The Bureau of Internal Revenue (BIR) has signaled that it will conduct transfer pricing audits with the promulgation of its Transfer Pricing Audit Guidelines under Revenue Audit Memorandum Order (RAMO) No. 1-2019. The Transfer Pricing Guidelines were issued in 2013 through Revenue Regulations (RR) No. 2-2013.
What can taxpayers expect?
A transfer pricing audit, like any other audit, is definitely not a welcome development for taxpayers. However, we are aware that we will come face to face with this progression sooner or later, and sooner here it comes. It would be best to view it on a positive note and to respond to the certainty by taking appropriate actions and decisions.
RAMO No. 1-2019 provides standardized audit procedures and techniques in auditing taxpayers with related party or intra-firm transactions to ensure a quality audit. While the RAMO is primarily a manual for BIR officers, taxpayers can take valuable insights into and guidance on how to prepare for the audit and avoid transfer pricing adjustments. If commenced at the time the taxpayer gets an audit notification, some preparations require significant lead time which may not be possible to put together within the deadline. The first notice to give information about related party transactions provides a five-day period to comply.
Who are covered and what will be the scope of the audit?
The guidelines will apply to controlled transactions or transactions between related parties where at least one party is taxable in the Philippines. It will cover the sale, purchase, transfer and utilization of tangible and intangible assets, provision of intra-group services, interest payments, and capitalization.
A Philippine branch of a foreign corporation will be treated as a separate entity from its head office for tax purposes. Hence, the transactions of the branch with its head office, as well as with other branches or subsidiaries in the group, shall also be subject to transfer pricing rules.
The BIR has not yet provided thresholds on the extent of control necessary to be covered by the rules. At the most, RAMO No. 1-2019 suggests that companies with shareholders owning more than 25% of the equity or those with related party transactions that are more than 20 percent of the relevant threshold are not deemed independent and should be rejected as comparables for benchmarking.
How will the audit be conducted?
The transfer pricing audit will be governed by the same rules of regular audits. A Letter of Authority (LoA) will also be served. The request for documents can include the following, among others:
a. information about the related party transactions;
b. segmented financial statements;
c. functions, assets, and risks (FAR) analysis;
d. characteristics of the business;
e. comparability analysis;
f. transfer pricing method used;
g. comparables used in applying the arm’s length principle;
h. determination of the fair prices/profits in the related party transactions.
Most information is part of the transfer pricing documentation prescribed in RR No. 2-2013. Other documents and information, including contracts, can be requested in the course of the audit.
Revenue officers are tasked to prepare for the audit by studying the available documents, conducting research, and discussing with the taxpayer to identify issues on which the audit can be focused.
The audit implementation phase involves three major activities: understanding the characteristics of the business and the transactions, selection of the transfer pricing method, and application of the arm’s-length principle.
As in a regular audit, revenue officers will report on their audit, which will include a critique of the taxpayer’s methodology, their analysis, and a determination of the appropriate arm’s-length price based on their analysis.
If the revenue officers find that the price or margin in the controlled transaction is not in accordance with the arm’s-length principle, they will propose an adjustment by imputing the arm’s-length price, margin, or interest rate. For sales of goods and services, adjustments will be proposed if the consideration received is less than the arm’s-length price or if there is no fee charged. For purchases of goods and services, an adjustment will be necessary if the price or fee is deemed excessive.
The revenue officers will discuss their findings and confirm with the taxpayer their agreement with the facts and the issues identified. This phase could be the Notice of Informal Conference (NIC) stage.
Thereafter, the audit should proceed pursuant to the regular rules, including on the remedies available to the taxpayers.
The manual does not mention the penalties applicable on the adjustments. These should, therefore be governed by the general audit rules.
In RAMO No. 1-2019, there are mentions that corresponding adjustments can be requested by the other party to the transaction, referred to as secondary adjustments. For example, an excessive transfer price was disallowance: the RAMO suggests that the seller-affiliate can request to reduce its revenue and, correspondingly, its income tax liability, based on applicable tax regulations. This should be explored by the affected taxpayers operating in the country so that the transfer pricing adjustments can be neutral.
The manual describes in greater detail the transfer pricing methods, their applicability on different types of transactions, the comparability factors that must be considered in selecting comparable companies for benchmarking, and the adjustments that can be adopted to increase the comparability if there are differences that may affect the price or profit. It also provides guidance on when transactions should be tested individually or evaluated as combined transactions.
Other than the purchase and sale of goods and services, the manual devoted separate chapters on the following special topics: business restructuring, intra-group services, intangible assets, cost-contribution arrangements, and intra-group loan transactions.
Business restructurings where profits are reduced can be accepted only if there were corresponding reductions in the FAR. An independent party would not restructure its business to its disadvantage.
For intra-group services, such as the provision of management, administrative, technical, commercial, and other support services to the group, the manual highlights the need to evaluate that the services have actually been performed and provided economic benefits to client affiliates. Comprehensive guidance is provided in determining the arm’s-length charge under different circumstances.
Companies that are incurring losses need to establish that the losses are commercial in nature or a result of valid business strategies. Documentation is best maintained to establish non-transfer pricing factors that contributed to the losses.
After the BIR issued the transfer pricing guidelines in 2013, Philippine taxpayers have started to prepare for a possible transfer pricing audit. However, the lack of guidelines and certainty on how the audits will be conducted have somehow put transfer pricing concerns on the sidelines for some companies, considering the many other tax compliance requirements and minding the core business. With the certainty that audit notices may be coming, it is good to place transfer pricing concerns front and center. Once standard compliance is established, routine updating will be easier and the company can be confident that it can face and challenge a transfer pricing audit.
Let’s Talk Tax is a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
Lina P. Figueroa is a principal of Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.
As published in BusinessWorld, dated 17 September 2019