by Amaka Samuel-Onyeani and Omobolanle Otukoya
In the last three (3) years, there has been a significant increase in the number of Transfer Pricing (TP) audits conducted by the Federal Inland Revenue Service (FIRS). TP audits are generally lengthy, involving the submission of significant amounts of documents and attendance of various reconciliation meetings. From experience, despite international best practices and taxpayers’ efforts to defend their TP positions, taxpayers often have to compromise and agree with positions adopted by the FIRS with respect to certain complex transactions such as intangible transactions. This is usually due to the unwillingness of taxpayers to proceed to litigation because of the lengthy and expensive judicial process in Nigeria as well as the absence of precedence in the courts to guide the treatment of such transactions.
Globally, intangible transactions are a source of significant TP controversy due to their complexity. Tax authorities are usually skeptical about these transactions, and require substantial proof from taxpayers to justify royalty costs or the appropriateness of royalty income derived.
In this article, we discuss intangible transactions and share our experiences from TP audits (focusing on the manufacturing industry), highlighting the FIRS’ treatment of these transactions.
What are Intangibles?
Paragraph 6.6 of the OECD TP Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines) defines intangibles as; “something which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstance.”
According to the OECD Guidelines, intangibles may be broadly categorized into marketing and trade intangibles. Marketing intangibles relate to marketing activities that aid in the commercial exploitation of a product/service and/or has an important promotional value for the product concerned. Examples include trademarks, trade names, customer lists, customer relationships etc. Trade intangibles are intangibles that are not marketing intangibles. Examples include, patents, know-how and trade secrets, propriety formulas, rights under contracts and government licenses etc.
Prior to the revision of the OECD Guidelines in 2017, ownership of intangibles tended to hinge on legal ownership. This meant that an entity within a Multinational Enterprise (MNE) group was deemed to own an intangible, if it possessed legal title, which entitled it to earn remuneration from the licensee for the exploitation of the intangibles.
The revised OECD Guidelines clearly indicates that legal ownership is not sufficient to confer on the owner, a right to earn the returns from the use of the intangible asset. Other members of the MNE group depending on the functions performed, assets utilized and risks assumed toward the Development, Enhancement, Maintenance, Protection or Exploitation (DEMPE functions) of the intangible may be entitled to some of the returns. Entities within the MNE Group who carry out at least one of these functions are referred to as economic owners of the intangible, and should be compensated for their value adding activities.
The remuneration for the transfer of intangibles depends on the nature of the transfer of rights, considering, the functions performed by parties to the arrangement and the profit and loss variable the intangible drives. For example, where a marketing intangible drives revenue of the licensee because of significant brand recognition, the remuneration is typically a royalty rate as a percentage of the licensee’s net sales/ revenue that the intangible is driving.
Treatment of Intangibles during an Audit
Intangible transactions face more scrutiny from the FIRS due to their complexity and the fact that the associated royalty payments are usually outflows. During the audit, the FIRS often requires documentary evidence to demonstrate the following:
whether the intangible is valuable and of benefit to the licensee or transferee
which entities within the Group perform the DEMPE functions and are entitled to compensation from the exploiters of the intangible
evidence that the licensee exploited the intangible in the relevant period
where the intangibles includes the provision of services, evidence that the services were performed
The FIRS may seek to confirm that ministerial approval has been obtained from the National Office of Technology and Promotion (NOTAP) for qualifying royalty payments to offshore related parties. This will be more relevant if the audit covers years prior to the passage of the Finance Act 2019. The Finance Act settled the prior debate whether NOTAP approval was needed for tax deductibility purposes, by stating that deductibility hinges on compliance with the Income Tax (Transfer Pricing) Regulations, 2018 (TPR).
The FIRS may also seek to interview persons within the organization to establish the use and benefit of the intangibles to the business. For example, where technical know-how for manufacturing is included in the suite of intangibles provided by the related party, the FIRS may seek to interview the production manager to gain an understanding of how this intangible is used in the manufacturing process. This information is critical to establishing substance (i.e. the transaction occurred and was of benefit to the taxpayer). Where substance is not established, the FIRS may totally disallow the transaction.
The above notwithstanding, we have observed that the FIRS often adopts the following positions with respect to the treatment of intangibles:
Trade Intangibles: For trade intangibles involving propriety formulae or technical know-how, the FIRS may seek to establish that this intangible was not used in the taxpayer’s manufacturing process, especially where there are limited manufacturing activities in Nigeria. For example, where the Nigerian company is just involved in the packaging and distribution of the products, the FIRS may argue that the technical know how was not used during the packaging and distribution process. Further, where the taxpayer purchases raw materials or semi-finished goods from related parties, the FIRS tends to argue that the value of the intangible has been embedded in the price of the goods being purchased therefore, a separate royalty fee should not be paid.
