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Thin capitalization rules prevent companies from using excessive debt financing to reduce taxable profits through interest deductions. Nigeria has specific rules limiting interest deductions when companies are funded primarily by debt rather than equity. This guide explains how these rules work and how to stay compliant.

What is Thin Capitalization?

Definition

Thin capitalization occurs when a company is funded with a high proportion of debt relative to equity:

Thick capitalization: Mostly equity funding
Thin capitalization: Mostly debt funding

Why It Matters for Tax

Interest on debt is tax-deductible; dividends on equity are not:

Funding Type	Tax Treatment
Equity	Dividends paid from after-tax profits
Debt	Interest deductible before calculating tax

Companies may prefer debt to reduce tax:

Example:

Equity Funded	Debt Funded
Profit before interest	₦100M	₦100M
Interest expense	₦0	₦50M
Taxable profit	₦100M	₦50M
CIT @ 30%	₦30M	₦15M
Tax saved	—	₦15M

The Problem

Related parties can manipulate this:

Parent company lends to subsidiary (instead of equity)
Excessive interest payments reduce Nigerian tax
Interest flows to parent (possibly lower-tax jurisdiction)

Thin cap rules limit this benefit.

Nigeria's Thin Capitalization Rules

The Debt-to-Equity Ratio

Nigeria limits interest deductions based on debt-to-equity ratio:

Maximum ratio for foreign-related debt: Typically 2:1 (debt:equity)

This means:

Equity: ₦100M
Maximum related party debt: ₦200M
Interest on debt exceeding ₦200M: Not deductible

Scope of Rules

Debt Type	Subject to Thin Cap?
Loan from foreign parent	Yes
Loan from foreign affiliate	Yes
Loan from domestic related party	May be subject
Third-party bank loan	Generally no
Guaranteed loans	May be subject

Equity Definition

For thin cap purposes, equity includes:

Share capital
Share premium
Retained earnings
Capital reserves

Does not typically include:

Revaluation reserves
Some hybrid instruments

Calculating the Limit

Step 1: Determine Equity

Calculate qualifying equity:

Component	Amount
Share capital	₦50,000,000
Share premium	₦10,000,000
Retained earnings	₦40,000,000
Total equity	₦100,000,000

Step 2: Calculate Maximum Debt

Apply the ratio:

Maximum debt = Equity × 2
Maximum debt = ₦100,000,000 × 2 = ₦200,000,000

Debt Source	Amount
Loan from parent company	₦180,000,000
Loan from sister company	₦70,000,000
Total related party debt	₦250,000,000

Step 4: Determine Excess Debt

Maximum allowed: ₦200,000,000
Actual: ₦250,000,000
Excess: ₦50,000,000

Step 5: Calculate Disallowed Interest

If average interest rate is 12%:

Interest on excess = ₦50,000,000 × 12% = ₦6,000,000
This interest is not deductible for CIT

Interest Limitation Rules

EBITDA-Based Limitation

Nigeria also limits interest deductions based on EBITDA:

Maximum deductible interest: 30% of EBITDA

Calculation	Amount
Earnings before interest, tax, depreciation, amortization	₦100,000,000
30% of EBITDA	₦30,000,000
Actual interest expense	₦40,000,000
Disallowed interest	₦10,000,000

Which Rule Applies?

The more restrictive of:

Debt-to-equity ratio
EBITDA percentage

You must satisfy both tests.

Practical Examples

Example 1: Compliant Structure

Item	Amount
Equity	₦500,000,000
Related party debt	₦800,000,000
Debt:Equity ratio	1.6:1
Maximum allowed	2:1
Status	Compliant

All interest on the ₦800M debt is deductible (subject to EBITDA test).

Example 2: Non-Compliant Structure

Item	Amount
Equity	₦100,000,000
Related party debt	₦300,000,000
Debt:Equity ratio	3:1
Maximum allowed ratio	2:1
Maximum debt	₦200,000,000
Excess debt	₦100,000,000
Interest rate	10%
Disallowed interest	₦10,000,000

Example 3: EBITDA Limitation

Item	Amount
EBITDA	₦50,000,000
30% of EBITDA	₦15,000,000
Total interest expense	₦25,000,000
Disallowed interest	₦10,000,000

Types of Debt Affected

Clearly covered:

Parent company loans
Sister company loans
Shareholder loans
Any connected person lending

Guaranteed Debt

Third-party loans guaranteed by related parties may be treated as related party debt:

Scenario	Treatment
Bank loan, no guarantee	Not subject to thin cap
Bank loan, parent guarantee	May be subject to thin cap
Bank loan, cash collateral from parent	May be subject to thin cap

Back-to-Back Loans

Arrangements designed to circumvent rules:

