Intra-related transactions – transactions between related parties or associated enterprises – are a common practice in the globalization of trade. These transactions apply to a parent company and a subsidiary, or two or more companies controlled by a common parent (directly or indirectly and whether or not legally enforceable). When said parties establish a price for the above transactions, they are engaging in Transfer Pricing (TP).
TP can be considered to be the most significant tax issue emerging from globalization confronting tax administrations worldwide. This is because related companies are more concerned in their income as a whole rather than as individual corporations, and as such, there is likelihood of manipulating the transfer price by taking advantage of the loopholes in the tax system. As a result, income reported from intra-related transactions decreases. Hence, revenue collection also decreases. And so transfer pricing may really be called transfer mis-pricing!
Please note, however, that decrease in the transfer price should not at all times be attributed to manipulation by the related parties. The Organisation for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines provide that the tax administrators should not automatically assume that associated enterprises have sought to manipulate their profits as they may truly experience difficulty in accurately determining a market price, in the absence of market forces or when adopting a particular commercial strategy. OECD TP Guidelines are the motherhood guidelines after which most, if not all, TP guidelines of different jurisdictions have been patterned.
By way of addressing the TP issues, a standard for TP between or among associated enterprises has been recognized. In international language, this is called the Arm’s Length Principle. This requires the transaction with a related party to be treated as a transaction with an independent party. For example, if trading would be made by unrelated parties, a market price would generally result. Market price (also known as the arm’s length price) is a product of genuine negotiation. Such price should also be the price for intra-related transactions.
Just recently (or maybe belatedly), the Philippines, through the Secretary of Finance officially issued Revenue Regulations No. 02-2013 (RR No. 02-2013) that cover the guidelines in applying the arm’s length principle for TP.
Scope – RR No. 02-2013 applies to cross-border and domestic-related party transactions. The Bureau of Internal Revenue (BIR) recognizes that while the TP typically applies to cross-border transactions, it can also occur in domestic transactions. Accordingly, there is a domestic TP issue when income is shifted in favor of a related company that has special tax privileges, such as enterprises registered with the Board of Investments or Philippine Economic Zone Authority. This also applies when expenses of a related company with special tax privileges are shifted to a related company subject to regular income taxes. Simply put, a TP issue arises when income or expenses are transferred to a related party in order to minimize tax liabilities for the group.
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Methods to be Used – RR No. 02-2013 states that the most appropriate of the TP methods under the OECD TP Guidelines can be utilized. Whichever method that produces the most reliable results, taking into account the quality of available data and the degree of accuracy of adjustments, should be the one to use. The methods are as follows:
• Comparable Uncontrolled Price Method
• Resale Price Method
• Cost Plus Method
• Profit Split Method
• Transactional Net Margin Method.
The use of the methods will provide a number of comparables companies/transactions for the related-party transactions.
Allocation of Income and Deductions – RR No. 02-2013 also recognizes the authority of the Commissioner of Internal Revenue (CIR) to make TP adjustments. The CIR’s authority to distribute, apportion, or allocate gross income or deductions between or among related parties is pursuant to Section 50 of the Tax Code which aims to ensure that taxpayers clearly reflect income attributable to related-party transactions and to prevent the avoidance of taxes with respect to such transactions.
Optional Remedies – RR No. 02-2013 provides for optional remedies for taxpayers engaged in cross-border transactions with related parties located in tax jurisdictions having tax treaties with the Philippines. Accordingly, an Advance Pricing Arrangement (APA) may be entered into between the taxpayer and the BIR to determine in advance an appropriate set of criteria (e.g. method, comparables, and appropriate adjustments thereto) to determine the transfer prices of controlled transactions over a fixed period of time. The use of APA by taxpayers reduces the risk of TP examination and double taxation.
On the other hand, if a taxpayer does not choose to enter into APA and its transactions are subject later on to TP adjustments, it may still invoke the Mutual Agreement Procedure (MAP) provided in the tax treaties. The MAP is a means under the tax treaties, together with other tax jurisdictions, through which tax administrations consult each other to resolve disputes regarding the application of these tax treaties. It is also a mechanism for eliminating double taxation issues arising from TP adjustments.
Separate guidelines will be issued for the availment of the APA and MAP.
Documentation Required – Under the said regulations, taxpayers should be able to prove that efforts were exerted to determine the arm’s length price for related party transactions. Such proof is by way of documentation. The taxpayers are to maintain adequate documentation for purposes of:
• defending their TP analysis
• preventing TP adjustments arising from tax examinations
• supporting their applications for the MAP.
Documentation, however, is not required to be submitted upon filing of tax returns. However, it should be retained by the taxpayers within the period provided under the Tax Code. It should also be submitted to the BIR when required or requested to do so.
Further, the documentation should be contemporaneous (existing or is brought into existence at the time the related parties develop or implement any arrangement that might raise TP issues or review these arrangements when preparing tax returns).
Effectivity – RR No. 02-2013 will take effect after 15 days following publication in a newspaper of general circulation. Considering that said RR was published in Manila Bulletin on Jan. 25, 2013, therefore it should take effect on Feb. 9, 2013.
Now that the TP regulations are in place and will nearly come into effect, the BIR may have to issue circulars clarifying matters regarding the implementation of RR No. 02-2013. These clarifications become necessary since various concerns have been raised. Here are some of the most common concerns:
1. Are taxpayers required to have a TP study? Presumably, yes, as the taxpayers are required to retain said documentation. (Although said documentation is not required to be submitted). What will happen if during the TP audit, no documentation has been submitted by the taxpayer?
2. Regarding TP audit, will the TP examination have its separate auditing procedures just like the VAT audit program? Or will it be part of the regular audit since the issues covered by TP pertain to income tax. And will the TP adjustments impact also other tax types (e.g. VAT)? From which taxable period will the TP examination/audit be pegged?
3. Concerning the TP adjustments, are the taxpayers required to amend their returns after said adjustments? Under which item in the financials will the adjustments be lodged?
4. It is stated that the TP documentation is contemporaneous, that is, if it exists or is brought into existence at the time the associated enterprises develop or implement any arrangement that might raise TP issues. Are related parties required to have TP documentation for the arrangements concluded prior RR No. 02-2012 but are still standing?
5. How could RR No. 02-2013 impact the industry standard set in the benchmarking of taxpayers under Revenue Memorandum Order (RMO) No. 005-2012? RR No. 02-2013 in way, also set an industry standard. But one possible scenario is when comparables for intra-related party transactions arrived at under RR No. 02-2013 are not confined locally and, therefore, not included in the entities used by the BIR for benchmarking under the said RMO No. 005-2012.
Well, more of these can be expected to arise in the absence of a more detailed guidelines implementing RR No. 02-2013. The primordial concern here is that no room for subjectivity shall be left to either the BIR or to the taxpayers in interpreting RR No. 02-2013 because otherwise, the noble objectives of the new regulations to manage the opposing interests of both parties will not be achieved.
Rey T. Llesol is a supervisor from the tax group of Manabat Sanagustin & Co. (MS&Co.), the Philippine member firm of KPMG International.
This article is for general information purposes only and should not be considered as professional advice to a specific issue or entity.
The view and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG International or MS&Co. For comments or inquiries, please email firstname.lastname@example.org or email@example.com.