Businesses today are confronted with numerous and wide ranging concerns as a result of the COVID-19 pandemic. There are pressing issues on production or client servicing, supply chains, human resources, cash flow, market demand, financing, or survival at the extreme. Tax obligations, likewise, have to be dealt with regardless of the company’s financial position.
For companies transacting with related parties, transfer pricing is another concern.
Except for a few strategic industries or sectors, most businesses anticipate a reduction in profits or even losses due to the lockdowns and continued slowdown in business activity.
CAN A COMPANY WITH RELATED-PARTY TRANSACTIONS INCUR LOSSES?
Revenue Audit Memorandum Order (RAMO) No. 1-2019 or the Transfer Pricing Audit Guidelines provide guidance to taxpayers on losses for companies with related-party transactions. RAMO 1-2019 mentions the need to establish that the losses are commercial in character and aligned with the nature of the business and the company. RAMO 1-2019 also requires taxpayers to maintain contemporaneous documentation of the factors that contributed to the losses. It is crucial to prove that non-transfer pricing factors are the cause. In the case of a 2020 transfer pricing audit, it is not sufficient to claim that the losses or reduced profits resulted from the COVID-19 outbreak.
CAN A COMPANY TRANSACTING EXCLUSIVELY WITH RELATED PARTIES INCUR LOSSES OR REDUCED PROFITS?
RAMO 1-2019 cites the case of a contract or toll manufacturer that only produces the product in volume and quality, and on schedules as ordered by the related-party customer. Since it does not perform other functions, such as operational strategy setting, product research & development, and sales, the contract manufacturer is expected to maintain a consistent level of profitability. Fluctuations in the profit margins, whether up or down, are only enjoyed or suffered by the entities with the entrepreneurial functions.
Most business process outsourcing (BPO) companies are in the same category. They perform the specified services, and are assured of compensation, usually on a cost-plus basis. The markup is generally fixed and is determined based on the arm’s-length markup of comparable independent companies. They are equally affected by the crisis. Their clients may have experienced business slowdown; hence, reduced demand for services. On the other hand, even if the demand for services was unaffected, the problem could be with servicing clients. Employees are unable to go to the office, and work-from-home arrangements had to be put in place. Some employees are unable to work from home, because of poor internet connection or unsuitable working space. Are they allowed to incur losses or reduced profits?
RAMO 1-2019 notes that the contract manufacturer can still incur losses as long as these are not arising from the related-party transaction. However, if the contract manufacturer deals exclusively with related parties, there could be few non-transfer pricing factors to which the losses can be attributed.
HOW MUCH REDUCTION IN PROFITS CAN BE ALLOWED?
2020 is not a typical year that can be benchmarked against information from prior years. The arm’s-length level of profitability may only be determined once the financial statements for 2020 become available, which is Q3 2021. If the company will have reduced profits, it is best to test the level once the information for benchmarking can be accessed.
Typically, reductions in profit margins for contract manufacturers and BPOs can also be justified if there are changes in the functions, assets, and risks they shoulder for the transaction. To address disruptions brought about by the COVID-19 pandemic, some multinational groups have considered restructuring the functions of the different entities across various jurisdictions to take advantage of the availability of resources or ease of doing business where quarantines are less strict. Such restructuring may require a reexamination of the transfer pricing policy.
The same issues and analysis apply in the case of shared services among local conglomerates.
For those who have put up transfer pricing documentation for their related-party transactions, justifying the changes against the established policy would be easier than where a benchmark is not available.
If you thought you could take a long rest after settling your company’s annual income tax obligations as of yesterday, taxation is far from over.
Your organization’s annual income tax return could be the subject to a BIR audit in as soon as a few months. A transfer pricing audit may also be looming for companies with related-party transactions. The company has to document and justify any changes in profitability in preparation for such an examination. It is always worthwhile investing in a comprehensive transfer pricing documentation.
Let us still hope, though, that tax authorities will be more considerate when tackling compliance for the years affected by the COVID-19 situation.
Let’s Talk Tax 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.
Lina P. Figueroa is a Principal of the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.