All is Fair in Love, War, and Transfer Pricing?

An overview of Transfer Pricing and the Arm’s Length Principle

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Many have referred to business as war since it is not an easy task to grow and maintain one. But in reality, it may not be all competition. In most cases in the Philippines, business is also a family affair and if undertaken by a couple, an extension of their love affair. As the business grows, partnerships and alliances turn a single entity into a group of companies.

Naturally, as much as practicable, business is kept within the family. Why go to a third party if your parent company can supply the raw materials for the shoes you are manufacturing? And if a sister company would need shoes manufactured, wouldn’t it make more sense to go to you?

There is nothing wrong with these transactions between and among related parties, and there is nothing that disallows it. But while business may be war and all is fair in love and war, this is not entirely true when it comes to Transfer Pricing which requires that transfer prices between and among related parties should always comply with the arm’s length principle (“ALP”).

Arm’s Length Principle

The Arm’s Length Principle is the basis for transfer pricing rules in most countries, including the Philippines. The principle is this: the price for the transfer of products or services (the “Transfer Price”) in a controlled transaction or a transaction between related parties or associated enterprises should be the same as the transfer price that third parties would have charged each other under similar circumstances.

To illustrate, let us assume that you are in the market for suede leather as raw materials for the shoes you manufacture. If the average market price for a yard of suede leather of a particular quality is ₱2,000.00, your affiliate should generally sell you suede leather of similar quality for also ₱2,000.00 per yard. In the alternative, if your affiliate also sells to third parties, your affiliate may sell to you the same price it charges third parties for the same raw materials.

The Principle may not always be easy to apply to related party transactions (“RPTs”). While third parties transacting with each other are motivated by the market forces of supply and demand, RPTs are not as influenced by such forces because in most cases, what drives the transactions are corporate synergies and relationships.

In recent years, the rising global political and public concerns on tax evasion have brought about the strengthening of transfer pricing (“TP”) rules that is underpinned by the ALP.

What is sought to be avoided is the scenario where these relationships will be used by multinational entities (“MNEs”) to focus less on the individual company, and more on the overall profitability of the group by shifting the profit to jurisdictions charging less taxes to reduce the overall tax burden of the organization. If non-arm’s length transactions are allowed, with MNEs shifting the profits to lower tax countries, higher taxing countries risk decreased tax collections from these RPTs.

Transfer Pricing in the Philippines

While globally, TP rules generally cover only cross-border transactions, TP rules in the Philippines are unique as they also cover all transactions between or among Philippine associated enterprises, including a scenario where profits will be purposely shifted from a party subject to regular tax rates to a related party enjoying incentive/ preferential tax rates. Thus, even if a conglomerate in the Philippines does not deal with foreign related parties or do not transact with them, so long as members of the group all located in the Philippines transact with each other, the TP rules/guidelines still apply.

TP guidelines and policies were only fairly recently issued by the Bureau of Internal Revenue (“BIR”), but it has long found statutory basis in Section 50 of the National Internal Revenue Code (“NIRC”) that empowers the BIR to distribute, apportion or allocate gross income or deductions of related parties to prevent evasion of taxes or to clearly reflect the income of each related party.

BIR Transfer Pricing Requirements

To ensure proper disclosure of RPTs and compliance with the ALP, the BIR has released various issuances in 2020 including Revenue Regulations (“RR”) No. 34-2020 issued on 21 December 2020 to streamline the guidelines and procedures for the submission of BIR Form No. 1709 (Information Return on Transactions with Related Party) (“RPT Form”) and the Transfer Pricing Documentation (“TPD”).

Who are required to file the RPT Form?

The RPT form is required to be filed by a taxpayer together with its Annual Income Tax Return (“AITR”) if the following conditions are present:

  1. The taxpayer is required to file an AITR;
  2. It has transactions with domestic or foreign related party during the concerned taxable period;
  3. It falls under any of the following categories:
    Large Taxpayers;

    • Taxpayers enjoying Tax Incentives (i.e. BOI-registered and economic zone enterprises, those enjoying Income Tax Holiday or subject to preferential income tax rate);
    • Taxpayers reporting net operating losses (for income tax purposes) for the current taxable year and the immediately preceding two (2) consecutive years; and
    • A related party which has transactions with A, B, or C.

As clarified by Revenue Memorandum Circular (“RMC”) No. 54-2021, in case of failure to file the RPT Form or provide any material information therein, taxpayers may be penalized for such failure.

What is TPD and who are required to prepare it?

TPD is a report that details the RPTs of a taxpayer and its compliance with the ALP. It comprehensively documents the TP method/s selected and applied to arrive at the arm’s length price or allocation. The TPD is not required to be attached to the taxpayer’s AITR. However, once the BIR requests the production of the TPD pursuant to a duly issued Letter of Authority (“LOA”), TPD shall be submitted within 30 calendar days subject to a one-time 30-day extension.

The preparation of a TPD shall be mandatory if the taxpayer is required to file the RPT Form and meets any of the following materiality thresholds:

  1. Annual Gross Sales/Revenues for the subject taxable period exceeding Php150,000,000.00 and the total amount of RPTs with foreign and domestic related parties exceeds Php90,000,000.00;
  2. Sale of tangible goods involving the same related party exceeding Php60,000,000.00 within the taxable year;
  3. Service transaction, payment of interest, utilization of intangible goods or other RPT involving the same related party exceeding Php15,000,000.00 within the taxable year; or
  4. If TPD was required to be prepared during the immediately preceding taxable period for exceeding 1 to 3.

The risk of failing to prepare the TPD is being subjected to a transfer pricing audit which preparation of a TPD may mitigate.

Transfer Pricing Risks

RMC No. 54-2021 explicitly states that when subjected to audit, even taxpayers who are not mandated to submit the RPT Form and to prepare a TPD must still present sufficient evidence to prove that their RPTs were conducted at arm’s length. Therefore, taxpayers with related party transactions must not be complacent in supporting their related party transfer prices merely because their transactions fall below the materiality thresholds.

Pursuant to Section 50 of the NIRC, and the relevant regulations of the BIR on TP, the BIR may, during audit examinations, adjust a taxpayer’s taxable income for non-compliance with the ALP to reflect the appropriate arm’s length price of its RPTs, this simply means a potential assessment for deficiency income tax or disallowed expenses. In case of an upward adjustment, the taxpayer may be assessed for deficiency tax and imposed the corresponding penalties, unless the taxpayer is able to defend that its prices are arm’s length through sufficient evidence, including the TPD that documents the compliance with ALP.

Forging Ahead

As a best practice, associated enterprises should already consider compliance with the ALP before entering into new transactions with related parties to avoid audit risks.

Beyond mere compliance with forms and documentation, companies would benefit from knowing the arm’s length transfer prices which more importantly provides a bird’s eye view of the economic and financial environment of entities entering into the same transactions, having the same functions, or being in the same industry.

This article is for general information purposes only. It is not intended to provide tax advice or recommendation for any particular circumstance. While we have endeavored to ensure accuracy, we do not accept responsibility or liability for any actions taken based on the information indicated herein. Thus, any reliance placed upon such information is solely at your own risk.

Aemie Maria Jordan

Manager, Tax Advocacy Group

[email protected]

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