Also, where the taxpayer has incurred Research and Development (R&D) costs, the FIRS may query these costs and the impact of the local R&D in the development, enhancement, or maintenance of the intangible. Where it can be established that the R&D conducted locally significantly helped maintain and/or enhance the intangible in the local market, the FIRS may seek to disallow part or in extreme cases, all of the royalty payments.
Hence, taxpayers benefitting from the use of such intangibles must demonstrate where the use of the intangibles creates significant value within the supply chain, which may include packaging functions, to substantiate any royalty payments made for the exploitation of trade intangibles.
“Despite international best practices and taxpayers’ efforts to defend their TP positions, taxpayers often have to compromise and agree with positions adopted by the FIRS with respect to certain complex transactions such as intangible transactions. This is usually due to the unwillingness of taxpayers to proceed to litigation because of the lengthy and expensive judicial process in Nigeria as well as the absence of precedence in the courts to guide the treatment of such transactions.”
Marketing Intangibles: For products, especially those sold to the final consumer, marketing intangibles such as trade name or trademark create the differentiating factor in the market. For example, an apple phone may be sold at a higher price than other phone brands because of the significant brand recognition and brand equity that the apple brand enjoys in the market. Hence, a subsidiary in Nigeria utilizing such valuable brand in the distribution of its products, may be expected to pay royalties to its related party that economically owns the brand. The FIRS typically seeks to determine if the marketing intangibles had a direct impact on the sales of the product. The FIRS is particularly skeptical if the product has been in the Nigerian market for a long time and may be perceived to have an established market in Nigeria.
Further, where the seems taxpayer have incurred significant marketing costs in Nigeria, the FIRS may argue that the taxpayer is actively involved in the enhancement of the brand and should be entitled to some compensation from the owner of the intangible or not be required to pay part or all of the royalty payments for marketing intangibles. Meanwhile, the fact that a taxpayer incurs these costs does not necessarily mean that it has contributed to the enhancement of an intangible. The OECD Guidelines differentiates between routine and non-routine distribution and marketing activities that will determine if a licensee of an intangible is entitled to a remuneration. This is dependent on the nature of these marketing costs and the contractual obligations of the licensor and licensee. While some of the queries raised by the FIRS may be valid, due consideration must be given to the value contributions that marketing intangibles bring to the taxpayer to enable the entity sell in the Nigerian market. Hence, adequate compensation in the form of royalty payments by the licensee may be required for the exploitation of these intangibles.
We have also observed that the FIRS tends to disallow royalty payments relating to intangible transactions for distributed products i.e. products bought directly for resale. While it can be argued that the impact of the trade intangibles such as know-how may have been included in the price of the product bought for distribution, these products may benefit from marketing intangibles, such as valuable trademarks and tradenames. Particularly, full-fledged distributors may exploit the marketing intangibles in the sales and distribution of the products in the market. Hence, disallowing royalty payments for distributed products may be inconsistent with the globally accepted arm’s length standard and lead to double taxation for the taxpayer and its related party.
Arm’s Length Pricing: Prior to the Finance Act 2019, there were several arguments as to whether the NOTAP approved rates or the arm’s length rate should be adopted for pricing intangible transactions. As intangibles generally drive revenue, an arm’s length remuneration for intangibles is generally a percentage of revenue which is often higher than the NOTAP approved rate. This is because, unlike foreign exchange control bureaus around the world, e.g. South Africa, NOTAP does not consider TP practices when determining its approved rates. Consequently, in practice, the FIRS generally adopted the pricing that best suited them i.e. for an outward royalty payments, the lower of the NOTAP approved rate or the arm’s length price.
Nevertheless, the Finance Act 2019 shifted focus from NOTAP and stated that all Related Party Transactions (RPTs) must be consistent with the TPR. This implies that the determination of the arm’s length price for RPTs would be based on the provisions of the TPR.
Regulation 7(5) of the TPR restricts allowable deductions of royalty payments on intangibles to five percent (5%) of Earnings before Interest, Tax, Depreciation and Amortization (EBITDA) plus the intangibles consideration. This provision is deemed inconsistent with the arm’s length principle as it doesn’t factor in the arm’s length price in determining the restriction.
This provision has resulted in significant double taxation risk for taxpayers in Nigeria involved in intangible transactions and further impacts the perception of foreign investors interested in doing business in Nigeria.
Based on our experience, it is advisable for taxpayers to review their intangibles arrangements, putting into consideration some of the positions that the FIRS may adopt during an audit. Documentary evidence supporting their position should be proactively retrieved and collated.
Furthermore, organisations, such as Nigeria Employers’ Consultative Association (NECA) or Manufacturers Association of Nigeria (MAN) may consider discussing some of these practices with the FIRS or the Ministry of Finance, considering the impact of such practices on the businesses they represent and potential foreign investments in the country.