In our previous article “BIR transfer pricing audits — the next wave?,” we looked into Revenue Audit Memorandum Order (RAMO) No. 1-19 which is the current regulation in force when it comes to Transfer Pricing (TP) audits. The RAMO explained in detail how the Bureau of Internal Revenue intends to conduct its audit of related-party transactions.
In my experience so far, only a few BIR officers have tried to include TP findings in their tax investigations, or at least discussed how related party transaction (RPT) prices are derived. Because the RAMO was introduced in 2019, no TP controversies have reached the courts as yet.
Confucius once said that anyone who wants to define the future must study the past, because without history, there is no future. As such, any glimpse into the future of TP audits should begin with a study of what came before. What can taxpayers glean from past TP cases in preparing for TP audits in the future?
BURDEN OF PROOF LIES WITH THE TAXPAYER
In a 2005 Court of Tax Appeals (CTA) case, the BIR used the taxpayer’s documents to scrutinize the prices of products sold to both related and unrelated parties. Based on the documents, the BIR concluded that the taxpayer did not declare all its export sales, based on the price comparison it conducted.
The requirement of scrutinizing taxpayer documents has been reiterated in the RAMO guidelines. Among the initial audit steps is for the BIR to schedule a meeting with the taxpayer to gain an understanding of the taxpayer’ data with respect to its transactions with related parties and transfer pricing policy. Examination of contracts, audited financial statements, income tax returns, and BIR Form No. 1709 (Information Return on Transactions with Related Party), among others, must be conducted to collect additional information.
More importantly, the BIR may request and analyze the taxpayer’s TP documentation (TPD) especially if the taxpayer is required to maintain such files based on the criteria set by the BIR. Compliant TPD must be contemporaneous. This means that it is brought into existence at the time the related parties develop or implement any arrangement that might raise transfer pricing issues, or review these arrangements when preparing tax returns, or not later than the deadline to file the annual income tax return.
Since the taxpayer has the burden to prove that the related-party transactions comply with the TP rules, it is best for the taxpayer to maintain TPD and other relevant records and have these ready for a possible TP audit.
COMPARABILITY AND FAR ANALYSIS
In a 2005 CTA case, the BIR asked a taxpayer why prices offered to foreign affiliates were lower than domestic prices. The taxpayer explained that the domestic selling price is not a benchmark price for export sales because export and domestic markets are different. For one, the export market is competitive while the domestic market is a captured market. Another reason is that to beat quotes of other sellers with lower production costs than those of the Philippines, the taxpayer offers lower mark-ups on export products in order to get the business and in the process maximize the utilization of its production facilities. Finally, the taxpayer said export sales maximize productivity, which in turn results in a lower unit cost of production as fixed overhead is spread over larger volumes.
The above reasons were found by the Court to justify setting a lower price for exports. Thus, the Court ruled in favor of the taxpayer.
The RAMO guidelines provide that the BIR officer conducting the audit should be able to draw conclusions about the characteristics of the taxpayer’s business and the functions performed by related parties, and to examine the appropriateness of the remuneration received by the taxpayer and related parties relative to the functions performed, assets used, and risks borne by each party through review and analysis of accounting data, interviews, plant tours and site visits.
The BIR may also perform a comparability analysis. That is the audit in transfer pricing that compares the condition of related-party transactions and that of independent transactions. Accordingly, the taxpayer should include in its documents reasons that make commercial sense if there are differences in the pricing policies.
In summary, taxpayers should be thoroughly familiar with the characteristics of their products or services and their comparability with other products or services offered to independent parties or offered in an independent transaction. Understanding the functions, assets, and risks is crucial because this would lead to the correct characterization of the taxpayer’s business operations and expected level of return.
BE FAMILIAR WITH THE TP RULES
In a 1995 CTA case, the BIR alleged that the taxpayer overstated its cost of goods due to the transfer pricing of products to its mother corporation. Specifically, the BIR alleged that a fourth-generation antibiotic should not be allowed to incur costs of improvement eight times higher than its supposed precursor, doxycycline, a third-generation antibiotic.
The taxpayer was able to demonstrate the physical characteristics and circumstances involved in the production of minocycline, a completely different kind of antibiotic from doxycycline, with each one having a separate and unique chemical structure and production process. Also, the development costs of both antibiotics are different. The taxpayer contended that there is no sufficient basis to compare the two as they are not in the same generation of antibiotics. The taxpayer explained that the cost of improvement for minocycline should be gauged against another fourth-generation tetracycline developed likewise from Declomycin in order to produce comparable and reliable data.
In this case, the taxpayer challenged the transfer pricing method used by the BIR in deriving its TP findings. Needless to say, taxpayers should be familiar with the tax rules so they can intelligently defend their related party transactions, TP policy and TPD.
Under the RAMO guidelines, specific rules need to be followed by the taxpayer and BIR examiners. These include the selection of TP methods. In the antibiotic case, the BIR was imposing the comparable uncontrolled price (CUP) method in determining the arm’s-length price. However, the same seems not applicable because of the differences in the characteristics and circumstances surrounding the taxpayer’s products, which could have a material impact on the price of goods.
KNOW MORE ABOUT TP AUDIT PREPARATION
P&A Grant Thornton will be offering a free webinar on June 20, 2023, “Am I TP audit ready?” We hope we can help taxpayers in preparing their companies for possible TP audits in the future. Join us in our discussion.
Let’s Talk TP is an offshoot of Let’s Talk Tax, a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
Marie Fe F. Dangiwan is a director from the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.