5 tax issues that could cost the Financial Services Industry a lot of money
A lot has been happening in the tax space. Maybe not a lot of it has happened in the financial services industry; but it is only a matter of time. Here are five tax issues that we think business leaders in the financial services (FS) industry need to consider and prepare for, because as they say: “it is best to learn from the follies of others”.
Tax exempt income and attributable expenses
We spent a good number of days this year trying to keep the Federal Inland Revenue Service (FIRS) out of a client’s pockets.
The client was being audited and the FIRS was asking for a big cheque running into billions of naira. One of the issues in contention was this: The client entity had tax exempt income streams, as well as taxable income streams; the FIRS believed the entity was using some of the expenses incurred in generating the tax exempt income to reduce the profits (and hence income tax due) from the taxable business.
In essence, the FIRS was making the argument that tax deductions should not be made for expenses that are attributable to income that is not taxable. This argument has a basis in law since the Companies Income Tax Act (CITA) only allows taxpayers to take deductions for expenses that have been incurred for the production of taxable profits. While this case did not involve a financial services company, it is an issue FS players should begin to think seriously about. Before now, it was hard to imagine that the FIRS would raise such issues.
This experience has shown that it is a real possibility. The question for many companies in the FS industry is whether they have properly attributed expenses to their tax exempt income streams or whether they are guilty of deducting expenses related to exempt profits against taxable profits. If business leaders have never considered this to be a serious risk, now would be a good time to reassess.
We managed to work out a good defence for this client; but not everybody will be that lucky. The trick is to start to prepare on time.
Do you have an approval from the Minister of Finance?
This question came from the FIRS during a recent tax audit. It caught a client entity off guard. The company (a Nigerian company) had provided management services to another related Nigerian company.
The FIRS had refused the recipient company a tax deduction for the charge and was asking for 32% (income tax plus tertiary education tax) of the amount as additional tax. The reason? The recipient company did not have an approval for the management fee from the Minister of Finance. Before now, companies would never get this type of query from the FIRS for a management fee charged between two Nigerian companies.
Not that this provision of the law was new, it was just that the FIRS had never applied it to a transaction involving two Nigerian companies. In the past this section was only applied to management fees from abroad. If you got a National Office for Technology Acquisition and Promotion (NOTAP) approval for the fees however, you were deemed to have satisfied the requirement of the law.
The lesson here is that more and more people at the FIRS are reading the law; and reading it well too. Nigerian groups that operate shared service centres or have domestic head offices charges will need to take this one seriously.
It is better to look into this now before the FIRS comes knocking with an assessment.
Appropriate allocation of outbound charges for head office and other support services
Pareto’s principle indicates that 80% of problems or success will come from only 20% of the possible sources. Business leaders would have probably seen this play out over and over again; those handful of employees that drive 80% of profits; those 20% of branches or subsidiaries that create 80% of the group’s problems; and the list goes on. Many group or head office staff with oversight for non-Nigerian operations and other subsidiaries will admit that dealing with a number of the smaller businesses takes up an inordinate amount of their time and efforts. But when it is time to charge for the services of the group or head office, what happens?
Are, say, 80% of the group’s costs charged to these businesses? Chances are they aren’t. Very little, or nothing at all is charged; after all, the businesses are just growing and the group does not want to wipe out what little profits the subsidiaries have to show with these group charges.
This makes perfect sense from a business perspective, but not from the perspective of the FIRS. The FIRS wants a charge out of those costs so that more profits are shown in Nigeria and of course more taxes are paid. But is charging only a small portion of the costs completely inappropriate? Not necessarily.
Even in transactions between independent parties, Pareto’s principle comes into play. Many independent consultants point out that their lesser paying jobs sometimes take up a disproportionate amount of their time; and they have to live with it. With some careful thought, group companies in this situation can build a good case to justify their decision to charge only the costs that these fledgling businesses can afford to pay. Depending on the materiality of the costs however, these groups may have to brace for a long fight with the FIRS.
