Background
Nigeria’s power sector has faced interesting times since its privatization and subsequent handover to private companies in November 2013. The signing of The Finance Act 2019 (“The FA”) into law by the President of the Federal Republic of Nigeria in January 2020 may make the times even more interesting.
One key challenge that the sector has faced is that of liquidity. The non-application of cost-reflective tariffs by the Distribution Companies (Discos) has not helped in the resolution of this issue. Discos have continued to report gross loss up until the end of the 2018 financial year as the cost of their product exceeds the sale price. This does not even consider the significant collection losses faced by several Discos. Government and the Industry have continued to seek ways to resolve the myriad of issues facing the industry, but the passage of the FA may further impact the industry in ways that may not have been considered when it was passed.
The introduction of fiscal decrees, which sought to amend identified shortcomings in our tax laws as well as introduce new provisions to strengthen Government’s ability to raise revenue to fund its annual budget, was a highlight of the budget pronouncements during the military regimes. This changed when the country transitioned to civilian rule in 1999. Finance and tax practitioners had long advocated for a return to the past practice as is the norm in several developed countries. The need to also reform some of our tax laws, which had become archaic. was a basis to return to those times. The process of passing legislation in any bicameral legislature is typically cumbersome but Appropriation Bills must always be passed; otherwise, Government runs the risk of being shut down. Therefore, including a Finance Bill as part of the Appropriation Bill is a sure way of getting through some of the changes to the Nigerian tax laws that were over-due. It was, therefore, a highpoint of this year’s appropriation bill that it was accompanied by a finance bill, which thereafter passed as the FA. The enactment of the FA is generally seen as a milestone achievement for the country given the various objectives it seeks to achieve.
The power sector industry, especially the Discos, may not share the same sentiments though because of the potential issues it may have thrown up. Some of these issues are discussed below.
Changes to the minimum tax regime
The application of minimum tax is one of them. Every company doing business in Nigeria, and is not exempted from the payment of income tax, is expected to pay an amount of tax annually even in years in which they do not make profits. There are exemptions to this rule though and these include companies involved in agriculture, companies with at least 25 percent of their equity contribution imported from abroad and companies in their first four calendar years of operations. It is obvious that the only condition that could have applied to the Discos is that of imported equity. However, the FA has removed that condition and replaced it with companies whose gross turnover (less franked investment income) is less than 25million Naira per annum. All Discos currently exceed that value and so would not be able to claim any exemption from minimum tax even though they have been loss-making since incorporation.
Another change to the provisions on minimum tax is the basis for its computation. Practitioners had argued that the previous basis was complex and difficult to understand, so Government tried to simplify it. Minimum tax will now be computed as 0.5 percent of a company’s turnover in the year in which they either had no tax payable or tax payable which was less than the minimum tax. The simplification of the process should have been a victory for tax practitioners but that would be without considering the model of the Discos.
Discos are the primary source of revenue for the entire power sector, or at least for those players who supply power through the National grid. Even though they are predominantly loss-making, their revenue is huge as they bill and collect on behalf of the entire sector (transmission and generation). Any application of tax using their revenue as a base would ultimately be significant. Obviously, asking a sector already reeling under huge operating losses and liquidity challenges to begin to pay significant taxes will only worsen the situation. Limited resources, which may be applied towards network infrastructure development, may end up being sacrificed to pay the significant taxes that may crystallize as a result of this change.
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It has been argued that the Discos are not in any unique position as retailers the world over typically bear the burden of collecting revenue on behalf of manufacturers, who ultimately fix the recommended retail price (RRP). There are, however, significant differences. A retailer has the option to refuse to stock the product of a manufacturer if the RRP does not allow it to generate enough return to cover its cost and return a profit. Discos do not have the same liberty. Therefore, they would have to make this work within the constraints that already exist.
A few people have argued that the solution to the problem is to allow Discos treat their gross profit as their revenue for minimum tax purposes as the difference between that and the revenue reported in their financial statements represents amount collected on behalf of other sectors of the industry (Transmission and Generation). There are, however, a few issues that this simple solution may throw up. They include:
Several Discos had, prior to the 2019 financial year, reported a gross loss (cost of sales exceeds revenue), so they would have no revenue for minimum tax purposes. This isn’t a fault of the Discos anyway so it should not be an issue for them, if they don’t get to pay minimum tax because they don’t fix the prices.
Some organisations deduct tax on payments due to the Discos. These organisations have argued that nothing specifically exempts electricity bills from the application of withholding tax (WHT). Given that the brunt of failure to deduct is borne by the consumer, it is in their best interest to deduct until there is clarity on the matter. Discos have, in turn, argued that the supply of electricity should qualify as “sale in the ordinary course of business” which should be exempt from the application of WHT. There is a basis for this position, even though as stated earlier, there is no specific provision which supports it, thus leaving it open to challenge. In the absence of clarity, these organisations have continued to deduct tax and provide the Discos with the evidence of remittance in the form of WHT credit notes. A few Discos, which have had course to pay minimum tax, have utilised these credit notes while others may have reported the unutilised notes as assets in their books. If we take the argument initially outlined that the Discos revenue is not the amount received from the sale of electricity but that retained after remitting the cost of the electricity then the Discos cannot lay claim to the entire value of the WHT credits they had in the past utilised or recognised.
