By Tayo Ogungbenro
On June 20, 2016, a new foreign exchange policy effectively commenced in Nigeria. It was a major shift from the controlled regime to a market-based one. According to the Central Bank of Nigeria, naira will now trade in the open market under some general guidelines. Foreign exchange rate of the naira will now be determined by the invisible hands of demand and supply in a competitive and transparent system.
At the close of the first trading day, the price of naira in the US dollar reacted sharply. Price fell at the parallel market and the hitherto pegged official rate significantly rose. Naira exchanged for N282 per dollar against the hitherto official exchange rates of N197, a depreciation of more than 40 per cent in just one day!
The negative impact of the change on companies’ financial position is best imagined. To put it mildly, the balance sheet of companies with significant US dollar denominated liabilities (who do not have the corresponding assets in similar basket of currencies) shrank. The magnitude of the shrinkage is a function of the proportion of the liability to the net value of the each company.
The potential impact on the companies’ tax liability could however be worse. This is due to the difference in the treatment of foreign exchange losses or gains by both tax laws and accounting standards. The Nigerian tax laws further distinguished the gains or losses into two: those attributable to principal versus interest. If the issue is not properly managed, it may create a going concern problem for companies with huge foreign exchange liabilities.
The International Financial Reporting Standards require that liabilities should be recognised as soon as it is noticeable. Once done, the impact of the currency depreciation in the form of forex losses may wipe out the accounting profit of some companies. In the extreme, it may be responsible for the total accounting losses for a reporting period.
Unfortunately, the company may be required to pay tax, despite the burgeoning accounting losses. This is because the forex losses will not be recognised for tax purposes until the underlying liability is liquidated. The Nigerian Companies Income Tax Act does not permit deduction of forex losses that have not been realised. Similarly, any forex gain arising from book translations is exempted from taxation until the liability or asset is disposed.
Even where the liability is settled, there are differing opinions on how the portion attributable to the principal should be treated for tax purposes. Whilst one school deems the portion as capital repayment or expenditure of a capital nature, which is therefore not deductible for tax purposes, the other thinks it is a form of finance charge which should be fully deductible as an expense wholly, reasonably, exclusively and necessarily incurred for the purpose of generating taxable income. The jury is however out there in respect of which is the correct and tax-compliant treatment. The dearth of judicial interpretation on the issue has not helped matters!
Nevertheless and for our purpose in this article, it is sufficient to note that the difference in tax and accounting treatments will create deferred tax impact. Based on the newly introduced forex regime, the difference will most likely be a loss and it is therefore safe to assume that the deferment will be an asset. If we also assume that the entire forex loss is deductible for tax purposes, the deferred tax asset will reverse in future when the liability is extinguished. To the extent that unrealised forex loss is however not tax-deductible in any year of assessment when it has not been realised, the highly exposed companies will face double negative impact.
In the first instance, if the company reports an accounting loss, it may forestall payment of any dividend to the hapless shareholders. On the other hand, the same company will be required to pay companies’ income and education taxes, which are approximately 32 per cent of the forex loss, since it (i.e. forex loss) will be disregarded for tax purposes. Government’s take out of the business will therefore be earlier than the shareholders’. The latter will only benefit from reduction in tax payable when the deferred tax asset reverses.
It is therefore advisable for companies to find solutions to this imbalance. A situation where government still gets its share of business “returns” from a problem inflicted by the same government’s business-unfriendly policies definitely calls for careful response from companies that will pay the liability!
One of the major ways out of this imbroglio is to design a structure that “realizes” the forex losses immediately. Simply put, companies should restructure its debt portfolio in a way that enables them to liquidate the liability immediately, but simultaneously rebooks it (i.e. the liability) at the prevailing forex rate. This is akin to a “sale and leaseback” arrangement.
A properly structured and implemented “liquidate and rebook” where the liability is liquidated will permit the company to deduct the forex losses from the taxable income. However, since the company still needs the credit, it should recreate the debt, which will now be at the current forex rate. Literally, this means that companies should pay the debt today and borrow the same amount, possibly from the same person, the morning after! The possibility that the tax authority will deem the transaction as artificial or purposely designed to avoid payment of tax should be addressed by careful consultation, planning and execution. This will most likely make an unbiased third party agree with the necessity for the restructuring.
Finally, it should be noted that the timing of introduction of the new forex regime, mid–2016, provides an ample opportunity for companies to commence and conclude any restructuring before the financial statements (especially for companies with December 31 accounting year-end date) is closed.
The restructuring is also worth considering immediately because there is every likelihood that the forex rate will not fluctuate materially from the current level in the next foreseeable future. The affected companies will thus stand in a position to benefit.
In conclusion, tax has become a “stay-awake” issue for all business stakeholders all over the world. Business executives and managers should therefore be proactive and creative in addressing environmental issues that may drain scarce and expensive resources of their companies.
Ogungbenro is a partner in KPMG Advisory Services and headsthe Transfer Pricing services unit. The opinions expressed in this article are his and does not represent that of the firm.
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