Transfer Pricing Audits Coming Soon in the Philippines

Tax audits in The Philippines may soon be seeing some changes. For many years now, the tax authorities (Bureau of Internal Revenue or the “BIR”), taxpayers and tax practitioners have responded to what they have termed “tax audits.” From now on, a new term may find itself commonly mentioned among BIR examiners as well as finance executives’ and in tax practitioners’ circles. “Transfer pricing audit” will be an often repeated phrase in this and future years, as the BIR formally includes “transfer pricing issues” as one of the 29 criteria for Priority Taxpayers/Industries in the latest BIR audit program contained in BIR Revenue Memorandum Order No. 19-2015 dated September 15, 2015 (“RMO 19-2015”).

A closer look at the RMO reveals some insights into the direction that the BIR will take as far as tax audits of Philippine corporate taxpayers in the future are concerned. Notably, it appears that the priority list of the BIR’s current audit program is “heavy” on transfer pricing and indicates that the BIR is determined to enforce the Philippine transfer pricing rules under Revenue Regulations No. 2-2013, as a part of its ongoing tax collection efforts. With a significant tax collection target of 2.025 trillion pesos for 2016 (a 21% jump from the 2015 collection goal), the BIR has a huge task ahead.

Several of the criteria enumerated under the section on Priority Taxpayers/Industries (Section II.2 of RMO 19-2015) closely resemble the criteria used by tax authorities in other jurisdictions in the Asia-Pacific region to select taxpayers for transfer pricing audits. In those other tax jurisdictions, most of the priority list criteria in the RMO would be considered “red flags” for transfer pricing investigation, such that corporate taxpayers that exhibit one or more of the stated criteria would typically be considered to be at “high risk” for selection for transfer pricing audits.

Listed below are the criteria stated in RMO 19-2015 that would potentially lead a normal tax audit into a transfer pricing audit:

• Issue-oriented audits (e.g., transfer pricing, Base Erosion Profit Shifting [BEPS], industry issues, etc.);
• Taxpayers enjoying tax exemptions/incentives;
• Taxpayers reporting gross/net loss or no taxable income or no tax due for two consecutive years;
• Taxpayers with income tax due of less than 2% of gross sales/revenues;
• Taxpayers with increase of assets of more than 50% from the previous year but with reported net loss;
• Taxpayer deriving its revenue/income exclusively or substantially from its parent company/subsidiaries/affiliates;
• Taxpayers with shared expenses and other inter-related charges being imputed by a parent company to its affiliates and likewise an affiliate to other affiliate in a conglomerate; and
• Taxpayers with zero-rated sales.

The criterion “issue-oriented audits (e.g., transfer pricing, BEPS, industry issues, etc.)”, especially when it makes reference to “transfer pricing” and “BEPS”, is one broad category that can touch upon or cover any or all of the other criteria or any of the “Priority Industries” that are listed in the RMO.  However, as to which of the many action plans in BEPS or which BEPS issues would be the subject of scrutiny is still unclear.

It is relevant to note that the priority industries in the current BIR audit program include the following:

• Real estate industry;
• Telecommunications industry;
• Sellers of goods and services via e-commerce;
• Hospitals, clinics, medical/dental laboratories;
• Amusement/entertainment/event centres;
• Advertising agencies;
• Business Process Outsourcing companies;
• Insurance companies; and
• Restaurant/fast food chains/catering services/bars/coffee shops.

Comments

As in other countries, it would seem that the BIR’s audit focus will turn to companies that have:

• Continuous losses for at least 2 years or have losses, but are expanding;
• Low profitability when compared to other companies in the industry;
• Revenue derived solely or substantially from a related party;
• Inter-company service charges and cost allocation;
• Tax incentives; or
• Export sales.

Though the BIR’s current audit program adopts a more or less focused, risk-based approach to tax/transfer pricing audits using certain criteria and thresholds, a few questions around those criteria in RMO 19-2015, remain.  One example would be the criterion regarding the losses at either gross or net level for 2 consecutive years, which effectively requires start-up companies to record profits after only one year of operation (which is a short timeframe by global standards). There is also the question of whether the BIR will conduct a transfer pricing audit separately from a tax audit or whether the transfer pricing audit will be merely an add-on to a general tax audit.  We understand from informal sources that it is the latter, at least in the initial years of the transfer pricing audit regime.  However, it is hoped that the BIR will soon issue its guidelines on transfer pricing risk assessment under its Transfer Pricing Priority Program contained in Revenue Memorandum Circular 3-2015 dated 13 January 2015, to provide clearer guidance to taxpayers.

In the context of the accelerating pace of implementation of BEPS initiatives by other tax authorities in the region and globally, the current BIR audit program will inevitably evolve to include a greater emphasis on transfer pricing issues. The BIR now appears intent on taking the first few practical steps to enforce local transfer rules through tax audits and is likely to integrate some BEPS issues into those tax audits, in order to catch up with recent developments on the international tax scene. Though clearer guidance is still required, it is envisaged that, sooner or later, stand-alone specific transfer pricing audits, or transfer pricing investigations as part of general tax audits, will become the new norm for corporate taxpayers in the Philippines.

What should taxpayers do?

Steps need to be taken as the tax audit regime in the Philippines evolves and to better prepare for the changes. There is a need for Philippine companies with domestic or international related party transactions to undertake a detailed review of their business models, transfer pricing compliance and risk management practices and tax/transfer pricing structures. They also need to assess whether they comply with the requirements under the Philippine transfer pricing regulations (RR 2-2013) and, to the extent applicable, the OECD’s BEPS action plans released in October 2015.

Additionally, Philippine companies should be mindful of the criteria for Priority Taxpayers/Industries of RMO 19-2015 and to take steps to minimize the chances of being classified as taxpayers at “high risk” for selection for a transfer pricing audit.

At the very least, a corporate taxpayer should undertake detailed transfer pricing documentation preparation in accordance with RR 2-2013 and the OECD Transfer Pricing Guidelines, to demonstrate that the pricing of its inter-company transactions satisfies the arm’s length principle. In a transfer pricing audit, such transfer pricing documentation would serve as its first line of defence.