Proposed Revenue Regulations on Transfer Pricing Guidelines

January 7, 2013 DOF MEMORANDUM FOR : The Secretary SUBJECT : Proposed Revenue Regulations on Transfer Pricing Guidelines The Bureau of Internal Revenue (BIR) submits, for the Secretary's consideration and signature, the proposed Revenue Regulations (RR) providing Transfer Pricing Guidelines pursuant to Section 50 of the National Internal Revenue Code of 1997. Background Transfer pricing is generally defined as the pricing of cross-border, intra-firm transactions between related parties or associated enterprises. Typically, transfer pricing occurs between a taxpayer of a country with high income taxes and a related or associated enterprise of a country with low income taxes. Transfer pricing becomes a tax issue when a tax jurisdiction is deprived of revenues from a transaction between related parties, which, because of their objective of maximizing the worldwide after-tax profit as a group, enter into transactions that are not considered arm's length. This is usually done by concentrating profits with related entities in low-tax countries and minimizing profits in locations where tax rates are high. This inevitably reduces the taxable base. While transfer pricing issue typically occurs in cross-border transactions, it can also occur in domestic transactions. An example is where one enterprise, entitled to income tax exemptions, is being used to allocate income away from a company subject of regular income tax. In the Philippine setting, this may occur involving BOI or PEZA-registered enterprises and their fiscal incentives. IcCATD Proposed Policy The objectives of the proposed RR are the following: (i) Implement the authority of the Commissioner to review controlled transactions among associated enterprises and to allocate/distribute related parties' income/deductions to determine the appropriate revenues and taxable income of the associated enterprises; (ii) Prescribe guidelines in determining the appropriate revenues and taxable income of the parties by providing methods of establishing the arms length price; and (iii) Require maintenance or safekeeping of the documents necessary for the taxpayer to prove that efforts were exerted to determine the arm's length price or standard in measuring transactions among associated enterprises. The proposed RR is anchored on Section 50 of the NIRC 1 which gives the Commissioner the power to allocate income/expenses between related parties if the income reported does not reflect the true taxable income. The Organisation for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrators, particularly the methodologies contained therein, is likewise used as basis for the proposed RR. Through the proposed RR, the Commissioner is authorized to make transfer pricing adjustments, in line with the purpose of Section 50 of the NIRC, to ensure that taxpayers clearly reflect income attributable to controlled transactions and prevent avoidance of taxes with respect to such transactions. Salient Features The proposed RR provides the following definitions: Associated Enterprises. Two or more enterprises are associated if one participates directly or indirectly in the management, control, or capital of the other; or if the same persons participate directly or indirectly in the management, control, or capital of the enterprises. These are also referred to as related parties. Control refers to any kind of control, direct or indirect, whether or not legally enforceable, and however exercisable or exercised. Moreover, control shall be deemed to be present if income or deductions have been arbitrarily shifted between two or more enterprises. Controlled transaction means any transaction between two or more members of the same group of controlled parties/related parties. cAaTED Comparable transaction. A transaction that is comparable to the controlled transaction under examination taking into consideration factors such as the nature of the property or services involved, functional analysis of the transactions and parties, contractual terms, and economic conditions. Comparable uncontrolled transaction. A comparable uncontrolled transaction is a transaction between two independent parties that is comparable to the controlled transactions under examination. Arm's Length Principle The proposed RR uses the arm's length principle as the most appropriate standard to determine the transfer prices of related parties. The arm's length principle requires the transaction with a related party to be made under comparable conditions and circumstances as a transaction with an independent party. If two associated enterprises derive profits at levels above or below the comparable market level solely by reason of the special relationship between them, the profits will be deemed as non-arm's length. In such cases, the Commissioner can make the necessary adjustments to the taxable profits of the related parties so as to reflect the true value that would otherwise be derived in an arm's length basis. The application of the arm's length principle requires the following steps: 1. Conduct a comparability analysis identification of comparable transactions undertaken by independent parties, against which the controlled transaction is to be benchmarked; 2. Identify the tested party and appropriate transfer pricing method; and 3. Determine the arm's length results. 