By Chizaram Modline Oparaji, Deloitte Middle East, Dubai
The Nigerian Tax Appeal Tribunal, on February 19, delivered its judgment in Prime Plastichem Nigeria Limited’s appeal of tax assessments arising from Federal Inland Revenue Service transfer pricing adjustments.
The tribunal ruled in favour of the Service, holding that the additional assessments were in line with Nigeria’s transfer pricing regulations and the OECD’s transfer pricing guidelines.
This decision, which is the first transfer pricing case to be decided by any court in Nigeria, offers a glimpse into how the Federal Inland Revenue Service may treat future transfer pricing assessments and how transfer pricing method should be applied by taxpayers in determining the arm’s length nature of controlled transactions.
Prime Plastichem Nigeria Limited’s dispute
The appellant, Prime Plastichem Nigeria, trades in imported plastics and petrochemicals. In the course of its business, the appellant purchases petrochemicals from Vinmar Overseas Limited, a related party.
In line with the transfer pricing regulations, Prime Plastichem Nigeria prepared transfer pricing documentation for financial years 2013 and 2014 and submitted these to the respondent, the Federal Inland Revenue Service, upon request.
For its 2013 transfer pricing documentation, Prime Plastichem Nigeria selected the comparable uncontrolled price (CUP) method as the most appropriate method for determining the arm’s length nature of its purchases from Vinmar Overseas Limited.
In applying the CUP, Prime Plastichem Nigeria compared the prices which Vinmar Overseas Limited sold petrochemicals to it to the prices at which Vinmar Overseas Limited sold to Vinmar International Limited, a related party doing business in Nigeria.
However, for 2014, Prime Plastichem Nigeria applied the transactional net margin method (TNMM) with operating profit margin as the profit level indicator, as the most appropriate method for determining the arm’s length nature of its purchase from Vinmar Overseas Limited, due to unavailability of reliable information for applying the CUP.
The Service rejected the application of the CUP for 2013. Although the Service accepted the use of the TNMM for 2014, it rejected Prime Plastichem Nigeria’s use of the operating profit margin as profit level indicator.
As a result, the Service applied the TNMM for both years using the gross profit margin as profit level indicator, following which it assessed Prime Plastichem Nigeria to additional taxes of approximately USD 4,736,170 (N1,738,481,875.33). Dissatisfied with the additional assessment, Prime Plastichem Nigeria filed an appeal at Nigeria’s Tax Appeal Tribunal.
At the hearing, Prime Plastichem Nigeria made a three-pronged argument. First, that the Service had previously accepted the methods applied by the Prime Plastichem Nigeria for testing the purchase transaction for both years as consistent with the arm’s length principle.
Second, that it had furnished the Service with adequate and appropriate supporting documents to substantiate the selection and application of the CUP to the controlled transaction in 2013; and having done so, the Service could not reasonably reject the application of the CUP on grounds of lack of sufficient data or information.
Third, that the very nature of the TNMM, which tests the net profitability of a controlled transaction and benchmarks this against net profitability achieved by independent persons in comparable transactions, does not allow the application of gross profit margin as profit level indicator.
Therefore, the Service’s use of gross profit margin as the appropriate profit level indicator for testing the controlled transaction is contrary to internationally recognized transfer pricing best practices and the UN and OECD transfer pricing guidelines.
The Service argued that Prime Plastichem Nigeria did not provide adequate supporting documents to justify the application of the CUP in 2013. According to the Service, its review of Prime Plastichem Nigeria’s supporting documents for the application of the CUP shows that the transaction between Vinmar Overseas Limited and Vinmar International Limited is not comparable to the transaction between Prime Plastichem Nigeria and Vinmar Overseas Limited due to differences between Prime Plastichem Nigeria and Vinmar International Limited’s business activities.
In addition, when reviewed in the context of the comparability factors under the OECD transfer pricing guidelines, both transactions are not comparable. As a result, the Service concluded that there was insufficient and reliable data to support the appellant’s application of the CUP hence the Service’s rejection of the CUP in 2013.
