The much awaited maiden Transfer Pricing (TP) Judgment in Nigeria finally arrived with a big bang! For those of us who have been preaching that TP is one of the riskiest areas, if not the riskiest, in taxation and taxpayers should be highly proactive in mitigating those risks, the outcome of this case is a testament to that assertion. The case between Prime Plastichem Nigeria Limited (PPNL or the Company), the Appellant, and the Federal Inland Revenue Service (FIRS), the Respondent, at the Tax Appeal Tribunal (TAT) involved the assessment of approximately ₦1.7 billion additional tax liabilities for the audit of PPNL's related party transactions for the 2013 and 2014 Financial Years (FY).

Considering the significant additional tax liability involved and the fact that this is the first TP Ruling by the TAT in Nigeria, it is imperative that we perform a technical review of the case and share our views on the lessons learned.

Background

PPNL is in the business of importing plastics and petroleum products for sale to third parties in the Nigerian market. It purchases these products from a foreign related party, Vinmar Overseas Limited (VOL), meaning that this transaction falls under the purview of the Nigeria Transfer Pricing Regulations (NTPR). In line with the NTPR, in addition to its annual TP returns filing obligations, PPNL is required to prepare an annual contemporaneous TP Documentation to demonstrate to the FIRS that its related party transactions were conducted in line with the Arm's Length Principle (ALP); therefore profits were not shifted to VOL.

The ALP requires that transactions between related parties be conducted in a manner similar to what would have occurred between independent parties (i.e. using market prices to test whether transfer prices are reasonable).

The FIRS, upon review of PPNL's TP disclosures, audited its FY 2013 and 2014 controlled transactions with VOL to determine consistency with the ALP. Considering that the TP Documentation is the first line of defence for a taxpayer in demonstrating compliance with the ALP, PPNL submitted its FY 2013 and 2014 TP Documentation to the FIRS.

For FY 2013, PPNL argued that they had reliable internal data to test the controlled transaction; i.e. VOL sold the same products to independent parties, and this price (a market price) can be compared to the price VOL sold to PPNL, with necessary adjustments carried out to increase the reliability of the results of the comparability analysis. This methodology is called the Comparable Uncontrolled Price (CUP) method using internal data (Internal CUP). Where applicable, this method is the most direct method and therefore deemed the most appropriate; and the use of internal data usually meets the high product comparability requirements.

However for FY 2014, PPNL argued that there was not adequate information on VOL's sale to independent parties to enable them apply the Internal CUP method reliably. Hence, they considered other methods in the NTPR, the Organisation for Economic Cooperation and Development (OECD) Guidelines and the United Nations (UN) TP Manual, and selected the Transactional Net Margin Method (TNMM) as the most appropriate method.

It is instructive to note that, the TNMM indirectly tests the arm's length nature of the transfer price charged by VOL to PPNL by comparing the net profit margin earned by PPNL for its distribution function to that of independent distributors performing similar functions, utilizing similar assets, and bearing similar risks. The definition and application of the TNMM is critical to this case and will be revisited later in this article.

The FIRS upon reviewing PPNL's TP Documentation for FY 2013 and 2014 rejected the Company's use of the Internal CUP method for FY 2013 and concluded that the TNMM was the most appropriate method for both years. With the above background to the case, let us analyse the key technical lessons learned from this case.

The statement of issues for determination was flawed

Five issues were distilled for determination by the Tribunal. This article focuses on the first three issues which are technical and key to the assessment of additional tax liabilities:

1. Whether PPNL has proved its case before the Tribunal to be entitled to the claims and reliefs sought against the FIRS;

2. Whether the FIRS' action in benchmarking PPNL's related party transaction using TNMM for FY 2013 and 2014 was valid and in accordance with the NTPR and the OECD/UN Guidelines; and

3. Whether the FIRS' action of using the Gross Profit Margin (GPM) Method as the Profit Level Indicator (PLI) in the instant TP transaction is valid and in accordance with the NTPR, OECD and UN Guidelines.

Based on the facts of the case, in our view, issues 2 and 3 above should have been stated as follows:

  1. Whether the Internal CUP or the TNMM was the most appropriate method for FY 2013; and
  2. Whether the application of TNMM in the instant TP transaction was appropriate based on the NTPR and the OECD/UN Guidelines.

For issue 2, by combining FY 2013 and 2014 to determine whether the application of TNMM was appropriate or not, PPNL allowed the FIRS to argue that since PPNL had accepted TNMM as the most appropriate method for FY 2014, then logically the method should be acceptable for FY 2013. This line of reasoning is inconsistent with guidance on consistency in the application of TP methods across years in the OECD/UN Guidelines, as well as the required contemporaneity of the TP documentation in the NTPR (Reg. 6(5) and 5(2)), where for each FY, a taxpayer is expected to base the selection of the most appropriate method on the facts and circumstances pertaining to the controlled transaction for that period, as well as the availability of reliable data for the application of the selected methodology.

Also, because issue 2 was not stated to focus on each year's analysis, PPNL did not make a strong and persuasive argument to convince the TAT that an Internal CUP when appropriately applied is the most preferred method according to the OECD Guidelines.

