Gali Aka is a manager and Akaoma Osele is an experienced analyst in the transfer pricing services practice of KPMG Advisory Services in Lagos, Nigeria.
In this article, the authors examine the effect the coronavirus pandemic has had on related-party transactions in Nigeria and how these effects can best be managed.
“Related-party agreement” is the term used to indicate the transactional relationship between two or more entities in the same multinational group, typically under an oral or written arrangement. As the popularity of related-party transactions has advanced over the years, many countries have looked to regulate them to protect their country’s tax base and domestic profits. The relevant regulations in Nigeria are the Income Tax (Transfer Pricing) Regulations, first published in 2012 and revised in 2018.
Under the transfer pricing regulations, related parties are required to provide a list of material intercompany agreements on licensing of intangibles, research and development, cost contribution arrangements, and other material agreements in the master file, as well as “copies of contracts or agreements relating to controlled transactions and their execution” in the local file. This provision is expected to facilitate increased tax authority scrutiny of related-party transactions and ensure that transactions are carried out in line with the terms of the agreements and at arm’s length. However, despite the regulations, most multinational enterprises have yet to put agreements in place.
Like most contracts, related-party contracts may be drafted with the help of legal representatives, and strict attention should be paid to the contractual terms. The reality is that tax authorities look at the substance of a transaction over its form. Thus, if a contract states A, and the parties to the contract execute B, then the tax authorities would rely on the actions of the parties (B) over what has been stated in the contract (A). Contractual terms should, therefore, agree with the MNE’s transfer pricing policy. In a nutshell, the ability of the MNE to defend a transaction with contractual agreements assures the tax authorities that there was some thought put into its execution. Recently tax authorities have been looking aggressively into the related party transactions of MNEs in Nigeria. The need to raise more revenue has led to a rise in transfer pricing audits, and tax authorities will likely continue to focus on the conformity between MNEs’ internal agreements and intercompany transactional outcomes while trying to establish a link between the company’s business strategies and transfer pricing policies.
The coronavirus pandemic began in late December 2019. The first case in Nigeria was reported February 27 in Lagos. The government’s immediate response was to initiate domestic and international travel bans and restrictions, halt business activities, and pause domestic and international market activities. The COVID-19 outbreak has put many businesses in serious trouble, causing delays in the delivery of goods and supply chain disruptions in the procurement of raw materials, all of which have had serious consequences on business organizations and the economy at large. Many companies find themselves at a loss on how to manage the crisis’s effect on their business, especially concerning contracts signed pre-COVID-19. It is therefore important that all MNEs review their internal and external agreements by identifying clauses regarding transfer pricing regulations.
Transfer pricing can be seen as the fusion of business and legal activities, in which related entities enter into transactions while reassuring tax authorities by remaining compliant with the arm’s-length principle. The effect of the COVID-19 pandemic on many businesses will be contract breaches and increased liabilities. Contracting parties may seek to blame any delay in the performance of duties, or nonperformance, on the pandemic, citing it as grounds for renegotiating prices and general contract terms. This article seeks to highlight the effects the pandemic is having on related-party transactions in Nigeria and how these effects can best be managed.
With rates of infection again on the rise in Nigeria, and circumstances remaining fluid, businesses need to consider the impact on their existing and future contracts. By being aware of its rights and obligations, a company can manage risks appropriately and guide its relationships with suppliers, customers, related entities, and tax authorities to avoid future disputes.
Current and Future Potential Controversies
It can be assumed that business arrangements with independent third parties are carried out at arm’s length. However, with transfer pricing, the line between legitimate use and tax avoidance is thin and can be misconstrued by tax authorities. For example, entity A can manipulate its transfer prices for the provision of intragroup support services by reducing accounting profits in countries with high tax rates by overstating the value of its imports and understating the value of its exports. A properly executed related-party contract can support pricing assumptions.
However, the reality is that most MNEs, especially those located in Nigeria, still engage in related-party transactions without drawing up contracts, arguing for the application of the substance-over-form rule, which favors the actions of transacting parties over what is contained in a contract. In cases in which no intercompany agreement exists, disputes may arise from the nonperformance of contracts — bad enough to cause business disruptions — and MNEs will find it difficult to legally defend their transactions. The main issue is how tax authorities will treat transactions entered into without a contract post-COVID-19. The nonexistence of a related-party contract will give tax authorities the freedom to interpret these transactions however they see fit.
