Nigeria: An Analysis Of Key Developments In 2021 And Their Implications For Nigeria's Transfer Pricing Practice In 2022

Introduction

The year 2021 brought with it significant economic and social challenges as well as innovations, presenting Nigerian policy makers with the onerous task of reviewing and updating existing economic models and policies to match the unprecedented developments. The COVID-19 pandemic (the pandemic) continued to threaten normal existence and the functioning of economies. Global containment efforts remained high thereby limiting demand-driven expansion of major industries, drastic reduction in many service sector operations, disruptions to global supply chains, lower demand for imported goods and services, and larger regional losses in international tourism and business travels. As a result, the trajectory for 2022 appears to be centered on fixing the fault lines exposed by the pandemic and positioning the economy to withstand future unexpected large-scale business disruptions.

In this article, the authors seek to analyze key developments in the general tax and transfer pricing (TP) space as well as the financial sector and present a forward looking assessment of how these events may affect the Transfer Pricing practice in Nigeria. The following events of 2021 have been identified as key factors of change in Nigeria's TP practice in 2022 and beyond: The G20/OECD's work on the tax challenges arising from the digitalization of the economy, with a focus on the Base Erosion and Profit Shifting (BEPS) Pillar 1 and 2 projects; the introduction of the Central Bank of Nigeria (CBN) Shared Services Arrangement (SSA) Guidelines (SSA Guidelines); financial sector events related to the transition plan from LIBOR to alternative benchmark rates; the effects of real-time e-filing; and finally, a concise examination of the impact of Nigeria's aggressive TP audit effort on compliant businesses.

1. G20/OECD's work on the tax challenges arising from the digitalization of the economy

Addressing tax challenges raised by digitalization is a primary goal for the OECD/G20 Inclusive framework and has been a key focus area of the BEPS project since its inception. As of November 4, 2021, about 137 countries, apart from Nigeria, have signed on to the new two-pillar solution to reorganize international taxation regulations and ensure that multinational enterprises (MNEs) pay a fair share of tax of from profits generated in market jurisdictions. The concern of losing taxable income from MNEs, especially those in the digital business is one of the key reasons why Nigeria has not signed on to this initiative.

BEPS Action 1 - OECD Two-Pillar Solution

Pillar one, the re-allocation of taxing rights, is defined by the need to ensure a fair allocation of profits and taxing rights among countries with respect to the largest MNE's (turnover of €10 billion and profit margin of 10% or more) operating within these countries. This project aims to distribute a share of residual profits from MNEs to the markets where they generate revenue, regardless of whether they have a physical presence in those jurisdictions. The scope of covered enterprises under pillar one has shifted away from the initial intention of highly digitalized businesses, and while extractives and regulated financial services are out of scope, other industries are generally covered.

Pillar two, a global anti-base erosion (GloBE) mechanism, attempts to establish a global minimum tax rate that will help numerous countries protect their tax bases. The global minimum tax rate of 15% (independent of where MNEs are headquartered or which jurisdictions they operate) is expected to produce an additional $150 billion in global tax revenues per year¹. Enhanced tax certainty and stability in the international tax environment are projected outcomes of this pact. This pillar is divided into two parts: the GloBE rules, which is made up of (i) an Income Inclusion Rule (IIR), that imposes top-up tax on a parent entity in respect of a constituent entity's low taxed income; and (ii) an Undertaxed Payment Rule (UTPR), that demands a corresponding adjustment to the extent a constituent entity's low tax income is not subject to tax under an IIR; and the tax rules, which include a restriction that applies first to GloBE and might prevent treaty benefits on some passive related party payments. MNEs with consolidated group revenues of €750 million or more are included in the scope of covered enterprises, while government bodies, international organizations, non-profit organizations, pension funds, or investment funds that are UPEs of an MNE group are not subject to this rule. While the two-pillar solution is gaining traction in the global sphere, its influence is expected to be felt later in 2022 and beyond.

Further, Nigeria's decision to refrain from signing up to the two-pillar solution would have implications for the country in terms of managing international relations, implementing its unilateral solutions for taxing MNEs with significant economic presence in Nigeria and management of global controversies that may result from the conduct of transfer pricing audits on MNEs. How this plays out remains to be seen, as the year unfolds.

