Transfer Pricing Audit in Nigeria.

Abdulateef Olatunji Abdulrazaq (AOA)

Senior Manager - Tax, Regulatory & Advisory Services

Saffron Professional Services,

Lagos, Nigeria.

1.     Introduction

The Income Tax (Transfer Pricing) Regulation No 1, 2012 released by the Federal Inland Revenue Service (FIRS) in August 2012 which set guidelines on related parties’ transactions. Companies are required to file their Transfer Pricing documentation together with their Income Tax Returns from 2014. For example, companies whose financial years are January 1st to 31st December are required to file Transfer Pricing documentations with their Income Tax Returns by 30th June 2014.

Transfer pricing (TP) audit primarily focuses on reviewing transfer pricing returns and supporting TP documentation submitted by taxpayers who had engaged in related party transactions. This approach is necessary in order for FIRS to independently confirm the arm's length nature of the related party transactions as documented in the TP reports, and to arrive at an appropriate TP adjustment, if any. Transfer Pricing audit have switched from an exercise in documentary compliance to an examination of the substance of the reporting. In anticipation of audits; companies need a clear and uniform approach to transfer pricing. Contemporaneous documentation by multinational companies is critical throughout the transfer pricing process. FIRS require companies to effectively provide sufficient transfer pricing documentation to audit companies. Failure to conduct appropriate analyses or to document transfer pricing policies could result in significant transfer pricing adjustments and related penalties.

2.     Selection of Taxpayers for Transfer Pricing Examination: Risk Assessment

Effective risk identification and assessment are important steps toward ensuring that the most appropriate companies are selected for audit. Given the resource constraints, it is important for FIRS that high risk transfer pricing cases do not “slip through the tax net”. However, even the most robust risk identification and assessment tools and processes may not always guarantee success in audit. The reason for this is that the level of detail available at the risk assessment stage may not always be sufficient to draw reliable conclusions regarding the arm’s length nature of profits/prices. This will depend on functional classification (based on the risks assumed, functions performed and risks borne by each party), the methods applied, allocation keys selected and so forth. There are several ways FIRS may conduct its risk identification and assessment, and the approach taken is largely dependent upon the type of information and data that is available and accessible. It is important to draw a distinction here between the information related to filing a tax return and that contained in transfer pricing documentation. This may vary from country to country but in essence is as follows:

·         Filing information typically relates to questions on a tax return. This may entail a tick the box (i.e. yes or no) a “fill in the box” response (e.g. inserting a quantum or value);

·         Documentation, in the context of transfer pricing, will generally include more substantial information such as questions about a transfer pricing policy document, legal contracts, invoices, valuations etc.

3.     Organization and Staffing of Transfer Pricing Audits

The Nigeria Transfer Pricing team was established in October 2013. This centralised team is located at the FIRS Building in Ikoyi, Lagos. Presently, the Division comprises of about 31 officers; a Head of Division who is a Deputy Director assisted by two Heads of Units in the rank of Assistant Directors and twenty eight other officers.In the first fifteen months of the Division's existence, focus has been on aggressive capacity building of the team and on sensitisation of taxpayers and other tax offices on their obligation in successfully implementing the TP regime in Nigeria. The spectrum of transfer pricing work undertaken, policy regulations, level and complexity of Materiality is a concept often used in auditing and accounting. It denotes the significance of a stated amount, a transaction or a discrepancy to the financial accounts. In this context a small transaction by a large company may not be material to the financial accounts to that company, even if there is an error or discrepancy.

Transfer pricing is not an exact science and requires judgement and discretion; audits are often complex and time intensive. Owing to this, it is critical that adequate resourcing is available for such audits. Developing countries are generally more constrained in transfer pricing resources, and a tax administration can be challenged by the complexity and volume of audits. The matching of adequate and appropriate skills and resources to a transfer pricing audit is nevertheless critical to the efficient, timely and successful conclusion and even resolution of an audit. The challenge most developing countries face is the ability to employ, develop and retain these resources. In this regard, developing countries need to be innovative and strategic. Implementation of targeted recruitment and structured training programmes will assist developing countries in attracting, developing and retaining transfer pricing skills.

4.     Planning for a Transfer Pricing Audit

Where the transfer pricing unit (TPU) of FIRS decides to audit transfer pricing documents of a company, the audit team should ideally be comprised of:

• An overall manager who has responsibility for more than one audit;
•  A team leader who will manage the day-to-day examination of a taxpayer;
•  A domestic examiner who is responsible for audit activities primarily relating to domestic issues;
• An international examiner who is responsible for audit activities primarily relating to international issues;
• A transfer pricing economist who provides economic analysis and support for the audit;
• A lawyer who is available for consultation on legal aspects and may be involved in audit planning and implementation; and
• A computer audit specialist who assists with the soft ware needed to analyse computer readable data received from the taxpayer, and in organizing the data to assist the domestic and international examiners as well as economists in analyzing transfer pricing issues.

5.     Preliminary Examination

The FIRS have certain transfer pricing information in their possession before a transfer pricing audit starts. A desk audit of such information, especially financial statements, should be made to evaluate whether there are any transfer pricing issues. For instance, computing the following financial ratios based on tax and financial data may be useful:

• Gross profit to net sales;
• Operating profit to net sales;
• Operating expenses to net sales;
• Gross profit to operating expenses (Berry ratio); and
• Operating profit to average total assets.

