The Arm’s Length Principle is an important aspect of taxation, especially concerning transfer pricing (TP) and cross-border transactions. It ensures that transactions between related parties are conducted as though they were independent, with the ultimate goal of preventing profit shifting, tax avoidance, and securing the tax base for respective jurisdictions.
This means the terms, pricing, and other conditions of the transaction must reflect market realities. This principle seeks to prevent manipulation of pricing, which can lead to artificial profit allocations, allowing companies to reduce their tax burden in higher-tax jurisdictions by shifting profits to low-tax areas.
This practice can reduce a government’s tax revenue and potentially expose companies to double taxation. To address these issues, numerous countries have incorporated the Arm’s Length Principle into their legal frameworks. In Nigeria, this principle is embedded in the Income Tax (Transfer Pricing) Regulations 2018, established by the Federal Inland Revenue Service (FIRS).
Understanding Transfer Pricing
Transfer pricing can also be understood as the price set by one division or group within an organization for a product or service provided to another division or group within the same organization. These internal transactions may involve the exchange of tangible goods, intangible assets like technology or brand names, as well as services or financial arrangements.
For example, when a subsidiary sells products to its parent company, the amount the parent company pays is considered the transfer price. Tax authorities closely scrutinize transfer pricing methods, as these prices directly influence the taxable income of the entities involved. In Nigeria, there is growing concern over the potential for foreign investors to manipulate transfer prices, given the significant financial impact on national revenue.
Transfer pricing can sometimes serve as a method for multinational companies to allocate their net profits or losses across the countries where they operate. While transfer pricing in itself is not illegal, it becomes problematic when companies use it to avoid taxes by recording profits in countries with lower tax rates.
This practice raises concerns for tax authorities, who closely monitor these transactions. International tax regulations, guided by the OECD (Organization for Economic Cooperation and Development), are enforced by local tax authorities and audit firms in each jurisdiction.
When Is a Transaction Considered to be at Arm’s Length?
A transaction between related parties is considered to be at Arm’s Length when it is carried out as if the parties were independent, with no prior relationship affecting their dealings. Essentially, the transaction should mirror how unrelated third parties would conduct business under similar conditions.
A taxable person has the right to set their transfer prices, but they must ensure these prices align with the arm’s length principle. Suppose related-party transactions do not align with the Arm’s Length Principle. In that case, the Regulation authorizes the FIRS to adjust the taxable profits from these transactions, ensuring they conform to the Principle.
Transactions subject to transfer pricing adjustment include:
- Sale or purchase of tangible goods
- Sale, purchase, or lease of intangible assets
- Financing Arrangements
- Transfer, purchase, licensing, or use of intangible assets (including intellectual property)
- Provision of services
- Business restructuring transactions
- Lending or borrowing of funds
- Manufacturing agreements
- Sales or purchasing of financial instruments
- Any transaction that may affect profit and loss or is incidental, related, or connected to the above transactions, etc.
Transfer pricing adjustments often lead to additional tax liabilities, which the tax authority may impose on top of the originally assessed tax amount.
Key Nigerian Regulatory Frameworks Related to the Arm’s Length Principle in Nigeria
1. The Federal Inland Revenue Service (FIRS):
The FIRS enforces transfer pricing regulations and has the authority to review transactions and make adjustments where necessary to reflect arm’s length pricing. FIRS can impose penalties on companies that fail to comply with these requirements, including documentation requirements, which demonstrate that prices charged in related party transactions are consistent with the Arm’s Length Principle.
2. Companies Income Tax Act (CITA):
This is the principal legislation that governs company income tax in Nigeria. Section 22 of CITA, as amended, gives the Federal Inland Revenue Service (FIRS) the power to adjust the tax liability of a company if it appears that a related party transaction is not conducted at arm’s length, resulting in understated taxable profits in Nigeria.
3. Transfer Pricing Regulations (2018):
This regulation requires that all transactions between related entities must comply with the Arm’s Length Principle. Nigerian TP Regulations align closely with the OECD Transfer Pricing Guidelines, although certain adjustments reflect Nigeria’s unique economic and tax conditions. Companies are required to document their TP policies and the rationale behind related party transactions to ensure compliance.
