Enhanced transfer pricing regime amidst the pandemic
Globally, the coronavirus disease 2019 (Covid-19) pandemic is requiring governments to design and implement strategies to cope with the deepening impact of the virus. They are introducing measures to cushion the blow from the economic downturn, such as drawing from reserves and intensifying tax collection efforts.
As entire countries and major cities have been placed under lockdown to control the spread of the virus, many multinationals (MNCs) face major disruptions to their global supply chain and are suffering unprecedented financial losses, which has now set off a global economic crisis.
Transfer pricing considerations
MNCs need to consider transfer pricing (TP) seriously when they review and reevaluate their global supply chains. TP is the arm’s length pricing of goods, services, intangibles and financial transactions between related entities.
Tax authorities use TP laws to prevent MNCs from artificially reducing their tax bill by shifting profits from high to low-tax jurisdictions using the transfer prices of transactions with related parties. In 2013, the Bureau of Internal Revenue (BIR) issued its TP guidelines under Revenue Regulations (RR) 2-2013 for this purpose.
Operating losses and low margins
This pandemic has resulted in increased business costs, either from loss of revenues or from additional spending to deploy business continuity measures. Local Philippine subsidiaries of MNCs characterized as “routine” entities such as contract manufacturers and routine distributors (undertaking routine functions and bearing limited risks within the overall supply chain), may face significant losses or reduced profits as a result. However, this does not necessarily mean that these entities should bear those expenses or losses.
Tax authorities generally expect an MNC’s local subsidiaries performing routine functions to be remunerated with stable returns, while the related party takes on the residual profits or losses in line with its entrepreneurial functions and economic risks. For example, if supply and inventory risks are managed centrally by an MNC’s Singapore headquarters, it may not be appropriate for the downside costs from the disruption to be assumed locally by the Philippine routine distributor.
The entity(ies) within an MNC’s supply chain that is to bear the losses should be carefully identified, analyzed and documented, as this area could be challenged by tax authorities to limit the impact of lost tax revenues in their respective jurisdictions. In 2019, the BIR issued Revenue Memorandum Order 1-19, which provides standardized audit procedures and techniques in auditing taxpayers with related parties to guide the examination of the remuneration received by a Philippine MNC’s operations.
TP adjustments and documentation
Amid the pandemic, in July 2020, the BIR issued RR 19-2020, which requires taxpayers to submit information on related party transactions (BIR Form 1709) along with supporting documents, including TP documentation, as an attachment to the annual income tax return.
TP documentation requires information about the Philippine taxpayer as well as its counterparties for its related party transactions. In simple terms, the documentation sets out the analysis on how the price actually charged between the related parties compares with the prices that independent comparable third parties would have charged on similar transactions (i.e., prices at arm’s length). Where economic adjustment is applied to approximate the pandemic’s impact on the comparables, this should be explained in the documentation along with a robust support on the presence of any losses or significant fluctuations in the profitability of the Philippine taxpayer.
Where there is a difference between the results achieved by independent comparable companies and the Philippine taxpayer, the BIR is likely to make upward adjustments to the taxpayer’s results and collect the corresponding tax as well as penalties from the adjustment. RR 19-2020 is BIR’s proactive approach to capturing tax leakages from TP outcomes of related party transactions that are not at arm’s length.
It is also imperative to examine if there are movements in the functions and risks of entities within an MNC as part of a supply chain realignment to cope with the pandemic. The corresponding transfer pricing position should be adjusted to reflect these shifts, and documented in an intercompany agreement and in the TP documentation.
Proactive mitigation strategies
TP has been a priority of tax authorities around the world since the Organization for Economic Cooperation and Development (OECD) took the initiative to tackle base erosion and profit shifting (BEPS) activities of MNCs. The Philippines’ TP guidelines and tax audit approach largely adopted the outcomes of this project.
Since no one can predict when this pandemic will end, MNCs will have to analyze the crisis’ longer-term effects on their operations. They need to consider the potential impact, review their supply chains and the corresponding TP positions, and introduce steps to mitigate compliance and audit risks. If these effects are not managed and addressed appropriately, MNCs may find themselves bearing heavy tax burdens.
In addition, non-compliance with the submission requirements of the new BIR form and the TP documentation could expose the taxpayer to potential tax adjustments and penalties. This is a position no organization can afford to take at a time when everyone is already stretched thin.