Nigeria is a major target location for foreign direct investment (FDI) in Africa and attracts investors in various sectors such as power, energy, real estate etc. In recent times, notable capital-intensive investments have been made in Nigeria through FDI. Nigeria witnessed an increase in FDI between 2019 and 2020. According to the United Nations Conference on Trade and Development (UNCTAD) 2021 World Investment Report, FDI flows to Nigeria totalled US$ 2.4 billion in 2020, showing a slight increase of 4.3% from the previous year (US$ 2.3 billion in 2019)1 , despite the global economic crisis occasioned by the Covid-19. However, this trend has not been maintained as the total value of foreign investment, and capital importation into Nigeria dropped on a quarter-on-quarter basis by 28.1 percent to $1.6 billion in the first quarter of this year2 . According to data published by the National Bureau of Statistics (NBS), capital importation dropped by 17.5 percent from $1.9 billion in the first quarter of 2021. The total value of capital importation into Nigeria in the first quarter of 2022 stood at US$1,573.14 million from US$2,187.63 million in the preceding quarter showing a decrease of 28.09%. Compared to the corresponding quarter of 2021, capital importation decreased by 17.46%3 .

It is easy to blame the decline in foreign investment on factors such as insecurity, lack of infrastructure, upcoming 2023 elections etc. However, one of the causes of the decline in FDI is unfavourable fiscal policies. Amongst such unfavourable fiscal measures are the various restrictions on the tax deductibility of interest expense introduced under the Finance Act 2019 (“the Finance Act”) and Petroleum Industry Act 2021 (PIA). Under the Finance Act, deductible interest expenses on loans or debts obtained from a foreign-connected person are limited to 30% of earnings before interest, tax, depreciation and amortisation (EBITDA). Any excess can be carried forward and utilized in the next year, for up to a maximum of five years. With respect to companies operating in the upstream oil and gas sector, section 264 of the Petroleum Investment Act (PIA) provides that no tax deduction against Hydrocarbon Tax will be granted for finance costs, bank charges and interest on borrowing. The restriction under the PIA is of broader coverage as it applies to both related party transactions and transactions between unconnected parties.

Impact of Thin Capitalisation on Foreign Direct Investment in Nigeria

Loan and debt financing is a significant source of funds for emerging businesses. The recently introduced restrictions on the tax deductibility of interest expense may be regarded as thin capitalisation rules. Thin capitalisation refers to the situation in which a company is financed through a relatively high level of debt compared to equity. A highly leveraged company would be able to deduct more interest expenses on related party loans compared to a lower leveraged company. This will ultimately reduce the taxable profit of the company. Thin capitalisation has been identified as a strategy for base erosion and profit shifting, leading to the introduction of thin capitalisation rules in many countries. Prior to the year 2020, there was no cap on the tax deductibility of interest expense arising from related party loans under the Companies Income Tax Act. This gave investors the comfort to finance their local subsidiaries in Nigeria through a flexible mix of debt and equity financing. Debt financing was further incentivised by the possibility of obtaining up to 100% tax exemption on interest payment depending on the tenure, repayment period and moratorium of the loan. The recently introduced restrictions on tax deductibility of interest expense will adversely affect the investment decision. This will reduce the inflow of capital and foreign direct investment. The impact of these unfavourable fiscal measures on the level of FDI inflow can be illustrated with the scenario painted below:

Assuming back in 2018, AEX Space LLC, a multinational entity engaged in the business of sales, installation and maintenance of solar power equipment decides to expand its operations to Africa. To commence business in Nigeria, AEX Space LLC will incorporate a local subsidiary in Nigeria. The local subsidiary will be heavily dependent on the parent company for start-up funds and running cost. Based on the provisions of applicable laws, as at that material time, AEX Space LLC will fund its Nigerian subsidiary through a flexible mix of debt and equity. Lots of solar power equipment will be imported to support the business of the Nigerian subsidiary and serve as inventory. The imported solar power equipment (where no consideration is paid on the transaction) may be recognised as equity or loan in the balance sheet of the local subsidiary. In this scenario, AEX Space LLC will be at liberty to inject as much loan capital as may be required to grow the business of its Nigerian subsidiary to global standards. However, same will not be true if the investment decision was being contemplated today. The newly introduced restriction on interest deductibility practically reduces the amount of loan capital AEX Space LLC will be able to import into its Nigerian subsidiary. Thus, there may be difficulties with growing the business of the Nigerian subsidiary to global standards.

Impact of Thin Capitalisation Rule in other Jurisdictions

Cross-border intercompany transactions account for a very high percentage of global trade in terms of value. Data gleaned from economies with thin capitalisation rules across the globe reveals the adverse effect of thin capitalisation on foreign investment. A working paper published by the Fiscal Affairs Department of the International Monetary Fund (IMF) in February 2021 clearly identified thin capitalisation rule as a factor that raises the cost of capital for affected affiliates and can negatively affect real investment. Exploiting unique panel data on multinational companies in 34 countries between 2006-2014, the IMF estimate that the size of this adverse investment effect can be large and dependent on the statutory corporate tax rate and the tightness of the safe-haven ratio4 .

Another notorious fact is that location choices for setting up affiliates of multinational corporations are also affected by the thin capitalisation rules.

Conclusion

Today, investors are left the choice of providing more equity funding for their local subsidiaries or relocating their subsidiaries to neighbouring countries with more favourable fiscal policies. Nigeria is a developing economy and is still very much in need of FDI. It is, therefore, imperative for the legislature and policymakers to objectively examine the impact of the recently introduced restrictions on the tax deductibility of interest both under the Finance Act and under the PIA. As Nigeria is soaring higher on the World Bank's ease of doing business ranking, newly introduced fiscal measures should be such that will attract more FDI and make Nigeria a choice location for MNEs.

It is very important to strike the crucial balance between raising government revenue and economic development. From a revenue generation and tax base protection perspective, the focus should be more on the numerous tools already enshrined in the tax laws to ensure government gets its fair share on returns from any taxable business activity. One such tool is the "minimum tax", which is chargeable on a company's turnover. Other earmarked taxes are assessed based on assessable profit, profit before tax or turnover. Further amendments to the existing fiscal framework are highly desirable to make Nigeria a choice destination for FDI and to attract more capital inflow.

Footnotes

1 UNCTAD's World Investment Report - https://unctad.org/data-visualization/global-foreign-direct-investmentflows-over-last-30-years

2 Business Day Newspaper Report – 2 June 2022 - https://businessday.ng/business-economy/article/foreigninvestments-into-nigeria-drops-by-28-to-1-6bn-in-q1/

3 National Bureau of Statistics Report - https://nigerianstat.gov.ng/elibrary/read/1241180

4 International Monetary Fund: At A Cost: The Real Effects of Thin Capitalization Rules; February 2021 -  https://www.imf.org › wpiea2021023-print-pdf

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