Nigeria: Tax Incentives, Transfer Pricing And Foreign Direct Investments In Nigeria

Background

GlaxoSmithKline (GSK) recently announced a formal exit from Nigeria, which generated a lot of emotions in the country. It was seen by many as a fall out of how the economy had been managed over time especially in a country where unemployment remains a big issue (at least in the eyes of the average observer even though recent data issued by the Nigerian Bureau of Statistics (NBS) indicates that unemployment rate in the country now stands at 4.1% which is comparable to what you have in most of the developed world). The country is also dealing with a significant revenue crisis where its receipt from the sale of oil and gas has dwindled due to reduced production numbers. There is therefore increased pressure to improve collection from non-oil and gas sources. The loss of a significant entity like GSK from the Nigerian economy will not do much to improve tax revenue collection for the Government.

The argument against Tax Incentives

It is against this backdrop that I found some of the conversations I have engaged in recently very interesting. The conversations centred around the negative impact tax incentives and transfer pricing has and continues to have on Government's ability to improve tax revenue in the country. The argument is that the Government is very quick to grant incentives to multiple players in various sectors of the economy which hinders its ability to increase tax collection. An example that was raised in many of the conversations was the tax holiday granted to telecommunications companies when they made their initial foray into the country a few decades ago. These companies have turned out to be significant businesses employing thousands of people who in turn pay income taxes in the various States of the country in which they reside, but this fact is maybe lost. The companies have also since come out of the tax holiday period and the sector is one of the largest contributors to tax revenue today. This point is further buttressed by the fact that the Government recently introduced new laws which extended the tax compliance obligations of the major players in the sector to include the requirement to act as an agent of the tax authorities for the collection of Value Added Tax (VAT) from their vendors, an obligation which was until recently only placed on Government and its agencies, Oil and Gas players as well as entities which dealt with non-resident vendors. The introduction of this additional obligation was an affirmation from Government that the telecommunications sector had become a major player in the Nigerian tax and economic space. The growth of the sector cannot be ascribed to the grant of the tax holiday upon take off, but it does provide some insight as to how tax incentives can be applied to generate foreign direct investment and growth in a particular sector of the economy.

Transfer Pricing – Problem or Solution?

The same arguments were also extended to transfer pricing where most of the people I was in contact with over the period felt that Nigeria typically gets the short end of the stick when it came to allocation of prices and value. They argued that foreign companies were likely to push more cost to Nigeria as a basis for reducing the tax base of subsidiaries in the country and shift profits to more cordial jurisdiction. Transfer pricing is a big issue especially for developing countries. This cannot be overemphasised. However, is it as big an issue as these conversations holds it out to be and is it the reason why the tax base of entities operating in the country have remained stagnant? The conversations reminded me of a meeting with tax authorities in the country where they had queried the mark up applied by a Nigerian based limited risk distributor. The distributor had applied a 5% mark up and this could be substantiated by relevant transfer pricing documentation. However, the tax authorities argued that the mark up rate could not be stagnant and that it had to be subject to annual inflation. It didn't matter that this wasn't a transfer pricing audit (the tax authorities have a specialised transfer pricing team at the tax authorities which should conduct such audits) or that the cost of the goods itself was not stagnant and reflected inflation to the extent of its price and demand elasticity. This just highlights the mindset of the average Nigerian with respect to the alleged twin demons of tax incentives and transfer pricing.

The real question however, is whether these are the real issues affecting our ability to increase tax revenue in the country?

The case for Tax Incentives and its Reform

There is nothing wrong with the grant of tax incentives. Many have argued that tax incentives are not the key driver for foreign investors looking for where to direct limited resources, and I totally agree. However, that it is not the key driver is not the same thing as that it is not a key driver. I think it can be a key driver especially in the highly competitive world in which we live in today. Nigeria is signatory to the African Continental Free Trade Agreement (AfCFTA) which seeks to liberalise trade amongst countries on the continent. It is expected that when the AfCFTA becomes fully operational, it would spur growth of inter African trade and allow for multinationals to situate productive bases in specific areas on the continent with the benefit of access to the entire African market from these bases. It is therefore important for every African country to begin to look at policies which would ensure that its territory ranks high in the consideration for this foreign capital deployment. This is where the use of tax incentives may play a major role.

I will come back at this point to the GSK exit announcement. It is important to note that the announcement never stated that the exit would mean the disappearance of GSK products from the Nigerian market. In fact, it is expected that the exit would have no impact whatsoever on the ability of GSK to continue to access the Nigerian market. The only thing that the exit may have done for GSK is reduced its exposure to the country risk it carried while it had formal access to the market. It is only just transferring that risk to a third party. I am not party to the internal workings of GSK and do not have access to the numbers which helped them come to the conclusion that they are better off as a Group with access to the market through a third party distributor than through a formal GSK entity in Nigeria. I though understand though that it is a business and decisions need to be taken at various points to ensure long term sustainability. It is up to the country to ensure that at every point in time, it makes economic sense for businesses to keep their doors open in their domain and that is where the effective use of tax incentives may come to play.