Comparing the taxpayer’s financial ratios to applicable standard industry ratios is useful if standard industry ratios can be found. Substantial deviations from standard industry ratios may indicate a transfer pricing problem. The findings from the desk audit should be analysed to determine what further action, if any, is needed. Understanding the taxpayer’s business operations is an essential part of the transfer pricing examination. This study can be commenced before starting a transfer pricing audit or even after that time, and should include an understanding of the following:

• The taxpayer’s operations;
• The operations of its affiliates (domestic and foreign);
• The relationship between the taxpayer and its affiliates (domestic and foreign);
• The role each entity plays in carrying out the activities of the controlled group; and
• How much control and direction the taxpayer receives from the headquarters of the group.

The following may be useful sources for gaining an understanding of the taxpayer’s business operations:

• Transfer pricing documentation;
• Annual reports;
•  Books and other publications describing the taxpayer’ s operations;
• Internal audit and management reports;
• Organization charts (the preparation of which may require the taxpayer’s cooperation);
• Minutes of board meetings, committee meetings and shareholders meetings;
• Policy and procedure manuals;
• Internal approval documents;
• Written inter-company pricing policies;
• Sales catalogues, brochures, and pamphlets; and
• Written correspondence between the taxpayer and its affiliates.

6.     In preparation for a tax audit, the taxpayer is advised to

• Manage its TP risks proactively
• Ensure contemporaneous TP documentation  and policy is in place
• Proper disclosure of related party transactions and pricing arrangements
• Develop controversy strategy
• Consider industry and other relevant developments
• Generally comply with the provisions of the TP Regulations
• Consider obtaining FIRS rulings and/or APA if possible
• Prepare well in advance
• Engage the services of a TP advisor as early as possible
• Make ready the required documentations for review.
• Establish structured communication with tax officials
• Manage presentations with the TP auditor

7.     The documents which the TP auditor may request during TP audits include:

• Country specific TP documentation report
• TP policy papers and country risk assessment
• Legal agreements related to inter- company transactions, and employment agreements
• Intercompany billings, invoices and debit notes
• Minutes of (annual) general shareholder's meeting and minutes of the meetings of board of directors
• Intellectual property right registrations and policy statements
• Description of key personnel functions and structure
• Corporate income tax returns
• Financial statements
• Other documents such as Withholding Tax (WHT) and Value Added Tax (VAT) returns on intercompany settlements, depreciation/ amortization schedules, shareholder register, bank account statements and intercompany correspondences.

8.     Frequently asked question by FIRS during TP Audit:

1. What is your Transfer Pricing framework or Plan?

The term ‘planning’ is generally used in a transfer pricing context to denote the process by which a company designs intercompany pricing frameworks and prioritizes its transfer pricing initiatives for a given time period. Before a company sets, implements, or documents its intercompany prices, it must have a plan for doing so. A strategic mindset is imperative in the planning phase, as the quality of the decisions made in this phase will determine whether a company’s time and resources will be wasted or put to good use and whether the most important exposures will be neutralized, or the greatest opportunities realized.

2. How do you identify Intercompany Transaction for Analysis?

The planning phase consists of identifying the relevant intercompany transactions within the organization, understanding the roles and responsibilities of the parties to the transactions, and prioritizing the company’s risks related to those transactions.

3. What are the type of Intercompany transaction in your organization?

 Intercompany transactions between related parties fall under services provided.

4. How do you determine the potential Transfer Pricing Risk of associated transactions

Companies determine the potential transfer pricing risk as follows:

·         General description of services being transferred;

·          Current intercompany pricing policy;

·         Payment terms between entities;

·         Existence of intercompany agreements corresponding to these transfers;

5. How do you determine the price of associated transactions?

Companies should select appropriate methods for analysing and pricing the transactions and understanding the rules and requirements as stated under the Nigerian Transfer Pricing Regulations.

6. How often do you update your TP documentation?

Companies should update their TP documentation when there is a significant change in the conditions used in the comparability analysis.

7. Is there any Transfer Pricing Policy and Procedure Manuals for the Group?
8. How do you obtain information on comparable transactions or companies in order to verify your TP with related parties?

Companies relied on Databases such as ‘Bureau van Dijk’s Orbis Global’ in testing the arm’s length nature of the transactions.

9. What are the criteria and relevance of the functional analysis performed.

Companies process leading to the selection of the most appropriate method considered the following:

·         Strengths and weaknesses of each of the OECD recognized methods;

·         Appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis;

·         The availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method and/or other methods, to the extent that they are consistent with the arm’s length principle;

·         The degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them.

10. Do you have any Advanced Pricing Agreement (APA) in place or it could be considered in future?

9.     Conclusion

The global growth of transfer pricing concerns makes it more essential that consultant of multinational companies understand transfer pricing audit triggers, audit processes, and methods to resolve significant tax disputes. A company consultant ought to communicate with various executives in the company about preparing for a transfer pricing audit to understand what is likely to happen during an audit and to resolve it satisfactorily. Increasingly, multinational companies must perform substantial functional, risk, contractual, and economic analyses throughout their global operations.

Contemporaneous documentation throughout the multinational company is critical in this whole process. Failure to conduct appropriate analyses or to document transfer pricing policies could result in significant transfer pricing adjustments and related penalties. These costs should be transparent in the company’s financial statements. However, documentation requirements for small companies should not require excessively expensive transfer pricing studies that discourage global business expansion. Advisers should encourage multinational companies to consider entering into some type of APA with at least one tax authority.

Olatunji is Senior Manager  (Tax ,Regulatory & Advisory Services) with Saffron Professional Services(Member firm of Geneva Group International), Lagos, Nigeria.                                                                 E-mail:Oabdulrazaq@saffron-ng.com,Oabdulrazaq11@gmail.com