Implications for Contract Performance
The pandemic’s impact on related-party transactions will take one of these forms:
a complete termination of the contract;
a review or modification;
litigation; or
fulfillment of the contract.
If control measures put in place by different countries to curb the spread of the virus delay performance of a contract or create a cost increase, termination or rescission may be explored as an option based on one of the contracting parties’ inability to fulfill its obligations. For example, in the real estate sector, if space has been leased for training or a conference that is subsequently canceled, the parties involved will likely agree on a rescission of the contract and call for a refund of any advance payments or deposit. Similarly, in a situation in which the execution of contractual responsibility is still feasible but with significant cost changes, the parties could adjust the terms based on fairness.
Related entities must give timely notice to facilitate reasonable risk-mitigating measures by contracting parties. Failure to do so might result in the inability to apply force majeure or frustration measures as a defense. Then again, the fact that the pandemic is considered a force majeure does not create an easy escape from contract obligations. Courts of law will do their best to keep the terms of a contract alive and encourage modification. MNEs are therefore encouraged to review their contracts appropriately.
Implication for Retainership Arrangements
A retainer arrangement may cause disputes between MNEs and tax authorities post-COVID-19. Consider this scenario: company A, located in Nigeria, manufactures nonessential products. It has a retainership arrangement with company B, a related entity in China, for procurement services of supplies or raw materials. The service fee is paid quarterly in advance, in line with the procurement schedule.
Assume that company B has received its first-quarter fees, but company A had to shut down manufacturing activities as a result of the lockdown and restrictions in Nigeria and will not need to procure first-quarter supplies. Because procurement arrangements are typically a major focus area during transfer pricing audits in Nigeria, perhaps the Federal Inland Revenue Service (FIRS) may disallow company A to deduct the first-quarter payment made to company B, even though the force majeure did not originate with company B.
For other arrangements, like services provided on-call, MNEs may be left in limbo as to how COVID-19 will influence the stance of tax authorities for the periods affected. The question would generally be whether the availability of on-call services justifies an arm’s-length charge for nonbusiness activities during lockdown periods.
Whether these charges would be an allowable deduction may depend on convincing the FIRS that the need for the service was not remote, and the on-call services are not obtainable promptly and readily from other sources without the need for standby arrangements.
Implication for Fixed-Fee Arrangements
When related parties contract for the transfer of rights to use intellectual property or other intangible assets, fees are usually set at some percentage of revenue, net sales, or earnings before interest, taxes, depreciation, and amortization. It’s possible one party will miss a fee payment. During the lockdown, most businesses engaging in the manufacture and sale of nonessential products may earn no revenue from sales and, depending on the length of the lockdown period, may have no obligation to pay royalties for use of know-how and trademark. This is understandable from the standpoint of both the licensee and the licensor.
On the flip side, tax authorities may have concerns with fixed-fee arrangements for the use of trademarks and know-how. They may disallow (fixed fee) royalty payments during the COVID-19 period in circumstances where the licensee is unable to exploit the intangible asset due to lockdown.
COVID-19 Response Recommendations
It is uncertain how the FIRS will approach tax and transfer pricing audits for the COVID-19 tax year. MNEs are therefore advised to assess their intercompany agreements proactively and take steps to eliminate any gaps. Similarly, MNEs should evaluate the impact of the COVID-19 pandemic on their businesses and related-party arrangements.
Agreements should be reviewed and modified to suit realities. Necessary modifications may include introducing more lenient terms to an existing contract while leaving its purpose unchanged. It is also important that MNEs consider actions taken and resolutions reached on third-party contracts.
Documents associated with related-party contracts, including modifications, COVID-19 impact analysis, and communication with relevant government agencies, should be kept safe and easily retrievable in case of audit. Similarly, documentation of decisions reached by the MNEs on strategies to adopt post-COVID-19 should also be strictly documented. This is pertinent because these records may be needed during an audit.