2. Impact of the CBN's Circular on Shared Services Arrangement's (SSA) in financial institutions.

A vast majority of Nigerian banks and non-operating financial holding companies (HoldCos) are involved in SSAs with their parent and other group entities. This is driven by the need to secure cost efficiencies, leverage existing skills, and ensure uniformity in specific operations within the group. However, over the years, the Federal Government of Nigeria (FGN) has detected inconsistencies in SSAs within financial institutions, which has resulted in uneven management and the indiscriminate use of SSAs as tax shield. In response, the FGN has issued a guideline that will take effect from June 1, 2022. This Guideline is thus issued to provide direction to banks and other financial institutions subject to the CBN regulatory and supervisory scope on the establishment and evaluation of SSAs. The objectives of this guideline are, among other things, to establish a CBN oversight on the SSAs between connected persons in a group, to ensure compliance with the arm's length principle on which the precepts of TP are built, to reduce the emergence of profit shifting or tax evasion by entities, and ultimately, to reduce operational costs of benefiting institutions. To avoid penalties and sanctions, businesses will need to take prompt and prudent steps to comply with the SSA Guidelines.

Implications for financial institutions

In adherence to the SSA Guidelines, the following compliance measures must be in place by 2022 to meet the first reporting requirement due in January 2023:

• Prepare a shared services agreement: A contract should be drawn up between financial institutions and parties to an SSA. This agreement should state the terms and conditions of service, including duration, fees, TP methodology used in analyzing the transaction, etc. This agreement is to be reviewed annually to reflect economic realities and submitted to the CBN for approval.

• Establish policies and procedures for shared services: Financial institutions will have to prepare TP policies that confirm that SSAs are conducted in a manner consistent with the arm's length principle.

• The financial institution's board of directors is responsible for overseeing the SSA and may assign the monitoring and management to a board committee led by an independent director.

• Appoint an independent consultant: To be executed by the board of directors of the entity.

• Submit annual review report: Every year, the independent consultant must assess the efficacy of the shared service agreement and submit its conclusions to the CBN no later than the 31st of January of the relevant financial year.

• Disclose information on the SSA in the entity's annual report and website.

• Ensure and demonstrate strict compliance with the Nigeria Income Tax (Transfer Pricing) Regulations, 2018 ("the NTPR")

• Documentation of SSAs: Financial institutions must ensure that the fees in respect of SSAs are adequately documented as though the parties are unrelated (i.e., must meet the arm's length criteria). Records for this could be in the form of invoices, bills, contracts etc. It is pertinent that entities keep adequate record of these documents to support and demonstrate compliance with the arm's length principle.

In 2022, the scramble by taxpayers to meet the regulatory requirement will begin. Financial institutions need to be aware of the various compliance obligations and the board's role in engaging independent consultants to aid compliance. This additional regulatory requirement will lead to increased costs for financial institutions. It is also expected that this new development will eliminate occurrences of governance, financial and tax mismanagement in affected institutions. In addition, the SSA Guidelines indicate that approvals will be contingent on these institutions' ability to undertake the shared activities on their own in the future. This singular implication could contravene one of the stated objectives of the SSA Guidelines i.e., to reduce the operational costs of benefiting institutions. This may also jeopardize the aim of many SSAs, which are designed to cut costs by pooling resources. The CBN would do well to prioritize business and efficiency needs in its approval decisions. Furthermore, it is expected that the CBN will seek realistic ways to assess the success of the Guidelines in eradicating instances of governance, financial, and tax mismanagement in financial institutions.

There is also the question of whether the CBN's approval of financial institutions' SSA is final. That is, during TP audits, will the Federal Inland Revenue Service (FIRS) still subject SSAs approved by the CBN to additional review for compliance with the arm's length principle?

