Related parties, transfer prices and revenues

One topic expected to gain prominence in the coming months from the purview of the Bureau of Customs (BoC) and the Bureau of Internal Revenue (BIR) is that of transfer pricing. It would be worth exploring this issue a little closer now, since word has circulated that a formal and codified set of transfer pricing regulations from the BIR may be promulgated within the year.

What is it?

Simply defined, a transfer price is the price at which a commercial entity sells to a related party. This concept essentially applies to multinational companies having a presence in different territories between which actual commercial transactions take place. Naturally, commercial entities transacting with related parties would most likely have a systematic internal arrangement with regard to how prices between them would be set.

Such a system may take into consideration various factors which may include: the profitability of the market in a particular territory, the level of risk absorbed by the buyer or the seller, additional expenses such as marketing and promotions, and netting-off provisions. Understandably, from the perspective of the private sector, businesses operating in a regional setting would want to spread their risk and costs to as wide an area as possible to ensure that bottomlines are safeguarded. This concern is simple and makes perfect business sense.

The revenue angle

However, the complexities of transfer pricing implications become clear when the basis of direct (e.g. corporate income tax) and indirect taxes (e.g. customs duties, value added tax) is to be determined. Since price is an integral function of both income and cost, any changes in price would inevitably alter a company’s tax base, and consequently, the amount of taxes or duties assessed.

In theory, price alterations would not be a problem if the buyer and seller are unrelated, as it would be logical to assume in such a scenario that the price set between the two would cover the cost of the product, incidental expenses, and a reasonable amount of profit. This roughly constitutes an “arm’s length” transaction. A sensible tax base would most likely obtain in this situation - to the satisfaction of the revenue authorities.

On the other hand, related parties – by their nature - are equipped with the ability to spread their profits, cross-subsidize prices, or even sell below their product’s actual cost resulting in different price structures. It is these possibilities within related party pricing that may raise the brows of revenue authorities, giving them reason to be more scrutinizing to ensure that the proper tax bases are being declared, and the appropriate amount of taxes and duties are collected.

The BoC and BIR divide

What then are revenue authorites looking for in a transfer price to find the same acceptable? A simple answer would be evidence that the same was set in accordance with “arm’s length” principles – which will be explained in a while. However, a more practical and inquisitive answer would be: it depends on which revenue authority.

BoC and BIR may take different sides in viewing and making a determination on the acceptability of a transfer price. This is understandable, considering the different subjects of their assessments. BoC assesses duties on a transaction per transaction basis, levying the same on the transaction value of the imported product. Thus, the higher the cost or transaction value, the more favorable to BoC since this would amount to higher collections. If BoC sees a transfer price that falls below reference threshholds, then it may undertake to look deeper into the details of the transaction to see if certain costs may have been omitted. The Bureau of Internal Revenue however examines the profits and income of a company. Thus, to BIR (unlike BoC), a higher transfer price, would be less to their liking since this would imply lower income for the company and, corollarily, a lower income tax base.

In view of the various areas of potential conflict, what objective methods then should be employed in ascertaining the validity of a transfer price for BIR and BoC purposes? Careful and valid documentation in this aspect is of high importance for multinational companies since an unjustified transfer price may exact penalties from both revenue authorities.

In determining the dutiable value, BoC makes use of the 6 step appraisement hierarchy established by Agreement on the Implementation of Article VII of the General Agreement of Tariffs and Trade (GATT). The primary method under this hierarchy is the Transaction Value, or the price actually paid or payable. In the first instance, BoC examines the commercial condition of the sale and may use reference values, such as comparable prices from unrelated party transactions. Should BoC cast any doubt on the acceptablity of the transaction value, then it would proceed hierarchically to the following methods namely: the transaction value of identical goods, transaction value of similar goods, the computed value, the deductive value (the latter two being interchangeable), and the fall-back value.

Although BIR has yet to adopt formal transfer pricing regulations, it would be safe to assume that its rules would more or less mirror Article 9 of the Organization for Economic Cooperation and Development (OECD) guidelines. These guidelines give out criteria to check comparability between controlled and uncontrolled transactions. These criteria include, among others, characteristics of the product, the function of the transacting parties, assets and risks assumed, terms of contract, strategies employed and economic circumstances. These techniques are utilized in different methods, the applications of which vary depending on the nature of the business: comparable uncontrolled price, resale price, transactional net margin, profit split, and cost plus.

Time to prepare

As early as now therefore, companies should carefully review their related party transactions and see to it that the prices they set would be in compliance with both the BoC and BIR methodologies. Such an exercise could provide two fold benefits. First, it would improve a company’s corporate governance standing, protecting it from penalties and additional assessments should the BIR and/or the BoC perform enforced compliance audits of its records. Secondly, it may open opportunities to save on tax and customs duties especially if possible overdeclarations are uncovered.

(Jeremy I. Gatdula  is a Principal for International Trade and Customs Services of  Manabat & Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. This article is for general information only and is not intended to be, nor is it a substitute for, informed professional advice. While due care was exercised to ensure the quality of the information contained in this article, readers should carefully evaluate its accuracy, completeness and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances. For comments or inquiries, please email [email protected] or [email protected]).