Time flies — in three months, we will bid 2017 goodbye. For us accountants, the end of the year means the start of busy season! There is the closing of books, the annual audit, and the filing of annual tax returns — tasks that often lead to sleepless nights. During this season, we are advised to take vitamins so we can endure the upcoming work load. Simply neglecting to take vitamins may lead to sickness, affecting not only our work, but also our savings, because of medical bills.
This situation also applies to taxpayers, especially during Bureau of Internal Revenue (BIR) examinations. Taxpayers may end up paying a significant amount, because of simple oversight.
Being with P&A Grant Thornton for two years, I see that some BIR findings involve related party transactions that were allegedly not subjected to tax. Was it done intentionally? Perhaps the companies are unaware of the tax implications of these transactions? I think it’s the latter because companies are so focused on the transactions affecting third parties, such as purchases from suppliers and sales to customers, that they overlook transactions with affiliates. These raise a red flag for me, because related-party transactions involve millions of pesos. If noncompliance is proven by the BIR, it could hurt the cash flow of the company. Failure to pay the proper taxes involves at least a 25% surcharge and 20% interest on the tax that should have been paid.
As a reminder, here are some of the usual related-party transactions and their tax implications:
Loans and advances: The parent company or affiliates advance loans to the Philippine company for various business uses, such as for purchasing a high-value asset, or to help the company during a cash shortage; hence, additional funds will be transferred to the company. These loans and advances are subject to documentary stamp tax (DST) at a rate of P1 for every P200. Since DST is a tax on a document, some companies argue that their intercompany loans are not subject to DST, because the funds are just electronically transferred and there are no actual loan agreements made. In 2011, however, the BIR issued a circular stating that even journal vouchers, debit/credit memos, and bank advices are valid loan documents for DST purposes.
Interest expense on related parties: Loans and advances provided to affiliates do not incur interest. However, some companies opt to charge their affiliates interest as a fee for the opportunity cost, had the funds been invested in other income-generating activities. Interest expense payable to an affiliate that is a non-resident foreign corporation is generally subject to 20% final tax, unless either of the companies file for tax treaty relief with the BIR. Such interest is deductible for income tax purposes, except if the same should fall under Section 36(B) of the 1997 Tax Code, as amended.
Allocated costs and reimbursable expenses: Allocating costs is done if only one company is paying on behalf of all the affiliates for the expenses incurred by the group. One example is software or IT-related expenses, wherein the parent company is usually the one transacting with the service provider and allocates the cost to the group. In return, the related companies pay their share of the cost to the parent company. Since this is a reimbursement of cost and does not constitute income from the parent company, this does not require the withholding of tax. However, the group should ensure that these expenses are supported with a cost allocation agreement so that there is a basis for companies claiming the rightful amount of expense. If one of the companies is established to perform services for the group, though, the cost billed to each entity will now be subject to income tax and value-added tax (VAT), as this transaction is considered income. Consequently, the counterpart expense of the related parties may be subjected to withholding tax, depending on the type of the services.
Intercompany sales and purchases: We all know that intercompany sales and purchases are subject to income tax and VAT, because these are considered income. However, if the seller also has loans or accounts payable to the buyer, the parties sometimes agree to offset such liabilities from the accounts receivable from the buyer. These are often overlooked and were not subject to VAT, most especially on the sale of services, because there were no receipts of payment. By offsetting, the seller constructively collected the payment, hence, the offsetting amount should be subject to VAT if it is related to the sale of services.
Transfer pricing documentation: Another issue on intercompany sales and purchases is whether the prices charged between related parties are within the market rate. In case of a BIR audit, the examiner may request transfer pricing documentation if he or she sees that there is a related-party transaction. If the company cannot present transfer pricing documentation, it may be difficult to prove that the transactions are conducted at arm’s length. Hence, the taxpayer may be at risk. The BIR is allowed to allocate gross income and expenses among companies if it determines that the transaction does not reflect the true income or expense of a taxpayer.
The transactions mentioned above are just some of the intercompany transactions that may have tax implications. Taxpayers should be proactive in checking their compliance with these transactions to save them from paying penalties. As doctors say, an ounce of prevention is better than a pound of cure.
Kristine Mae P. Villegas is a senior with the Tax Advisory and Compliance division of P&A Grant Thornton.
As published in BusinessWorld, dated 03 October 2017