In this article, we discuss the financial reporting, tax and legal considerations for conversion of intercompany loans to equity.
An intercompany loan is one which both the lender and the borrower are within the same group structure. The essence of an intercompany loan in most cases is to move cash to a business unit that may have a cash flow deficit. It can also be an amount or advance given by one company (in a group of companies) to another company (in the same group of companies) for numerous purposes which may include to help the cash flow deficit, fund the fixed assets or the normal business operations of the borrowing company. An intercompany loan usually results to an interest income to the lending company and an interest expense to the borrowing company.
As a result of the COVID-19 pandemic, a lot of organisations have struggled to keep operations running, thereby sourcing for external finance. In the same vein, related companies have accessed loans within their group to cushion the effects of the pandemic on their businesses. However, in some cases, the inability to meet up with the loan obligations results in the conversion of the loans to equity (debt-to-equity swap).
A debt-to-equity swap is a capital reorganization where a creditor converts indebtedness owed to it by another company into one or more classes of that company’s share capital.
Financial Reporting Considerations
In practice, intercompany loans are usually provided for various reasons ranging from a parent company sending money to a subsidiary to cover working capital requirements, availability of low lending rate in either parent or subsidiary home country, group-wide cashflow management, etc. Often, intercompany loans are issued at below market value rates since the parties involved do not necessarily intend to enter a commercial arrangement.
In some cases, intercompany loans are not repayable at all or may be repayable at will by the lender; in this case the loan has the feature of equity contribution. The loan may therefore be reclassified as equity in favour of the lender at the instance of the lender. The lender recognizes the loan as an investment in the subsidiary, while the subsidiary records as an equity (where loan is from parent to subsidiary). If the loan is provided by the subsidiary, the parent company would recognize such loan as a distribution from the subsidiary.
The International Financial Reporting Standards (IFRS) 9 requires that financial instruments are initially recognized at fair value without exceptions. Therefore, if a loan is issued at interest free or below market interest rate, the loan should initially be recognized at present value (PV) using the market interest rate.
Section C of the Organization for Economic Cooperation and Development (OECD) Transfer pricing guidelines on financial transactions, provides guidance on determining the arm’s length conditions for intra-group loans. The general considerations in the OECD guidelines include the credit assessment, which is usually not carried out for intercompany loans, however, assessment conditions such as creditworthiness, credit risk and economic circumstances are relevant.
From the Federal Inland Revenue Service (FIRS) perspective, related companies must be able to demonstrate that loans are contracted at arm’s length. The FIRS may disallow interest on intercompany loans where there is no sufficient evidence to demonstrate that the loan terms comply with arm’s length principles.
In line with Section 24 and the Seventh Schedule to the Companies Income Tax Act (CITA), the interest payable and expenses of similar nature incurred by a Nigerian company (with exemptions to companies engaged in the business of banking and insurance), in respect of debt issued by a foreign connected person, in excess of 30% of earnings before interest, taxes, depreciation and amortization of the Nigerian company, will not be allowed for tax deductions.
The excess interest expense disallowed in the current year can be carried forward and treated as tax-deductible for a maximum of five years. This is important as interest on the loans would have an impact on the tax payable by both lender and borrower.
Withholding tax (WHT) of 10% is deducted from the interest paid by a Nigerian company to a non-resident company. third schedule of Companies’ Income Tax Act (CITA) relating to relief for foreign loans provides conditions for tax exemptions ranging from 10% to 70% on interest payable on foreign loans. This exemption depends on the repayment period and grace period including moratorium of the loan.
One benefit of converting intercompany loan to equity is the reduction or elimination of interest expense on the related party loan. This reduces or eliminates the need to restrict any excess on interest payable to 30% of EBITDA. Also, the need to demonstrate that the intercompany loan meets the arm’s length requirement and the applicability of WHT is also reduced or eliminated.
To convert an intercompany loan to equity, the lender has agreed to convert the outstanding loan from the borrower into shares in the company. This would mean a reduction in the loan balance and an increase in the share capital of the borrower.
The Companies and Allied Matters Act (CAMA) 2020 prescribes a new process for increasing issued share capital. Under section 127 of the CAMA 2020, a company that wishes to increase its issued share capital simply passes a resolution approving the allotment of new shares to named persons. The Corporate Affairs Commission (CAC) must be notified of the increase and allotment within 15 days of the relevant general meeting and it is at this point that stamp duty and CAC filing fees are paid on the amount of the increase, and a return of allotment filed.
The CAMA 2020 also sets out the process for dealing with circumstances where a company is unable to notify the CAC within the above-mentioned 15-days period. In such circumstances, the company is required to notify CAC of this fact within 15 days. Further, section 127(3) requires that the notice to the CAC be filed along with an affidavit sworn to by a director of the company.
Given the impact of the COVID-19 pandemic, high foreign currency exchange rates and the current economic realities in Nigeria, companies with huge indebtedness and high interest payment obligations may begin to consider a possible reorganization of their capital structure. This will unlock the much-needed funds to support working capital requirements, improve the quality and quantity of input and increase productivity.