Since introducing the Transfer Pricing (“TP”) Regulations in 2012, the tax authority in Nigeria has gone through a learning curve. The International Tax Department of the Federal Inland Revenue Service (“FIRS”) have significantly improved their skills, with support from multilateral agencies such as the United Nations, the Organization for Economic Cooperation and Development (“OECD”), the World Bank Group, International Monetary Fund, and the African Tax Administrators Forum.
Another trend that catalyzed the evolution of the Department is the OECD/G-20 Base Erosion and Profit Shifting (“BEPS”) project with Nigeria, as a member of the BEPS Inclusive Framework, following developments closely.
The first wave of TP audits commenced about three years ago. These were not without teething problems. Tax and TP practitioners are now experiencing the second wave of TP audits. Some of the key observations made during the ongoing second wave of TP audits are highlighted below.
Shared Services—Business Efficiency not Enough
As expected, the FIRS scrutinizes all forms of payments made or due to related parties in tax jurisdictions outside Nigeria.
There has recently been an increased trend in the centralization of support functions by multinational enterprises (“MNEs”). This is in a bid to increase business efficiency, benefit from economies of scale and scope and ultimately drive down the cost of doing business. A number of MNEs have moved their finance, IT support, human resources and administrative functions out of Nigeria to jurisdictions such as the United Arab Emirates, the U.K., the Philippines, Poland, Bulgaria.
As obvious as this trend may seem, the argument that such shared services are necessary and should be allowed for tax purposes needs to be proven and defended by taxpayers. The FIRS expects the taxpayer to demonstrate that benefit has accrued to it as a party to the group’s shared services arrangement. In cases where the Nigerian entity still retains part of the functions centralized, it has to demonstrate that there is no overlap of functions nor duplication of services.
Selection of Tested Party is Key
The tested party is typically the party involved in the controlled transaction to which a transfer pricing method can be reliably applied and for which the most reliable comparable companies (“comparables”) can be found.
Where the tested party is a foreign offshore entity, the FIRS would require the Nigerien entity (under audit) to provide the financial statements of the offshore entity and other relevant financial data which are likely to be in the possession of the offshore entity. This is with a view to testing the profitability of the offshore entity.
Considering the fact that the burden of proof rests with the taxpayer, non-provision of the financial statements/data of the offshore entity may result in the FIRS issuing a best of judgment assessment in the course of a TP audit.
Value Creation and Duplication of Services
The FIRS is interested in value creation when connected persons within an MNE transact with each other. The FIRS expects the taxpayer to demonstrate that profit earned by it in a given period is proportionate to the functions performed, assets deployed and risks borne. During the TP audit process, the FIRS will carefully verify the existence, nature and quantum of controlled transactions.
Closely linked to value creation is the issue of duplication of services.
There are instances where it appears that certain functions are performed by both personnel of the Nigerian entity and personnel at the regional or group level. For instance, the FIRS may query the rationale behind IT support charges from the MNE group when the Nigerian entity has a fully-fledged IT team on the ground.
While it may appear that there is duplication of function, a detailed review may show that even though both the local and the group IT team provide IT support services to the Nigerian company, there is no duplication of functions or overlap in responsibilities.
It is therefore key that taxpayers properly delineate the functions and responsibilities of teams at local and group level.
Section 26 and Burden of Proof
Section 26 of the Federal Inland Revenue Service Establishment Act empowers the tax authorities to request information and documents from taxpayers in respect of their income and profits.
The FIRS relies on the provisions of section 26 and other relevant sections of the Companies Income Tax Act to request various documents in respect of controlled transactions. These may include internal documents which the taxpayer may consider sensitive.
As the burden of proof rests solely with the taxpayer, there is an expectation that the taxpayer must be ready to prove beyond all reasonable doubt that the controlled transactions under review have been priced in accordance with the arm’s length principle. During the TP audit, this “heavy” burden of proof resting on the taxpayer may often lead to internal conflicts within MNEs operating in different jurisdictions while managing the FIRS’ expectations.
Although the FIRS tries to alleviate the concerns of the taxpayer by including a limitation on usage of information clause in the TP Regulations, there are still concerns across MNEs on how the information will and can be used during TP audits in their various operational jurisdictions.
Documentation, Documentation and Documentation
The need for taxpayers to maintain TP documentation cannot be overemphasized as it is the taxpayer’s first line of defense for establishing compliance with the arm’s length principle. It provides further insights on the controlled transaction and various factors and considerations that have influenced its pricing as well as detailed TP analysis and benchmark searches.
Typically, TP audits occur years after the transactions have been concluded. From the authors’ experience, where a taxpayer does not have a robust document retrieval system in place, the taxpayer may find it difficult to defend its position during the audit exercise. There are instances where the institutional knowledge resides in a few individuals who may no longer be in the employment of the company when the audit process commences.
It is, therefore, very important that companies ensure adequate and proper storage and easy retrieval of all documents pertaining to its controlled transactions.
The officials of companies that have oversight of tax and TP functions need to keep abreast of TP audit trends. By doing so, they will learn how to prepare for potential audit of their company’s tax and accounting records for compliance with the TP Regulations.
Similarly, taxpayers will be better prepared for the TP audit if they review and reflect on the lessons shared above relating to its impact on their TP compliance and audit preparedness.
Victor Adegite is a senior manager and Nana Abu is a senior adviser with KPMG’s global transfer pricing services, based in the firm’s Lagos, Nigeria office.