Financing arrangements and interest expense deduction: Finding the middle ground

Financing arrangements and interest expense deduction

To counter the negative consequences of loan financing with regards to tax collection, many countries have introduced measures to ensure that interest payments by companies operating in their jurisdictions are within ‘reasonable limits’ and do not erode the tax base.

 Financing arrangements and interest expense deduction

Companies primarily have two sources of funds - debt and equity, and the proportional mix of these funds makes up a company’s capital structure. While dividend is paid to equity holders, nterest is paid on debt. Reliance on debt in the capital structure commits a company to paying out a proportion of its income in the form of interest expense. These interest expenses are
usually deductible in arriving at the income tax payable, thus providing companies with an incentive to finance their operations with debt rather than equity, especially in countries with high tax rates.

Essentially, the more debt a company has, the more the obligation to make interest payments; the more the obligation to pay interest, the more the tax deductible expenses from a company’s earnings resulting from increased interest payments, thus leading to lower taxable income, and ultimately lower revenues from corporate taxes for the government.

Consequently, revenue authorities are concerned about the excessive interest deductions payable by companies to loan providers, especially related parties which is the primary focus of this discourse.

Although, Nigeria does not currently have specific rules governing financing arrangement and issues bordering on interest deductions, the FIRS should consider introducing some rules to deal with the issues noted. An established rule will no doubt erase any sort of ambiguity with respect to how much loan a company can obtain from its related party offshore, and how much it should pay in interest. Overall, the rules will engender certainty in policy and approach to resolving areas of conflict between revenue authorities and tax payers as far as interest deduction is concerned.

We hold the view that domesticating BEPS Action 4 is one way the FIRS can show that it is ready to administer a modern tax system. Not only will it serve to curtail profit shifting, it will also ensure certainty and clarity in tax administration and compliance by revenue authorities and taxpayers, respectively.

This excerpt is from our Newsletter document "Financing arrangements and interest expense deduction: Finding the middle ground". Click here to download the publication.

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