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Issue 9 - Arm's length principle: Basic IFRS and Transfer pricing considerations


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Two recent key developments within the Nigerian tax system are critical to an evaluation of the arm’s length requirement for related party transactions. These are Nigeria’s adoption of International Financial Reporting Standards (IFRS) effective from 1 January 2012 with final dateline for compliance as 1 January 2014 for all entities in Nigeria as well as Transfer Pricing (TP) Regulations (the Regulations) effective from 2 August 2012.  

Both IFRS and TP Regulations require that transactions between “connected persons” or transactions between “related parties” should reflect market conditions. Thus, both refer to the arm’s length principle.  

The arm’s length principle is thus the link between IFRS and TP and necessitates fair valuations/arm’s length measurement of transactions between connected/related parties.

Under Nigeria TP Regulations, arm’s length price implies that the conditions of a “controlled transaction” should not differ from those that would have applied between independent persons in comparable transactions carried out under comparable circumstances.

The Regulations define controlled transaction as a commercial or financial transaction between connected taxable persons. “Person” here refers to a natural or legal person, while “connected taxable person” includes persons, connected individuals, entities, companies, partnerships, joint ventures, trusts or associations or associated enterprise (business association where one enterprise participates directly or indirectly in the management, control or in the capital of the other, or the same person or persons participate directly or indirectly in the management, control or in the capital of both enterprises).

This concept is similar to IFRS definition of “arm's length transaction” - one between parties that do not have a particular or special relationship that would make the prices of the transaction uncharacteristic of market conditions. The transaction is presumed to be between unrelated parties, each acting independently.  

The requirements of IAS 24 are very much similar to that of the TP Regulations. IAS 24 is aimed at ensuring that an entity's financial statements contain the disclosures necessary to draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions with such parties.

Similarly, the TP Regulations mandates the preparation and maintenance of TP documentation; showing data, information and analyses to verify that controlled transactions were conducted at arm’s length.

In ensuring that transactions between connected persons are at arm’s length, companies are to employ any methods set out in Regulation 5 of the TP Regulations. The method adopted must be that which reflects the circumstance of a controlled transaction.  Therefore, consideration must be given to the functions performed, risks assumed as well as the assets employed by the parties to the controlled transaction.

IFRS on the other hand relies on ‘fair value measurements’ in ascertaining the correct value of transactions between related and even unrelated parties. For IFRS purposes, “Fair value” is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  This definition applies to entities adopting IFRS 13 effective from the beginning 1 January 2013.  For entities that are yet to adopt IFRS 13, fair value is “the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm's length transaction”.

The fair value concept and arm’s length price tend to portray market realities and transaction value that is obtainable with third parties or other independent parties. Though, this is not always true in all situations. This then leaves a lot of room to taxpayers in determining or selecting the methods, formulae and assumptions for each transaction based on its unique set of circumstances.

The apparent reality under both TP and IFRS is that each methodology and valuation technique has its own merits and may or may not be suitable for measuring the arm’s length price/fair value of a specified item or items in any given circumstances. In practice, different methods/valuation techniques can give rise to different prices/estimates of fair value; therefore, it is important to select the most appropriate methodology/technique for the particular circumstance.

  • Would there be a landing for these differences in valuation techniques?
  • Could they fall under ‘other methods’ (referred to in the TP Regulations) which the taxpayer can apply if they are most appropriate?
  • What values would the taxpayer eventually recognise in the financial statements for these similar transactions?

The above are some of the questions that would need to be addressed by regulators in due course as practical issues continue to evolve.  Nevertheless, enhanced disclosure of related party transactions is now a feature of the financials under IFRS in Nigeria.  Transactions such as interest free financing/loans, lease arrangements, pricing of intangibles, share based payments, employee-benefits, purchases of goods and services and intercompany exchanges of assets are also issues for TP considerations.

In conclusion, since TP and IFRS are both evolving in Nigeria, it is important that relevant tax authorities consider the practical impact of these frameworks on taxpayers and initiate appropriate measures to address these issues. In the meantime, companies are advised to prepare and retain proper documentation covering details of significant changes in financial position and profitability level arising from converting to IFRS, which may have significant impact for comparability for TP purposes.

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