3. Transition planning from LIBOR to alternative benchmark rates.

The London Interbank Offered Rate (LIBOR) is a global interest rate benchmark that is used as a reference rate for financial contracts as well as to evaluate borrowing costs and investment returns. For TP purposes, it is mostly used as a benchmarking tool for assessing financial transactions. Following the 2008 financial crisis, there was widespread distrust of LIBOR as a global interest rate, leading to allegations that banks manipulated the LIBOR to hide financial problems created by the global financial crisis. As a result, the number of panel banks contributing to the LIBOR calculation decreased, and the rate was no longer considered a reliable indicator of market conditions. In July 2021, the Financial Conduct Authority (FCA) announced that, beginning in 2022, it would no longer require panel banks to supply data for LIBOR calculations and suggested that the market shift to other risk-free rates. Market stakeholders are collaborating to ensure a smooth transition from LIBOR to other rates such as the Secured Overnight Financing Rate (SOFR), Sterling Overnight Index Average (SONIA), Euro-Short Term Rate (ESTR), Swiss Average Rate Overnight (SARON) and Tokyo Overnight Average Rate (TONAR).

Transition controversies

It is expected that controversies would arise because of this transition by 2022. The most notable being the choice of the most appropriate LIBOR alternative, which will assure uniformity in financial benchmarking. Also, since it is widely speculated that the ARR will reduce market risks and provide more acceptable benchmark rates, companies with loan and other financial transactions must review existing contracts and consider the effect of the transition to a new rate on prospective business arrangements.

Furthermore, the effect of the shift from LIBOR is likely to lead to changes in current interest rates and profit spreads by 2022, requiring financial institutions to re-strategize their measurement of market key performance indicators. In addition, counterparty credit risk exposures linked with derivative trading and default risks associated with loan transactions would also be impacted. This means that LIBOR transitional changes will have an influence on derivative valuations (entities must try to evaluate the likelihood and impact of a counterparty defaulting), particularly for uncollateralized derivatives and credit risk analysis for loan transactions.

Another area of impact is liquidity, as less will be available for LIBOR instruments. In the same vein, given their relative newness in the market, sufficient liquidity will also be an issue for the new rates that are being considered. Therefore, financial institutions will have to analyze the related impact on cashflows and potential liquidity.

Finally, entities should prepare for some disruptions in their operations, particularly in IT, since the transformative initiatives will necessitate the updating of vendor and in-house technological systems. There does not appear to be a certainty in the choice of interest rate that would replace the LIBOR and it is expected that the full impact of the decision to phase out the LIBOR rate will be realized in 2022 and beyond.

4. Nigeria's E-TP PLAT 2.0

Regulations 13 to 17 of the NTPR require taxpayers with related party transactions to file TP declaration and disclosure forms (TP returns) annually and establish the conditions for compliance with the NTPR. Activities of the Nigerian tax reforms, along with the unexpected invasion of the pandemic led to the development of the E-TP PLAT 2.0 (E-TP filing portal), which was officially launched in March 2020.

Due to the premature launch and the urgency with which the E-TP platform was adopted, taxpayers did not get any training on how to file TP returns online. As a result, rather than completing the TP forms generated by the platform, taxpayers preferred to upload their documents on the website. In June 2021, the FIRS rejected this means of filing TP returns and mandated taxpayers to complete the forms online. Consequently, the filing deadline was extended by one month to allow for the implementation of this rule.

Recommendations for full and effective utilization of the E-TP platform

The FIRS rejected more than half of the TP returns filed by taxpayers in 2021 on the grounds that they were incomplete. It is envisaged that this move will spark some debate in 2022, and trigger changes to the NTPR.

In light of the above, we recommend that the NTPR should be updated to include due processes for full digital filing, extension modalities, applicable penalties for rejected filings, and other pertinent rules that would apply to e-filing especially in situations where the taxpayer's financial statements are yet to be finalized by the due date of filing i.e., still in draft form.

Second, the FIRS should assess the E-TP filing platform and make improvements based on filing patterns in the 2020 and 2021 financial years (FYs). One of the most prevalent complaints from taxpayers about the online filing is that it is too complicated and ambiguous, and that it is significantly different from what they are used to. Technological advancements are expected to make processes faster and easier and if the E-TP filing platform fails to do so, a review of the process is required to enable ease of filing since "convenience" is one of the factors of a good tax system.

