The rise of the digital economy and its peculiar tax challenges have been a matter of intense debate for some years now. International tax has typically revolved around the concept of residency rather than source. This has limited the ability of countries to generate tax revenue from these transactions even though the participants generate significant revenue from these countries.
Companies transact with users across various jurisdictions online but do not pay tax in any of these countries as they do not have any physical presence (commonly called “permanent establishment”) in those countries.
This has subsequently led to the call for a review of the concept and basis of international taxation. The Organization for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) Action Point 1 is dedicated to this issue.
The Finance Ministers of the G-20 mandated the Inclusive Framework on BEPS, through the Task Force on the Digital Economy (TFDE), to come up with a report which contains long-term solutions to the impact digitalization has had on nexus and profit allocation rules.
The TFDE has come up with an interim report, Tax Challenges Arising from Digitalisation, which sets out three proposals to address the issue. They include the “user participation” model, the “significant economic presence” model and the “marketing intangibles” model.
These proposals are still under deliberation with a final report expected in 2020. However, due to concerns about the length of time it has taken the TFDE and the G-20 to come up with a final report, a number of jurisdictions have gone ahead with making amendments to their own tax rules to allow for the taxation of the digital economy.
Nigeria recently passed amendments to its tax rules, which allow for profits of a nonresident company (NRC) to be deemed to be derived from the country “if it transmits, emits or receives signals, sounds, messages or data of any kind by cable, radio, electromagnetic systems or any other electronic data storage, online adverts, participative network platform, online payments and so on, to the extent that the company has significant economic presence in Nigeria and profit can be attributable to such activity.”
The amendments also extend the concept of significant economic presence (SEP) to include transactions outside the digital economy, through the introduction of a provision which states that profits would be deemed to be derived from the country “if the trade or business comprises the furnishing of technical, management, consultancy or professional services outside of Nigeria to a person resident in Nigeria to the extent that the company has significant economic presence in Nigeria and profit can be attributable to such activity.”
This article focuses on the challenge that the extension of the amendments to include transactions which may not qualify as part of the digital economy would generate both for the tax authorities and for NRCs which may be impacted by it.
What is Significant Economic Presence?
The amendments do not define what will constitute SEP, as this is delegated to the Minister of Finance (MOF), who is yet to do so as at the time of writing (January 2, 2020). If we consider the SEP proposal referred to above, the concept is generally related to revenue and the value of revenue generated in a particular jurisdiction.
However, revenue is not the only consideration. The SEP proposals state that revenue generated on a sustained basis is the basic factor but such revenue, in isolation, would not be sufficient to establish nexus.
Revenue would have to be considered in conjunction with one or more other factors to establish a nexus for tax application. The other factors proposed include the following:
- the existence of a user base and the associated data input;
- the volume of digital content derived from the jurisdiction;
- billing and collection in local currency or with a form of payment;
- the maintenance of a website in a local language;
- responsibility for the final delivery of goods to customers or the provision by the enterprise of other support services such as after-sales service or repairs and maintenance;
- sustained marketing and sales promotion activities, either online or otherwise to attract customers.
It is debatable whether any of the factors listed above would apply to an NRC providing technical, management, professional or consulting services wholly offshore and whether the MOF will focus on revenue as the sole criterion for determining SEP for these services. If that is the case, will we have two definitions of SEP, one for the digital economy and one for this type of services?
SEP and Tax Application
It is also important to consider how the definition and establishment of an SEP may interact with the application of tax on the revenue earned. The amendments to the Nigerian tax code provide that “any withholding tax applicable under Section 81 of this Act shall be the final tax on the income.” This is understandable as it is easier to require the Nigerian beneficiary of a service to deduct the tax due on the transactions rather than wait for entities which do not have any physical presence in the country to self-account for the taxes.
The tax authorities also only have direct access to the books of the Nigerian recipients so they can easily confirm that that appropriate tax base has been reported (it is possible to request information from the tax authorities of the country where the service provider is resident).
However, it is just not that straightforward. Withholding tax (WHT), as contemplated under Section 81 of Nigeria’s Companies Income Tax Act (CITA), is a transaction-based tax deducted on all payments made for qualifying transactions. The SEP proposals refer to “revenue generated on a sustained basis” which indicates that the quantum and consistency of the revenue generating activity may be a factor.
This will create a challenge if Nigerian recipients are expected to deduct tax on every payment, as they may be unable to independently determine when the SEP threshold has been reached. We may, therefore, have NRCs suffering WHT on all payments for those services regardless of whether they meet the SEP threshold as Nigerian recipients may be wary of the potential penalty for non-deduction where the threshold is subsequently attained.
SEP and Potential Tax Refunds
This issue could be resolved easily with the existence of a simple and straightforward refund mechanism, but how many would describe the Nigerian system as such?
