In our previous article “BIR transfer pricing audits - the next wave?”, we have looked into Revenue Audit Memorandum Order (RAMO) No. 1-19 which is the current regulation set by the Bureau of Internal Revenue (BIR) when it comes to Transfer Pricing (TP) audits. The RAMO explained in detail how will the BIR conduct its audit of related party transactions.
In my experience so far, only a few BIR officers tried interjecting in their tax investigation the TP findings, or at least discussed how the related party transaction (RPT) prices are derived. Because the RAMO was recently introduced in 2019, there have been no TP controversies that have reached the court yet based on these new audit guidelines.
Confucius, a Chinese philosopher, once said that if one wants to define the future, they must study the past and that without history, there is no future. In a similar vein, the glimpse of the future of TP audit in the Philippines may have a clue from the past. This leads me to go over the TP cases of the past and capture the key points that taxpayers may use in preparing for TP audits in the future.
Burden of proof lies with the taxpayer
In a 2005 Court of Tax Appeals (CTA) case, the BIR used the taxpayer’s documents to scrutinize the prices of products sold to both related and unrelated parties. Based on the documents, the BIR has averred that taxpayers did not declare all their export sales upon comparison of prices among the customers.
Similarly, the requirement of scrutinizing taxpayers’ documents has been reiterated in the RAMO guidelines. Among the initial audit steps of BIR is to set a schedule for a meeting with the taxpayer to gain understanding loabout the taxpayers’ data with respect to their special relations with their related parties, their transactions, and transfer pricing policy. Examination of contracts, audited financial statements, income tax returns, and BIR Form No. 1709 (Information Return on Transactions with Related Party), among others, shall be conducted to collect additional information.
More importantly, the BIR shall request and analyze the taxpayer’s TP documentation or TPD especially if the taxpayer is mandated to have one based on the criteria set forth by the BIR. A compliant TPD must be contemporaneous. This means that it exists or is brought into existence at the time the related parties develop or implement any arrangement that might raise transfer pricing issues or review these arrangements when preparing tax returns or not later than the deadline to file the annual income tax return.
Since the taxpayer has the burden to prove that the related party transactions comply with the TP rules, it is best for the taxpayer to maintain its TPD and relevant documents and have these ready for possible TP audit.
Comparability and FAR analysis
In a 2005 CTA case, BIR asked the taxpayer why the prices offered to foreign affiliates were lower than those of the local market. The taxpayer explained that one of the reasons is that the domestic selling price is not a benchmark price for export sales because the export and domestic markets are two different markets. For one, the export market is competitive while the domestic market is a captured market. Another reason is that to beat the price quotations of other sellers of the product with a lower cost of production than the Philippines, the taxpayer offers the export products at a lower mark-up as compared to domestic sales in order to get the business and in the process maximize the utilization of its production facilities which were not fully utilized. And lastly, the taxpayer was able to justify that export sales maximize its productivity level, which in turn results in the lower unit cost of production as the fixed overhead is spread over a larger number of product units.
The above reasons were found by the Court as sufficient evidence to establish its position that the prices of its export sales may be lower than its local sales. Thus, the Court ruled in favor of the taxpayer.
Now, the RAMO guidelines provide that the BIR officer, when conducting audit should be able to draw conclusions about the characteristics of the taxpayer's business and the functions performed by its related parties, and to examine the appropriateness of the remuneration received by the taxpayer and its related parties to the functions performed, assets used, and risks borne by each party through review and analysis of accounting data, interviews, plant tours and site visitations.
The BIR will also perform a comparability analysis. That is the audit in transfer pricing is made by comparing the condition of related transactions and the condition of independent transactions. Accordingly, the taxpayer should include in its documents the commercial reasons that make economic sense if there are differences in the pricing policies over different controlled transactions or against independent transactions.
In summary, taxpayers should be thoroughly familiar with the characteristics of its products or services and its comparability with other products or services offered to independent parties or offered in an independent transaction. Understanding of the functions, assets, and risks is crucial because this would lead to the correct characterization of the taxpayer’s business operations and expected level of return.
Be familiar with the TP rules
In a 1995 CTA case, the BIR alleged that the taxpayer overstated its cost of goods due to the transfer pricing of products to its mother corporation. Specifically, the BIR alleged that a fourth-generation antibiotic should not be allowed to incur costs of improvement eight times higher than its supposed precursor, doxycycline, a third-generation antibiotic.
The taxpayer was able to demonstrate the physical characteristics and circumstances involved in their production, Minocycline is a completely different kind of antibiotic from doxycycline with each one having a separate and unique chemical structure and production processes. Also, their production process and cost of development are at variance with one another. The taxpayer has discussed that most important of all, there is no sufficient basis to compare the two as they are not within the same level of generation. The taxpayer explained that the cost of improvement for minocycline should be gauged with another fourth-generation tetracycline developed likewise from Declomycin in order to produce a comparable and reliable data.
In the above case, the taxpayer challenged the transfer pricing method used by the BIR in deriving its TP findings. Needless to say, taxpayers should be familiar with the tax rules so they can intelligently defend their related party transactions, TP policy and TPD.
Under the RAMO guidelines, there are specific rules that need to be followed by the taxpayer and BIR examiners. This includes the selection of TP methods. In the above cited case, the BIR was imposing the comparable uncontrolled price (CUP) method in determining the arm’s length price. However, the same seems not applicable because of the differences in the characteristics and circumstances surrounding the taxpayer’s products that could have a material influence on the price of goods.
Know more about TP audit preparation
P&A Grant Thornton will be offering a free webinar on June 20, 2023, entitled “Am I TP audit ready?”. We hope we can help the taxpayers in preparing the company for its possible TP audit in the future. Join us in our discussion.
Let's Talk TP is an offshoot of Let’s Talk Tax, 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 May 2023
