Background
In 1993, the Federal Inland Revenue Service (FIRS) announced uniform basis and rate for taxation of income derived by Non-Resident Companies (NRCs) from carrying out businesses in Nigeria. FIRS indicated that in order to reduce or eliminate the level of uncertainty, a uniform deemed profit rate of 10% would apply to the gross income derived by the NRCs from their operations in Nigeria. At the then 35% income tax rate, the effective tax rate for the NRCs was therefore 3.5%.
Three years later, specifically in 1996, the then Minister of Finance, Chief Anthony Ani, announced the doubling of the deemed profit rate from 10% to 20% and simultaneously reduced the corporate tax rate for income derived from non-exploration and production companies including those of NRCs from 35% to 30%. Thus, the effective tax rate applicable from that year till 2014 increased to 6%.
The deemed profit approach makes it very easy for most NRCs to plan their financial affairs in Nigeria. This is because the companies simply file details of revenue earned from every source by listing the invoices issued for a reporting period and applied 6% to the total taxable income. Since most would have also suffered withholding tax on the income at 5%, most NRCs simply attached a bank cheque of 1% to the tax return and deemed the tax compliance requirement for the reporting period concluded.
FIRS also adopted simplified approach in conducting tax audits during this period. The tax authority did not bother with the expenditure incurred by the NRCs to earn the income, but concentrated on ascertaining completeness of invoices disclosed in the annual tax returns. Thereafter, FIRS simply applied the effective tax rate of 6% and in some instances, even assumed remittance of 5% withholding tax by the beneficiaries of NRCs' services, thereby only required the NRCs to produce evidence of payment of the expected balance of 1%.
It should be noted that since the law also requires service beneficiaries to withhold and remit Value Added Tax (VAT) due on invoices issued by NRCs for qualifying transactions directly to FIRS, the method and process of tax compliance by the NRCs and FIRS' audit of the same was relatively simple and result oriented. FIRS also reported tax revenue arising from collecting the 1% over and above the WHT deducted and remitted at source.
This however changed with the introduction of transfer pricing (TP) regulations in 2012. FIRS modified the tax compliance process for the NRCs by requiring them to prepare audited income tax statement to determine the actual profit from business operations in Nigeria. This marked a new beginning in tax compliance and audit procedures for NRCs in Nigeria.
In this third segment of the series on certainty in the taxation of digital economy players in Nigeria, we have analyzed the current complexity in the new approach to tax compliance and audit of the NRCs in the country. We reckon that the current uncertainty in the taxation of NRCs in Nigeria, will be more pronounced when NRCs operating in the digital economy space join the fray from 2021 year of assessment (based on operating results for 2020 calendar year).
Tax compliance in Nigeria
Section 55(1) of the Companies Income Tax Act requires every company deriving income from Nigeria, whether or not the company was granted exemption from incorporation or taxation in the country, to file annual income tax returns with the FIRS. The law requires the companies to file duly completed and approved self-assessment forms, tax computations showing computation of taxable income and capital allowances (among others) and audited financial statements with the FIRS, not later than six months after each company's accounting year end date.
The above provision is also applicable to NRCs in Nigeria. By 2014, after the Circular was issued by the FIRS, directing all companies to comply, NRCs started to prepare properly audited financial statements to cover Nigeria's operations.
However, since most NRCs have operations in multiple jurisdictions, it is therefore not unexpected that the companies resulted to allocation of expenses to different Permanent Establishments (PEs) where such financial statements are required. The financial statements are nothing but subset of the audited financial statements of the NRC's legal entity. This implies an internal allocation of expenses to different jurisdictions (including the PE in Nigeria) in order to determine the profit for each affected jurisdiction. There were also significant issues relating to capital allowances especially where the fixed assets are highly mobile and are being put to use in multiple jurisdictions within a reporting period. For instance, it is not impossible to find an oil rig working in two jurisdictions during a calendar year. The question then arose as to how to compute and allocate capital allowances especially for the travelling period especially where the tax law in each jurisdiction clearly provides how such cost should be treated for tax purpose. Nevertheless, the NRCs had to comply with the law and filed tax returns as stated earlier.
However, before we share our experience in respect of audit of the NRCs in the last few years, we prelude this with a review of the economic situation in Nigeria. The significance of the economic situation further illustrates the unnecessary complexity introduced into the taxation of NRCs in Nigeria, thereby raising the level of uncertainty. The current COVID-19 pandemic is not expected to lighten the situation in nearby future.
Economic recession – 2016 to 2019
Nigeria is a mono-product economy. The country is basically dependent on revenue from oil and gas. Any shock in oil prices therefore significantly impacts the economy. Nigeria experienced major shocks from two angles in 2015 and 2016. There was a change of political power where a new political party took over at the national level.
