INSIGHT: Lessons from Nigeria’s First Tribunal Judgment on Transfer Pricing

Nigeria’s Tax Appeal Tribunal has made its first ever decision on a transfer pricing (TP) dispute under Nigeria’s Transfer Pricing Regulations (TP Regulations). In Prime Plastichem Nigeria Ltd vs Federal Inland Revenue Service, the Tribunal upheld the Federal Inland Revenue Service’s TP assessment of about $4.8 million.

In the judgment, the Tribunal supported the decision of the Federal Inland Revenue Service (FIRS) to use the gross profit margin (GPM) as a profit level indicator (PLI) for applying the transactional net margin method (TNMM).

This Insight will discuss some of the TP issues that were reviewed in the case and highlight the key lessons for taxpayers with TP obligations in Nigeria.

Background to the Case

Prime Plastichem Nigeria Ltd (PPNL) imports plastics and petrochemicals from a related party (Vinmar Overseas Limited, VOL) for resale to Nigerian customers. In 2016, PPNL was the subject of a TP audit for the 2013 and 2014 financial years.

PPNL justified the arm’s length nature of its purchases from VOL using the comparable uncontrolled price (CUP) method in 2013. The CUP method was applied by using the price charged by a sister company (Vinmar International Limited, VIL) to Nigerian third-party customers as a benchmark.

The company applied the TNMM and not the CUP in 2014. PPNL was the tested party and the selected PLI was the operating profit margin (OPM)—calculated as earnings before interest and tax (EBIT) divided by operating revenue.

The Position Adopted by the FIRS

The FIRS adopted the TNMM as the most appropriate method for both 2013 and 2014. In applying the TNMM, the FIRS used the GPM—calculated as gross profit divided by operating revenue —as the most appropriate PLI.

Key Issues Evaluated by the Tribunal

I have summarized some of the main TP issues that were debated in this case, including the decision reached by the Tribunal on these issues. I also present my take on the decision.

Burden of Proof

PPNL argued that the FIRS could not challenge its TP position because it had satisfied the burden of proof as required by the TP Regulations. PPNL argued that (i) it had prepared TP documentation in line with the law and provided all the information requested by the FIRS; and (ii) the FIRS did not provide a basis for rejecting the CUP method for 2013 and was therefore bound to accept the CUP as applied by the company.

The FIRS disagreed with PPNL. The FIRS argued that (i) PPNL did not provide reliable and sufficient information to allow it accept that the CUP was the most appropriate method in 2013; and (ii) PPNL had provided inconsistent information about the activities of VIL and as such the comparable transactions involving VIL were not a reliable benchmark.

The Tribunal agreed with the FIRS’ assertions.

Analysis

The TP Regulations place the burden of proof on the taxpayer to show that its transactions are arm’s length.

The decision appears to have turned on the inability of PPNL to provide information that was considered reliable and sufficient to prove its case. It is however not clear that the Tribunal examined the information provided by PPNL against any standard of proof.

The decision suggests that a taxpayer must be able to not only prove its case but also disprove any assertions made against it by the FIRS.

From a practical perspective this means that taxpayers must provide all the information that is required to justify their TP practices. Sufficient information will sometimes include elaborate details of the activities of related parties that are based outside Nigeria.

The fact that PPNL made inconsistent representations to the FIRS at different times in the course of the dispute also seemed to play a significant role in the Tribunal’s decision. For example, the FIRS asserted that VIL had been presented first as a service provider and then a distributor at different times. In addition, PPNL had stated during a meeting that the CUP was applied in error in 2013.

Taxpayers must ensure that they always provide correct and consistent information to the FIRS.

Can Different TP Methods be Applied for Different Years?

One of the reasons given by the FIRS for rejecting PPNL’s use of the CUP in 2013 was that PPNL had applied different TP methods for the different years.

The FIRS argued that under TP principles, TP methods must be consistently applied from year to year where the facts are not materially different.

The Tribunal agreed with the FIRS on this point. Strangely, in giving judgment, the Tribunal quoted a nonexistent paragraph of the Organization for Economic and Development (OECD) TP Guidelines. According to the judgment, paragraph 29.4 of the OECD TP Guidelines requires the application of the TP method to be consistent from year to year.

The 2010 OECD TP Guidelines (applicable at the time of the transaction) do not contain a paragraph 29.4 and do not state this rule anywhere. This is also true for the 2017 version of the Guidelines.

Analysis

It is reasonable to expect that the same TP method is applied consistently. There are however instances where a change in TP method can be warranted.

Paragraph 6.1.3.3. of the 2013 UN Practical Manual on Transfer Pricing for Developing Countries (UN TP Manual) suggests that a change in TP method can be appropriate when there are any changes in (i) the facts of the transactions; (ii) the functionalities of the parties to the transaction; or (iii) the availability of data.

The FIRS built its case on the fact that the functionalities of the parties to the transaction and the facts of the transaction had not changed. PPNL’s case was based on the non-availability of data.

