When we hear the term “profit shifting,” we often associate it with cross-border transactions between and among members of multinational companies (MNCs) aimed at reallocating profits across different countries or tax jurisdictions to minimize tax liabilities. Profit shifting enables businesses to move profits from high-tax jurisdictions to low-tax or no-tax areas to reduce the total tax liabilities of a conglomerate or a corporate group. While this strategy may be used to somehow avoid tax, it raises concerns about the fairness of tax computations and the revenue foregone by governments, resulting in the need for stricter regulations to ensure proper payment of taxes.

Although profit shifting often involves intercompany transactions among MNCs, it is not solely an international practice, as it can also occur within a single country. In some cases, businesses take advantage of tax incentives granted to certain industries or areas or engage in intercompany transactions among parent/holding companies, subsidiaries, and affiliates or entities under common ownership to unduly improve their tax positions.

The Bureau of Internal Revenue (BIR) acknowledged this risk and acknowledged that while transfer pricing issues typically occur in cross-border transactions, they can also occur in domestic transactions. The BIR illustrated how domestic transfer pricing issues may arise when income is shifted from a company subject to regular income tax to a related company enjoying special tax privileges from the Board of Investments (BoI) or the Philippine Economic Zone Authority (PEZA). Similarly, expenses from a tax-incentivized entity may be transferred to a related company subject to regular income taxes, or income and expenses may be strategically allocated among related parties to reduce a group’s tax liabilities.

This practice of domestic profit shifting can take many forms, often involving intercompany transactions that manipulate income and expenses to achieve tax avoidance. Businesses may engage in below-market or unreasonably high transfer pricing. These strategies allow companies to shift profits to entities enjoying lower tax rates or tax exemptions, which results in minimization or total elimination of tax liabilities.

COMMON WAYS OF DOMESTIC PROFIT SHIFTING
1. Transfer of goods and services among related parties

When a company sells goods or services to a related party at prices below market value or nothing is charged at all, particularly when the purchasing entity operates in a tax-incentivized zone, such as an economic zone, the selling party reports lower taxable income, while the purchasing party benefits from tax exemptions or reduced tax rates, resulting in a lower consolidated tax liability.

2. Management, consultancy, IT, finance, audit, and other back-office support

A tax-incentivized service provider may charge unreasonably high fees for management, consultancy, IT, finance, audit, and other back-office services to its related parties, which the latter recognize as deductible expenses. This reduces their taxable income while the service provider records a higher income, which may be tax-exempt or subject to a lower preferential tax rate, diminishing the total tax liability of the group.

3. Lease agreements between related parties

When a business rents real estate or equipment from an affiliated company at inflated rental rates, the leasing entity, if located in a tax-incentivized area, can report overpriced rental income, while the lessee claims the rent as a deductible expense, thereby lowering its taxable income.

4. Income and cost allocation within a corporate group

This normally occurs when a corporate group with multiple business units incurring shared expenses allocates a higher portion to entities subject to regular income tax rates while directing more revenue to entities enjoying tax incentives. With this practice, the company reduces taxable income where higher tax rates apply while increasing taxable income where lower tax rates apply.

5. Shifting income to entities with unutilized and expiring tax credits

Allocating more income to entities with unutilized and/or expiring tax credits, such as net operating loss carryovers (NOLCO), creditable withholding taxes, prior-year excess credits, excess minimum corporate income tax over regular corporate income tax, tax credit certificates, and other tax credits, allows businesses to utilize these tax benefits to lower the taxes due. By shifting income to a related company with available tax credits, the group ensures that these credits are fully utilized before they expire, which results in the offsetting of taxable income and lowering tax obligations. Meanwhile, the related entity incurring the corresponding expense reports understated taxable income, further diminishing its tax liability.

REGULATORY RESPONSE AND COMPLIANCE MEASURES
These examples are just some of the ways businesses engage in domestic profit shifting. Conglomerates or corporate groups engaged in different industries may take advantage of intercompany transactions to strategically minimize the tax obligations of the whole group.

Recognizing the impact of these practices on government revenues, the BIR has implemented regulations aimed at detecting and minimizing such activities. As a countermeasure, the BIR has begun closely examining transactions between related parties, particularly those involving significant expense allocations or income shifting. If an expense appears excessive or unwarranted, or does not meet the arm’s-length principle, meaning it was not incurred under fair market conditions between unrelated entities, the BIR has the authority to disallow the deduction.

Some companies may unknowingly engage in these practices and not fully understand their tax implications, or the potential risks involved. In many cases, intercompany transactions are structured based on business needs, with little consideration for how they might be viewed from a tax compliance perspective. Nevertheless, the BIR continues to strengthen and advance its monitoring and enforcement efforts to identify transactions that result in undue tax minimization, whether intentional or not. Failure to properly assess and document the rationale behind intercompany pricing and expense allocations can lead to tax deficiencies, penalties, and disallowed deductions, potentially causing significant financial losses for businesses.

PROPER TRANSFER PRICING DOCUMENTATION (TPD)
This is why maintaining proper TPD is crucial, even for companies that are not explicitly required by law to prepare such reports. Proper documentation serves as a safeguard, ensuring that all intercompany transactions are conducted at arm’s length and reflect fair market value. It provides transparency in pricing policies and helps justify the reasonableness of income and expense allocations, as well as the factors considered in setting prices between related entities. TPD assists in minimizing the risk of penalties, disallowed deductions, and tax adjustments that could arise from perceived profit shifting.

While profit shifting may offer short-term tax advantages, it comes with the risk of scrutiny, tax deficiencies, and penalties.

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.

Aaron Paul A. Santos is a manager from the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.

pagrantthornton@ph.gt.com