The Philippines is perhaps one of the last countries in Southeast Asia to enforce its transfer pricing rules. Since the Bureau of Internal Revenue (BIR) issued its transfer pricing regulation in January 2013 (Revenue Regulation No. 2-2013, “Transfer Pricing Guidelines”, issued on 23 January 2013), very little progress has been made with the enforcement of the rules. The BIR took almost a decade to issue Revenue Audit Memorandum Order No. 1-2019 – issued on 20 August 2019 and took effect immediately upon approval – (RAMO 1-2019 or RAMO), which provides a framework for conducting transfer pricing (TP) audits. Aside from these regulations, there are no other transfer pricing rules in the Philippines.
The 2013 regulation adopts the arm’s length principle and is based largely on the Organization for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines. It requires contemporaneous documentation, that is, taxpayers are expected to prepare a transfer pricing report at the time of the transaction or filing of the tax return at the latest. Specific pieces of information, including agreements, are required to be documented in the report. The absence of a report can lead to adjustments in the transfer prices to arm’s length levels and can result in the rejection of an application for Mutual Agreement Procedure (MAP).
Before the issuance of RAMO 1-2019, the different tax offices around the country were already working on capacity building beginning late 2016. Since the issuance of the RAMO, audit cases have been scant and have so far focused on denying royalty and service payments for lack of documentation. The RAMO has generally adopted the Base Erosion and Profit Shifting (BEPS) Action Plans 8 to 10, although the Philippines is not a member of the Inclusive Framework on BEPS.
One of the new requirements introduced by the RAMO is the submission of transfer pricing forms during a transfer pricing audit. Six forms should be submitted within five days upon request. While most of the information may be collected from the transfer pricing report, there are pieces of information that are not readily available and could create issues for taxpayers, namely:
On July 8, 2020, the BIR issued Revenue Regulation 19-2020 mandating the submission of a TP disclosure form that should be attached to the tax return. The form requires taxpayers to disclose all of their related party transactions, including the value and terms and conditions of the transactions.
Departing from the previous local practice, the RAMO appears to accept foreign companies that are found in regional databases as comparable. The guideline specifies stringent search criteria that must be observed in selecting the comparable companies, which may give rise to disputes on the comparable set in future audits.
Control over functions and risks
Importantly, the RAMO does not have provisions on the principle of control over functions and risks. This omission may result in risks for routine manufacturers that perform contract research and development (R&D) and intra-group support services.
Manufacturing with contract R&D services
RAMO 1-2019 includes a specific chapter on intangible assets. It appears to distinguish between economic and legal ownership and adopts the principle of development, enhancement, maintenance, protection and exploitation (DEMPE) functions as a test for ownership of intangibles. Since the majority of manufacturers in the Philippines also perform contract R&D for their principals, tax officers in the country have been instructed to examine these manufacturers’ contribution to the development of the intangible assets.
There are two specific provisions that may give rise to controversies for manufacturers with contract R&D services. First, the RAMO provides that the existence of R&D expenses may be “considered” evidence of the existence of intangible assets. Thus, contract R&D service providers, which record these costs, may be viewed as the economic owners of intangibles despite the absence of their control over the functions and risks relating to DEMPE. Second, the RAMO also states that development activities performed “on behalf of” another entity responsible for R&D may signify ownership. These provisions could result in either the denial of any royalty payments by the manufacturer or possible increase in the remuneration of the manufacturer.
Intragroup support services
The guideline also has a dedicated chapter on intra-group services (IGS), which lays down the requirement of utilization and benefits. It does not distinguish between low and high value-adding services, and states that the pricing of IGS “should be based on the costs actually expended in providing the services”. This implies the use of a cost-based approach for the pricing of all types of IGS regardless of nature or value added. The RAMO also does not provide any guidance on the expected mark-up for IGS.
A significant number of shared services companies in the Philippines conduct support activities for entrepreneurial functions. In the absence of a control over functions principle in the RAMO, the tax authority may argue for a higher profitability for entities that record support expenses, despite the fact that these entities perform low value-adding activities.
Highly leveraged companies are also at risk with the introduction of two new required ratios in the RAMO: (1) Debt-to-Equity Ratio (DER), and (2) Interest Coverage Ratio (ICR). These ratios illustrate the taxpayer’s ability to repay the indebtedness.
Since these restrictions are new, many multinational companies operating in the Philippines do not yet observe these financing limitations and must, therefore, review their loan transactions and ensure compliance.
Chapter IV of the RAMO discusses business restructuring in a very limited context, i.e. where there is a change in the characterization that led to a reduction in the profitability of the company. In this case, the restructuring must be supported by a commercial purpose and analysis of “options realistically available”.
Over the last two years, business restructuring that has been undertaken in view of the removal of the tax holidays and incentives in the Philippines could be challenged in the absence of proof of reduced functions, commercial purpose, and analysis of options realistically available.
Considering that the Philippines is the last among Southeast Asian countries to have introduced TP audit guidelines, RAMO 1-2019 is a welcome development. While the release of the RAMO is significant progress towards improving the country’s TP regulatory environment, there are opportunities for refinement. The BIR should reconsider areas where local rules deviate from the OECD Guidelines.
In the same vein, Philippine taxpayers are advised to be vigilant by (1) ensuring their intercompany dealings comply with the new guidelines, and (2) contemporaneously preparing TP documentation in line with RAMO 1-2019. The application of the new rules could lead to significant exposure if tested.