Transfer pricing audits are coming… Get ready!

(First of two parts)

Related party transactions have come under renewed scrutiny from regulators lately due to their importance in promoting corporate good governance and in preventing further erosion of the tax base.

In April, the SEC issued Memorandum Circular (MC) No. 10, requiring all publicly-listed companies to submit a policy on material related party transactions (RPT). The MC was issued to protect the interests of minority investors and to promote good governance by ensuring that these transactions do not create financial, commercial and economic benefits to favored individuals or affiliated companies.

About three weeks ago, it was the Bureau of Internal Revenue (BIR)’s turn to issue Revenue Audit Memorandum Order (RAMO) No. 1-2019, prescribing the procedures and techniques in conducting an audit of taxpayers who have RPTs and intra-firm transactions.

The guidelines (known as the Transfer Pricing [TP] Audit Guidelines) are the anticipated sequel to the TP regulations, which the BIR issued in 2013. In the experience of countries or jurisdictions that have adopted their own TP regulations, the TP regulations are first issued, followed by the conduct of TP audits in order to test the application of the arm’s-length standard and the principles contained in the TP guidelines.

The RAMO applies to RPTs where at least one party is assessable or chargeable for tax in the Philippines, and those between a permanent establishment (PE) and its head office or other related branches. Also covered are intra-firm transactions, which occur when a firm engaged in business activities that are subject to different tax regimes (such as income tax holiday, the 5% gross income tax and the regular corporate tax) misallocates profits and costs to minimize tax liabilities.

Including intra-firm transactions means that an entity — without engaging in a transaction with another affiliate but undertaking different business activities — may be subjected to a TP audit. An example would be if its costs or expenses are heavily allocated to activities where these costs or expenses can be deducted to reduce the income tax liability, over other activities where costs or expenses will not be deductible because of income tax exemption or a gross-income based taxation.

On the covered transactions, no threshold amounts — either in terms of revenue or costs/expenses from such transactions — were specifically mentioned in the RAMO to identify the transactions that would be subject to audit.

Thus, regardless of amount, all taxpayers with RP transactions are potential candidates for a TP audit.

It is also unclear whether a TP audit will be an integral part of a regular tax audit. As a fact-intensive exercise, a TP audit is time-consuming because it involves a more extensive collection and analysis of data on the different aspects of business operations, such as those dealing with the industry of the taxpayer, the functions of the parties to the RP transaction, their financial results and the potential comparables. In many cases, it will require documents and other information in the possession of members of a multinational group other than the local affiliate.

If a TP audit is incorporated into the regular audit, a company faces the prospect of preparing all the necessary documents and information to defend its TP policy on its RPTs within a relatively short period of 120 days, the general timetable required to complete such regular audit. Also, a company’s TP policy has to be further supported by industry information, as well as functions, assets, risk (FAR) and comparability analyses.

In TP, the compensation to be received by a related party to a transaction is the result of the value created from the functions that it performs, the assets that it employs, and risks assumed in the RPT. In all cases, these three factors, functions, assets and risks, cannot be readily inferred from the intercompany agreements executed by the parties to the transactions nor from the audited financial statements of the parties involved. Interviews have to be conducted with employees involved in the operations to determine the distribution of functions and headcount within the organization. The group’s value chain will have to be analyzed to determine where the company under audit stands in relation to the other members of the group in terms of the value contributed to the business of the group.

There is also the comparability analysis, which requires the company to support its TP analysis with the necessary benchmarks. Again, data on comparable transactions or companies are not readily available and, even if the data are available, the comparables will have to be further analyzed to determine whether they meet certain comparability criteria.

In countries or jurisdictions that have adopted their own TP audit guidelines, TP audits have resulted in huge deficiency tax assessments and years of litigation. This has put a strain on companies’ financial resources and has exposed companies to reputational risk. More importantly, due to the years that a TP case can remain pending in courts, the TP assessment results in significant uncertainty for the business.

Thus, a TP audit cannot just be dismissed as like any regular tax audit. The key to managing the risk from a TP audit is really preparation. Given the audit process involved in a TP audit as outlined in the RAMO, there has never been a better time than now to prepare TP documentation. To begin with, TP documentation is among the first items that may be requested by the BIR in a TP audit. It simplifies the audit and creates a favorable impression that the taxpayer has done prior due diligence work in ensuring that its pricing policies for RPTs are conducted at arm’s-length conditions. Moreover, the taxpayer is spared the additional time and effort required to produce the information and documents to support its TP policy since the facts and data supporting the TP analysis are already summarized in the TP documentation.

In the next article, we will continue our discussion on the other provisions of the RAMO on intra-group services, interest payments and intangibles.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.

Reynante M. Marcelo is a Partner for International Tax and Transaction Services of SGV & Co.