Nigeria currently does not have any incentive framework to encourage research and development (R&D) in the country. If GSK had decided to set up a factory to manufacture drugs in the country, it would most likely be eligible to a 5-year, income tax holiday period. There is also a VAT exemption on the sale of medical products but that applies whether the drugs are manufactured in country or imported, so it cannot be a defining factor. The cost of setting up the drug manufacturing company in the country is expected to be significant and may require a significant part if not all the 5 years to recover. You could conceivably be in a position where you are not able to enjoy any of the tax holiday because there is no or minimal profit during the period. We have however continued to push the tax holiday incentive even though there is very little evidence that it has in any way attracted the level of investment into the economy that would lead to a significant productive base in the country. The exist of a GSK owned distributor in favour of a local distributor is a big loss. The inability to attract a GSK into significant R&D and subsequently manufacturing activity in the country is a much bigger loss to the country.

We have complained incessantly about the lack of adequate investments in our tertiary institutions and Government does not have the resources to change the narrative significantly in that sector. However, an extensive R&D incentive framework which encourages multinationals to invest in conjunction with our tertiary institutions may be the silver bullet which helps solves some of these issues. It also helps us develop home grown technology and technical expertise which then forms the basis for productive development. 

Nigeria has tried in the past to force transfer of technology and expertise through the Nigerian Office for Technology Acquisition and Promotion (NOTAP) which mandates all relevant agreement for technical and managerial expertise to be submitted for approval. The terms of grant of the approval typically requires the entity seeking the approval to submit as part of its application, a plan for the transfer of the knowledge and expertise to qualified Nigerians. This has gone on for decades, but it is unclear if any knowledge and or technical expertise have been successfully transferred to Nigerians through its work. It is maybe time to consider a different approach which encourages and incentivises local research and development in the country.

Tax Incentives and its link to Transfer Pricing

There is a limit to how much value we can as a country obtain through transfer pricing from transactions between multinationals and their Nigerian subsidiaries and or dependent agents in the country. We can continue to push the envelope to ensure that no amount is lost through transfer pricing, but we will always be limited in our ability to recover value through the quantum of productive activities which take place in the country. The more productive activities which takes place in the country, the more the value generated and the more we can get from insisting that the right transfer price is applied.

The key maybe is in tweaking how our current incentive system works. A popular Presidential candidate in Nigeria once said he would rather subsidise production than consumption. The use of tax incentives is a way for Government to provide subsidies to corporations. We just have to be more ingenious in the way and manner in which we apply these subsidies.

Another case in point where incentives may not have been properly applied is in the power sector. Any investor in a gas fired plant today would be eligible again to VAT exemptions at the point where it brings in its equipment into the country (Another place where I may add again that we probably may be able to design and develop home grown power plants and save on importation if we focus on incentivising local R&D) and a 5-year income tax holiday. The plant is unlikely to hit peak profitability within the first 5 years of operation so while the tax holiday is a good to have for most, it will not be a defining factor for the decision whether to invest in the plant or not. There are many challenges which impact the sector, but it is possible to define an incentive scheme which changes the dynamics of the sector and suddenly becomes the primary driver for investment decision. The Economist in its article on “The German economy ; from European leader to laggard” of 17 August 2023 reports that Germany is granting subsidies to Intel to the tune of USD$10Billion (one third of the total investment cost of USD$30Billion) to facilitate the setup of a chip manufacturing hub in the country. The report was terse on the makeup of the subsidy, but I am almost certain that it was targeted to ensure that its grant and application became a deal maker for the Intel. We cannot continue to use a general incentive framework if there are specific aspects of the economy we want to target and encourage their growth. We should not be afraid to go big but it has to be a decision driven by data.

Conclusion

The NBS reports that over 90% of Nigeria's active work force are employed in the informal sector of the economy. This in no small measure contributes to the low tax to Gross Domestic Product (GDP) ratio in the country. The bulk of people who pay income taxes in the country consist of companies in the formal sector and their employees who are in a sense forced to pay due to the operations of the PAYE system which mandates employers to deduct at source. A few States in the country complain of low internally generated revenue and the high cost of collection of tax from the informal sector compared to the value that may be generated at the end of the day. This is unlikely to change unless we take deliberate steps to shrink the informal sector and grow the formal sector.

Tax incentives and subsidies if applied in the right manner may provide us with the opportunity to attract the right form of investments into critical sector of the economy that allow for the growth of big firms which would employ more people and at the end contribute more to Government and society. It is time we begin to review our approach to tax incentives application and hopefully benefit more from the application of appropriate transfer pricing.

The opinion expressed in this article is solely personal and does not represent the views of any organization or association to which the authors belong.