It’s been almost two years since the Bureau of Internal Revenue (BIR) released several issuances involving updated reporting requirements for related party transactions (RPTs) and compliance with transfer pricing (TP) regulations. Since then, a lot of business entities have been anticipating how the tax authorities will be conducting audit investigations on RPTs, and whether they will be among the first ones to get to experience the TP audit.
While it is normal to feel anxious about matters that involve uncertainties and the great unknown, it helps to be equipped with at least a bit of knowledge about what to expect.
Last January 27, 2022, P&A Grant Thornton held a free webinar on TP concepts and documentation requirements. Summarized below are the salient points discussed in the webinar.
1. Concept of transfer pricing and the arm’s length principle (ALP)
TP issues occur when transactions between two or more related entities, especially those located under different taxing jurisdictions, with different income tax rates, are entered into in a manner that is not conducted within ALP, with the desire to minimize tax payments while maintaining the same level of group profits.
The ALP states that transactions among associated enterprises should be made under comparable conditions and circumstances as transactions with an independent party. Simply stated, the material contractual terms and conditions, including the price charged, that a particular entity would agree to transact with a related party, shall not differ significantly if transacted with an independent third party.
2. RPTs and intra-group services
There is a wide variety of RPTs which include, but are not limited to, purchases or sales of goods, purchases or sales of property and other assets, rendering or receiving of services, leases, royalties, trademark, license, provision of guarantees or collateral, and loans.
RPTs also include “intra-group services” or those that are rendered by one party within the group which provide benefits for one or more other members of that same group. Some examples are services related to management, technical, purchasing, marketing, administration, distribution, and routine support services (e.g., accounting and auditing, accounts receivable and accounts payable processing, IT support, payroll and employee benefits support, general administration, legal services, staffing and recruitment, and training and employee development).
Intra-group services require an arm’s length service fee to comply with the ALP. Hence, mere reimbursements at cost or without mark-up, or not charging any amount at all for these intra-group services, do not support the ALP.
3. Tax-driven transfer pricing schemes
Transfer pricing, per se, is not illegal nor is it discouraged. However, due to global related party transactions becoming more and more complex over the years, transfer pricing has become subject to abuse by many entities with the intent of avoiding or minimizing taxes.
Tax authorities around the world are allocating enormous resources towards TP enforcement because they suspect that companies use TP to shift profits to low-tax jurisdictions by failing to charge appropriate prices for intercompany transactions. In a global scale, TP has led to harmful tax practices which have resulted to tax revenue losses of governments around the world.
TP schemes are also present in intra-firm or domestic transactions with the aim to maximize income tax incentives or tax assets of a related entity through RPTs.
4. Transfer pricing methodologies
There are five (5) commonly used transfer pricing methods (TPMs) in determining the ALP of the RPTs. These are the Comparable Uncontrolled Price (CUP) Method, Resale Price Method (RPM), Cost Plus Method (CPM), Profit Split Method (PSM), and the Transactional Net Margin Method (TNMM). While the BIR does not have a specific preference for any one of these methods, the regulations require that the TPM that produces the most reliable results should be used depending on the available data and present circumstances.
5. Substance over form
Just like how this concept applies to accounting standards, TP also gives more importance on the substance or the actual nature of an RPT over any documentation that otherwise provides for its supposed characteristics. In conducting a TP analysis, consistency must be established between the material terms and conditions as stated in contracts or agreements supporting the RPTs with the facts and conditions as per the actual conduct of the transaction by the contracting parties. Any significant differences may provide room for the tax authority to assume that the RPT was entered into without the objective of observing a commercially rational purpose. Consequently, the tax authority may re-characterize the RPT involved and impose a corresponding tax penalty if it is proven that the misrepresentation of the RPT resulted into improper reporting of a taxable event.
Operating losses are normal for businesses to experience, especially during challenging times like this. However, reporting consistent losses might cast doubt on the part of the tax authorities as to the actual purpose and intention of the entity’s existence. The risk of getting investigated would be even greater if the entity is involved in several RPTs.
In determining whether operating losses incurred are commercially acceptable, it is important to ensure that RPTs entered into are commercially realistic and makes economic sense. Therefore, a taxpayer with RPTs needs to establish or justify that the losses it incurred are commercial in nature and not merely because of the presence of an RPT. Maintaining a documentation which clearly outlines the non-TP factors that have contributed to the losses is therefore beneficial for a taxpayer in providing support for any questions that may be raised by the tax authorities.
In terms of justifying the operating losses due to the adverse impact of the COVID-19 pandemic, taxpayers are advised to maintain relevant reports and documents, among others.
7. Transfer pricing documentation (TPD) requirement
Under existing regulations, there are only several taxpayers explicitly mandated to comply with the requirements of maintaining a TPD. However, nothing prevents any taxpayer from preparing a TPD and presenting the same during tax audit. Though not required to prepare a TPD, the taxpayer must still present sufficient evidence to prove that their RPTs were conducted at ALP.
Preparing a TPD is not a simple task. A wide array of information and data is needed to complete a TPD, which mainly involves internal information such as organization structure, nature of business of each party and RPT, and financial data. External data and information are also necessary such as research papers, articles, and publications about the industry in which the company operates, database of comparable companies, contracts, agreements, market interest rate, credit ratings, audited financial statements and general information sheet of comparable companies, and market prices, if any. While the BIR has probably not started doing TP audits on a full-blown scale yet, taxpayers should anticipate it any time soon, especially now that the tax authorities have already received enough information to perform their initial TP risk assessments thru the analysis of BIR Form 1709 or the Information Return on Related Party Transactions submitted by taxpayers. Instead of having a sit-and-wait mindset, taxpayers should start performing internal risk assessments on their RPTs, check compliance with the TP requirements, and be prepared to face a TP audit. It also helps to be in the know about developments in this subject matter by regularly attending tax and transfer pricing webinars, as well as to talk to experts who can give sound advice and assist taxpayers with their TP woes.
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.
As published in BusinessWorld, dated 01 February 2022