(Second of two parts)
In the previous article, we discussed the salient points of RAMO No. 1-2019, the Transfer Pricing (TP) Audit Guidelines and the urgent need to have a TP documentation to prepare for the TP audits.
These guidelines also provide the audit procedures to be applied to specific TP issues that are quite common to groups of companies today. These issues relate to intra-group services, intangible assets and interest payment transactions.
Under the RAMO, intra-group services are activities undertaken within a group that provide benefits for one or more other members in the group. Intra-group services may take the form of management, administration, technical, support, purchasing, marketing, distribution and other commercial services provided in connection with the group’s business.
Of the above forms of intra-group services, the most common are the management services for which a parent company or another company within the group charges a management fee, and the “shared services,” which include non-core or other support services that are centralized into and provided by a shared service center within the group.
Under the guidelines, it is not enough that an arm’s-length fee is charged for these services. It is equally important to prove that the other party receiving the service has derived economic benefit from the service. Such benefit is derived by considering whether an independent party in similar circumstances would be willing to pay another independent party for the service or would just perform the services itself.
There are also certain kinds of services that cannot be considered intra-group services because there is no economic benefit to the service recipient. These services include shareholder activities, duplicative services, those that provide incidental benefit, and on-call services. In such a case, such services do not justify a charge to the service recipient.
Thus, the possible risk is a total disallowance or the downward adjustment of the service charge to the service recipient, insofar as it pertains to the excluded services, resulting in deficiency income tax from the additional income arising from a disallowed or lowered service fee.
Given all these considerations, it is, therefore, important to revisit management and shared services agreements and the TP documentation itself. These agreements must be closely examined to ensure that the services described in the agreements fall within the category of intra-group services and not under the exclusions.
The RAMO also provides procedures for identifying intangible assets in the conduct of functions, asset and risk (FAR) analysis of the parties to the related party transaction (RPT). Intangible assets are those that are neither physical nor financial assets. A higher profitability level than the average for the industry is a factor that may establish the existence of an intangible asset. It is not necessary that such intangibles be recorded as an asset in the balance sheet or registered with the Intellectual Property Office. Even costs or expenses incurred in connection with research and development and the marketing of a product may indicate the existence of an intangible asset.
In transfer pricing, the existence of an intangible asset is an indication that the owner is engaged in high-value functions in its transaction with affiliates. In such a case, the owner of such an intangible asset should be compensated with more than a mere routine return for its functions. The owner must be remunerated at a higher return that will allow it to recover the costs incurred for the development of such an intangible asset.
In addition, a company that owns an intangible asset cannot, in most cases, be selected as a comparable for a company that performs routine manufacturing or distribution functions. Thus, as part of the TP documentation, an analysis has to be made on whether a company, by the nature of its functions, owns such intangible assets.
Finally, the RAMO also prescribes audit procedures on intra-group loan transactions. The two areas of focus are the arm’s-length nature of the debt-to-equity ratio and the reasonableness of the interest rate and other expenses for the intra-group loan transaction.
In testing the interest payments, an analysis must be made of the need for the debt and the market conditions at the time the loan is extended. In determining the need for the debt, the level of debt held by the borrower of the affiliate should be considered. The debt-to-equity ratio of the borrower is also benchmarked against the debt and equity of similar companies, although the purpose for determining such ratio is unclear in the regulations.
In other countries or jurisdictions, the debt-to-equity ratio is a factor that is taken into account in determining if a company is thinly capitalized, that is, whether the higher level of related-party debt than equity is intended to take advantage of the interest deductions that comes with financing with debt rather than with equity. Where a company is thinly capitalized, its interest deduction attributable to the higher debt-to-equity ratio may be disallowed.
In the TP documentation covering the interest payments on intra-group loans, it is, therefore, important to establish what is an acceptable debt-to-equity ratio within the industry and to ensure that related-party debt is within the benchmarked ratio.
Given the complexity of TP audits and the preparations being undertaken by the Bureau of Internal Revenue, it is now more vital than ever that companies consider the factors we presented when establishing a pricing policy for intra-group services, intangible assets and interest payment transactions. Companies with foresight will make advance work, prepare TP documentation or revisit an existing one, to be better positioned in managing risks brought on by a TP audit.
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.