Inside Tax : Issue 15 - Transfer Pricing Methods under Nigeria's TP Regulations: A disposition to flexibility
Regulation 5 of Nigeria's Transfer Pricing Regulations sets out as follows the transfer pricing methods that will apply in determining whether the prices of controlled transactions are at arm's length:
- Comparable uncontrolled price method
- Resale Price method
- Cost Plus Method
- Transactional Net Margin Method
- Transactional Profit Split Method
- Any other method which may be prescribed by regulations made by the Service from time to time (Regulation 5(1)(iv))
The Comparable Uncontrolled Price Method - makes a comparison between the prices charged by taxpayers in transactions with both related and unrelated parties under similar or comparable circumstances (internal comparable), or prices charged between unrelated parties in similar transactions and under similar circumstances (external comparable). Any differences in the prices may suggest that the related parties may not have conducted transactions at arm's length.
The Resale Price Method - considers the price at which resold goods were purchased from related parties. The resale price is discounted by an appropriate profit margin which independent entities in comparable circumstances and performing comparable transactions earn. The gross margin represents what an independent party would seek to earn to cover its selling and other operating expenses and make an appropriate profit. The difference between the resale price and gross margin provides the arm's length price which is expected to coincide with the price at which the product was originally purchased from the related party.
The Cost Plus Method - compares the mark-up charged by taxpayers on costs incurred in provision of products or services to both related and unrelated entities (internal comparable), as well as the mark-up charged by unrelated entities in similar circumstances (external comparable).
The Transactional Net Margin Method (TNMM) - compares the net profit margin achieved by a taxpayer in relation to an appropriate base (e.g., costs, sales, assets) in its related and unrelated party transactions (internal comparables), as well as the margin achieved by unrelated parties in comparable transactions and circumstances ( external comparables). Where external comparables are used, the same profit level indicator should be used in analyzing both the controlled and uncontrolled transactions.
The Transactional Profit Split Method - splits the total profits arising from related party transactions between the parties in a manner that would be expected between independent third parties, taking into consideration the functions performed, the risks borne, as well assets employed by each of them. This approach is suitable were the related party transactions are too interwoven to be segregated and evaluated properly. The first step in this method is the identification of combined profits to be split, as well as the ratio, percentage or other valid basis to be used for the division of profits between the participating entities. In determining the split profits, the contributions from each related party must be considered. The splitting should be based, as much as possible on objective data (such as sales to unrelated parties).
The above methods are consistent with the methods enumerated in the Transfer Pricing Guidelines published by the Organization for Economic Cooperation and Development (OECD) and the United Nations' Practice Manual on Transfer pricing for Developing Countries. However, to ensure that the taxpayer is not constrained in its ability to consider, evaluate and select other methods not yet “prescribed by regulations” by the tax authorities, Regulation 5(4) provides that the taxpayer can apply a TP method other than the aforementioned where it is able to establish that:
- none of the listed methods can be reasonably applied to determine whether a controlled transaction is consistent with the arm's length principle; and
- the method used gives rise to a result that is consistent with that between independent persons.
In some jurisdictions, additional or alternative methods are also prescribed. In the United States for example, the following methods are in use:
- Comparable Uncontrolled Transaction Method
- Service Cost Method
- Comparable Uncontrolled Service Price method
- Gross Services Margin Method
- Cost of Services Plus Method
- Comparable Profits Method, etc.
Whatever the case is, the taxpayer involved in related party transactions must use the “most appropriate method (MAM)” to determine the arm's length prices of such transactions. The reference to “most appropriate” evokes reference to the “best method rule” under the OECD Guidelines.
In determining the MAM (or making a judgment thereon), the following considerations become relevant both for the taxpayer and the tax authorities under Nigeria's TP Regulations:
- What are the respective strengths and weaknesses of the TP method in the particular circumstances of each transaction?
- How appropriate is the method relative to the nature of the related-party transaction in the context of analysis of the functions performed, assets employed and risks assumed by each party to the transaction?
- Is information required to apply the TP method available and reliable?
- What is the degree of comparability between the controlled or related party transaction and uncontrolled transactions?
- How reliable are the adjustments, if any, that may be required to eliminate any differences between comparable transactions?
Irrespective of the method used (whether already listed, prescribed or freshly originated), one question that remains consistently relevant when determining the TP method to adopt is whether the method is the MAM for testing the prices of the related party or intercompany transaction? The taxpayers should bear in mind as the rule of thumb that the MAM is that method that produces the most reliable measure of arm's length results.