The Service submitted that Prime Plastichem Nigeria’s switch to the TNMM in 2014 is contrary to the principle of consistency, as the characteristics of the controlled transaction did not change between 2013 and 2014. The Service also submitted that it rejected Prime Plastichem Nigeria’s benchmarking analysis because the appellant had “cherry-picked” comparable companies to enable it to arrive at a preconceived result.
To justify its use of the gross profit margin as the appropriate profit level indicator for the TNMM analysis, the Service took the view that the only profit elements relevant for a determination of whether or not Prime Plastichem Nigeria’s controlled transaction is at arm’s length are revenue and cost of sales. The application of a net margin profit level indicator like the operating profit margin would include revenue and cost items not directly linked to the controlled transaction and, as such, was not suitable for determining the arm’s length nature of the controlled transaction.
The Service also submitted that its use of the gross profit margin was based on the actual delineation of the appellant’s controlled transactions derived from the functional analysis.
The tribunal ruled in favour of the Service, concluding that the appellant had not proved its case, that the Service had acted in accordance with the transfer pricing regulations and the OECD transfer pricing guidelines and that the Service’s determination that the gross profit margin was the most appropriate profit level indicator is in line with best practices.
The Service’s use of the gross profit margin as a profit level indicator in a TNMM analysis may be misleading. As Prime Plastichem Nigeria submitted, by its very nature, the TNMM is applied to test margins achieved in a controlled transaction at the net level. A reading of the Service’s arguments suggests that the Service’s application of the TNMM with gross profit margin as profit level indicator was in fact an application of the resale price method (RPM).
The RPM is generally accepted as appropriate and applicable where an entity performs distribution functions and is calculated at the gross profit level by expressing the gross profit as a percentage of sales (the gross profit margin). The Service’s submission that it had considered the appellant’s functional analysis in deciding that only revenue and cost of sales were necessarily for determining the arm’s length nature of the controlled transaction, thus, warranting the use of the gross profit margin supports this point.
One would have expected that the tribunal’s decision would stem from an in-depth analysis of the submissions of both parties with respect to the technical aspects of transfer pricing particularly the application of the transfer pricing methods and the appropriateness of the appellant’s benchmarking analysis. However, this was not the case. The tribunal appears to have merely glossed over the arguments of both parties before adopting the submissions of the Service and delivering judgment in the Service’s favour.
Hopefully, on appeal (if Prime Plastichem Nigeria decides to appeal against the Tribunal’s decision), the appellate court will provide more robust analysis of the issues so as to give better insights into how the court will interpret Nigeria’s transfer pricing regulations
Without prejudice to the correctness or otherwise of the Service’s position on the application of the CUP, the Service’s position reiterates the point that although tax authorities have a general preference for the CUP, the fact that a taxpayer has applied the CUP in determining the arm’s length nature of its controlled transactions does not mean that a tax authority will automatically accept the taxpayer’s application of the CUP.
A proper application of the CUP requires robust comparability analysis using the comparability factors, supported by appropriate documentation. Where the seemingly comparable transaction falls short of the comparability analysis, a tax authority will reject the application of the CUP.
There is need for taxpayers to be consistent in their approach to setting transfer pricing policies as well as justifying the arm’s length nature of their controlled transactions. As far as possible, comparable transactions should be analyzed consistently in a similar manner. Change in transfer pricing method applied may expose companies to a risk of challenge from tax authorities.
Where there are circumstances, which justify the use of different approaches for analyzing similar controlled transactions, those circumstances should be documented and supporting documents maintained to justify the deviation.
The case is a timely reminder for multinational enterprises with operations in Nigeria that the tax authority is keen to ensure that controlled transactions are concluded at arm’s length. Therefore, multinational enterprises need to take steps to ensure that they have defensible transfer pricing policies in place, adhere to their transfer pricing policy and maintain robust annual transfer pricing documentation to justify the arm’s length nature of their intragroup transactions.