Choosing Transfer Pricing Methods: The Case of PPNL, FIRS and TAT

The Tax Appeal Tribunal (TAT) sitting in Lagos, recently ruled in its first Transfer Pricing (TP) case, in favor of the Federal Inland Revenue Service (FIRS) for an additional tax assessment of N1.738,481,875.33 on Prime Plastichem Nigeria Limited (PPNL).

This judgement of the TAT has caused a lot of stir, as stakeholders hold the view that the technicalities of the case were not properly laid out/ discerned before judgement was given, owing most likely to the fact that both the TAT and PPNL’s representatives, are not grounded in the technicalities of Transfer Pricing. The FIRS, on the other hand, has issued a press release alluding to misrepresentation of information by the company and how this action by PPNL indicates that the related party transactions under dispute were not made at arm’s length.

Summary of the case:

The tax suit arose following disagreement between PPNL, a company that engages in the business of trading in imported plastics and petrochemicals, and the FIRS, on the TP documentation filed by PPNL for 2013 and 2014 concerning PPNL’s transaction with a related company, Vinmar Overseas Limited (VOL).

The major point of dispute was that PPNL adopted the Comparable Uncontrolled Price (CUP) in 2013, for determining the arm’s length pricing of its related party transaction and subsequently in 2014, the Transactional Net Margin Method (TNMM) with a Profit Level Indicator (PLI) of Operating Margin (Net operating profits / Operating revenue), while the FIRS insisted that the Transactional Net Margin Method (TNMM) with a Profit Level Indicator (PLI) of Gross Margin (Gross profits / Operating revenue), was more appropriate in the circumstance.

The TAT resolved all issues raised in favour of the FIRS, submitting that “the appeal filed by the Appellant (PPNL) is dismissed in its entirety.”

Choosing a transfer pricing method:

To choose the TP method for determining arm’s length pricing in any related party transaction, the following should be considered: 

  1. Substance of the related party transaction over its form;
  2. The operational models, functions performed, risks assumed, and assets employed by the related parties under consideration;
  3. Availability of comparable data in an uncontrolled transaction. In other words, can one find reliable publicly available data of companies that are not related but engage in similar transactions with each other and have similar operational and functional models as the related parties under review?
  4. Where transactional methods e.g. TNMM are to be applied, availability of independent enterprises that bear close transactional similarities with the related party under review, especially when certain factors that may adversely affect net margins (on which the TNMM is based) are at play. These factors include but are not limited to: 
  • threat of new entrants in the industry; 
  • competitive position; 
  • management efficiency; 
  • individual strategies; 
  • threat of substitute products; 
  • varying cost structures (e.g., the age of plant and equipment); 
  • differences in the cost of capital (e.g., self-financing versus borrowing); and 
  • the degree of business experience (e.g., start-up phase or mature business). 

If there are material differences between the tested party[1] and the independent enterprises that affect the net margins, appropriate adjustments should be made to account for such differences.

When to use TNMM:

When faced with a transfer pricing issue one should always start with considering the CUP method – in the case of PPNL, this method would require the availability of comparable products, imported by an entity from a non-related party. Given PPNL’s industry sector, it is not likely that much reliable comparable data between unrelated parties exist. 

The Cost-plus method would normally be correctly applied to the related party manufacturer. Available information on this case does not show that Vinmar Overseas Limited (VOL) is the related party manufacturer that sells directly to PPNL.

The resale price method can be considered in this situation as resale price is more applicable to related party distributors, which PPNL represents. In applying the resale price method to establish an arm’s length transfer price, the market price of products resold by the related party distributor to unrelated customers (i.e. sales price) is known, while the arm’s length gross profit margin is determined based on a benchmarking analysis. This will entail a search for distributors which perform functions and incur risks comparable to those of PPNL. If, however, due to, for example, different reporting of certain costs between cost of goods sold and operating expenses between the tested party and the comparable distributors, the gross profit margins are materially affected for which no reliable adjustments can be made, because sufficient data about the comparable are not available, it may be better to choose the TNMM. 

The TNMM:

The TNMM is a ‘Transactional method’ of transfer pricing[2] . The TNMM examines the profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realizes from a controlled transaction. The TNMM can be applied on either the related party manufacturer or the related party distributor as the tested party for transfer pricing purposes, but it is recommended to apply the TNMM on the related party that has the least complex operations because generally more comparable data will then be in existence and fewer adjustments will be required to account for differences in functions and risks between the controlled and uncontrolled transactions.

There are 7 Profit Level Indicators (PLI) under the TNMM. A profit level indicator (“PLI”) is a measure of a company’s profitability that is used to compare comparables with the tested party. A profit level indicator may express profitability in relation to (i) sales, (ii) costs or expenses, or (iii) assets. 

The choice of PLI depends on the facts and circumstances of a particular case. Multiple PLIs can also be applied, to test if they all speak to the reliability of the results. If the differences in the results are significant, important functional and structural differences between the tested party and the comparable should be examined. Other factors that do not affect transfer pricing, but adversely affect net margins, as enumerated above should also be considered and proper adjustments made, where applicable.

The TNMM and the PPNL Case:

The two PLIs under contention in PPNL’s case, should, if applied properly as explained above, with reliable comparable data from independent enterprises, give results that speak to the same or similar arm’s length pricing or price range. But in a situation where a cumulative estimated taxable profit adjustment of  N5.3Billion (N1.7Billion grossed up by 32% effective tax rate) is made by the FIRS on the results from another PLI under the same TP method, more work needs to be done to arrive at a reliable arm’s length pricing, either by PPNL or the FIRS.

The following questions beg for answers:

  1. To which of the related parties did PPNL apply the Net Operating Margin PLI under contention, to arrive at its transfer price?
  2. To which of the related parties did the FIRS apply the Gross Margin PLI to arrive at an additional N1.7B tax liability?
  3. Were the functional and transactional analyses properly done to ascertain the real substance of the related party transaction?
  4. Were operating and distribution costs appropriately captured by PPNL?
  5. How credible is the comparable data used by either PPNL or the FIRS. What are the respective sources of comparable data?
  6. Have considerations been given, by the FIRS, to distortions, manipulations and inconsistencies that are associated with accounting categorization of expenses between operating expenses or cost of sales among different enterprises (which may have erroneously been captured as comparable data), which is the chief reason why the gross margin method is not favored in practice?
  7. Have other special factors (mentioned above) that may adversely affect net margins been adequately considered, checked among comparables and adjusted appropriately on the determined transfer price by PPNL?

The answers to these questions would help clear much doubts about the case, if the disputing/ arbitrating parties possess and can apply the appropriate technical and administrative resources to evaluate them.

In conclusion, capable and meticulous resources need to be applied to managing and resolving TP issues. Compliance to TP requirements can be expensive but is nothing compared to liabilities that may arise on TP adjustments when the process of arriving at the arm’s length pricing is faulty. Also, the accounting standards require that financial statements should be transparent, credible and faithfully represent the affairs of the company. Beyond additional tax liabilities and reputational damage, group companies that cut corners in managing/ resolving transfer pricing compliance issues may face accounting inconsistencies leading to sub-optimal decision-making processes, breach of trust with stakeholders and even going concern problems.


[1] The related party in a controlled transaction that is being evaluated for determining the arm’s length pricing. 

[2] The traditional transfer pricing methods include the ‘Comparable Uncontrolled Price’ (CUP), the ‘Cost Plus’ and the ‘Resale Price’ method. While the non-traditional methods are the transactional methods – the TNMM and the Transactional Profit Split Method.