Overview of the draft transfer pricing revenue regulations

(Third of three parts)

Advance pricing arrangements (APAs)

The draft RR makes reference to APAs, which may be unilateral, bilateral, or multilateral. It states that an APA shall formally be initiated by the taxpayer.

However, the draft RR provides that the BIR shall only start accepting the applications for APAs after the release of the complete set of procedures in processing APAs. It would appear then that even if the draft RR is finalized and issued, no APAs may be applied for immediately. Taxpayers may have to wait for another issuance providing for the procedure in obtaining APAs.

The APA shall apply only to prospective years and transactions. Moreover, the prospective tax years should not be beyond three years from the date of conclusion of the APA, subject to renewal if things or situations do not change.

Nevertheless, the agreed TP methodology under the APA may be applied to resolve similar TP issues in open prior years subject to the agreement with the BIR and, where appropriate, the tax treaty partner. Notwithstanding this, the draft RR does not provide the guidelines/procedure for obtaining the agreement.

Specific situation – thin capitalization

The draft RR mentions specific situations and the general rules that should apply to them. One of these is thin capitalization. A corporation, other than banks, financing company, non-bank financial intermediary performing quasi-banking functions is considered to be thinly capitalized if the ratio of debt-to-equity exceeds three is to one (3:1) unless a different debt-to-equity ratio is prescribed by special laws. If the draft RR is finalized, this will be the first time the BIR will formally state that it follows the 3:1 debt-to-equity ratio. Previously, when it was implementing joint examination of related parties sometime in 1998 as provided by Revenue Audit Memorandum Order (RAMO) No. 1-98, the BIR merely pointed out that the debt-to-equity ratio should be reasonable considering all factors surrounding the case.

Under the draft RR, any amount of debt resulting to a higher debt-to-equity ratio than that prescribed shall be considered as excessive debt and shall be treated as equity. Correspondingly, interest payment or accrued interest attributable to the excess debt shall be treated as dividend and shall be taxed accordingly. Moreover, it shall not be deductible in computing taxable income.

Cost contribution arrangements (CCAs)

The draft RR discusses the concept of CCAs and reiterates the general guidance for CCAs as provided under the OECD TP Guidelines. It is silent on the tax treatment of adjustments made to the contributions by participants to the CCAs. However, based on the draft RR, the BIR sees the need to review CCAs. At present, the BIR is known to have questioned already during audits of taxpayers’ books of accounts the allocation of cost made by related parties and have requested the submission of the supporting documentation. While such examinations have not prospered into actual TP audits, the BIR has recognized that the sharing in the costs should be in proportion to the respective share of anticipated benefits.

Conclusion

It is hoped that the overview of the draft RR will allow taxpayers to do some planning regarding their related-party transactions in preparation for the formal issuance of the RR on TP.

Taxpayers should be aware of some items for considerations. As early as 1998, through its RAMO 1-98, the BIR has noted that the remarkable decrease in collection from interrelated groups of companies has seriously affected the collection efforts of the BIR. While interrelated transactions account for a big percentage of the transfer of goods and services in the Philippines, the revenue collection from related-party groups continues to go on a downtrend. Hence, RAMO 1-98 requires that focus must be made on the following audit issues:

• Use of tax shelters (such as a foundation or a tax-exempt company) in order to avail of tax exemptions or of lower tax rates

• Shifting income and/or expenses in favor of a related company with special tax privileges (e.g. income tax holidays)

• Transfer pricing in inter-company supply of goods (tangible and intangible) and services

• Inter-company loans and advances, and financing arrangements where the interest charged for the use of money is not at arm’s length

• Arbitrary cost-sharing arrangements for common expenses

• Tax avoidance through resale and agency arrangements

• Thin capitalization.

With the issuance of the RR on TP, the BIR might prioritize the audit for TP purposes of taxpayers having these audit issues.  

Based on the BIR’s audit programs for each year, priority taxpayers identified for examination by the BIR include taxpayers reporting net loss or no taxable income in their tax returns and taxpayers with income tax due of less than two percent of gross sales/receipts. These priority taxpayers may be candidates as well for TP audits considering that transfer prices determine income and expenses and, therefore, taxable income of taxpayers.

(Maria Carmela M. Peralta is a Principal for Tax & Corporate Services of Manabat Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative.

The views and opinions expressed herein are those of Maria Carmela M. Peralta and do not necessarily represent the views and opinions of KPMG in the Philippines. For comments or inquiries, please email [email protected] or [email protected]).