Rather than evaluate “non-availability of data” as a relevant factor supporting the need to change the TP method in 2014, the Tribunal viewed it as additional evidence that the CUP data used in 2013 was not reliable to start with.

The practical lesson here is that changing TP methods increases the risk that the FIRS will challenge a taxpayer’s TP practices.

GPM as a PLI for Applying the TNMM

PPNL applied the TNMM in 2014 and argued that the correct PLI was the OPM. The FIRS argued that the TNMM should be applied for both 2013 and 2014. It chose the GPM as the correct PLI.

PPNL argued that applying the GPM as a PLI under the TNMM was not in line with the OECD TP Guidelines.

The FIRS on its own part expressed the view that (i) the GPM was a permitted PLI under the TNMM; (ii) since the transaction was a purchase and resale of products, the GPM was the PLI that was most directly affected by the transaction; and (iii) unlike the OPM, the GPM was not influenced by other costs of doing business that did not have a direct link with the transaction in question.

The Tribunal agreed with the FIRS. According to the Tribunal, it was persuaded by the FIRS’ ability to establish that the GPM was in line with best practices and took account of the various factors enumerated by the OECD.

Analysis

It is not correct that the use of the GPM when applying the TNMM is in line with global best practice and the OECD TP Guidelines.

The Tribunal accepted the FIRS’ assertions on this matter without taking steps to verify these assertions. The TP Regulations provide that when applying the TNMM, the net profit margin relative to an appropriate base (e.g. sales or costs) is to be used. This is also consistent with the definitions in both the OECD and UN TP Guidelines.

If the TNMM was indeed the right TP method to be applied in this instance, then the correct PLI ought to have been the OPM as applied by PPNL. Paragraph 2.90 of the OECD TP Guidelines suggests that when the TNMM is the appropriate method, the OPM is the right PLI when the transaction involves a purchase from a related party for resale to a third party.

If we excuse the Tribunal’s misunderstanding of the TP methods, we can reframe the dispute as being about whether the resale price method (RPM) was to be preferred to the TNMM as the right TP method under the circumstances. This is because, going strictly by TP principles, the FIRS’ use of the GPM was effectively an application of the RPM and not the TNMM.

The TP Guidelines recognize that the RPM can be applied in a situation where a person purchases products from a related party and resells to a third party without adding value to the product.

While the RPM has an intuitive appeal, whether it is the right method would depend on the quality of the comparables that are used as the benchmarks. For the RPM to give the right results, there should only be minor differences between the tested transactions and comparable transactions in terms of: products sold; functions, risks and assets; and the economic circumstances under which they operate.

Although we cannot tell from the judgment if the comparables used by the FIRS were indeed appropriate for applying the RPM, from experience, the RPM is not likely to give the correct result if the companies used as comparables for the benchmark did not deal in sufficiently similar products or have sufficiently similar functional profiles.

In practice, when the data on the comparable companies has been sourced from a subscription database (as was the case here) it is often difficult to get the type of information required to correctly apply the RPM. In many cases, the information contained in such databases is usually better suited to applying the OPM (under the TNMM) rather than the GPM (under the RPM) as a profit indicator.

In addition, contrary to the argument made by the FIRS that differences in accounting treatment between the tested party and the comparables make the GPM superior to the OPM, it is the opposite that is true (see paragraphs 6.3.12.2. to 6.3.12.5 of the UN TP Manual).

It appears that the intuitive appeal of FIRS’ arguments played a big role in swaying the Tribunal. In addition, PPNL seemed to focus on demonstrating that the GPM was not a recognized PLI for applying the TNMM and did not try to show why the OPM should be favored under the circumstances.

Planning Points

The decision presents several lessons for multinational groups operating in Nigeria.

First, taxpayers must not assume that the Tribunal is as sophisticated as they are on TP matters. They must be prepared to elaborate on their positions and present detailed authorities supporting their technical arguments. They must also evaluate their arguments from the perspective of an ordinary businessman and ensure they can present them in a manner that is intuitive and easy to understand.

Taxpayers will need to provide sufficient and concrete information to justify any positions they take on their TP affairs. Depending on the circumstances, this will sometimes involve providing detailed information on the activities of nonresident related parties.

Secondly, the taxpayer must involve TP specialists and senior personnel within their organization (including those outside Nigeria) in TP matters from the very start. This is to ensure that incorrect representations are not made to the tax authorities by persons who may not have the correct knowledge. In my experience, this can happen quite often when the people with the correct information within the taxpayer’s group do not get involved in time.

Finally, it appears that the FIRS prefers to apply the GPM as the arm’s length profit indicator when the tested transaction involves purchases from related parties for resale to third parties. As such, even where a taxpayer is convinced that a different PLI is more appropriate (e.g. OPM), the use of the GPM as a secondary check should be considered during the TP report preparation process.

Seun Adu is Partner, Tax and Transfer Pricing, with PricewaterhouseCoopers, Nigeria.

The author may be contacted at: seun.y.adu@pwc.com

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.