Legal Basis For Implementation Of The IFRS 9 Reporting Standard And Its Tax Implications For Nigerian Entities

Tax implications of IFRS 9 implementation for Nigerian entities 

The adoption and implementation of IFRS 9 has significant tax implications for entities carrying on business in Nigeria, in particular, in the areas of tax deductibility of impairment losses and tax treatment of financial assets at fair value through profit or loss.

1. Tax deductibility of impairment losses 

   The seeming logical approach of IFRS 9, which seeks to recognize credit losses on loans and other financial instruments, may occasion a major tax concern for entities operating in Nigeria. The new regime introduced “expected loss” impairment model, which requires entities to account for expected credit losses from when financial instruments are first recognized, and to recognize full lifetime expected losses on a timely basis.  This effectively addresses the delayed recognition of credit losses on loans and other financial instruments under the IAS 39 “incurred loss” impairment model.

   Whilst this innovation in the IFRS 9 regime is expected to ordinarily improve tax deductibility of bad and doubtful debts in Nigeria, there may be a practical implementation challenge, in view of the discretionary powers vested in the FIRS under section 24(f) of the Companies Income Tax Act (“CITA”)[11], which sets out the parameters for tax deductibility of bad and doubtful debts and, provides a legal basis for FIRS’ established practice in relation to the allowance of impairment losses for tax deduction purposes.

   Under the repealed IAS 39, financial assets measured at amortized cost were required to be subjected to annual impairment review, with the aim of ascertaining if any impairment loss has occurred in the relevant accounting period.  This was the infamous “incurred loss” impairment model. Recognition of impairment loss was limited to situations, where loss events impacting the recoverability of estimated future cash flow from financial assets had in fact occurred.  Thus, objective evidence that the cash flow relating to a financial asset may have become irrecoverable is necessary.

   The IFRS 9 “expected loss” model for assessing impairment of financial assets measured at amortized cost, allows business entities to recognize impairment loss on a financial asset from the first day of entering into the contractual arrangement upon which the impairment may occur; without waiting for the actual occurrence of the relevant loss event. This model effectively allows a business entity to reflect impairments of its financial assets on its financial statements on an expected credit loss basis, without waiting till when the relevant credit loss actually occurs.

   

   The IFRS 9 impairment requirements recognize 12-month and lifetime expected credit losses for all financial instruments for which there has been a significant increase in credit risk since after an initial recognition based on stage allocation.  The IFRS 9 expected credit loss regime also incorporates forward-looking macroeconomic forecast in its estimation and may be assessed on individual or collective basis. This impairment model may result in the overstatement of impairment charges, as it will incorporate not only incurred credit losses but also expected credit losses.

   The tax implication of this model is that, unlike what was obtainable under the IAS 39, the new regime attracts more scrutiny of specific impairment losses in the company’s profit-before-tax in an accounting year. This may cause the FIRS to disallow such impairment losses for tax purposes, relying on the discretionary powers of the FIRS, under section 24(f) of the CITA, in relation to the treatment of bad and doubtful debts.

   For the purpose of ascertaining the profits or loss of any company for any period from any source chargeable to tax under the CITA, bad debts incurred in the course of a trade or business (proved to have become bad during the period for which the profits are being ascertained) and doubtful debts (to the extent that they are respectively estimated to the satisfaction of the FIRS to have become bad during the said period) are deductible. Pursuant to the provisions of section 24(f)(iii) of the CITA, notwithstanding that such bad or doubtful debts were due and payable before the commencement of the said period, such deductibility shall be permissible, in so far as same is proven, to the satisfaction of the FIRS that the debts in respect of which a deduction  is claimed were either included as a receipt of the trade or business in the profits of the year within which they were incurred; or were advances not falling within the provisions of the trade or business in the profits of the year within which they were incurred; or were advances not falling within the provisions of section 23(1)(e) of the CITA[12], made in the course of normal trading or business

   Under the defunct IAS 39 regime, the FIRS established the practice of assessing the tax deductibility of impairment charges on an individual and collective basis. In this way, the FIRS allowed specific impairment on individually significant non-performing loans and disallowed deduction of collective impairment on performing and individually insignificant non-performing loans. This practice was based on the discretionary powers vested in the FIRS, which effectively allows tax-deductibility of bad or doubtful debts incurred in relation to ascertaining and computing a company’s profits for any relevant accounting period, only to the extent they are estimated, to the FIRS’ satisfaction, to have become bad or doubtful.

