Transfer Pricing (TP) compliance is still a relatively new idea for most of the taxpayers in the Philippines even though the Bureau of Internal Revenue (BIR) has issued the TP regulations in 2013 followed by series of issuances in 2019 until 2021.
Compliant or not, I do observe though that taxpayers are pretty much aware of the principle of TP and the objective of BIR to require TP compliance. That is, the controlled transactions with related parties are carried out in the same manner as that of third-party (referred to as the Arm’s-Length Principle or the ALP) to prevent loss of tax revenues for the government.
One of the TP compliances is the preparation of Transfer Pricing Documentation (TPD) which is required for certain identified taxpayers. Despite awareness of the requirement, some taxpayers have not prepared yet their TPD. I guess their reason could be because TP audits by BIR are less prevalent, unlike regular tax audits, so why bother prepare the TPD. Another reason could be due to limited resources or knowledge to prepare TPD.
With or without TP audits, it is best to start preparing the TPD because having one helps taxpayers make better business decisions. One of the components of a TPD is the Function, Assets, and Risks or FAR analysis. I will provide some guidelines in preparing FAR analysis in accordance with Revenue Regulations (RR) No. 2-2013 and Revenue Audit Memorandum Order (RAMO) No. 1-2019.
What is FAR analysis?
The ALP is based on a comparison of the prices or margins adopted or obtained by related parties with those adopted or obtained by independent parties engaged in similar transactions. One of the factor’s affecting comparability is the FAR.
The price or margin normally reflects and correlates to the function of the business, the assets or investments utilized, and risks assumed on producing/distributing the products or rendering the services. For instance, an entity selling a product with warranty should earn a higher return or price compared to another entity selling the same product without the provision of warranty. The difference in margin is due to the additional function performed and risk borne by the first entity. Likewise, a product with a reputable branding is expected to fetch a higher return or price compared to that of a similar product without the branding, due to the additional asset (in this case, trademark) employed in enhancing the value of the product.
Another example is a Business Process Outsourcing (BPO) entity who does entrepreneurial activities such as business development, generating and maintaining its own clients thru its selling and marketing activities is expected to earn a higher return compared to a BPO entity who merely provides routine support to the parent company or subcontracted by the parent company to perform client servicing. Likewise, a mobile game developer entity with significant investments in software and hires highly experienced engineers which enhance the visual and audio effects of a mobile game is expected to earn a higher return compared to a game developer having none or less of those assets employed. The difference in return is due to the additional functions performed, assets employed, and risks borne by the first entity.
Why is FAR analysis important?
FAR analysis is performed to obtain accurate identification on the characteristics of the taxpayer's business as well of their counterparts. By knowing them, the level of the risks borne and remuneration (profit) which are proportional with FAR by any of the parties can be predicted. For instance, the level of return of a full-fledged manufacturer cannot be compared to a toll or contract manufacturer because the latter has generally lesser functions, assets, and risks as compared to the first one. Likewise, the level of return of a full-fledged distributor cannot be compared to a limited-risk distributor or sales agents.
It is only when the proper FAR analysis and characterization is identified that we can do meaningful comparison of the price or level of income of the entity in a controlled transaction against the price or level of return from similar independent transaction.
How is FAR analysis done?
FAR analysis is a mapping or gathering of the economically relevant facts and circumstances surrounding the transaction between two or more related parties, and if applicable, allocate the functions, assets, and risks between the parties involved in the controlled transactions.
Typically, the FAR of each unit or division of the entity that is relevant to the controlled transaction are identified. For instance, in a manufacturing entity, the functions perform by the research and development, procurement, production, logistics, sales, marketing, and advertising, finance department, among others, are identified and documented.
For the type of assets used in performing various functions such as land, buildings, plant, machineries, equipment, intangible assets such as production know-how, patent of product or license of trademark, etc. should be identified and documented.
Lastly, an appraisal of risks is also important in determining arm’s length price or return. The possible risks assumed that should be considered in the analysis include market risks, risks of change in cost, price or stock, risks relating to the success or failure of research and development, financial risks such as changes in the foreign exchange and interest rates, credit risks, etc.
In practice, one cannot be expected to compare all functions, assets, and risks. Hence, it must be emphasized that only functions, risk and assets that are economically significant in determining the value of transactions or margins of entities should be identified and compared.
Where do we get the information?
The useful source documents to get the information relevant to the FAR analysis are the readily available information from entity, such as the annual audit reports, segmented financial statements, organizational chart and/or group structure, list of all employees with related job descriptions and the authorities of the employees, product or service flow manual, pricing policies etc.
Subsequently or as needed, interviews with the different personnel of the business units can be done to further understand or validate the information on hand. For example, key officers may provide context or rationale for entering into the affiliated transaction, validating with the finance personnel that the price per intercompany agreements are actually followed, ocular inspection with the production team to verify the existence of equipment, or confirming the risk of shrinkage of the stocks, etc. Again, facts are important to produce an accurate FAR analysis conclusion.
What do we derive from FAR analysis?
After performing the FAR analysis, one should be able to draw conclusions about the characteristics of the entity's business. The conclusion about the characteristics of the entity's business may be in the form of toll manufacturing, contract manufacturing, fully fledged manufacturing, fully fledged distributor, limited risk distributor, commissionaire, commission agent, service provider or others.
Again, such characterization is essential in finding the correct comparables which will prescribe the appropriate price or return received by the entity or its related parties to the functions performed, assets used, and risks borne by each party.
How FAR are you in TPD?
There is a saying, “So near, yet so far”. On your case, start preparing the FAR analysis and you are one-fourth done in your TPD. That is to say, “So near and not so far, when FAR is done.”
In our next articles, we will take you through the other components of the TPD. So, stay tuned.
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 30 August 2022