The new Philippine transfer pricing regulations
(First of two parts)
By Romulo S. Danao, Jr.
First Published in Business World (2/4/2013)
On 23 January 2013, the Bureau of Internal Revenue (BIR) finally released the much-awaited regulations on transfer pricing. Revenue Regulations (RR) No. 2-2013 implement the authority of the Commissioner of Internal Revenue under Section 50 of the Tax Code, to review controlled transactions among associated enterprises and distribute, apportion or allocate their income and deductions to reflect the true taxable income of such enterprises.
RR 2-2013 (more informally called the TP Regs) will take effect after fifteen (15) days following their publication last January 25, 2013. They prescribe the guidelines in determining the appropriate revenues and taxable income of the parties in a controlled transaction. The guidelines are largely based on the Organization for Economic Cooperation and Development (OECD) TP Guidelines, which have served as the framework for TP regulations around the world.
The TP Regs apply to both domestic and cross-border transactions of associated enterprises. The regulations recognize that, while transfer pricing typically occurs in cross-border transactions, it can also occur in domestic transactions with the goal of lowering tax obligations. This happens when income is shifted in favor of a related company enjoying special tax privileges such as the fiscal incentives granted by the Board of Investments (BOI) and the Philippine Economic Zone Authority (PEZA); or when expenses of a related company with such privileges are shifted to a related company subject to regular income taxes.
For example, Company A, a BOI-registered entity enjoying income tax holiday, sells its products at a high price to its local affiliate, Company B, which is subject to the 30% regular income tax. Company A, while reporting a higher income, is exempt from income tax while Company B, in claiming the expense, will be reporting a lower income subject to 30% income tax, resulting in an overall lower tax and higher profit for the group.
Transfer pricing in domestic transactions may also occur when expenses of a related company enjoying tax incentives or privileges are shifted to a related company subject to regular income taxes.
For example, Company C, a PEZA-registered entity subject to the 5% Gross Income Tax (GIT), and Company D, a company subject to normal income tax, are associated enterprises. Both incurred common administrative expenses, but since these expenses are non-deductible to Company C, Company D takes a bigger share of the common administrative expenses, and claims the same as deduction from its gross income. This results in a lower tax for Company D and an overall higher profit for the group.
Arm’s length principle
RR 2-2013 expressly adopts the “arm’s length principle,” which is the internationally accepted standard for determining the appropriate transfer prices of controlled transactions of associated enterprises. The principle requires that a transaction with a related party should be made under comparable conditions and circumstances as a transaction with an independent party. Essentially, a taxpayer’s income from a related party transaction must be equivalent to what would be earned by a similarly situated taxpayer from a transaction with a third party.
In the application of the arm’s length principle, RR 2-2013 provides for a three-step approach, namely:
1. Conduct a comparability analysis;
2. Identify the tested party and the appropriate transfer pricing method; and
3. Determine the arm’s length result.
The regulations adopt the OECD arm’s length pricing methodologies without any specific preference for any one method. These include the Comparable Uncontrolled Price Method, Resale Price Method, Cost Plus Method, Profit Split Method and the Transactional Net Margin Method. In determining the arm’s length result, the most appropriate method for a particular case shall be used. This should be the method that produces the most reliable results, taking into account the quality of available data and degree of accuracy of adjustments.
RR 2-2013 explicitly requires taxpayers to maintain and keep adequate and specific transfer pricing documentation to demonstrate that their transfer prices are consistent with the arm’s length principle. More importantly, the documentation must be contemporaneous, i.e., they must exist or are brought into existence at the time the associated enterprises develop or implement any arrangement that might raise transfer pricing issues or review these arrangements when preparing tax returns.
The information or details that should be included in the documentation are, but not limited to, the following:
► Organizational structure
► Nature of the business/industry and market conditions
► Controlled transactions
► Assumptions, strategies, policies
► Cost Contribution Arrangements
► Comparability, functional and risk analysis
► Selection of the transfer pricing method
► Application of the transfer pricing method
► Background documents
► Index to Documents
While TP documentation does not have to be submitted with the tax returns, these must be retained by taxpayers and submitted to the BIR when required or requested to do so. Moreover, they must be retained and preserved within the period specifically provided in the Tax Code as the retention period, which is three years from the filing of the Annual Income Tax Return. It will, however, be to the best interests of the taxpayer to maintain documentation for purposes of the Mutual Agreement Procedure (MAP) and possible TP examination.
The regulations do not have a safe harbor provision that would exempt taxpayers with insignificant related party transactions from the documentation requirements. Hence, the documentation requirements prescribed above would seem to apply to all taxpayers involved in controlled or related party transactions.
Advance Pricing Arrangement
Another feature is the opportunity for an Advance Pricing Arrangement (APA), which is an agreement entered into between the taxpayer and the BIR to determine in advance an appropriate set of criteria (e.g., TP method and comparables set to be used) to ascertain the transfer prices of controlled transactions over a fixed period of time.
The purpose of an APA is to reduce the risk of TP examination and double taxation. The APA may either be unilateral (an agreement between the taxpayer and the BIR), or Bilateral/Multilateral (an agreement among the taxpayer, the BIR and one or more countries). The APA is not a mandatory requirement; it can be undertaken by a taxpayer on a voluntary basis. The BIR will issue separate guidelines on the application of APA and MAP processes.
Penalties for non-compliance with the TP Regs shall be based on the provisions of the Tax Code and other applicable laws. Thus, in case of a deficiency income tax assessment arising from a TP adjustment, the penalties under the Tax Code shall apply, such as the 25% (50% in fraud cases) surcharge and 20% interest per annum on the basic deficiency tax due. There is no penalty relief provided in the regulations, unlike in other countries where the penalty is reduced if TP documentation has been prepared by the taxpayer or the taxpayer sought assistance in the preparation of documentation from an independent third party.
With the issuance of the TP Regs, the C-Suite will have to factor in these guidelines in their tax planning and risk management exercises. Dealing effectively with TP challenges should be among the priorities of covered companies.
Next week, we will discuss in detail the advance pricing arrangements and the mutual agreement procedure.
Romulo S. Danao, Jr. is a Partner of SGV & Co. and Country Leader of the Transfer Pricing Practice
This article 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.