“Cost sharing within a conglomerate [Part 1]” by Antonio P. Bonilla (May 10, 2010)

SUITS THE C-SUITE By Antonio P. Bonilla
Business World (05/10/2010)

(First of two parts)

Last April 19, this column featured transfer pricing as one area of focus in the BIR’s invigorated interest in conglomerates under Revenue Memorandum Order (RMO) No. 36-2010. The RMO, which prescribes a “Conglomerate Audit Program for Taxable Year 2009,” seeks a simultaneous investigation of companies comprising the conglomerate. This column now tackles cost-sharing arrangements as another area of focus in the Conglomerate Audit Program.

A cost-sharing arrangement (CSA) is defined by Revenue Audit Memorandum Order (RAMO) No. 1-98 as an agreement under which related parties “agree to share the costs in proportion to their respective share of anticipated benefits.” One example of a CSA would be the case where a designated member of the group (often the parent company) performs marketing, managerial, administrative, technical and/or other services for itself, and/or for the benefit or on behalf of the other members of the group.

Cost sharing is implemented by a conglomerate to take advantage of the inherent economies of scale provided by the interrelatedness of such companies. At the same time, it generally affords the tax benefit of being able to recognize a tax deduction for the amounts remitted by the companies as their share in the costs incurred, say, by the parent company.

In the case of conglomerates (particularly those with member companies which enjoy tax incentives or which operate in various taxing jurisdictions with diverse income or withholding tax rates), there is a natural tendency to take advantage of such differences in tax regimes in order to reduce the effective tax rate of the whole group. A CSA is one way to achieve this and, therefore, is quite commonly seen to exist in conglomerates.

But then, such possibilities for reducing tax liabilities of companies in a conglomerate provide the impetus for a direct challenge by tax authorities of related party transactions, as is now mandated under RMO 36-2010.

On several occasions, the Bureau of Internal Revenue (BIR) has already passed upon tax issues surrounding varied CSAs seen to occur among local and multinational conglomerates and related parties. These include the provision of common services such as human resources and general affairs; accounting and finance; utilities; information systems development (ISD) which includes the operation and maintenance of the ISD facilities and costs with respect to the Internet gateway maintained for a group of companies. The sharing of research and development (R&D) costs is also quite common.

Insofar as the mode used in the sharing of costs is concerned, two types seem to be favored.

One type is where the parent company or some other designated entity in the conglomerate either directly provides the shared services, or contracts with a third party provider of the services, in its own name but for the benefit of itself and the rest of the other entities in the conglomerate. The parent company or other designated entity in the conglomerate initially underwrites the cost of such services and then seeks reimbursement from each of the serviced affiliates in accordance with their respective usage or some other pre-agreed proration method.

The other mode is where the affiliates to be serviced make interim advance payment of their estimated share in the costs for a given period of time like a calendar or fiscal year, and these payments are pooled into a common fund held in trust, managed, and paid out by the parent or other designated entity. The latter then subsequently bills the rest for any shortfall in their final share in the costs at the end of the given period.

Regardless of the arrangement, the questions that arise from a tax standpoint — particularly whether shared costs constitute taxable income, the deductibility of these costs, and the documentation issues arising from cost-sharing agreements — remain the same.

At the heart of the BIR’s investigation would be this question: Where the recipient of shared services pays its pro-rata share in the cost of the services provided, say, by the parent company, is that payment considered taxable income and therefore subject to Philippine income and/or withholding tax, or to value-added tax (VAT)?

BIR rulings have consistently held that where the sharing of costs by related companies is made on a “no mark-up, mere cost reimbursement” basis, neither income nor withholding tax is due because reimbursement of cost is merely a return of capital and does not constitute income.

It has likewise been consistently held that the reimbursements paid by related companies merely to defray the expenses incurred by the related provider do not represent a fee or consideration that constitutes taxable gross receipts, hence, not subject to VAT.

There are, however, other factors that may come to light. If the provider of the intra-group services is a foreign, non-resident company, then the existence of a tax treaty between the Philippines and the country of residence of the foreign company is necessarily considered in the determination of its income tax liability. The treaty concept of a “permanent establishment” comes into play.

Even in the absence of an applicable treaty, the source of income rules in our Tax Code will apply, under which the tax situs for income from services is the place where the service is performed.

Thus, income of a non-resident foreign company from services rendered in the Philippines is considered Philippine-sourced income and will therefore be subject to Philippine income tax and withholding tax.

Consequently, in such cost-reimbursement type of CSAs, the BIR audit will devolve into questions of fact and law, namely: whether no mark-up is made by the provider and the sharing is based on actual costs commensurate to the actual benefits received from the provider; whether the services are rendered outside Philippine taxing jurisdiction; and the tax residence of the service provider.

Other issues, such as deductibility and documentation, will be discussed in next week’s column.

(Antonio P. Bonilla is a Tax Senior Associate of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.