   Conversely, the IFRS 9 regime requires entities to objectively assess their trade receivables for impairment at a balance sheet date, while charging the loss thereon to the income statement for the relevant accounting period.  The rationale for the global trend and convention in relation to bad and doubtful debts is to provide prudent accounting guidelines to entities reporting revenue for a certain period and perhaps, to ensure that these entities are not burdened with paying taxes on uncollected revenue. Clearly, the trend may have a practical implementation challenge in Nigeria, which may be attributable to the FIRS’ established practice of disregarding “expected loss” impairment projections made by companies in their financial statements, and preference of its subjective approach of allowing deductibility of bad and doubtful debts for tax purposes.  In effect, the IFRS 9 “expected loss” impairment model is therefore likely to occasion greater volatile impairment losses on the capital ratios of companies operating in Nigeria. This model may in our view potentially result in overstatement of impairment charges, which may likely be disallowed by the FIRS for tax deductibility purposes.

   Whilst Nigerian companies are permitted to deduct bad or doubtful debts from their taxable income and profits for any relevant accounting year, it is clear that the FIRS, in practice, has consistently relied on its discretionary powers under section 24(f) of the CITA to impose stringent conditions, as prerequisites for companies to qualify to deduct tax in respect of bad and doubtful debts. This is more so, due to the tendency of the FIRS to interpret the provisions of the CITA in a manner that will likely prevent taxable companies from claiming deduction on accrued impairment losses for relevant accounting periods. In our view, FIRS should exercise its discretionary powers in a more objective manner in order to ensure fairness and easy compliance. In March 2013, FIRS issued a circular on the Tax Implications of the Adoption of International Financial Reporting Standards (the “Circular”[13]). In the Circular, financial instruments classified as loans and receivables are to be treated in line with the provisions of relevant tax laws[14]. It also provides that impairment losses on individual financial assets classified as loans and advances shall be subject to section 20 of the CITA[15].

   The IFRS 9 “expected loss” impairment model which requires entities to objectively assess their trade receivables for impairment at a balance sheet date, while charging the loss thereon to their income statement for the relevant accounting period, will operate to ensure that corporate entities are not burdened with paying taxes on uncollected revenue; if applied fairly by the FIRS.

2. Tax treatment of financial instruments at fair value through profit or loss 

   With regard to the recognition and measurement of financial instruments under IFRS 9, paragraph 26.1 of the FIRS Circular provides that financial instruments classified at fair value through profit or loss held for trading or short-term profit-taking, such as derivatives, are revenue in nature and therefore liable to company income tax (to the extent they are not specifically exempted from tax) under the CITA. It also provides that the transaction will be taken as a separate line of business except where the taxpayer is already engaged in the same line of business[16].

   

   The Companies Income Tax (Exemption of Bonds and Short-Term Government Securities) Order 2011 (the “CIT Order”), which came into force on January 2, 2012, exempts income earned from government and corporate bonds/short-term securities from company income tax. In like manner, the Value Added Tax (Exemption of Proceeds of the Disposal of Government and Corporate Securities) Order 2011 (the “VAT Order”), which came into force on January 2, 2012, exempts proceeds from the disposal of short-term government and corporate bonds/securities from value added tax[17].

   The exemptions provided in the VAT and CIT Orders are only valid for a period of 10 years from January 2, 2012.  To the extent that the dispensation provided in the VAT and CIT Orders should lapse on January 1, 2022, it would appear that income earned from such transactions after January 1, 2022 will be subject to tax at the appropriate CIT or VAT rates.  However, the tax exemption of income earned from bonds issued by the Federal Government of Nigeria (“FGN”) under the CIT and VAT Orders will continue to apply after January 1, 2022.

   Regarding income derived from long-term investment securities classified as financial assets held at fair value through profit or loss, the question will turn on whether such income will be treated as revenue subject to company income tax at the rate of 30% or regarded as capital gains subject to capital gains tax at the rate of 10%.  It seems the FIRS has taken the view which is consistent with applicable case law that income derived from such investments will be treated as capital gain, subject to capital gains tax at the rate of 10%[18].

   It is noteworthy that section 30(1) of the CGT Act provides that gains accruing to a person from a disposal by him of Nigerian government securities, stocks, and shares shall not be chargeable gains under the CGT Act. “Nigerian government securities” is defined in the CGT Act to include Nigerian treasury bonds, savings certificates, and premium bonds issued under the Savings Bonds and Certificates Act[19].