Finally, the FIRS should consider providing a training manual to assist taxpayers in filing TP returns online. This process may be challenging for some tax managers and administrators who are not technologically savvy. Instances like this may lead to incorrect disclosures in the TP returns, which, according to the provisions of regulations 14(5) of the NTPR attracts a penalty of ?10 million or 1% of the controlled transaction incorrectly disclosed, whichever is higher. That way, taxpayers are subjected to unjust penalty because of incomplete knowledge of the filing procedures. In summary, tax authorities should allow taxpayers some time to learn and adjust to the system. Change is beneficial but change that results in regression is detrimental.

5. Steady increase in Transfer Pricing audits

2021 FY, like the 2020 FY, was an unusual year for most Nigerian taxpayers due to the economic impact of the COVID-19 pandemic. Despite the disruptions to businesses, the FIRS did not relent on its strategic adoption of TP audits as a tool to generating revenue from tax liabilities to offset the negative economic impact of the pandemic. However, it may be argued that another key motive of the increased TP audit is to ensure that incidents of profit shifting and tax benefits to the disadvantage of the Nigerian economy were significantly reduced. Consequently, the number of TP audit correspondence letters issued to taxpayers to analyze their transactions risk profiles increased during the year.

Impact of aggressive TP audits on compliant entities

Taxpayers and consultants spent a better part of the year entertaining TP audit visits, queries, and responses. At one of the discussions, a taxpayer questioned the FIRS' focus on compliant entities, arguing that compliance with existing regulations should to an extent exclude compliant entities from the rigorous examination of their controlled transactions. The response given by the tax authorities was that inquiries could only be conducted on controlled transactions that had been disclosed, and that the tax authorities were just confirming the accuracy of the TP methodology used in ascertaining compliance with the arm's length principle in accordance with the NTPR. Notwithstanding the validity of this viewpoint, taxpayers still find it discouraging that even after meeting the requirements of extant regulations, they are still forced to incur additional expenses from engaging consultants to provide adequate representation and support during these audit exercises amongst other expenses.

In 2022 FY, it is expected that audit exercises which started in the previous year would have progressed to the early stages of reconciliation, with significant reductions in disruptions to taxpayers' business operations, allowing taxpayers room to re-strategize the operations of their controlled transactions and implement changes that may have been suggested during the TP audit. One benefit of the increased scrutiny of taxpayers' operations is that it has served as a reminder on the need to maintain documentary records and evidence of controlled transactions. A few taxpayers suffered from the consequence of not having enough documentation to back up their argument of compliance with the arm's length principle and thus suffered additional liabilities that could have been avoided. Another lesson that taxpayers will take into 2022 is the importance of being completely compliant with all aspects of the NTPR, rather than cherry-picking for convenience.

Furthermore, many taxpayers have come to believe that the FIRS is out to get them regardless of their efforts to be compliant. The FIRS should take steps to manage this perception by maintaining a collaborative rather than combative stance during audits. According to the findings of a TP survey conducted by KPMG in 2021², about 81% of the respondents filed their TP returns from inception till date and 86% have their TP documentation in place for the relevant years. 5% and 14% respectively have neither filed TP returns nor prepared TP documentation. It is necessary that the FIRS seeks out means to identify these 5% and 14% non-compliant companies and demand compliance from them.

Finally, with respect to court rulings on TP audits, we hope that more taxpayers will be dissatisfied with the huge tax liabilities levied on them and will challenge the FIRS' position on their related party transactions in court.

Conclusion

Without a doubt, events in 2021 had a significant impact on TP practice, and it is expected that big innovations will occur in 2022, which will be carried forward and define the way things are done in the years to come. Taxpayers are advised to pay close attention to events in the larger tax space, both local and international as they will have a significant impact on their business environment. Tax authorities are also encouraged to ensure that the four canons of a good tax system, "equity," "convenience," "economy," and "certainty" are not lost on any changes to regulations and processes. Finally, tax consultants are expected to assist in maintaining a good relationship between the tax authorities and taxpayers, as this camaraderie will shape industry decisions more than anything else.

Footnotes

1. https://www.oecd.org/tax/beps/oecd-releases-pillar-two-model-rules-for-domestic-implementation-of-15-percent-global-minimum-tax.htm

2. https://assets.kpmg/content/dam/kpmg/ng/pdf/tax/transfer-pricing-awareness-survey-april-2021.pdf

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