Furthermore, the adoption of the argument that the revenue reported by Discos is not theirs but that of the entire sector immediately weakens their case that they should be exempted from the application of WHT as the exemption only applies to sales in the ordinary course of business. The Disco would no longer be involved in sales but in the provision of a service (electricity distribution)[1] for which a fee is charged. It is possible to argue that the changes to be made would relate to the recognition of revenue for minimum tax purposes alone and not necessarily the business model or revenue recognition of the Discos as per the relevant accounting standards, but this must be carefully considered.
The adoption of the argument on Disco revenue may also impact the application of Value Added Tax (VAT) for the Discos. Nigeria’s VAT system only allows companies involved in the manufacture and or sale of goods on which VAT is charged to claim allowable input VAT on the cost of raw materials or goods purchased for resale. Therefore, any system that inadvertently changes the Discos status from a trading company to a service company may impact any input VAT previously claimed as well as their ability to continue to claim going forward. It is important to state that the ability to claim input VAT allows Discos the opportunity to recover 100 percent of their allowable VAT costs as opposed to only 30 percent if they were unable to claim it. This is massive for a sector with the kind of liquidity issues faced.
Changes to the taxation of interest
The changes to the taxation of interest may also impact the entire power sector. It was possible to obtain 100 percent exemption from tax on interest payable on foreign loans provided several attainable criteria were met. Several players in the sector had obtained loans with which they were able to purchase Government’s interest in the legacy entities and engage in network development. These loans were structured to meet the minimum requirement for tax exemption as at the time they were obtained. This has now changed with the FA. The maximum exemption any foreign loan can enjoy is now limited to 70 percent of the tax due. The tax withheld is not expected to be borne by the payer of the interest. From experience, foreign lenders typically include clauses in the loan agreements that transfer this obligation to the Nigerian recipient of the facility. Therefore, the taxes introduced by the FA are more likely to be borne by the Nigerian entities which undertook the loans in the first place rather than the foreign lenders; thus, increasing the cost of doing business. This may not be a problem for a thriving business, but the power sector is not that now.
Another change to the interest regime that may impact the sector is the restriction of the amount of interest that can be deducted by a company, in arriving at its assessable profit for tax purposes in any given year, from loans obtained from connected parties. The value of interest is restricted to not more than 30 percent of their Earnings before Interest, Depreciation and Amortisation (EBITDA). Any excess over this amount can be carried forward for periods up to 5 years after which they elapse. This restriction was introduced to encourage more equity to debt investments in Nigerian companies. However, there are no transition rules which would allow companies either pay off or restructure existing loans. In addition, loans granted by third parties but guaranteed by another party will be treated as a connected party loan which would be subject to the same restriction. This must be considered within the context of the fact that most foreign lenders would typically be reluctant to lend to Nigerian companies without the guarantees of their foreign related party solely due to the ease of enforcement if it becomes necessary. In instances where no guarantees are required or requested, the cost of the loan is typically adjusted to reflect the perceived increased risks.
Several power companies and their promoters already have existing loans. An entity without a gross profit will not have any EBITDA and so will not be able to claim any interest paid on related party loans. It is also likely that the sector may not be able to claim any of the interest that it may be forced to carry forward in the 5-year window that it has, thus losing the amount totally. This does not also impact the WHT that would have been due and paid on the interest.
Increased VAT rate
VAT applies on the sale of electricity to consumers in the country. The increase in the VAT rate is, therefore, going to impact the cost of electricity without any commensurate value to the sector. Tariff has always been a sentimental issue for all stakeholders in the sector. It is trite that tariffs would have to be reviewed at some point as the current tariffs are unsustainable for the sector’s long-term viability. However, the process of tariff review has been difficult to manage given the concerns consumers have expressed about paying more without any noticeable improvement in power supply. Players have also argued that improvements would only come about with significant investments and this cost money. The argument that this money should be sourced independently from consumers does not hold water as investors and or lenders would be unwilling to put in more money into a sector which today cannot pay itself (not to talk of a return) because of the tariff issue.
Consumers would now have to pay more anyway solely due to an increase in VAT rate. This may make the tariff adjustments which are long over-due a tad more difficult. The complete exemption of the electricity value chain from the imposition of VAT has been canvassed in the past with the savings transferred to tariff increase and maybe now is the time to revisit that argument.
Conclusion
The Nigerian power sector is very critical to our aspirations to become an Industrialised Nation. The sector is also very nascent and tethering on the brinks. It is, therefore, important that we understand that it cannot be treated in the same way and manner as other developed sectors of the economy. Companies engaged in agriculture are currently exempted from the application of minimum tax amongst other incentives contained in the tax laws. However, the ability to grow and process agricultural products successfully depends on the availability of power. There is a case to be made in favour of the power sector and that case must be strongly made.
We cannot lump it together with established industries and expect it to thrive. A time is coming when it would no longer need special treatment. It hasn’t arrived yet.
Martins Arogie is an Associate Director at the Tax, Regulatory and People Services Division of KPMG