Nigeria Stock Exchange (NSE) rules on interested party transactions
This one is a bit tricky and it usually comes as a surprise to most CFOs during our discussions. More often than not, they’ve never heard of this rule before. Some of the questions they ask include: What do the rules require? Who is supposed to comply? When did the rules come into effect? These are the easier questions to answer. The rules came into force in November 2014. They apply to listed companies (issuers). An issuer is required to get an approval from its shareholders in order to enter into recurring transactions with interested parties (defined as a controlling shareholder, CEO, directors, or any person related to these people). The idea is to protect the interest of the minority shareholder by ensuring that the people that run or control the company do not ship out all the profits before it’s time to distribute dividends. As part of the process, the issuer is required to obtain an opinion from an independent financial adviser. The opinion should confirm that the policies and procedures adopted by the issuer for the transactions with interested parties will give rise to commercial results and will not be detrimental to the interest of the issuer and minority shareholders. To the tricky part: what happens if the issuer does not comply? There is nothing specific in the rules that addresses this but some corporate lawyers will argue that that the penalty could be anything from having to pay a few hundreds of thousands of Naira, to being delisted (assuming the NSE one day starts to take this seriously). These views are from the application of some of the general penalty clauses that can be found in the NSE’s listing rules. And there could be other angles to this. What if the Financial Reporting Council of Nigeria (FRCN) wades in? What if the argument is that a defaulting issuer cannot record the transaction because the NSE rules have not been followed? What if, following the same logic, the FIRS argues that the charges are illegitimate and disallows them? What if there are disgruntled shareholders and the matter becomes publicised? How will the case be tried in the court of public opinion? With matters like this, compliance could just be the cheaper option.
Country by Country Reporting
Have business leaders considered a situation where the FIRS could see all the profits that Multinationals (MNEs) report in all the different countries where they operate? Let’s paint a scenario. Imagine a colleague who you strongly feel should not be on the same pay grade as you because he does not work as hard or deliver half as much as you do. Now imagine you one day realise that he earns nearly twice as much as you? What would you do? Most people would either resign; or demand for a pay raise. Similarly, information on profits made by MNEs in other countries could make the FIRS ask for more. The FIRS plans to introduce Country by Country Reporting (CbyCR) legislation that will give it this type of information. MNEs with headquarters in Nigeria will have to submit data for all the countries where they operate. This data will include: number of people, revenues, value of assets; and profits (amongst other things) in each country For those with headquarters outside Nigeria, the FIRS could get this data from the tax authorities of the country where the headquarters is located. Alternatively, they could ask the Nigerian subsidiary to provide the information. CbyCR will typically apply for large MNEs with group turnovers in excess of 750 Million Euros. A number of proactive MNE groups are already assessing what CbyCR will mean for their business through simulations and test runs. Their observations are quite informative. Many of them agree that it is time consuming and that it takes a lot of effort to collate the data. They also think they will need to make changes to their IT systems to be able to generate some of the data required. Some groups found the results of their analysis alarming and could quickly see why any tax authority presented with the data would suspect foul play. Most of the outbound MNEs in Nigeria are from the financial services industry and many of them will be required to comply with CbyCR regulations. The smart thing to do now is to prepare and be ready.
The current thinking is that tax is the new oil. The FIRS’ revenue targets are ambitious and there is a lot of pressure for the budgeted collections to be realised even though there have been significant shortfalls to date. If companies in the FS sector are not mindful, they could end up being unwilling (and unpaid) financiers of this “FIRS budget deficit”. The FIRS is not pulling any punches in the bid to increase tax revenues. Businesses outside of the financial services industry are witnesses to this already. You don’t need a soothsayer to know that the focus will soon shift and it could be the financial services industry next. With tax matters, a lot depends on getting the right advice on time and acting on it quickly. Players in the financial services industry should start considering the extent to which the above matters could impact them… the clock is already ticking.