Some issues regarding the transfer pricing regulations

(Conclusion)

The application of the arm’s length principle will require a comparison of the prices or margins of related parties with those of unrelated parties engaged in similar transactions. This comparison will mean identifying first comparable situation(s) involving unrelated parties.   The economically relevant characteristics of the situations being compared must be sufficiently comparable. To be comparable means that none of the differences (if any) between the situations being compared could materially affect the price or margin being examined or that reasonably accurate adjustments can be made to eliminate the effect of any such differences. There are many factors affecting comparability. One will be the characteristics of the property or services involved. Another one will be the comparison of the functions taken on by the parties to the transactions, taking into account the assets used and risks assumed. Another one could be the markets in which the independent and related parties operate. (OECD Transfer Pricing Guidelines, Paragraphs 1.15, 1.19, 1.20, 1.30). 

The issue of comparability — that is, whether the “comparables” are sufficiently similar — will be most likely one area where the discussions by taxpayers with the BIR will focus on. Related to this will be if the BIR will require the “comparables” to be Philippine-based companies only. The OECD Transfer Pricing Guidelines have recognized that geographic location may affect market comparability. Tax authorities in other countries have accepted “comparables” located in the same region (e.g., Asia Pacific region) and not local companies only. This will be a matter for the BIR to decide. 

Another issue that will arise is the determination of the appropriate method to be used to identify or examine the transfer price. The OECD Transfer Pricing Guidelines provide for methods that may be used by taxpayers. These methods are grouped into two:  the traditional transaction methods and the transactional profit methods. 

Under the guidelines, the traditional transaction methods are the Comparable Uncontrolled Price Method, Resale Price Method, and Cost Plus Method. These methods are considered as the most direct means of establishing whether related party transactions are at arm’s length.  As a result, the traditional transactions methods are preferable to other methods. However, the OECD Transfer Pricing Guidelines have recognized that there are practical difficulties in applying the traditional transaction methods as when there are no data available or the available data are not of sufficient quality and, thus, may not be relied on (Paragraphs 2.49 and 3.50). The transactional profit methods comprise of the Profit Split Method and the Transactional Net Margin Method (TNMM). These methods are considered under the guidelines as methods of last resort. It should be noted, however, that the OECD is currently reviewing this position. It should be noted that the draft of the transfer pricing regulations states that the BIR does not have a specific preference for any one method. Instead, the method that produces the most reliable results, taking into account the quality of available data and the degree of accuracy of adjustments should be chosen.

Be that as it may, in practice, and view of the non-availability of reliable data, the TNMM is often applied by taxpayers. One question that might have to be addressed by the BIR is the acceptability of the profit level indicator (PLI) being used under the TNMM. The TNMM examines the net profit margin that a taxpayer realizes from a related party transaction. The net profit margin is examined relative to an appropriate base, which could be the total costs, sales, or assets (OECD Transfer Pricing Guidelines, Paragraph 3.26). What the PLI will be (otherwise-stated, what base may be appropriate) will be a question that might generate a lot of discussions between taxpayers and the BIR. By way of illustration, some tax authorities have accepted the Berry Ratio as a PLI. In simple terms, the Berry Ratio gets the net sales less the costs of goods sold and divides this resulting amount by the operating expenses. However, other tax authorities have reservations about the Berry Ratio as a PLI.

Who will be considered a related party might be another issue. Will the number of shares held by one corporation in another corporation be considered a factor in determining who a related party is? It should be noted, however, that the draft of the transfer pricing regulations includes a provision stating that control of an entity is said to exist if one entity holds not less than 30 percent of the outstanding shares entitled to vote of a corporation, in addition to other situations putting the parties in a controlled environment or relationships. 

It will be interesting to see if the BIR will identify some related party transactions as a priority for transfer pricing audits or as requiring special/additional guidelines/circulars.  Related party transactions cover a wide array of transactions, including the sale, lease, license, or any other transfer of tangible or intangible property, and the performance of services. These transactions include also inter-company loans, guarantees of performance made by related parties, and cost contributions agreements. 

As for intra-group services, one issue is whether services have in fact been provided.  Under the OECD Transfer Pricing Guidelines, the question of whether intra-group services have been rendered when an activity is performed for one or more group members by another group member should depend on whether the activity provides a respective group member with economic or commercial value to enhance its commercial position. This can be determined by considering whether an independent enterprise would have been willing to pay for the activity if performed for it by an independent enterprise or would have performed the activity in-house for itself. If this is not the case, the activity ordinarily should not be considered as intra-group services under the arm’s length principle (Paragraph 7.6).

It will also be interesting to see how the BIR will conduct transfer pricing audits. Of course, adjustments that the BIR might have to make to the transfer prices in order for these prices to be arm’s length may result in the imposition of deficiency taxes and penalties. One issue that might arise is if after making an adjustment to the transfer price and imposing deficiency taxes, how will the BIR treat the payments made by a related party that are over and above arm’s length price? Or how will the BIR proceed where the related party payments were below arm’s length prices? The OECD Transfer Pricing Guidelines have recognized that some tax authorities have asserted a constructive secondary transaction and will tax this accordingly.  Ordinarily, secondary transactions may take the form of constructive dividends, constructive equity contributions, or constructive loans. Secondary adjustments attempt to account for the difference between the re-determined taxable profits and the originally booked profits (Paragraph 4.67).

The above discussion shows only some of the issues/questions that might arise regarding transfer pricing regulations. There are other issues especially if one has to consider that many related party transactions are cross-border transactions. Thus, the transfer pricing requirements in other countries may have to be considered as well by the related parties. However, by understanding some of the issues, a taxpayer may start to understand what the issuance of the transfer pricing regulations may mean to him.

(Maria Carmela M. Peralta  is a Director for Tax and Corporate Services of  Manabat Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. Carmela is presently seconded to KPMG Singapore specializing in Transfer Pricing. 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]).