Parent deposits with bank
Bank lends to subsidiary
May be treated as related party debt

Compliance Strategies

1. Equity Conversion

Convert some debt to equity:

Before	After
Equity: ₦100M	Equity: ₦200M
Debt: ₦300M	Debt: ₦200M
Ratio: 3:1	Ratio: 1:1

2. Third-Party Refinancing

Replace related party debt with bank debt:

Bank loans not subject to thin cap (unless guaranteed)
May have different commercial terms

3. Capitalize Retained Earnings

Issue bonus shares from retained earnings:

Increases share capital
Increases equity for thin cap purposes
No cash required

4. Hybrid Instruments

Consider hybrid financing:

Instruments that are equity for thin cap
May provide some debt-like features
Complex—requires specialist advice

5. Optimize Interest Rates

If some interest will be disallowed:

Ensure interest rate is arm's length
Avoid additional transfer pricing exposure

Documentation Requirements

Supporting Documentation

Maintain records of:

Loan agreements
Interest calculations
Debt-to-equity calculations
EBITDA computations
Justification for financing structure

Annual Calculations

Each year:

Recalculate debt-to-equity ratio
Compare to EBITDA limit
Determine any disallowed interest
Adjust in CIT return

Transfer Pricing Link

Related party loans are also subject to transfer pricing:

Interest rate must be arm's length
Thin cap and TP are independent requirements
May have interest disallowed under either rule

CIT Return Treatment

Reporting Disallowed Interest

In your CIT computation:

Item	Amount
Accounting profit	₦80,000,000
Add: Disallowed interest (thin cap)	₦10,000,000
Add: Other adjustments	₦5,000,000
Adjusted taxable profit	₦95,000,000

Disclosure Requirements

Your return should show:

Total interest expense
Related party interest
Thin cap calculation
Amount disallowed

Interaction with Other Rules

Transfer Pricing

Rule	Focus
Transfer Pricing	Is the interest rate arm's length?
Thin Cap	Is the debt amount excessive?

You can have compliant TP but thin cap disallowance (arm's length rate, but too much debt).

WHT on Interest

Thin cap disallowance doesn't affect WHT:

WHT still applies on interest payments
Even on disallowed portion
WHT is on the payment, not the deduction

Dividends Reclassification

In some cases, disallowed interest may be treated as deemed dividends:

Additional WHT may apply
Complex—consult advisor

Common Issues

Issue 1: Year-End vs Average Debt

Question: Do I use year-end debt or average?

Approach: Generally, use an appropriate measure (often average debt during the year). Be consistent and document methodology.

Question: Do I aggregate all related party debt?

Answer: Yes. Total all debt from connected persons for the calculation.

Issue 3: Negative Equity

Question: What if I have negative equity?

Answer: No related party debt would be allowed. All interest would be disallowed.

Issue 4: Intercompany Current Accounts

Question: Are trade payables considered debt?

Answer: Genuine trade credit may not be debt for thin cap. However, extended or formalized arrangements may be treated as debt.

How Finora Helps with Thin Capitalization

Finora identifies related party balances:

Track loans from connected parties
Monitor debt levels
Alert when approaching thresholds

Calculation Support

At year-end:

Calculate equity for thin cap purposes
Determine debt-to-equity ratio
Compute EBITDA and interest limitation
Identify disallowed interest

Documentation

Maintain records:

Loan details and terms
Interest calculations
Annual thin cap workings
Support for CIT return

Planning Tools

Model scenarios:

Impact of additional borrowing
Effect of equity injection
Optimal financing structure

Frequently Asked Questions

Does thin cap apply to banks?

Financial institutions have separate rules. This guide covers non-financial companies.

What about shareholder loans?

Loans from shareholders (who are also related parties) are subject to thin cap rules.

Can I carry forward disallowed interest?

In some jurisdictions, disallowed interest can be carried forward. Check current Nigerian rules—treatment may vary.

What if I restructure mid-year?

Calculate based on the structure during the year. Pro-rate if significant changes occur.

Do thin cap rules apply to Nigerian-to-Nigerian loans?

Primarily focused on cross-border related party debt, but domestic related party transactions may be subject to other anti-avoidance rules.

Conclusion

Thin capitalization rules limit interest deductions when companies are excessively funded by related party debt:

2:1 debt-to-equity ratio is typical maximum
30% of EBITDA provides additional limitation
Both tests must be satisfied
Excess interest is disallowed for CIT purposes

Proper planning can optimize your financing structure while remaining compliant. The key is understanding your current position, modeling the impact of different structures, and maintaining proper documentation.

Finora helps track related party debt, calculate thin cap limitations, and document your position for CIT compliance.

Need to optimize your financing structure?

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