The new Philippine transfer pricing regulations

(First of two parts)

By Romulo S. Danao, Jr.
On 23 January 2013, the Bureau of Internal Revenue (BIR) fi nally released the much-awaited regulations
on transfer pricing. Revenue Regulations (RR) No. 2-2013 implement the authority of the Commissioner of
Internal Revenue under Section 50 of the Tax Code, to review controlled transactions among associated
enterprises and distribute, apportion or allocate their income and deductions to refl ect the true taxable
income of such enterprises.
RR 2-2013 (more informally called the TP Regs) will take eff ect after fi fteen (15) days following their
publication last January 25, 2013. They prescribe the guidelines in determining the appropriate revenues
and taxable income of the parties in a controlled transaction. The guidelines are largely based on the
Organization for Economic Cooperation and Development (OECD) TP Guidelines, which have served as the
framework for TP regulations around the world.
Coverage
The TP Regs apply to both domestic and cross-border transactions of associated enterprises. The
regulations recognize that, while transfer pricing typically occurs in cross-border transactions, it can also
occur in domestic transactions with the goal of lowering tax obligations. This happens when income is
shifted in favor of a related company enjoying special tax privileges such as the fi scal incentives granted
by the Board of Investments (BOI) and the Philippine Economic Zone Authority (PEZA); or when expenses
of a related company with such privileges are shifted to a related company subject to regular income
taxes.
For example, Company A, a BOI-registered entity enjoying income tax holiday, sells its products at a high
price to its local affi liate, Company B, which is subject to the 30% regular income tax. Company A, while
reporting a higher income, is exempt from income tax while Company B, in claiming the expense, will be
reporting a lower income subject to 30% income tax, resulting in an overall lower tax and higher profi t for
the group.
Transfer pricing in domestic transactions may also occur when expenses of a related company enjoying
tax incentives or privileges are shifted to a related company subject to regular income taxes.
For example, Company C, a PEZA-registered entity subject to the 5% Gross Income Tax (GIT), and
Company D, a company subject to normal income tax, are associated enterprises. Both incurred common
administrative expenses, but since these expenses are non-deductible to Company C, Company D takes a
bigger share of the common administrative expenses, and claims the same as deduction from its gross
income. This results in a lower tax for Company D and an overall higher profi t for the group.
Arms length principle
RR 2-2013 expressly adopts the arms length principle, which is the internationally accepted standard
for determining the appropriate transfer prices of controlled transactions of associated enterprises. The
principle requires that a transaction with a related party should be made under comparable conditions
and circumstances as a transaction with an independent party. Essentially, a taxpayers income from a
related party transaction must be equivalent to what would be earned by a similarly situated taxpayer
from a transaction with a third party.
In the application of the arms length principle, RR 2-2013 provides for a three-step approach, namely:
1. Conduct a comparability analysis;
2. Identify the tested party and the appropriate transfer pricing method; and
3. Determine the arms length result.
The regulations adopt the OECD arms length pricing methodologies without any specifi c preference for
any one method. These include the Comparable Uncontrolled Price Method, Resale Price Method, Cost Plus
Method, Profi t Split Method and the Transactional Net Margin Method. In determining the arms length
result, the most appropriate method for a particular case shall be used. This should be the method that
produces the most reliable results, taking into account the quality of available data and degree of
accuracy of adjustments.

Documentation requirement
RR 2-2013 explicitly requires taxpayers to maintain and keep adequate and specifi c transfer pricing
documentation to demonstrate that their transfer prices are consistent with the arms length principle.
More importantly, the documentation must be contemporaneous, i.e., they must exist or are brought into
existence at the time the associated enterprises develop or implement any arrangement that might raise
transfer pricing issues or review these arrangements when preparing tax returns.
The information or details that should be included in the documentation are, but not limited to, the
following:
Organizational structure
Nature of the business/industry and market conditions
Controlled transactions
Assumptions, strategies, policies
Cost Contribution Arrangements
Comparability, functional and risk analysis
Selection of the transfer pricing method
Application of the transfer pricing method
Background documents
Index to Documents
While TP documentation does not have to be submitted with the tax returns, these must be retained by
taxpayers and submitted to the BIR when required or requested to do so. Moreover, they must be retained
and preserved within the period specifi cally provided in the Tax Code as the retention period, which is
three years from the fi ling of the Annual Income Tax Return. It will, however, be to the best interests of
the taxpayer to maintain documentation for purposes of the Mutual Agreement Procedure (MAP) and
possible TP examination.
The regulations do not have a safe harbor provision that would exempt taxpayers with insignifi cant
related party transactions from the documentation requirements. Hence, the documentation requirements
prescribed above would seem to apply to all taxpayers involved in controlled or related party
transactions.
Advance Pricing Arrangement
Another feature is the opportunity for an Advance Pricing Arrangement (APA), which is an agreement
entered into between the taxpayer and the BIR to determine in advance an appropriate set of criteria
(e.g., TP method and comparables set to be used) to ascertain the transfer prices of controlled
transactions over a fi xed period of time.
The purpose of an APA is to reduce the risk of TP examination and double taxation. The APA may either be
unilateral (an agreement between the taxpayer and the BIR), or Bilateral/Multilateral (an agreement
among the taxpayer, the BIR and one or more countries). The APA is not a mandatory requirement; it can
be undertaken by a taxpayer on a voluntary basis. The BIR will issue separate guidelines on the
application of APA and MAP processes.
Penalties for non-compliance with the TP Regs shall be based on the provisions of the Tax Code and other
applicable laws. Thus, in case of a defi ciency income tax assessment arising from a TP adjustment, the
penalties under the Tax Code shall apply, such as the 25% (50% in fraud cases) surcharge and 20%
interest per annum on the basic defi ciency tax due. There is no penalty relief provided in the regulations,
unlike in other countries where the penalty is reduced if TP documentation has been prepared by the
taxpayer or the taxpayer sought assistance in the preparation of documentation from an independent
third party.
With the issuance of the TP Regs, the C-Suite will have to factor in these guidelines in their tax planning
and risk management exercises. Dealing eff ectively with TP challenges should be among the priorities of
covered companies.
Next week, we will discuss in detail the advance pricing arrangements and the mutual agreement
procedure.