RICHARD Dowden, director of African Society London and author of the book, “Africa: Altered States, Ordinary Miracles", was the guest speaker at the Anniversary Lecture in Abuja on 27 September 2011 organised by the Ministry of Foreign Affairs, to mark Nigeria’s 51st Independence Anniversary.
In his speech, he referred to a report by the Global Financial Integrity, a Washington-based think tank made up of former IMF economists. In their report “Illicit Financial Flows from Africa”, they had looked carefully at capital outflows from Africa and found that between 1970 and 2008 illicit financial outflows were approximately 854 billion dollars– that’s the conservative estimate. They may have been as high as 1.8 trillion dollars. These outflows were mainly from West and Central Africa and yes, you guessed right – the biggest outflow was from Nigeria. Unfortunately, since the report was written the illicit outflows have grown even larger.
There is no doubt that money laundered abroad by corrupt military rulers and politicians is part of these “illicit outflows” but that is a discussion topic for another day. Beside this the Global Financial Integrity report found that the bulk of it was transfer pricing and mispricing by global corporate companies operating in Africa.
So, what is transfer pricing? To start with, I will twist the question on the head and answer it the other way round, that is, what transfer pricing is not – at least from a tax point of view.
Many Nigeria based accountants and tax practitioners are quick to think that transfer pricing is not even a tax matter. They see it as being more relevant to management accounting in the sense that it has to do with the pricing of materials and semi-finished goods transferred between divisions or departments of the same organisation. Well, this is not the transfer pricing we are talking about although the principles are similar to some extent.
In a tax context, transfer pricing (TP) generally refers to how related parties price goods, assets, services, intellectual properties, loans, guarantees and other commercial transactions between them. The related parties referred to are taxable persons including individuals and organisations, not divisions or units within an organisation.
Why is transfer pricing important for tax purposes? Let’s assume that a man acquired a plot of land a few years ago for the sum of N10 million. The current market value of the land is now N50 million. If the man sells the land now he would realize a capital gain of N40 million and therefore be liable to 10% capital gains tax of N4 million. Imagine that instead of selling the land to an unrelated party for N50 million, the man decides to sell it to a member of his family or friend for N25 million. His capital gain would have reduced from N40 million to N15 million thereby reducing the capital gain tax payable proportionately from N4 million to N1.5 million. This implies that the taxman will lose N2.5 million as a result of his decision to sell the land to a related party at a price other than the open market rate.
Based on the general anti avoidance provisions of the law, related parties are required to carry out transactions between them at arm’s length. Where this is not the case, the tax laws empower the tax authorities to disregard the price charged to the related party and insist that applicable taxes be paid based on the market value. You may be thinking that the scenario just described is a discount granted by the seller to the buyer and should not in any way be an issue for the taxman. Again, this is true to an extent but if the discount is not available to unrelated parties then it is an issue for the taxman.
The prices paid for goods or services delivered or received have a direct impact on the profits of the seller and buyer and by implication, on tax. Unlike transactions between independent parities, when related parties deal with each other, there may be less emphasis on ensuring that the prices of the goods and services exchanged reflect market circumstances. It is estimated that 60% of global trade is conducted by multinational corporations and half of this amount is between related parties. Where a cross border transaction is involved, the taxman becomes more concerned because effectively any mispricing would mean a shift of tax base from one jurisdiction to another or worse still, to a tax haven.
According to the Tax Justice Network, transfer pricing is not, in itself, illegal or abusive. What is illegal or abusive is transfer mispricing, also known as transfer pricing manipulation or abusive transfer pricing.
To avoid mispricing, the arm’s length principle must be followed as much as possible. Arm’s length is similar to the accounting definition of fair value which is essentially the amount at which an asset can be exchanged or a liability settled between two willing and knowledgeable independent parties. As a matter of fact, transfer pricing rules are really guidelines about the application of the arm’s length principle.
The Federal Inland Revenue Service (FIRS) are currently concluding arrangements to issue transfer pricing (TP) regulations before the end of 2012. The TP regulations are designed to give Nigeria the opportunity to have a fair share of the profit of connected taxable persons’ transactions carried out within the country and to fight artificial transactions which often result in the shifting of profits out of Nigeria. When issued, the rules will apply to both local and multinational related parties.
Also, the rules will cover all transactions between connected persons within or outside Nigeria and those between a Permanent Establishment (PE) and its head office or other related branches (branches are treated as separate taxable entities for TP purposes). Specifically, the rules will apply to sale and purchase of goods, lease or sale of tangible assets, transfer or use of intangible assets, provision of services, lending or borrowing of money, manufacturing arrangements and any transaction which may affect profit and loss or any other incidental matter.
Based on the draft TP regulations, related parties are allowed to use any of the methods listed in the regulations as basis for their pricing. These are the comparable uncontrolled price method, the resale price method, the cost plus method, the profit split method and the transactional net margin method. If a taxpayer wants to have certainty regarding the acceptability of method used and desired price such person may approach the FIRS for advance pricing arrangement subject to certain thresholds and payment of non refundable processing fee of N5 million.
Every taxable person that will be affected must prepare documentation to demonstrate the arm’s length nature of their related party transactions. The documentation will usually include information on the group structure and business activities of the related parties, details of the related party transactions; the pricing method adopted; the reasons for selecting the method; and information on comparable transactions between unrelated parties. The documentation must be submitted along with annual tax returns. Failure to comply will attract a fine of 1% of TP adjustment and/or imprisonment for a term not exceeding 3 years or both fine and imprisonment in addition to penalties under the relevant tax laws.