Deductibility of Interest on intra-group borrowings by E&P companies

Over the years, deductibility of interest on such intra group loans has been a major area of contention between E&P companies, which seeks to enjoy available incentive under tax laws, and tax authorities whose aim is to maximize tax payable. This is as a result of the contrasting provisions of the PPTA on the treatment of interest on intercompany borrowings as set out in sections 10 (g) and 13(2) of the Petroleum Profits Tax Act CAP P13 LFN 2007.

Section 10(g) of PPTA states that “all sums incurred by way of interest on any intercompany loans obtained under terms prevailing in the London Inter-Bank Offer Rate, by companies that engage in crude oil production operations in the Nigerian oil industry” shall be deductible for tax purposes. Conversely, Section 13(2) states that interest accruing from borrowings from another related company are non-deductible for tax purpose. Another company, according to the section refer to a subsidiary, a company that has an interest in the other company or both companies have direct or indirect interests in another company.

The 2014 case between Nigeria Agip Oil Company Limited and Federal Inland Revenue Service is typical of the wrangling on the correct treatment of intercompany borrowings. The TAT ruled that the interest on related party loans should be treated as a deductible expense, provided it was at arm's length; thereby emphasizing the importance of arm's length principle as a criteria for  deductibility. Hence, in the event that the tax authority could not verify that the intercompany borrowing is at arm's length, the expense would be treated as non-deductible for tax purpose.

While the ruling (and subsequent one that followed the same pattern) appeared to have put the controversy to a rest; should tax authorities seek to appeal, there could be other considerations that may undermine the rationale for the ruling. This is more so in view of the declining prices of oil and the shift in emphasis to taxes as a significant source of revenue for the Federal Government of Nigeria.

In the event of an appeal, it may be possible to argue based on the provision of section 13(2) that the restriction applies “notwithstanding” any other provision in the tax laws. Therefore if read strictly, it should supersede section 10(g). This argument must however be appreciated within the context of the following factors before any conclusive landing is made thereon:

• Legislative history: Section 13 (2) had been part of the PPTA, as a general anti avoidance provision, since 1959. But Section 10(g) was inserted by Decree 30 in1999. The provision of section 13(2) was not amended to cover section 10(g), therefore the former could not have envisaged the latter and the “notwithstanding” does not extend to the provision of section 10(g).
• Legislative intention: Section 10(g), in recognition of the erstwhile restrictions, came as a succour for E&P companies to allow deduction of sums incurred by way of interest on any loan they obtain for their petroleum operations. The only restriction being arm's length rate; using the London Inter-Bank Offer Rate (LIBOR) as the relevant benchmark.

The logic of using arm's length pricing is to ensure the government would not be in a worse position (with less income) had the borrowing been from an unrelated party. Thus, where an E&P company can justify the arm's length interest rate using appropriate transfer pricing mechanism, it will be difficult to prove that the government has been short changed and the whole essence of the restriction in section 13(2) falls apart.

However, while the provision of section 10(g) allows deductibility based on underlying interest rate and expense; it does not address impact of granting higher quantum of loan (thin capitalization). Though there are no formal thin capitalization rules in Nigeria, tax authorities could rely on the general anti-avoidance rule on related party transactions.

Therefore, tax authorities may challenge interest deduction on the ground that the quantum of loan (not interest rate) was not at arm's length. Here, tax authorities would rely on its powers of adjustment in the PPTA. This rule also has the potential of becoming significant source of controversy in view of the lack of clarity on what would be considered arm's length leverage.

In view of the above, it is imperative for the tax authority and legislature to address the ambiguity in PPTA and offer clarification to enable taxpayers adopt right treatment of their intercompany borrowings. One of the canons of taxation remains clarity and the Nigerian National Tax Policy has emphasized the country's commitment to achieving clarity. Presently and barring any contrary decision by a superior court on appeal, the applicable rule is that interest on intra group loans are deductible for tax purposes.