1. Comparability Analysis The arm's length principle is based on a comparison of the prices or margins adopted by related parties with those adopted by independent parties engaged in similar transactions. For such price or margin comparisons to be meaningful, all economically relevant characteristics of the situations should be sufficiently similar so that none of the differences can materially affect the prices or margins being compared, or in the case of any such differences, reasonable accurate adjustments can be made to eliminate the effect of. Factors affecting comparability include the characteristics of goods, services or intangible properties, analysis of functions, risks and assets involved, and commercial and economic circumstances. TIcEDC 2. Identification of the Tested Party and Appropriate Transfer Pricing Method (TPM) For an entity to become a tested party, the Bureau requires sufficient and verifiable information on such entity. The selection of a TPM is aimed at finding the most appropriate method for a particular case. Thus, the method that provides the most reliable measure of an arm's length result shall be used. The nature of the controlled transaction shall be considered, as well as the availability of reliable information and the degree of comparability between the controlled and uncontrolled transactions. The RR provides six TPMs and states that there is no specific preference for any one method. Instead, the TPM that produces the most reliable results, taking into account the quality of available data and degree of accuracy of adjustments, should be utilized. In exceptional circumstances where there may not be comparable transactions or sufficient data, the BIR may extend any of the TPMs or use a combination or mixture of the TPMs. In all cases, the taxpayer should be able to explain through proper documentation why a specific TPM was selected or used in recording the controlled transaction. 3. Determination of Arm's Length Results As it is generally difficult to arrive at specific ratio or range of deviation that may be considered as arm's length, the use of ranges to determine an arm's length range shall be applied. If the relevant condition of the controlled transaction is within the arm's length range, no adjustment should be made. If the relevant condition falls outside the arm's length range, the taxpayer should present proof or substantiation that the conditions of the controlled transaction satisfy the arm's length principle. If the taxpayer is unable to establish this fact, the BIR must determine the point within the arm's length range to which it will adjust the condition of the controlled transaction. Comparability adjustments must be made to account for the differences between the transaction of the comparables and that of the tested party, in order for the comparables to be useful as basis. In any proposal for a comparability adjustment, a resultant improvement or increase in the accuracy should be demonstrated. Arm's Length Pricing Methodologies The proposed RR provides the following methods may be used: a. Comparable uncontrolled price (CUP) method the amount charged between independent parties is used for determining arm's length. EADSIa b. Resale price method the gross profit margin realized in comparable uncontrolled transactions is used for determining arm's length. c. Cost-plus method (CPM) focuses on the gross mark-up obtained by a supplier who transfers property or provides services to a related purchaser and attempts to value the functions performed by the supplier of the property or services. d. Profit-split method seeks to eliminate the effect on profits of special conditions made or imposed in a controlled transaction by determining the division of profits that independent enterprises would have expected to realize from engaging in the transaction. e. Transactional net margin method (TNMM) examines the net profit margin relative to an appropriate base such as costs, sales or assets attained by the member of a group of controlled taxpayers from a controlled transaction. Uses the operating profit earned in comparable uncontrolled transactions as basis for arm's length. Advance Pricing Arrangements and Mutual Agreement Procedure An Advance Pricing Arrangement (APA) is an agreement entered into between the taxpayer and the BIR to determine in advance an appropriate set of criteria ( e.g. , method, comparables, and appropriate adjustments thereto) to ascertain the transfer prices of controlled transactions over a fixed period of time. The purpose of an APA is to reduce the risk of transfer pricing examination and double taxation. This is allowed by the proposed RR. Documentation The proposed RR likewise requires taxpayers to keep adequate documentation in order for them to defend their transfer pricing analysis, prevent transfer pricing adjustments arising from tax examinations, and support their applications for mutual agreement procedure (MAP). The proposed RR requires the taxpayer to retain documents and submit the same to the BIR only when required or requested to do so. Although there is no retention period specified, the RR provides that it is in the best interest of the taxpayer to keep said documentation. Penalties The penalties as provided in the Tax Code and other applicable laws shall be applicable to any person who fails to comply with or violates the provisions and requirements of the proposed RR. Recommendation Based on the foregoing, we find the proposed Revenue Regulations to be legally proper and in order. We recommend approval. Attached therefore, for the Secretary's signature, is the proposed Revenue Regulations. cHTCaI (SGD.) CARLO A. CARAG Undersecretary Revenue Operations & Legal Affairs Group Footnotes 1. SEC. 50, NIRC. Allocation of Income and Deductions. In the case of two or more organizations, trades or businesses (whether or not incorporated and whether or not organized in the Philippines) owned or controlled directly or indirectly by the same interests, the Commissioner is authorized to distribute, apportion or allocate gross income or deductions between or among such organization, trade or business, if he determined that such distribution, apportionment or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such organization, trade or business.