4. Personal Income Tax Act (PITA):
Though primarily focused on individuals, PITA also includes certain provisions on arm’s length transactions in cases where individuals involved in business dealings might use related party transactions to reduce taxable income.
Methods for Determining Arm’s Length Pricing in Nigeria
The FIRS recognizes several methods for determining whether related-party transactions meet the Arm’s Length Principle. These methods are adapted from OECD guidelines and are used to evaluate different types of transactions. They include:
1. Comparable Uncontrolled Price (CUP) Method:
This method compares the price charged for goods or services in a related party transaction with the price charged in a comparable, unrelated transaction under similar circumstances. This method is preferred by the OECD if comparable data is available, to ensure prices are at arm’s length.
2. Resale Price Method:
This method calculates the gross margin on goods bought from a related party and resold to an independent party, suitable for resellers and distributors. It identifies arm’s length pricing based on comparable resale margins.
3. Cost Plus Method:
Used mainly for manufacturing, this method takes the cost of producing goods or services and adds a standard markup to the cost of goods sold between related entities. It is useful for manufacturers or suppliers with long-term arrangements. The markup should reflect what independent entities earn in similar transactions.
4. Transactional Net Margin Method (TNMM):
Compares net profit margins from related-party transactions to margins in independent transactions, often based on sales, costs, or assets. This method is widely used as it allows flexibility when direct price comparisons aren’t possible.
5. Profit Split Method:
When it is challenging to determine comparable transactions, this method divides combined profits or losses from related-party transactions based on the contributions of each entity, duplicating how profits would be split between independent entities. Two main approaches are:
- Contribution Analysis: Splits profits based on the functions and risks each party assumes.
- Residual Analysis: Allocates profits in two stages: first, each party receives compensation for their functions; remaining profits are then split based on transaction specifics.
Organizations can choose the most suitable method depending on available data, transaction comparability, and the nature of the transactions.
What Are the Implications of Not Complying With the Arm’s Length Principle?
The Regulation imposes strict penalties for related-party transactions that do not adhere to the Arm’s Length Principle. Key aspects of these transactions and their tax implications include:
- Export and Import of Commodities
For exports, if the price agreed upon by related parties is lower than the prevailing price on an international or domestic commodity exchange on the transaction date (“quoted price”), FIRS will disregard the agreed price and use the quoted price to calculate taxable profits. For imports, if the agreed price is higher than the quoted price, FIRS will similarly use the quoted price for tax calculations. However, if the taxpayer can demonstrate that any price deviation is reasonable, these adjustments may not apply.
- Intra-Group Services
FIRS assesses whether services provided by a taxpayer to a related party comply with the Arm’s Length Principle by evaluating if the service enhances the recipient’s economic or commercial position. It considers whether an independent entity, under comparable circumstances, would pay for the service at the agreed price or perform it internally. If these criteria are unmet, FIRS may adjust the taxpayer’s taxable profits.
- Transfer of Intangible Property Between Related Parties
Intangible assets include copyrights, patents, goodwill, trademarks, and trade names. FIRS determines if an independent party, in the transferor’s position, would transfer the asset at the agreed price and if, in the transferee’s position, would find the asset valuable to its business. Regardless, tax deductions for intangible property are capped at 5% of earnings before interest, tax, and depreciation.
Unfortunately, many Nigerian companies, especially local businesses with international ties, struggle to understand and implement transfer pricing rules. This complexity can lead to unintentional non-compliance or reliance on costly consultants.
Conclusion
In conclusion, the arm’s length principle is fundamental to fair and effective transfer pricing. It ensures that transactions between related entities are priced as they would be between independent parties. By aligning transfer prices with the arm’s length standard, companies contribute to a transparent tax system that prevents profit shifting and ensures fair tax allocation across jurisdictions.
For businesses, adhering to transfer pricing regulations is essential not only for compliance but also for minimizing risks of tax adjustments and penalties. As global and local transfer pricing rules continue to evolve, proactive and well-documented transfer pricing practices will ensure sustainable and lawful business operations.
