The 2020 Financial Year (FY) was an unprecedented year for most taxpayers in Nigeria due to the economic impact of the COVID-19 pandemic. Companies were faced with various unexpected disruptions to business brought about by the pandemic. Nevertheless, towards the end of the year there was an influx of correspondence from the Federal Inland Revenue Service (FIRS) requesting for documents to assess the risk profile of taxpayers, in an attempt to commence Transfer Pricing (TP) audits.

The audit drive at a time when businesses were closing operations for the year can be seen as an attempt to ensure that the FIRS did not miss auditing companies' records for years about to be statute barred in line with the 6 years statute of limitation provided in the various tax laws. It was observed that the Information Document Requests (IDRs) received by most companies included FY 2014 and in some cases FY 2013, which in line with the law should not be revisited except in case of an investigation. Further, the FIRS stood to benefit from imposing penalties on companies that failed to submit the documentation within the timeframe specified by the Nigerian TP Regulations (the Regulations).

With the increase in IDRs, which typically signal the start of TP audits, it is important that taxpayers are armed with the relevant knowledge on how to effectively manage a TP audit process. This article highlights the different stages of a TP audit in Nigeria, drawing from our wealth of experiences in each phase and suggests strategies taxpayers should adopt to minimize the risks associated with a TP audit.

The TP Audit Phases

A TP audit is a detailed review of a taxpayer's Related Party Transactions (RPTs) to ensure that they have been conducted in a manner consistent with the arm's length principle. It usually involves the review of the taxpayer's business operations, documents, records, financial and economic data.

The TP audit exercise in Nigeria is typically carried out in four (4) phases:

1.TP Risk Assessment and Desk Review: TP audits are resource-intensive thus, the FIRS carries out risk-assessment procedures to ascertain the risk profile of taxpayers before deciding to proceed with the TP audit. In practice, the documents received through the IDRs including TP documentation, financial statements, agreements etc. are used for this process. 

From our experience, taxpayers are usually unprepared for this stage and are overwhelmed by the number of documents requested by the FIRS. Often, taxpayers have either archived the information requested or have not kept proper records of information required to demonstrate the arm's length nature of RPTs, despite the requirement of the Regulations to keep such information contemporaneously.

The robustness of the TP documentation and the quality of information supplied to the tax authorities at this stage may go a long way in determining whether the tax authorities will proceed to the next stage of the audit. Other factors considered by the FIRS in their risk assessment include the type of RPTs entered into, the value of RPTs compared to third party transactions, the tax residence of the related parties among others. For example, transactions with entities resident in tax friendly jurisdictions, procurement transactions, intangible transactions, financing arrangements etc. are considered high risk and may result in the FIRS proceeding to the next phase of the audit. Where the FIRS deems the taxpayer as low risk, the TP audit will be concluded at this phase. 

2.Field Audit: This is the fact-finding stage of the TP audit and is very crucial to the success of the audit. The FIRS will notify the taxpayer prior to the commencement of the field audit. The objective of this phase is to get an understanding of the RPTs by ascertaining the substance of the RPTs– functions performed, assets utilized and risks borne and the pricing arrangement of each RPT. Where the substance of the transaction cannot be demonstrated, the entire transaction can be disallowed for tax purposes. 

At this stage, the taxpayer may be required to make presentations to the FIRS on its business operations and the RPTs carried out during the years under review. The FIRS will also conduct interviews with process owners with insight into the RPTs conducted by the Company. The FIRS may also conduct a factory/office/warehouse tour.

Due to the importance of this stage, the persons interviewed should be knowledgeable about the RPTs, as misrepresentation of facts could affect the outcome of the audit. For example, for a procurement transaction, the head of procurement would most likely be more knowledgeable about the details of the transaction and articulate the value proposition better than a factory worker. Also, it is paramount that taxpayers have the support of their tax advisers to guide them through the process.

After the interview sessions, the FIRS will issue interview notes for the interviewee's review and attestation. This document will serve as evidence of the facts gathered during the audit and will be referred to throughout the audit. It is therefore critical that the taxpayer and advisers critically review the interview notes and ensure the facts surrounding the RPTs were not misinterpreted. This phase ends with a close-out meeting with the FIRS. The FIRS may also request for additional documents.