The current mechanism allows for refunds to be granted upon conclusion of a tax audit exercise conducted by the tax authorities. These refund audits typically extend beyond the coverage of the particular tax and years for which a refund is requested. NRCs with no physical nexus in the country may, therefore, be required to submit their books for review by the Nigerian tax authorities before they can be granted any refund.
The NRCs may soon find out that the cost of such audits (financial and otherwise) as well as the time required for their conclusion may outweigh the value of the refund.
Refunds will not only arise where deductions are made on payments to companies, which subsequently do not meet the defined SEP criteria. The Section, which introduces the concept of SEP in relation to these transactions, states that “the profits can be attributable to such activity.” WHT is computed on revenue, not profits.
It is therefore possible that the NRC’s margins are less than the rate of tax deducted on its revenue putting it in a loss-making position. Therefore, in the absence of profits, should the NRC still be liable to pay tax in the country?
The amendments do not appear to contemplate a scenario where NRCs can file returns at the end of the year if they deem it necessary and reconcile their actual profits and tax payable position in the country with the quantum of withholding tax suffered. It is likely that most NRCs will treat this WHT as an additional cost of doing business which will be passed on to the Nigerian consumer.
It is ironic that BEPS Action Point 1 and the TFDE’s interim report also considered the application of a WHT on payments to NRCs for goods and services. However, the WHT suggested is meant to be an advance payment of income tax, with the NRCs still expected to compute actual tax due on profits and file returns at the end of the year. A modified deemed profit approach (which is not unusual in Nigeria) was suggested as the basis for determining actual tax payable based on profits.
BEPS Action Point 1 and the TFDE report also suggested that the rate of WHT is made low. Technical, management, consultancy and professional services provided by an incorporated entity attract the highest rate of WHT in Nigeria today—so is this something we may need to reconsider?
SEP and Double Tax Treaties
There is also the issue of the interaction of this amendment with the provisions of the existing double tax treaties (DTTs) on permanent establishments (PE). The DTTs contain provisions which determine the scenarios under which an entity resident in a contracting state would be deemed to have a PE in the other contracting state. The DTTs typically take preeminence over local tax codes where there are conflicts, so does that mean that this will not apply to companies resident in countries with a DTT with Nigeria?
The smart answer should be yes, but it is also important for this matter to be clarified so that businesses can properly plan.
The Nigerian government may need to amend the provisions of the current DTTs where it intends to extend the coverage of this provision to cover entities resident in a jurisdiction with which Nigeria currently has a DTT. This will require the buy-in of treaty partners, and underscores the importance of a unified approach in tackling this issue.
Definition and Classification of Services
Finally, there is the issue of how each of these services would be defined.
Technical, management, professional and consulting services are very broad categories and several items can be grouped into any of these categories. The definition of what can fall under these categories has always been a matter of dispute at audits conducted by the various tax authorities.
These categories currently attract a higher rate of WHT so there is always the potential for conflicts on what should and can qualify. Some of the cases include the provision of security and cleaning services (which has been argued would fall under professional services) or the provision of repairs and maintenance services (which some have argued is a technical service).
The tax authorities had, in the past, attempted to clarify what may constitute technical services (FIRS Information Circular 2006/02), by stating that “the use of industrial machinery/equipment to carry out a service does not render it Technical because the industry position requires that only arrangements that involve a transfer of technology should be classified as Technical.”
It is unlikely that an NRC providing services to a non-related Nigerian company on ad hoc basis would be looking to transfer technology to that Nigerian company. Is there very little likelihood that any of the services provided by an NRC offshore would be classified as technical services? Your guess is as good as ours.
A Nigerian court has ruled, in the past, that opinions issued by the tax authorities are at best advisory and do not carry the force of law. They are therefore not bound by those opinions.
Also, what is the basis for the “industry practice” referred to in the opinion offered? Which industry exactly are they referring to, or those that apply across all industries?
The tax authorities also clarified in the same document that “these are specialized services rendered by persons with the required knowledge and skills.” The problem again is, why would a Nigerian company go offshore to obtain a service that is not specialized and does not require any particular knowledge and skill? So, does this mean all services performed by an NRC will be covered?
There is need for this issue, among others, to be clarified.
Nigeria’s tax code has long needed a review, so it is laudable that the government has finally taken the initiative on this matter.
However, it is important for government to continue to engage companies operating in the country to understand the impact of the review and challenges faced from its implementation, such that steps can be proactively taken to address them in line with government’s stated objective of improving the ease of doing business in the country.
These changes are a step in the right direction, but only just the first step. It is important that subsequent steps consider the issues from the first.
Martins Arogie is Associate Director and Itoro Adediran is a Manager with KPMG Advisory Services Nigeria.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.