UPDATES IN TAXATION

TRANSFER PRICING RULES IN THE PHILIPPINES by: Atty. Edwin R. Abella, CPA, LLMA Presentation at the National Tax CongressCrowne Plaza GalleriaOctober 17, 2014 Presentation OutlineEvolution of Transfer Pricing (TP) in the Philippines

Survey of the New Transfer Pricing Regulations (RR No. 2 2013)Key provisions of the TP RegulationsTransfer Pricing methodologiesWhat requirements to be observed in compliance with the Regulations?ERA 10.17.142Main sources of TP rules National Internal Revenue Code (NIRC)

Philippine Transfer Pricing Cases

Revenue Issuances

ERA 10.17.143Main Tax Code ProvisionSection 50. 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 organizations, trade or business, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such organizations, trades, or businesses.ERA 10.17.1444Other Tax Code ProvisionsSection 100 Transfer for Less than Adequate and Full Consideration. The difference between the fair market value and the consideration received is deemed as a gift. Section 106(E) Authority of the Commissioner to Determine the Appropriate Tax Base where the gross selling price is unreasonably lower than the actual market value.Section 130(B) - Determination of Gross Selling Price of Goods Subject to Ad Valorem Tax. Price at the level of the agents or other establishments wholly or partly owned by the manufacturer. If the price is less than the cost to manufacture and sell, imputation of not less than 10% profit margin shall be made.ERA 10.17.1455 Phil. Transfer Pricing CasesCIR v. Cyanamid Philippines, Inc., 1999Involves use of a third party comparable due to alleged similarity of ingredientBIRs Allegations:Taxpayers Aurofac is similar with Pfizers Vigofac because both contain an antibiotic which is penicillin used for animals.Taxpayers Minocycline is simmilar to Pfizers Doxycycline because both are tetracycline antibiotics used to combat bacterial infections in the human body. Ruling: The drugs are different as to the:Use Aurofac is a cure for animal diseases while Vigofac is growth stimulant.Production process Minocycline takes 5 steps and uses less raw materials while Doxycycline takes 3 steps and uses more raw materials.ERA 10.17.146Philippine TP Cases Avon Products Manufacturing, Inc. v. CIR, 2005Involves comparison of sale to local affiliate with exportation to a foreign affiliate

BIR Position: Taxpayer underdeclared export sales because export price is lower than the price of the local sale.

Ruling:Lower export price is justified because of difference in the market. Best price gets the business.ERA 10.17.147Philippine TP CasesING Barings Securities Philippines, Inc. v. CIR, 2005Involves comparison of price of services to third parties v. services rendered to an affiliate.

BIRs Position:Additional commission income should be imputed because price given to its foreign affiliate is not at par with its other foreign clients. Ruling:Not comparable because the foreign affiliate performs other duties for the Manila office in terms of marketing, research and execution of transactions.ERA 10.17.148Previous Administrative IssuancesSec. 179 of Revenue Regulations No. 2-40

Revenue Audit Memorandum Order (RAMO 1-98) Audit Guidelines and Procedures in the Examination of Iterrelated Group of Companies.

Revenue Memorandum Order No. 63-99 Determination of Taxable Income on Intercompany Loans or Advances.

Revenue Memorandum Circular No. 26-08 (Interim Transfer Pricing Guidelines) BIR formally adopted the OECD Guidelines in resolving transfer pricing issues.ERA 10.17.149The new TP GuidelinesRevenue Regulations (RR) No. 2-2013Dated January 23, 2013Effective: February 9, 2013Adopts the OECD (Organization for Economic Cooperation & Development) ModelImplements Section 50, NIRCERA 10.17.1410 Objectives and scopeImplement the authority of the Commissioner:To review controlled transactions among associated enterprisesTo allocate or distribute their income and deductions in order to determine the appropriate revenues and taxable income of the associated enterprises involved in controlled transactions Prescribe guidelines in determining the appropriate revenues and taxable income of the parties; andRequire the maintenance or safekeeping of TP documentationERA 10.17.1411 Key Terms under the TP GuidelinesComparable 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 provided, functional analysis of the transactions and parties, contractual terms, and economic conditions.

