Introduction
Intangibles are an integral part of the value creation process of businesses and a fundamental part of their continuing success. Intangibles such as brand names and trademarks distinguish players within the same business segments and determine their ability to charge premium fees and generate outstanding profit margins. As with anything of value, intangibles can be licensed or sold to another party and such license or sale arrangements can take place between related parties operating across different jurisdictions with varied tax rates. Given the unique nature of intangibles, the difficulty in ascribing a value to them and ultimately establishing an arm's length price for them, it comes as no surprise that tax authorities all over the world have taken a keen interest in these transactions.
The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2022 (the OECD Guidelines), which provide a global standard for pricing transactions between related parties, 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 circumstances."
Further, Paragraph 6.6 of the OECD Guidelines states that:
"... the thrust of a transfer pricing analysis in a case involving intangibles should be the determination of the conditions that would be agreed upon between independent parties for a comparable transaction."
Based on the above, tax authorities seeking to apply Transfer Pricing (TP) methods to determine if intangible transactions have led to tax leakages in their jurisdiction should adopt the arm's length principle (ALP). The ALP seeks to ensure that transactions between connected persons are priced as though they were between completely independent parties acting in their own self-interest.
Overview of Regulation 7(5)
Regulation 7 of the Income Tax (Transfer Pricing) Regulations, 2018 (the Regulations), which covers intangibles transactions generally aligns with the OECD Guidelines. However, Regulation 7 (5) introduces a restriction on the maximum amount payable for intangible transactions that can be treated as an allowable deduction for income tax purposes in Nigeria.
Specifically, Regulation 7(5) states that:
Notwithstanding any other provision of these Regulations, where a person engages in any transaction with a related person that involves the transfer of rights in an intangible, other than the alienation of an intangible, the consideration payable in that transaction that is allowable for deduction for tax purposes shall not exceed 5% of the earnings before interest, tax, depreciation, amortisation and that consideration, derived from the commercial activity conducted by the person in which the rights transferred are exploited.
Interestingly, in addition to complying with the cap on the fees in line with Regulation 7(5), taxpayers are also required to prepare TP documentation (including benchmarking analysis) on an annual basis to demonstrate that their intangibles transactions with related parties have been consistent with the ALP.
The Cap and the ALP
The cap introduced by Regulation 7 (5) appears to deviate from the OECD Guidelines which upholds the strict application of the ALP having duly considered the functions performed by the parties to transaction. These functions include the development, enhancement, maintenance, protection and exploitation of the intangible in question.
From experience, a review of transactions involving the transfer or rights in an intangible reveal that independent parties entering such arrangements often charge fees that are based on a percentage of revenue. Therefore, independent parties involved in such transactions would always be paid a fee even when the independent licensee does not generate any profits from the business venture in which the rights were used.
Therefore, the restriction imposed by Regulation 7(5) is not only inconsistent with one of the core objectives of the Regulations which is to "provide a level playing field for both multinational enterprises and independent enterprises carrying on business in Nigeria," but it also undermines the integrity of the ALP as contained in OECD Guidelines, and may impact the ability of Nigerian businesses to benefit from valuable intangibles developed and owned by its related parties.
It seems that the origin of the limitation in Regulation 7(5) may be the royalty limitation rule proposed by the African Tax Administration Forum (ATAF) as part of its suggested approach to drafting TP legislation. However, ATAF's suggestion did not specify any percentage and left this to the discretion of each tax authority. It however advised that a tax authority that choses to adopt this rule may "select its largest corporate taxpayers and calculate the impact on tax revenue of applying different percentage rates based on their last three years tax returns to assess an appropriate percentage level "
ATAF cited the difficulty faced by tax authorities in Africa in determining arm's length prices for royalties and other consideration relating to intangibles as the reason for suggesting the alternative approach.
Conclusion and suggested modifications to Regulation 7 (5)
While Regulation 7(5) may have been drafted with good intentions, it introduces complexity and uncertainty for taxpayers exploiting intangibles owned by related parties. Additionally, the provision may lead to disputes.
Hence, we suggest a revision to Regulation 7 (5) to align with the international best practice as contained in the OECD Guidelines by adopting any of the following alternative approaches
- Option 1: Permit the carry forward of any fees above 5% of EBITDA for up to five years provided that the fees are priced in accordance with the ALP. This approach is similar to the limitation on interest deductibility rules for foreign related party loans introduced via Finance Act, 2019 and helps to ensure fairness and compliance with international best practices.
- Option 2: Adopt the 5% of EBITDA as a safe harbour for all transactions involving intangibles. The OECD Guidelines defines a safe harbour as:
"A provision that applies to a defined category of taxpayers or transactions and that relieves eligible taxpayers from certain obligations otherwise imposed by a jurisdiction's general transfer pricing rules."
This approach affords taxpayers the option of opting to align with this safe harbor and reap the benefit of reduced compliance costs and scrutiny by the tax authority in the event of TP audit. I
Should the tax authority choose to maintain Regulation 7(5,) it will be interesting to see the interplay between the recently introduced guidelines on Advance Pricing Agreements (APA) and this provision of the Regulations especially in bilateral or multilateral APA negotiations involving jurisdictions that strictly adopt the OECD Guidelines with no local restrictions on the pricing arrangements for intangibles.
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.
