“Cost sharing within a conglomerate [Part 2]” by Antonio P. Bonilla (May 17, 2010)
SUITS THE C-SUITE By Antonio P. Bonilla
Business World (05/17/2010)
(Second of two parts)
In last week’s column, we talked about how conglomerates resort to cost-sharing agreements (CSAs) to take advantage of certain benefits like economies of scale and tax deductions or exemptions and how payments received under these CSAs are taxed.
In this week’s column, we talk about the deductibility and documentation of shared costs as areas of focus in the Bureau of Internal Revenue’s (BIR) audit of a conglomerate.
Issue of deductibility
This is the flipside of the issue on taxability of shared costs. Payments for shared costs may arguably not be taxable, but are they tax deductible by the payor? How does the arm’s length principle operate upon the issue of deductibility?
It is well-settled that tax deductions are in the nature of tax exemptions and must be strictly construed against the taxpayer. Hence, the entity that claims the expense has the burden of justifying the cost allocation.
In several decisions, the Supreme Court ruled that, to be deductible, a business expense must meet the following tests: (1) the expense must be ordinary, necessary and reasonable; (2) it must have been paid or incurred within the taxable year; (3) it must have been paid or incurred in carrying a trade or business; and (4) the taxpayer must substantially prove by evidence or records such deductions being claimed under the law.
The high court has conceded that there are no hard and fast rules to determine if an expense is ordinary, necessary and reasonable.
However, as a guide, it has posited that to be considered as “ordinary and necessary,” the expense ought to be normal and helpful in relation to the business of the taxpayer; and to be “reasonable,” it cannot be inordinately large in amount relative to the annual volume of operations of the taxpayer and other factors of the taxpayer’s business, even if the expense is deemed necessary to the business.
Shared costs among a conglomerate will certainly be subjected to this test for deductibility. The “reasonableness” of the shared cost could be particularly contentious as it will inevitably be tied up with how the conglomerate allocates the shared costs among its member entities.
This is so because an allocation that does not seem to have any rational basis may indicate a motivation that transcends the mere sharing of costs which may lead the BIR to inquire further.
Hence, it is critical for the conglomerate to document its bases for allocating costs among its members in order to mitigate, if not entirely avoid, the inherent difficulty of measuring the reasonableness of the shared costs.
As earlier mentioned, the test of deductibility requires proper substantiation of the deductions claimed by a taxpayer. Documentation is crucial in a tax audit; it ultimately determines whether a valid claim will actually be allowed as a deduction by the BIR and the courts, if and when a tax assessment is litigated.
Needless to say, a properly documented CSA which, among others, spells out the bases for the allocation of costs among the parties, will be the initial object of examination of a BIR audit. A transfer pricing study supporting the CSA, showing comparative independent party costs for the same or similar type of services as those of the CSA, would conceivably be helpful. Alternatively, a confirmatory BIR ruling covering the CSA, obtained prior to the BIR investigation, would greatly influence the outcome of such audit.
In Revenue Audit Memorandum Order 1-98, the BIR said that examiners should consider benefits received, size of the company, and participation in the venture, among others, in determining the appropriateness of the CSA. The existence of an evidentiary paper trail will therefore prove critical. The BIR expects the entity providing the services to have issued billing statements or invoices to the recipients of its services. In the case where the designated entity contracted with a third party for the shared services, proof must be provided that the withholding tax and/or VAT (if applicable to the transactions) have been paid.
There is word that the BIR is now looking to finalize the Transfer Pricing Regulations which it first drafted in 2006. The draft included detailed documentation requirements such as the submission of the detailed information on the conglomerate’s line of business, industry dynamics, market, regulatory, and economic conditions in which the entity operate. Detailed information on the group’s past, present and future business models and strategies and a full report on the conglomerate’s functions, risks and assets employed must also be made available to the BIR. More information will be required for Philippine entities that are affiliated with worldwide conglomerates. These are information that will prove material in the BIR’s determination of the tax treatment of a CSA in a conglomerate audit.
In conclusion, suffice it to say that being able to identify the many faceted issues that underlie the tax audit of a conglomerate, and the possible ways by which such issues may be approached, should enable both the conglomerate and the BIR audit teams to navigate their way through the audit process to a mutually satisfactory resolution. Conglomerates should particularly pay attention to the issues discussed above and even consider undertaking a pre-audit checkup to ascertain whether it can pass muster. It has been said that “an ounce of prevention is worth a pound of cure.” In tax talk, that means companies should try to avoid audit problems in the first place rather than try to fix them when they arise.
(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.