Comparable uncontrolled transaction A transaction between two independent parties that is comparable to the controlled transactions under examination. Can be internal comparable or external comparable.ERA 10.17.1412Key Terms (continued)Control refers to any kind of control, direct or indirect, whether or not legally enforceable, and however exercisable or exercised.

Independent enterprises or parties two enterprises are independent enterprises with respect to each other if they are not associated enterprises.ERA 10.17.1413Some Key Features of Phil. TPAdvance Pricing arrangements (APA) Agreement entered into between the taxpayer and the BIR to determine in advance an appropriate set of criteria to ascertain the transfer prices of controlled transactions over a fixed period of time.Unilateral APA or Bilateral/Multirateral APANot mandatory but may reduce the risk of TP reexamination and double taxationSeparate guidelines will be issued

Mutual Agreement Procedure (MAP)As per Article 25 of the OECD Model Tax ConventionSeparate guidelines will be issuedERA 10.17.1414Basis of the TP GuidelinesArms length Principle

Requires the transaction with a related party to be made under comparable conditions and circumstances as a transaction with an independent party.ERA 10.17.1415 Arms length principleParagraph 1, Article 9 (Associated Enterprises) of the OECD Model Tax Convention on Income and Capital authoritative statement of the arms length principle.Par. 2, Art. 7 (Business Profits) provides that when attributing profits to a PE, the PE should be considered as a distinct enterprise engaged in the same or similar activities and under the same or similar conditions application of the arms length principle.ERA 10.17.1416Application of arms length principleERA 10.17.14173-step approach:Application of arms length principleERA 10.17.1418Application of arms length principle

ComparabilityComparison of prices or margins obtained by related parties with those adopted by independent parties engaged in similar transactionsAll economically relevant characteristics of the situations compared should be similar so that:None of the differences can materially affect prices or marginsAdjustments can be made to eliminate the effects of differences

Factors Affecting ComparabilityCharacteristics of Goods, Services or Intangible PropertiesAnalysis of Functions, Risks and AssetsCommercial and Economic CircumstancesApplication of arms length principleERA 10.17.1419Factors Affecting Comparability

1. Characteristics of Goods, Services or Intangible PropertiesSpecific characteristics are important in determining values in the open market

Include, among others: (or goods) physical features, quality and reliability, availability and volume of supply (in case of transfer of goods); nature and extent of services; (for IP) form of transaction, type, duration and degree of protection, and anticipated benefits.Application of arms length principleERA 10.17.1420Factors Affecting Comparability 2. Analysis of Functions, Risks and AssetsEconomics dictates that level of return should be directly correlated to functions performed, assets owned, and risks assumedCrucial step is to identify the economically significant functions, risks and assets, of a related party, with that of independent companiesBut not all, only those significant in determining the value of the transactions /marginsApplication of arms length principleERA 10.17.1421Factors Affecting Comparability

3. Commercial and Economic Circumstances

The markets and economic conditions in which the entities operate/where the transactions are undertaken should likewise be comparableGovernment policies and regulation may also have an impactBusiness strategies21APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1422Determination of the Tested Party

Tested Party: entity in which a transfer pricing method can be most reliably applied to, and from which the most reliable comparables can be found.

BIR requires sufficient and verifiable information on such entity.22APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1423Selection and Application of the TP Methods (TPM)Aimed at finding the most appropriate and reasonable method for a particular caseNo specific preference for any one methodShould produce the most reliable results, taking into account the quality of available data and degree of accuracy of adjustmentsIn all cases, the taxpayers should be able to explain why a specific TPM was selected23APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1424Transfer Pricing Methods:

Comparable Uncontrolled Price MethodResale Price Method Cost Plus MethodProfit Split MethodTransactional Net Margin Method24 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1425TP METHODSComparable Uncontrolled Price (CUP)Compares the price (or amount) charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances.A reliable method where an independent enterprise sells or buys the same product or service as that sold between the two related parties concerned.Standard of comparability under the CUP Method is very high25 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1426TP METHODSResale Price Method (RPM)Evaluates the arms length character of a controlled transaction by reference to the gross profit margin realized in comparable uncontrolled transactions.

