Written by Carlos T. Carado II, 24 April 2008
With all the frenzy happening in the BIR, where new revenue issuances are issued one after the other, transfer pricing seemed to have taken a back seat for a while. The draft transfer pricing rules and regulations which were painstakingly prepared by the BIR and submitted to the Department of Finance for approval more than a year ago has not been released to date.
This is not to say, however, that transfer pricing is held in abeyance. In fact, the BIR has been actively undertaking transfer pricing audits in pursuance of its recent paradigm shift in revenue collection. In line with this, the BIR recently issued Revenue Memorandum Circular (RMC) No. 26-2008 dated March 24, 2008 to inform all internal revenue officers and employees that the draft transfer pricing rules and regulations are currently being revised and that in the interim, the BIR, as a matter of policy, subscribes to the OECD Transfer Pricing Guidelines.
The OECD Transfer Pricing Guidelines is broad and comprehensive. However, for purposes of this column, I have set forth below certain relevant guidelines for the readers’ reference:
1. Taxpayers who have significant related party transactions are expected to document their transfer pricing arrangements. The OECD Guidelines recognize that there must be a balance between the cost and the benefits that will be derived from preparing documentation. This means that taxpayers who have minimal level of related party transactions can afford to prepare minimum documentation (or even none at all) while companies whose transactions consist solely or substantially of intercompany transactions, must prepare a full set of documentation. A full set typically includes both functional and economic analyses which show compliance of the transactions with the arm’s length standard.
2. Traditionally, under the OECD Guidelines, the transaction methods of determining the arm’s length standard, e.g., Comparable Uncontrolled Price, Resale Price and Cost Plus Methodologies, have been the preferred methodologies since they are considered to be the direct means of establishing whether conditions in the commercial and financial relations between related enterprises are arm’s length.
Other transfer pricing methodologies, e.g., Profit Split and Transactional Net Margin Method or TNMM, were given lesser weight. Thus, companies following these other methodologies would still have to ensure that their transfer prices pass the arm’s length standard applying the transactional methods.
It will be noted, though, that recent developments in the international arena and the OECD show a shift to give equal preference to the profit-based methods. Thus, companies who have tested and fixed their transfer prices using the profit-based methods should no longer be further required to show compliance of their transfer prices with the arm’s length test applying the transactional methods.
3. Companies using the profit-based methods, particularly the TNMM, in testing their transfer price must use multiple year data. Net profit margin indicators should be derived from several years of data in view of the risk that data for a single year may be distorted by certain factors such product life cycles and short term economic conditions. The OECD Guidelines state that examining multiple year data is useful so that differences in business or product cycles are taken into consideration, ensuring an appropriate level of comparability between the taxpayer and uncontrolled comparable companies. The number of years to be examined will depend on the facts and circumstances of the case and the availability of data.
4. The OECD acknowledges that, since transfer pricing is not an exact science, the use of a range for the period of arm’s length data points takes into account that the application of the most appropriate method may produce more than one result. This means that each data point in a range of results is consistent with the arm’s length principle.
Based on the OECD Guidelines, a range may be produced with substantial deviation among points, and in such cases, further analysis of those points may be necessary to evaluate their suitability for inclusion in an arm’s length range. In such cases, a widely-accepted statistical method to construct a more reliable arm’s length range is the use of an inter-quartile range. The inter-quartile range represents the middle 50% of the observations. Thus, a financial result that falls within a range of results from comparable companies should be considered by the BIR as arm’s length.
There are other rules adopted under the OECD Guidelines. However, I believe that the BIR examiners should not confine themselves to the OECD guidelines in conducting the transfer pricing audits. US rules and jurisprudence on transfer pricing may likewise be applied considering that our law on transfer pricing (i.e., Section 50 of the 1997 Philippine Tax Code, as amended) was patterned after the US transfer pricing law. It is also significant to note that almost all of the transfer pricing cases that have reached our courts were decided by reference to US rules.
In the end, whatever form the Transfer Pricing Rules and Regulations will take, this should provide the appropriate perspective for resolving any transfer pricing dispute. Meanwhile, this author, like many concerned taxpayers, can only wish that the rules and regulations will be finalized soon.
