Understanding Transfer Pricing Regulations in the Philippines: Frequently Asked Questions (FAQs)
With the ever-growing interdependence of economies and the dramatic increase in globalization of trade, tax leakages are expected to exist. Cross-border, intra-firm transactions between related parties for capital inflows and outflows have highlighted a multitude of loopholes in both local and international taxation. To these related parties, the idea is simple – minimize tax payments between and among them and maximize net income as a group, rather than as individual entities.
To plug these leakages linked to related party transactions (RPT), governments worldwide have adopted their respective transfer pricing regulations.
In the case of the Philippines, the Bureau of Internal Revenue (BIR) has been guarding against these riddling tax losses since the issuance of Revenue Regulations (RR) No. 2-2013 on January 23, 2013.
In this article, we will lay down the key points of the said regulation:
What is Transfer Pricing?
Transfer Pricing (TP) is generally defined as the pricing of cross-border, intra-firm transactions between related parties or associated enterprises.
What is covered by the TP regulations of the Philippines?
The regulations apply to both domestic and cross-border transactions of associated enterprises (to simplify, we shall refer hereto as “related parties”).
Who are “associated enterprises”?
The regulations define “associated enterprises” as two (2) or more enterprises whereby one participates directly or indirectly in the management, control, or capital of the other; or if the same persons participate directly or indirectly in the management, control, or capital of the enterprises.
How does Transfer Pricing apply to domestic transactions of related parties?
Several domestic transactions may also be covered by TP regulations, i.e.,
- When income is shifted in favor of a related company enjoying special tax privileges such as the fiscal incentives granted by the Board of Investments (BOI) and the Philippine Economic Zone Authority (PEZA); or
- When expenses of a related company with such privileges are shifted to a related company subject to regular income taxes.
What is the “Arm’s Length Principle”?
The Arm’s Length Principle requires the transaction with a related party to be made under comparable conditions and circumstances as a transaction with an independent party. It is founded on the premise that where market forces drive the terms and conditions agreed in an independent party transaction, the pricing of the transaction would reflect the true economic value of the contributions made by each entity in that transaction. Essentially, a taxpayer’s income from a related party transaction must be equivalent to what would be earned by a similarly situated taxpayer from a transaction with a third party.
In applying the Arm’s Length Principle, RR No. 2-2013 provides for a three-step approach, namely:
- Conduct a comparability analysis;
- Identify the tested party and the appropriate transfer pricing method; and
- Determine the Arm’s Length result.
What are the taxpayer’s obligations under TP Regulations?
RR No. 2-2013 explicitly requires all taxpayers involved in related party transactions to maintain and keep adequate and specific TP documentation. More importantly, the documentation must be contemporaneous, i.e., they must exist or are brought into existence at the time the associated enterprises develop or implement any arrangement that might raise transfer pricing issues or review these arrangements when preparing tax returns.
The information or details that should be included in the documentation include but are not limited to the following:
- Organizational structure
- Nature of the business/industry and market conditions
- Controlled transactions
- Assumptions, strategies, and policies
- Cost Contribution Arrangements
- Comparability, functional, and risk analysis
- Selection of the transfer pricing method
- Application of the transfer pricing method
- Background documents
- Index to Documents
Note that, while TP documentation does not have to be filed along with the tax returns, these must be retained by taxpayers and submitted to the BIR when required or requested to do so. This is especially important during a transfer pricing audit, which we will be discussing later on.
In addition to the above, these documentations must be retained and preserved within a period of three (3) years from the filing of the Annual Income Tax Return. It will, however, be to the best interests of the taxpayer to maintain documentation for a longer period of time for purposes of the Mutual Agreement Procedure (MAP) and possible transfer pricing audit.
Can the taxpayer reduce their risk of undergoing potential transfer pricing audit and/or adjustment?
Under the TP regulations, the taxpayer is given the opportunity to arrive with an Advance Pricing Arrangement (APA) in order to determine in advance, with conforme of the BIR, an appropriate set of criteria (e.g., TP method and comparables set to be used) to ascertain the transfer prices of controlled transactions over a fixed period of time.
