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It is a common practice amongst Financial Technology (Fintech) Companies to have in place inter-company agreements for the use or transfer of IP rights from one related party to another within a Multinational Group (Group).
Conventionally, when an IP (intangible) is internally developed, relevant accounting standards do not permit the recognition of the IP on the Financial Statements for purpose of reporting.
Subsequent to the disposal or acquisition of the Fintech Company, the IP may be recognised in the books of the new owner (Acquirer and oftentimes the Parent Company), who typically gains contractual rights and control over the IP following the acquisition conducted at arm’s length.
However, most Parent Companies often license the exploitation rights of the intangibles back to the Fintech Company or to another associate (usually in a preferred location) within the Group, who then sub-licenses the rights to the Fintech Company. The consideration is usually in the form of “Royalties”.
This arrangement creates a Related Party Transaction (RPT), and therefore royalties allowable would be subjected to Transfer Pricing (TP) regulations.
For TP purpose, there will always be an analysis to review and establish the ownership of the IP based on substance over form. This is often a contentious issue with the Tax authorities.
Legal ownership derived from either the registration of the IP or contractual arrangement will not automatically entitle the holder to a significant portion of the proceeds from the exploitation of the IP. It is considered a passive contribution, which should attract only basic returns or nominal share of the proceeds from the IP, if any at all.
Economic ownership, on the other hand, should entitle the party to a significant portion of the proceeds from the IP. A major consideration introduced by the Organization for Economic Co-operation and Development (OECD), in determining economic ownership is to identify the entity performing the so-called “DEMPE” functions, which stands for Development, Enhancement, Maintenance, Protection, and Exploitation of intangibles.
Hence, these two ownership concepts may not always converge in one party. In other words, it is possible that the Fintech Company transfers its legal ownership of IP in a merger or acquisition deal, but still retains the economic ownership post-transaction or vice versa.
The Nigerian Transfer Pricing Regulation (NTPR) requires that Taxpayers should examine the conduct of each party, and only use the contractual agreement as the starting point; thus, alluding to economic ownership over legal ownership.
Specifically, Regulation 7(1) of the Income Tax (Transfer Pricing) Regulation, 2018 requires that in determination of arm’s length conditions for controlled transactions, in relation to exploitation of intangibles assets, that certain considerations be examined. These include the function performed by the person as well as the management and control of those functions, amongst other factors.
Further, Regulation 7(2) states that: in cases where the contractual arrangements diverge from these factors, “regards shall be taken of those factors in determining the arm’s length reward from the exploitation of the intangible”.
Hence, a functional analysis of the IP arrangement of the Group will accurately delineate the functions performed by the parties, the assets used, and the risk assumed in respect of the DEMPE activities. This topic will be dealt with in details in our subsequent articles.
In essence, this analysis will establish the basis for the determination of the amount of inter-company royalties allowable for tax purpose and the comparability of the licensing arrangement with similar transactions.
3.Other Relevant Consideration
Also, where the economic owner performing the DEMPE function is ascertained, the amount of periodic royalty consideration may still be affected by other factors. Some of these factors include whether the Fintech Company carried out further adaptation, modification, or customisation; or whether the Company incurred other additional expenditures (e.g., Marketing costs) related to the IP that may be deemed to have enhanced the IP value.
In these instances, the economic owner of the original IP may be deemed to have benefited from these investments through increased royalty income from additional returns. Hence, the Fintech Company may require compensation for its investment through either cost reimbursement or adjustment to the royalties payable to the Parent Company.
There may also be other contractual arrangements, for instance, a separate Research and Development (R&D) contract that may be considered in connection with the licensing arrangement; hence, potentially impacting the royalties agreed by the parties.
More so, there may be multiple economic owners within a Group, as well as multiple legal ownership of IP. Further, in practice, there may be multiple classes of IPs in the portfolio of a Multi-product Fintech company that requires separate TP consideration. (These issues are beyond the scope of this article.)
The point here is that, there may be a combination of different factors that will affect the determination of arm’s length remuneration in an IP licensing arrangement. Therefore, Fintech Companies have to review their intra group IP arrangements so as to establish the roles or contribution attributable to the Group members and determine the appropriate royalty rate or licensing fees.
4. Deduction Cap
In Nigeria, Regulation 7(5) of the Income Tax (Transfer Pricing) Regulation, 2018 caps the allowable consideration (royalties) on the transfer of rights in intangible to not more than “5 percent of the Earnings Before Interest, Tax, Depreciation, Amortization (EBITDA) and that consideration, derived from the commercial activity conducted by the person in which the rights transferred are exploited.”
This is a departure from the arm’s length principle advocated by the Regulation itself.
There was no such cap in the Companies Income Tax Act (CITA)-the Principal act, and unlike interest expense, there is no provision to carry forward any excess royalties for deduction in future tax returns. This treatment seems not to be equitable when compared with similar items.
Consequently, Taxpayers are encouraged to challenge the basis of this royalty cap where they are denied tax deductions for legitimate costs that were Wholly Reasonably Exclusively and Necessarily (WREN) incurred in line with the Principal Act. It is noteworthy to state that in the past, similar cap on inter-company loan interest deductions was successfully challenged in the Court of Law.
Nonetheless, Taxpayers can explore the provisions of the double tax treaties, including other legitimate tax planning measures within CITA, to potentially mitigate this adverse treatment.
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