Simultaneously, there was a change of guard at the national level in the United States of America (USA). Former President Donald Trump was sworn in on 20 January 2016 as the 45th president of the country, which also happens to be the largest importer of crude oil in the world and Nigeria as well. The former President however made a major change in its economic policy by pursuing more nationalistic one, rather than globalization. This created a glut in the international oil market and price of crude nosedived. The price fell from all time high of US$110 per barrel pre-2015 to all time low of sub-$30 in 2016 and 2017. Most companies operating in the oil and gas sector reported unexpected losses. Nigeria's economy took a downward plunge and entered into a recession in more than two decades.
It was in the midst of this crisis that COVID-19 arrived the global scene in late 2019 to early 2020. Most economies all over the world suffered recession and Nigeria was not left out. Nigeria entered economic recession for the second time within five years.
Nigeria had no choice than to forcefully look at alternative sources of funding the annual budget. This led to the introduction of the regime for the taxation of players in the digital economy. The Minister of Finance, Her Excellency Zainab Ahmed, signed the Income Tax (Significant Economic Presence) Regulations 2020 into effect. The Regulations only gave effect to the new modality for filing income tax returns by the NRCs, but did not materially alter the basis as explained earlier.
Audit of NRCs income tax returns
From 2014 tax year, NRCS have started filing income tax returns based on the new modality stipulated by the FIRS. However and possibly coincidental, most of the income statements filed by the NRCS were nothing but net tax losses from operations. The losses were too obvious to be ignored since they reflected the economic situation in the country. Where some were able to show taxable profit, the profit levels were significantly below the hitherto 20% deemed profit rate. Thus, since most of these companies would have suffered WHT at source, usually at 5%, they were in net refund position. Some NRCs have even filed for refund of WHT suffered at source based on Section 23 of the FIRS Establishment Act (2007).
By 2019, FIRS had commenced the transfer pricing audit of the accounting and tax records of the NRCs. FIRS basically disagreed with the net loss position shown by the NRCs in their annual income tax returns. In one instance, rather than perform further review, FIRS assessed an oil service companies to income tax at the erstwhile effective tax rate of 6%. The companies objected, but FIRS insisted, and the issue was referred to the Tax Appeal Tribunal (TAT). The Tribunal ruled in favour of the taxpayers and directed FIRS to revisit the audit exercise. The Tribunal held that while the FIRS have the power to re-assess taxpayers to additional taxes if it has doubts about the level of profit disclosed, it can only do so after conducting a comprehensive review of the taxpayers records to ascertain the true and correct position. Consequently, FIRS commenced detailed audit of NRC's tax and accounting records.
Some of the major issues that arose from the tax audit exercise are as follows:
- Profit level – In most instances, FIRS do not agree with the audited financial statements of NRCs indicating net tax loss. It is their inherent belief that NRCs cannot continue to operate in Nigeria if it is not earning decent level of profit. They therefore intuitively rejected the audited financial statements.In order to attribute reasonable level of profit to the NRCs, FIRS conduct benchmark studies to obtain expected profit rates from companies operating in comparable circumstances. In some other instances, FIRS also assume that the profit declared at the group level for each NRC should be adopted. If either is higher, FIRS usually try to assess the PE operations of the NRC to tax using the higher profit rate. One of the indications of the final profit rate adopted is that the resulting tax rate should not be lower than the WHT suffered at source by the affected NRCs. This, in their view, will at the minimum prevent a case for tax refund, if the company is not expected to make additional cash payment to the tax authority. It should be noted that this approach is usually resisted by most NRCs, therefore resulting in elongated discussion and negotiation in order to conclude the exercise without resulting to litigation.
- Expenditure re-allocation – Another approach adopted by FIRS is to question the basis of expense allocation. They not only queried the allocation keys, but also challenge the allocation of certain expenses to Nigeria's PE. In some instances, they try to impose tax on the expenditure by seeking to establish if the payment beneficiary triggers a fixed base in Nigeria in the course of providing the service.
- Grant of capital allowance – Another major issue is the grant of capital allowance. The income tax law permits only the owner of a fixed asset to claim capital allowance on the amount incurred to acquire the asset. However, in reality, since most Nigeria PE's use assets of related parties in Nigeria, FIRS has been thrown into double dilemma. Whilst it is undeniable that the assets contributed immensely in earning the taxable income, FIRS is not able to grant capital allowance to the company since one of the conditions precedent for the grant of the allowance is absent.
Way Forward
The issues raised above would be more complicated when the NRCs that are operating in the digital economy commence to file their income tax returns from 2021. The level of uncertainty will exacerbate. It is therefore in the collective interest of all stakeholders that the FIRS revisit the modality for filing income tax returns by NRCs. We have made some suggestions in part four (final installment) of this series.
Tayo Ogungbenro is a Partner in the Tax, Regulatory & People Services Division of KPMG Advisory Services in Nigeria. Victor Adegite was an Associate Director in the same Division and this article was completed before his demise. It was probably the last one he prepared the draft. He will be sorely missed. The opinion expressed in this article however remains that of the authors.
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.