Most useful where it is applied to operations that do not add significant value to the goods or services in which they deal e.g. distributors.26 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1427TP METHODSCost Plus Method (CPM)Focuses on the gross mark-up obtained by a supplier who transfers property or provides services to a related purchaserMost useful where semi-finished goods are sold between associated enterprises or where the controlled transaction involves the provision of servicesAlso useful in cases involving the manufacture, assembly, or other production of goods that are sold to related parties27 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1428TP METHODSProfit Split MethodSeeks to establish a price for a controlled transaction by determining the division of profits that independent enterprises would have expected to realize

Provides an alternative in cases where no comparable transactions between independent parties can be identified such as when transactions are very interrelated or in situations involving a unique intangible28 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1429TP METHODSProfit Split Method

Approaches in the allocation of profit or loss:

1) Residual Profit Split ApproachUse other method to establish returns for basic functionsSplit residual between parties2) Contribution Profit Split ApproachSplit profit between parties29 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1430TP METHODSTransactional Net Margin Method (TNMM)Examines the net profit margin relative to an appropriate base (i.e. costs, sales, or assets) attained by the member of a group of controlled taxpayers from a controlled transactionSimilar principle to RPM and CPM just uses later point in income statementTends to be used frequently in practice, because of information constraints on the use of the other methods30 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1431TP METHODSTNMM Selection of Profit Level Indicator (PLI)PLI measures the relationship between profits and sales, costs incurred or assets employedRight choice of a PLI ensures better accuracy in the determination of the arms length price of a controlled transactionsPresented in the form of a generally recognized or utilized financial ratioReturn on CostsReturn on SalesReturn on Capital Employed

31 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1432Comparability Adjustments:Intended to eliminate the effects of differences that may exist between situations being compared and that which could materially affect the conditions being examined in the methodology.Not to correct differences that have no material effect on the comparison Neither routine nor mandatory

Arms Length Results:Could be a specific figure or ratio (e.g., price or margin), or a range of ratios, provided comparables are reliable32 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1433Arms Length Results:

NOTE:If controlled transaction is within the arms length range- no adjustment needed If the relevant condition of the controlled transaction falls outside the arms length range asserted by the BIR, the taxpayer should present proof/substantiation that:The conditions of the controlled transaction satisfy the arms length principle, andThe result falls within the arms length range (i.e., arms length range is different from the one asserted by the BIR)33 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1434TP Documentation:Purposes of maintaining TP documentation:

Defend taxpayers transfer pricing analysis;Prevent transfer pricing adjustments arising from tax examinations; andSupport taxpayers application for MAP.

TP documentation generally demonstrates compliance with the arms length principleAll TP transactions regardless of the amount involved, must be properly documented34 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1435TP Documentation:

Contemporaneous requirement it exists or is brought into existence at the time the taxpayer develops or implements any intercompany arrangement, or reviews these arrangements when preparing tax returns;

TP documents should be submitted to the BIR when required or requested to do so;

Retention PeriodTP document must be retained within retention period under the Tax Code (i.e. 3 years)

No TP - specific penalties on non-compliance of the requirement/provisions in the TP Guidelines35 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1436TP Documentation:Documentation Details

Organizational StructureNature of the business/industry and market conditionsControlled transactionsAssumptions, strategies, policiesCost contribution arrangements (CCA)Comparability, functional and risk analysisSelection of transfer pricing methodApplication of the transfer pricing methodBackground documentsIndex to Documents36 APPLICATION OF ARMS LENGTH PRINCIPLEERA 10.17.1437Documentation may include any and all evidence of the reasonableness of determined transfer price/policy:

Related Party AgreementsTP PolicyInvoicesCost Structure (i.e., basis, etc.)Benchmarking of arms length profits/marginsInternal MemoGlobal/Local TP Report37Thank you !Have a nice day!

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