3. Post-Field Audit: Following the field audit phase, the FIRS will issue an audit report stating their position on the RPTs based on information gathered during the first two phases. The taxpayer is allowed to rebut the FIRS' position and provide further documents to support its position. From experience, where the FIRS has arrived at a position, it can be difficult to change their position without a superior argument supported by ample documentary evidence.

Several reconciliation meetings may be held with the aim of arriving at an agreeable position to both parties. Where both parties are able to arrive at an agreeable position, an assessment will be raised by the FIRS and thereafter settled by the taxpayer thereby concluding the audit process. However, where an agreeable position cannot be reached, the audit progresses to the fourth phase.

4. Dispute Resolution: At this stage, the taxpayer may exercise its right to explore the following dispute resolution options to conclude the audit:

  1. Decision Review Panel (DRP) – The Regulations allow for TP disputes to be presented before the DRP for resolution. The Panel which consists of five (5) members of the FIRS includingthe Head of the TP department is to deliberate on the issues taking into consideration the objections from the taxpayer. Unlike other dispute resolution options, the Regulations stipulate that the Head of the TP department is responsible for presenting issues before the Panel. There is no indication that the taxpayer can present its case before the Panel or be represented during the proceedings. Therefore, taxpayers may query the objectiveness of the Panel in resolving disputes due to the Panel being constituted of only FIRS officials.
  2. Litigation – Taxpayers have the option of presenting their disputes to the courts starting from the Tax Appeal Tribunal up to the Supreme Court. This option is very expensive and usually the last resort. However, in adopting this dispute resolution option, it is imperative that the taxpayer has a TP expert working with its lawyers in building a case. One of the key learning points from the first TP case in Nigeria (Prime Plastichem Nigeria Limited vs FIRS) is the importance for an in depth understanding of TP when going through a litigation process.
  3. Negotiation – This option provides an avenue for both parties to come to a mutually agreeable position through dialogue and negotiation. While this option ensures that the audit is concluded fairly quickly, issues resolved with this mechanism may be the subject of future disputes as positions agreed to are not legally binding.

We have observed that Nigerian taxpayers often select the negotiation option due to the lengthy and costly legal processes in Nigeria. Further, since TP is relatively new in Nigeria, there is a risk that the judges may not be able to have an appreciable understanding of the issues of the case. The DRP option has also been scarcely patronized because of the presumed bias due to the composition of the panel.

Taxpayers need to proactively adopt strategies that will enable them manage the risks associated with the TP audit. The place of proactivity cannot be over-emphasised and it begins from the preparation of the TP documentation and filing of TP returns. We have highlighted below some of the strategies to have in place in preparation for a TP audit:

  1. Conduct TP Risk Assessment: Taxpayers should carry out reviews of their RPTs for the purpose of identifying the level of risk associated with each RPT. This enables the taxpayer proactively develop strategies to manage their TP risk exposures.
  2. Prepare TP Audit Defence File: Phases I and II of the TP audit are information-intensive and require the taxpayer to provide the FIRS with the requested information within a stipulated timeframe. Usually, TP audits occur several years after the RPTs have been carried out. It is therefore, imperative that taxpayers proactively retrieve and collate documents, in a defence file, to support the arm's length nature of their RPTs prior to receiving the IDR. Please note that the Regulations include stiff penalties for failure to provide information requested by the FIRS.
  3. Interview Readiness: From experience, the FIRS has been known to latch on to statements made by the taxpayer's representatives during the interviews especially where the statements support their position. These statements are often taken out of context and may be borne out of the lack of preparedness of the interviewee. Taxpayers should therefore ensure that all personnel involved in the RPTs are duly informed and prepared for the field audit phase.
  4. Evaluation of Dispute Resolution Options: Following the assessment of risk, it is crucial that taxpayers proactively evaluate the dispute resolutions options prior to the commencement of a TP audit.
  5. Engage Seasoned TP Experts: TP is a very technical topic and it is critical that the taxpayers have adequate support from the preparation of the TP documentation and throughout the TP audit process. Having a technically strong TP expert may make the difference during the TP audit process.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.