What are the penalties for non-compliance with the TP Regulations?
In case of a deficiency tax assessment arising from a TP adjustment after a tax audit was conducted by the BIR, the penalties under the Tax Code shall apply, such as the 25% (50% in fraud cases) surcharge and 12% interest per annum on the basic deficiency tax due. A compromise penalty of up to PhP50,000.00 may also be imposed.
More than half a decade after the TP regulation was issued, the BIR signaled yet another strong push for TP compliance. On August 20, 2019, Revenue Audit Memorandum Order (RAMO) No. 1-2019 (otherwise known as the TP Audit Guidelines) was issued to pave the way for the conduct of transfer pricing audits.
Unpopular as it may seem, RAMO No. 1-2019 provided for the standardized audit procedures and techniques in auditing taxpayers with related party or intra-firm transactions to ensure quality audit.
While the RAMO is primarily a manual for BIR officers, taxpayers can take valuable insights from the issuance and use it for guidance in preparing for future audits and avoid transfer pricing adjustments.
Who is covered by a TP audit?
The TP audit guidelines apply to all transactions between related parties where at least one party is taxable in the Philippines. For example, a Philippine branch office of a foreign corporation will be treated as a separate entity from its head office for tax purposes. Hence, the transactions of the branch with its head office, as well as with other branches or subsidiaries in the group, shall also be subject to transfer pricing rules.
What will be the scope of a TP Audit?
It will cover the sale, purchase, transfer, and utilization of tangible and intangible assets, provision of intra-group services, interest payments, and capitalization.
How will a TP audit be conducted?
A TP audit will be governed by the same rules as regular audits.
Issuance of the Letter of Authority (LOA)
A LOA shall also be served and shall include a request for pertinent documents such as:
- Information about related party transactions
- Segmented financial statements
- Functions, assets, and risk analysis
- Characteristics of the business
- Comparability analysis
- Transfer pricing method used
- Comparables used in applying the Arm’s Length Principle
- Determination of the fair prices/profits in RPT
Noteworthy is the fact that most of these information form part of the transfer pricing documentation which we discussed earlier.
As in a regular audit, revenue officers conducting a transfer pricing audit will report on their findings. Normally, this includes a critique of the taxpayer’s methodology, their analysis, and a determination of the appropriate Arm’s Length price based on their analysis. If the revenue officers find that the price or margin in the controlled transaction is not in accordance with the Arm’s Length Principle, they will propose an adjustment by imputing the Arm’s Length price, margin, or interest rate. For sales of goods and services, adjustments will be proposed if the consideration received is less than the Arm’s Length price or if there is no fee charged. For purchases of goods and services, an adjustment will be necessary if the price or fee is deemed excessive.
Notice of Informal Conference (NIC)
The revenue officers will then discuss their findings and confirm with the taxpayer their agreement with the facts and the issues identified.
Thereafter, the audit should proceed pursuant to the regular rules, i.e., issuance of a Preliminary Assessment Notice (PAN), Final Assessment Notice/Formal Letter of Demand (FAN/FLD), including on the remedies available to the taxpayers.
When is there a transfer pricing risk?
According to firsthand experience with the BIR, the Bureau tends to focus on multinational companies with local activities, entities with activities in the economic zones, or those enjoying special tax privileges.
The following are some of the triggers for increased attention by the BIR:
- Management fees invoiced from head offices to the Philippines
- Service fees invoiced from the Philippines to related parties abroad (especially those involving high-value-added activities such as Research and Development, technical design, consultancy, or knowledge processing and outsourcing services)
- Income is shifted to a related company with special tax privileges
- Companies showing sharp swings in profits (especially after a tax holiday).
- Companies generating profits below industry standards
Prior to the issuance of RAMO No. 1-2019, many taxpayers sidelined their transfer pricing concerns due to the lack of guidelines and certainty on how the audits will be conducted. Now, with the inevitability of TP audit notices, it is time to place transfer pricing concerns front and center; because to the BIR, the goal is similarly simple – to generate more tax collection.