Redefining revenue: The new derivation principle in VAT distribution

BY NOJEEM YUSUF

Two sets of tax bills supposedly drafted by the Presidential Committee on Fiscal Policy and Tax Reforms, which could significantly alter the distribution of Value Added Tax (VAT) revenues among Nigeria’s federal, state, and local governments, have been made public.

Current VAT revenue distribution

Under current law, VAT is allocated in a 15%, 50%, and 35% split to the Federal Government, State Governments (including the Federal Capital Territory), and Local Governments, respectively. For the portion attributable to State Governments (and perhaps Local

Governments), states retain 20% of the VAT revenue collected within their borders. 30% of the VAT is distributed based on the population of the states, while the remaining 50% is shared equally among all states. However, this formula lacks consideration for the principle of derivation, leading to perceived inequities where regions contributing more to VAT might not receive proportional benefits.

Introduction of the derivation principle

Under the new proposal, the distribution would shift to 10%, 55%, and 35% for the same respective tiers, with a critical twist: 60% of the VAT revenue would be distributed based on derivation. This means that where VAT is collected becomes as crucial as the amount collected, potentially favouring regions where consumption activities are concentrated.

The introduction of the derivation principle seems aimed at dissuading states that contribute more to the VAT pool from pushing for the administration of VAT to be handled by State Governments. A few years ago, Rivers State and Lagos State took legal action regarding this matter, which appears to have been temporarily settled through political means.

Implications for businesses and tax administration

For businesses, this principle introduces a new layer of complexity. This shift will compel businesses to trace their VAT collections to specific states and local government areas (LGAs), necessitating upgrades to enterprise resource planning (ERP) systems for accurate data collection. Federal Inland Revenue Service (FIRS), possibly soon renamed Nigeria Revenue Service (NRS), will require a sophisticated electronic system to manage this complex VAT administration.

Preparation and transition

A transitional period, possibly two years, might be necessary to allow businesses and tax authorities to adjust to these changes. Immediate implementation could lead to administrative failures and financial burdens on businesses, which might need to invest in technology and additional staff for compliance.

Navigating the complexities of VAT source determination

Determining the source of VAT could become a conundrum. For instance:

•     VAT on Imports: Imagine a scenario where a manufacturer imports raw materials through Lagos, but sells finished products across Nigeria. The VAT initially collected in Lagos for imports, plus differential VAT on sales, must now be attributed to where the final consumption occurs, not where the import was cleared. There’s also a bias towards port locations; for example, if a resident of Kogi State imports a car through Lagos for personal use, the import VAT would be remitted at Lagos port, while the actual point of final consumption i
•     Service-Based VAT: Consider Jaiz Bank, headquartered in Abuja, which pays a cybersecurity firm for services protecting its network nationwide. Here, the VAT paid cannot simply be allocated to Abuja; it needs to reflect where the cybersecurity service benefits, which might be all over Nigeria.
•     Telecommunications: With subscribers moving across states, how does a telecom company determine which state’s VAT pool a call or data usage contributes to?

These examples highlight the need for detailed administrative guidelines to simplify what could otherwise become an administrative quagmire. Even with the introduction of guidelines,one might intuitively anticipate that compliance with and administration of VAT will become more challenging than ever before under the proposed system.

Need for transition and flexibility

The implementation of such a system demands a thoughtful transition. Suggesting a two-year adjustment period would allow businesses time to budget for the additional compliance cost, and adapt their systems and for the FIRS/NRS to develop the necessary infrastructure for accurate VAT distribution. Moreover, extending VAT return periods from monthly to quarterly could provide businesses with the breathing room needed to comply with these new and extensive requirements. This proposal implies that VAT revenue would be collected only four times a year instead of twelve, which might make this option less appealing to the government.

Compliance and trust

Without clear repercussions for non-compliance, there’s a risk that both the FIRS/NRS, and businesses might not prioritise the precise allocation of VAT to specific states or LGAs. Therefore, I hope that the new legislation or any subsequent rules will include punitive measures for non-compliance, alongside incentives for those who adhere strictly to the eventual VAT distribution guidelines.

Moreover, state and local governments might harbor skepticism regarding the commitment of

FIRS/NRS to accurately distribute VAT according to the derivation principle. To address this, establishing a transparent mechanism, possibly facilitated by the Federal Accounts Allocation Committee (FAAC), could provide assurance that VAT revenues are indeed distributed in alignment with the derivation principle. However, this might not completely eliminate skepticism, but it would provide a central administrative body to address concerns from state and local governments. Additionally, there is a need to create a mechanism for swift dispute resolution regarding VAT allocation issues. Will we then burden our already overstretched courts with these matters?

Addressing pushbacks

Resistance to the derivation principle in VAT distribution has surfaced from several quarters. A primary concern is the “headquarters effect,” where VAT collected might unfairly favour states with a concentration of corporate headquarters. This could skew benefits towards these states, even if the actual consumption of goods or services occurs elsewhere. However, the proposed administrative framework seeks to address this by ensuring VAT is attributed to the point of consumption, not just where headoffice of the VAT collector is located.

Another key issue worthy of note is the potential neglect of states or LGAs that produce goods for national or international markets, especially if those goods are VAT-exempt or VAT is paid at a point distant from production. Critics argue that this principle might not adequately recognise the economic contributions of these areas. I personally do not believe compensating the economic contributions of these areas, through VAT, is a priority. To illustrate this point, consider a scenario where an individual in Nigeria imports a luxury car, like a Rolls Royce, from the UK. The UK does not impose VAT on this export, but Nigeria levies VAT upon import. Should Nigeria then compensate the UK for its role in manufacturing the car merely because it was produced there? Similarly, when cattle from Borno are sold and eventually consumed as beef in restaurants in Calabar, where VAT is collected, Borno should not receive compensation simply because the cattle originated there. The derivation principle focuses on rewarding where VAT is effectively paid, not where goods are produced.

While derivation does not directly compensate the ‘producing’ states and LGAs for their economic contributions, other yet-to-be-defined parameters determine the distribution of the remaining 40% of the VAT revenue allocated to state and local governments. I suspect this remaining 40% might be distributed akin to the pre-derivation formula (e.g., 20% shared equally and 20% based on population). This approach ensures that even regions less engaged in VATgenerating activities are not completely sidelined in the revenue-sharing formula.

Conclusion

The introduction of the derivation principle in VAT distribution is a bold step towards fiscal equity but comes with its share of challenges. As Nigeria moves forward with these tax reforms, balancing administrative feasibility with the intent of fair distribution will be key. This reform could not only transform how revenue is shared but also how businesses operate within the country, making transparency and adaptability more crucial than ever.

Yusuf writes from the United Kingdom.