“Special audits of related companies and conglomerates” by Romulo S. Danao, Jr. (April 19, 2010)

SUITS THE C-SUITE By Romulo S. Danao, Jr.
Business World (04/19/2010)

Tax authorities have long recognized that when related companies transact with each other, their pricing of goods or services may not necessarily be influenced by market forces, but by the need to improve overall profitability through tax efficiency.

Thus, the transfer pricing policy of these companies, more often than not, takes into account such factors as the differences in the tax rates of jurisdictions, availability of tax or fiscal incentives, and rigidity of tax enforcement.
While transfer pricing benefits the group, some tax jurisdictions are deprived of a higher tax take.

To address transfer pricing between or among related firms, tax administrators around the world have issued detailed transfer pricing rules which include, among others, the requirement to comply with the so-called “arm’s length standard” in pricing related party transactions. In essence, the arm’s length standard requires that the price for the transfer of goods or the provision of services between or among related parties be the same as, or comparable with, the price that would have been agreed upon by independent parties.

Unknown to many, the Bureau of Internal Revenue (BIR) already had several issuances in the past that sought to enforce compliance with the arm’s length standard for related party transactions. However, this did not seem to have resulted in too many transfer pricing audits. Unlike transfer pricing regulations in other countries, the BIR’s issuances did not prescribe specific documentation to support and justify the pricing policies adopted for related party transactions. There were no clear guidelines on how related parties could comply with the arm’s length standard required for their related party transactions.

In 2006, the BIR prepared more robust transfer pricing regulations that include guidelines on documentary support for intercompany pricing policies. Unfortunately, the regulations have yet to be finalized.

These proposed regulations were primarily based on the Organization for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines, which were originally intended to serve as a framework for the transfer pricing regulations of OECD-member countries, although many non-OECD member-countries decided to base their transfer pricing regulations on the said guidelines.

The Philippines seems to be moving in the same direction, and so, pending issuance of more detailed transfer pricing regulations, the BIR issued Revenue Memorandum Circular No. 26-2008 in March 2008 by which it formally adopted the OECD Transfer Pricing Guidelines as the interim transfer pricing guidelines in the country.

To show its resolve to scrutinize, if not challenge, the transfer pricing practices of certain companies, the BIR issued in July 2009 Revenue Memorandum Order (RMO) No. 23-2009, mandating its National Investigation Division (NID) to audit selected taxpayers, including companies that are related or that form part of a group of companies or conglomerates. The objective of the audit is to ensure that these taxpayers clearly reflect income and expenses that are attributable to transactions between and among controlled and related taxpayers. The audit also seeks to identify the various tax reduction schemes, including the use of tax-exempt entities or those with special tax privileges, related company loans and advances, cost-sharing, and the supply of goods and services. Particular attention will be given to transfer pricing issues, which will be considered in the audit findings.

Very recently, the BIR issued RMO No. 36-2010 which mirrors the objectives of RMO 23-2009. It prescribes the rules and procedures governing the conduct of special investigation and enforcement activities of related companies, conglomerates, their affiliates and subsidiaries for taxable year 2009. This latest issuance amends RMO No. 23-2009 and now directs the Large Taxpayers Service (LTS) and the Enforcement Service (ES) to identify the conglomerates consisting of related companies (parent company, affiliates and subsidiaries) that will be subject to audit under the program. Special audit teams from LTS and ES will be assigned to undertake a simultaneous, joint, and coordinated examination of the books of accounts of the taxpayers belonging to the same group of related companies. The investigation shall cover all internal revenue taxes for 2009 and has to be completed not later than six months from the issuance of the Letter of Authority.

The RMO also requires that, within 30 days from the date of completion, each audit team shall submit to the Commissioner its recommended set of guidelines, standards and procedures to be adopted in the audit and tax treatment of related parties and intercompany transactions. It shall include among others:

»identification of tax issues and tax planning schemes of related parties;

»tax treatment for controlled transactions including, but not limited to, transfer pricing, cost-sharing arrangements, inter-company loans and advances, provisions of goods and services, agency and/or resale arrangements; and

»audit procedures, rules and regulations for related party transactions.

It appears that the BIR is now focusing on transfer pricing issues and dedicating more resources on transfer pricing investigations.

With these developments, there is a need for related companies and conglomerates to review their existing intercompany pricing policies and put in place sufficient documentation to support and justify the pricing policies adopted. The burden of proving arm’s length pricing will always rest on the company, which may well expect a substantial tax assessment from the BIR if it fails to provide acceptable justification.

(Romulo S. Danao, Jr. is a Tax Partner and heads the transfer pricing practice 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.