You’ve probably heard that some Bureau of Internal Revenue (BIR) examiners are asking for transfer pricing documentation as part of regular audits. We are also aware that the BIR International Tax Affairs Division (ITAD) has been asking for transfer pricing documentation from companies applying for tax treaty relief for transactions involving related parties.
We may therefore be allowed to wonder, how will the BIR conduct the transfer pricing audit? What is the advantage of having transfer pricing documentation? How will the transfer pricing documentation affect our tax treaty relief application (TTRA)?
The Philippine transfer pricing guidelines or Revenue Regulations 2-2013 has among its objectives to require the maintenance or safekeeping of the documents necessary for the taxpayer to prove that efforts were exerted to determine the arm’s-length standard for its transactions with related parties. The guidelines state that adequate documentation will enable the taxpayers to (i) defend their transfer pricing analysis, (ii) prevent transfer pricing adjustments arising from tax examinations, and (iii) support their applications for Mutual Agreement Procedure (MAP). The documents may include the following:
1. Organizational structure
2. Nature of the business/industry and market conditions
3. Controlled transactions
4. Assumptions, strategies, policies
5. Cost contribution arrangements (CCA)
6. Comparability, functional and risk analysis
7. Selection of the transfer pricing method
8. Application of the transfer pricing method
9. Background documents
10. Index to documents
The documentation must be contemporaneous, that is, it must be in existence before or at the time of the transaction or at the time of filing the income tax return. It must be submitted upon request of the BIR.
A company which maintains transfer pricing documentation has taken one big step by showing that it has exerted effort to provide a basis for its transfer prices. At the very least, the taxpayer can show that it has diligently followed the transfer pricing guidelines in preparing the documentation and applied the appropriate transfer pricing method. In some countries, taxpayers that maintain adequate documentation enjoy the benefit of exemption from penalties in case transfer pricing adjustments arise. Philippine taxpayers will be happy if the same advantage can be granted to those who comply.
How and to what extent will the BIR will scrutinize the documentation maintained by the taxpayer? In case of payments made to related parties, the audit may be focused on proving that the transaction covered by the payment exists (there were goods delivered and services provided), that the Philippine company is actually benefiting from the goods or services that it paid for, and that the fee charged for the good or service is fair, based on the arm’s length principle. In case of revenue received, the focus will be on determining whether the price or compensation received for the good or service is reasonable, also based on the arm’s length principle.
In both cases, the BIR should put a premium on documentation and methodology for the analyses that comply with the documentation guidelines. Transfer pricing audit guidelines will hopefully be circularized to enable the taxpayer to prepare well for an audit and to know his rights and the available remedies.
Taxpayers who have not prepared adequate documentation may find that their transfer pricing issue would be much more difficult to resolve, according to the regulations. The BIR may impose its own arm’s length standard and such a standard may result in a transfer pricing adjustment, and consequently in deficiency taxes. The taxpayer should be prepared to argue that such standard cannot be validly imposed. Without its own study, that may be a big challenge for the taxpayer.
How will the transfer pricing documentation affect our TTRA?
There is a standard provision in the tax treaties on payments between related parties, specifically applicable to interest and royalties. The provision says that, if because of the relationship between the transacting parties, the amount of the interest or royalties exceeds the amount which would have been set in the absence of such relationship, the excess part of the payments shall remain subject to the regular tax. Only the portion that is deemed reasonable, or arm’s length in the transfer pricing language, shall be entitled to the preferential tax rates under the tax treaties.
Though a transfer pricing study is not among the enumerated documents for TTRA, the BIR-ITAD has recently been issuing notices for the submission of a transfer pricing report within 15 days to companies which have filed for treaty relief for payment of interest and royalties to related parties. It is not clear though, how the ITAD will treat applicants who cannot submit a transfer pricing report. Will the TTRA be archived? Will the application be denied? Does ITAD have benchmarks or data which they will use to determine the portion of the payment that exceeds that arm’s length amount which shall qualify for the treaty relief?
In case the TTRA applicant is able to submit a transfer pricing report, will the ITAD consider the report sufficient or will it further scrutinize the report for acceptability?
In its 2016 Priority Programs (RMC 14-2016), the BIR expressed its intent to implement a transfer pricing program that will complement the transfer pricing guidelines issued in 2016. The 2016 transfer pricing program has listed among its priorities the subscription to a commercial database for transfer pricing studies, development of a transfer pricing test case for LTS, finalization of transfer pricing-related issuances such as the Revenue Regulations on Advance Pricing Agreement (APA) and the Revenue Memorandum Orders on transfer pricing documentation and transfer pricing risk assessment.
The issues on transfer pricing can have very significant impact and is best approached with more caution.
The implementation of our transfer pricing rules affect not only the Philippine taxpayer but also, companies in the group which are operating in other jurisdictions. Significant amounts may be involved. For example, BPOs and KPOs whom we have encouraged to locate in the Philippines are mostly deriving a hundred percent of their revenues from related parties. Many export-oriented enterprises which we have registered in our ecozones are manufacturing for or selling to related parties as part of the global supply chain. A one percent adjustment can translate to significant amounts, hence the need for the adjustments to be fair.
Furthermore, transfer pricing is not an exact science. Each entity is peculiar -- its operations are a function of various factors which cannot be exactly the same as with another entity even in the same line of business. There is no exact formula and there may be more than one way of analyzing a transaction.
Looking at all the factors that may be considered in evaluating transfer pricing, I’d like to believe that the objective is, not simply finding an amount that is mathematically correct that can be assessed, but more towards achieving fairness and equity. This is a big responsibility.
Lina P. Figueroa is a principal of the Tax Advisory and Compliance division of Punongbayan & Araullo