For issue 3, the statement was technically flawed. First, there is no "method" called a Gross Profit Margin (GPM) Method in the NTPR and the OECD/UN Guidelines. Clearly, there was confusion between methods and PLIs. The OECD/UN Guidelines prescribe two methods that analyse transfer prices at the gross profit margin level; Cost Plus Method (CPM) and Resale Price Method (RPM).

For the purpose of analysing PPNL's purchase of products from VOL, an application of the CPM will mean determining whether the gross profit mark-up VOL charges for its procurement function (sourcing, buying and selling) is reasonable by comparing it to the gross profit mark-up it earns when it sells to third parties (an internal CPM) or to the gross profit mark-up that independent parties performing similar functions charge or earn. On the other hand, the application of the RPM will analyse the gross margin that PPNL as a distributor of the products to third parties in Nigeria should earn to cover its operating expenses and leave it with a reasonable net profit.

However, neither the FIRS nor PPNL selected any of the gross margin based methods (CPM or RPM) as the most appropriate method for both years under review. Rather, they both agreed that for FY 2014, the TNMM was the most appropriate method, whereas for FY 2013 PPNL chose the CUP method and FIRS the TNMM.

Thus, the obvious question is, what is the appropriate application of TNMM?

First, as the name connotes, the TNMM is a net margin method, not a gross margin method. The OECD Guidelines in its Glossary defines TNMM as "a transactional profit method that examines the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realises from a controlled transaction... " A similar definition can be found in the UN TP Manual B.3.2.2.1. It further clarifies the distinction between the application of TNMM a net margin method versus RPM or CPM (the gross margin) methods in B.3.2.2.2, where it states that "...As it uses net margins to determine arm's length prices the TNMM is a less direct method than the CPM and the RPM that compares gross margins."

Thus, it is very clear from both the OECD & UN Guidelines that the appropriate application of the TNMM by both PPNL and FIRS should compare the net margin earned by PPNL in distributing the products to third parties to the net margin earned by comparable independent distributors performing similar functions, utilizing similar assets and bearing similar risks. As a result, FIRS' use of the gross margin as the PLI in applying the TNMM is technically flawed, and as such we do not agree with the TAT's decision in favour of the FIRS in this regard. If the FIRS wanted to use the gross margin to test the reasonableness of the returns earned by PPNL, the RPM should have been selected as the most appropriate method.

The next obvious question is; if the FIRS' application of the TNMM was technically flawed, why did the TAT rule in its favour?

It appears the FIRS sounded more persuasive in arguing that the use of GPM for TNMM was in line with best practices, albeit false, with more references to the NTPR and the OECD/UN Guidelines as well as Exhibits of correspondences between the two parties. Technically, it appeared that the representatives of PPNL made more references to a number of seemingly unrelated non-TP court cases, rather than focusing more on the facts and circumstances related to the controlled transactions and making more persuasive references to the NTPR, the OECD/UN Guideline, and any relevant TP court cases in different jurisdictions. PPNL should rather have focused on explaining the appropriate application of TNMM in line with the relevant laws.

Thus, it was not too surprising that the TAT found a technically flawed FIRS position more persuasive and thereby ruled in the FIRS' favour.

The issue of inconsistency in the application of TP methods across years

Finally, the FIRS appeared to hang its hat on the argument that consistency in application of TP methodologies is so key to TP analysis that PPNL could not credibly apply the CUP Method for FY 2013 and change it to TNMM for FY 2014. This position is evidenced in TAT's conclusions on Issue 2, Point 4 where it states that "Consistency in the application of benchmarking method from year to year is also very important and fundamental (Par. 29.4 of OECD Guidelines)."

However, this statement is only partially true. This issue is clarified in the UN TP Manual Chapter B.3.1.3.3, which states that "Once a method is chosen and applied, taxpayers are generally expected to apply the method in a consistent fashion. Assuming that an appropriate transfer pricing method is being applied, a change in the method is typically required only if there are any changes in the facts, functionalities or availability of data." PPNL had argued that the reason for the change in method from the CUP Method to TNMM was because of unavailability of adequate internal data to apply the CUP Method for FY 2014. Although this was a good reason in accordance with both the OECD & UN Guidelines, PPNL did not make a strong and persuasive argument backed by facts and law to convince the TAT.

Concluding Remarks

The first Nigerian TP Judgment buttresses the fact that TP is arguably the riskiest area in tax and taxpayers need to have the end game in mind when filing their TP Returns and preparing their annual contemporaneous TP Documentation. A more robust TP documentation prepared with the expectation of being defensible in court is key in mitigating a taxpayer's TP risk especially the assessment of significant additional tax liabilities. Thus, a taxpayer's choice of TP advisors cannot be overemphasized as the advisors are to support them throughout a TP engagement cycle, from TP returns filing, through TP documentation preparation, TP audit support and support with TP litigation or negotiations. Proactivity can be the difference between assessment of zero/minimal additional tax liability and billions of Naira.

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.