Let’s Talk Tax

The Bureau of Internal Revenue (BIR) and the Department of Finance (DoF) have expressed a shared goal to increase taxes collected as a percentage of GDP from 14.6% in 2022 to 17.1% by 2028. They confidently expect to meet this goal as it will be driven primarily by economic growth and by offering taxpayers convenience through tax digitalization programs. While it is accurate to claim that the BIR will derive more revenue with a stronger economy and by providing more convenient avenues for taxpayers to pay their dues, taxpayers know well what this means — an upsurge of BIR assessments across all industries.

On Jan. 9, the BIR announced that the Commissioner met with the Japan International Cooperation Agency (JICA) to discuss JICA’s proposal for setting up a dedicated transfer pricing team in the BIR. The Commissioner also noted “leakage in transfer pricing” causing the Bureau to lose significant amounts of revenue from international transactions. This begs the question: are transfer pricing (TP) audits the next wave of incoming assessments?

The answer is yes, and it’s just a question of when. It wouldn’t hurt to plan for what may lie over the horizon. To guide taxpayers, let’s look at Revenue Audit Memorandum Order (RAMO) No. 1-19, the current regulations set by the BIR when it comes to TP audits.

As a general rule, all taxpayers are candidates for a tax audit. However, for a TP audit, the BIR lays down the selection process (i.e., gather and review BIR Form 1709, perform risk assessment, identify high-risk TP issues and select the entity or transaction subject to audit).

The Revenue Officer (RO) will kickstart the process with a review and analysis of the information contained in BIR Form 1709 (Information Return on Transactions with Related Party) submitted by taxpayers. This form aims to improve and strengthen the BIR’s TP risk assessment and audit.

Next, the RO will perform TP risk assessment and make an informed decision, at an early stage, whether to conduct a thorough review or audit of a particular entity or transaction. The BIR will focus its audit and commit its resources only to the most important or high-risk TP issues. The RO will give due consideration to the level of profit and tax paid in the Philippines. Then comes the selection of high-risk entity or transaction that will undergo the audit.

A TP audit is conducted to test the compliance in fulfillment of tax obligations of a taxpayer with related party transactions. The audit procedure on TP consists of preparation, implementation, and reporting.

In the preparation phase of the audit, the RO collects and studies a taxpayer’s data in respect of special relations with their related parties. This is done by reviewing the annual income tax return (AITR), audited financial statements (AFS), tax treaty relief applications, and prior year’s tax audit, among others. The RO will schedule a meeting with the taxpayer to gain an understanding of the general background of the business, product/service flow, value chain, worldwide structure, rationale for conducting the transaction, functions, assets and risks, and TP policy. The meeting is also conducted and designed to gather information about the worldwide effective tax rate, sources of income, transactions with related parties domiciled/located in countries or economic zones with low or zero tax rates, a determination whether the taxpayer’s net operating profit is lower than that of other companies in the same industry, and whether the taxpayer suffered losses over several years.

Implementation of the TP audit comprises the following: (1) Determination of the characteristics of the taxpayer’s business; (2) Selection of the TP method; and (3) Application of the arm’s length principle (ALP).

The reporting phase of the TP audit provides a summary of the factual background and functional analysis of the taxpayer and the transaction/s at issue, a summary of the taxpayer’s proposed economic analysis for the transaction at issue, a critique of taxpayer’s methodology and analysis of the transaction at issue, the RO’s determination of arm’s length price based upon economic analysis, and summary and conclusion.

The RO will require the taxpayer to prepare and submit the following annexes which are attached to RAMO No. 1-19:

• Annex 3 – Related Party Transaction

• Annex 4 – Segmented Financial Statements

• Annex 5 – Supply Chain Management Analysis

• Annex 6 – Functions, Assets and Risks Analysis (FAR)

• Annex 7 – Characteristics of business

• Annex 8 – Comparability analysis

The taxpayer is required to submit these within five days from the date of receipt of the request. It is worth noting that most of the information contained in the annexes listed above are also present in transfer pricing documentation (TPD). The TPD, on the other hand, must be submitted to the RO within 30 days from the date of receipt of the request.

The RO is expected to perform the audit in a three-step implementation phase, as discussed below.

1. Determination of the characteristics of the taxpayer’s business

In this step, the RO will identify the characteristics of the related party transaction in question by studying several sources of information as earlier discussed in the preparation phase.

A functional analysis will also be performed by the RO by taking into account the economically significant activities and responsibilities undertaken, assets used or contributed, and risks assumed by the parties to the transaction. The more functions, assets, and risks associated with the taxpayer concerning the tested transaction, the higher level of profit it is expected to generate. As a result of the functional analysis, the RO should be able to come to a conclusion as to the taxpayer’s characterization, which may take the form of toll manufacturing, contract manufacturing, fully fledged manufacturing, fully fledged distributor, limited risk distributor, commissionaire, commission agent, service provider, or others.

2. Selection of transfer pricing method

Next, the RO will identify available comparables, whether internal or external. Internal comparables are obtained when the tested party engages in transactions with unrelated parties. Meanwhile, external comparables may include, but are not limited to, the market price of commodity products, BSP rates, the SEC database, and commercial databases.

Thereafter, the most appropriate transfer pricing method is chosen from traditional transaction-based methods and transaction profit-based methods. These methods are used to compute the “arm’s-length price.” Traditional transaction-based methods include the comparable uncontrolled price method, resale price method, and cost-plus method. On the other hand, transaction profit-based methods include transactional net margin method and profit split method.

3. Application of arm’s-length principle

The crux of a TP audit lies in the performance of comparability analysis, wherein the controlled and uncontrolled transactions are weighed against each other. This step aims to answer the main question of whether the tested transactions are conducted at arm’s length.

The RO arrives at a conclusion whether the tested transaction was conducted at arm’s length based on the audit. If the relevant conditions of the controlled (e.g., price or margin) are within the arm’s length range of price or profit, no adjustment should be made.

However, if the relevant conditions of the controlled transaction fall outside the arm’s length range asserted by the RO, the taxpayer should have the opportunity to present arguments that the conditions of the controlled transaction satisfy the ALP, and that the result falls within the arm’s length range (i.e., that the arm’s length range is different from the one asserted by the RO). If the taxpayer is unable to establish this fact, the RO must determine the point within the arm’s length range to which it will adjust the conditions of the controlled transaction.

A TP adjustment will be proposed by the RO as part of his findings in an assessment when:

a. The consideration for the sale of services/goods is less than the arm’s-length price; or

b. The consideration for the purchase of services/goods is higher than the arm’s-length price; or

c.  No consideration has been charged to the related party for the supply of goods/services.

TP audits have yet to be fully integrated in most tax assessments as TP rules and regulations are relatively fresh and ROs are unfamiliar with their concepts. However, with JICA proposing to institutionalize an intensive transfer pricing team in the BIR, we can reasonably assume that regular TP audits are looming for multinational companies.

The TPD will serve as the main line of defense for taxpayers in the event of a TP audit as it has essentially pre-performed the procedures that are expected to be conducted by the BIR. This allows the taxpayer to re-evaluate its transfer pricing policies before an audit is conducted. If TP audits are the next wave of assessments from the BIR, the TPD serves as a surfboard and allows the taxpayer to ride the waves, be they calm or rough.

Let’s Talk TP is 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.


Kyle Benedict C. Paris is a senior in charge from the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.