oil and gas industry in Nigeria), ruled that once the arm’s length principle is satisfied, interest accruals on loans between inter-related companies are allowable deductions for tax purposes.

The decision of the TAT has re-inforced the importance of the Transfer Pricing rules and regulations in cross-border movement of capital as contained in the articles of the OECD Model Convention on Taxation of Income and Capital and as introduced in Nigeria as the Income Tax (Transfer Pricing) Regulations 2012 No. 1 (“the Regulations”).

Section 1 of Article 9 of the OECD Convention on Associated Enterprises provides as follows:

“1.        Where:

  1. a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State; or
  2. b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State,

and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would have been made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions have not so accrued, may be included in the profits of that enterprise and taxed accordingly”.

Similarly, Section 3 (1) of the Regulations provides that the “regulations shall apply to transactions between connected taxable persons carried on in a manner not consistent with the arm’s length principle and includes:

  1. Sale and purchase of goods and services;
  2. Sale, purchase or lease of tangibles assets;
  3. Transfer, purchase, licence or use of intangible assets;
  4. Provision of services;
  5. Lending or borrowing of money;
  6. Manufacturing agreement;
  7. Any transaction which may affect profit and loss or any other matter incidental to, connected with, or pertaining to the transactions referred to in (a) to (f) of this regulation”

From the above provisions, and in line with the ruling of the Tribunal, it appears that once the activities of a company are in compliance with the arm’s length principle in terms of asset used, functions performed and risk assumed, the tax authorities cannot, without more, disregard a loan transaction between related entities as being artificial and/or a sham.

In conclusion, the ruling of the Tribunal gave due consideration to the huge capital outlay required by companies involved in upstream operations in the oil and gas industry and the need for these companies to access capital from their foreign affiliates. Also, the ruling will serve as a catalyst for inflow of foreign direct investment (FDI) into the oil and gas industry in Nigeria and also give effect to the new world order of globalization and inter-jurisdictional movement of capital, goods and services.

[1] Article published in Africa Tax Law and Finance Hub Journal, September, 2014, available at : HERE

– Olalekan Sowande