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COVID-19 impact on transfer pricing documentation
27 Oct 2020Transfer pricing is the latest tax-related compliance issue in the Philippines after the Bureau of Internal Revenue (BIR) required all taxpayers with related-party transactions to file the Information Return on Related-Party Transactions (BIR Form 1709) alongside supporting documents including the transfer pricing documentation (TPD) as an attachment to the annual income tax return.
The ultimate objective of the TPD is for the taxpayer to justify with documentation that its related-party transactions are carried under comparable conditions and circumstances as transactions with an independent party and not solely because of the special relationship with each other.
Even though the Philippine transfer pricing regulations have been around since 2013, many taxpayers have not started preparing their TPD because it was only until mid this year that TPD is now a required document to be submitted. While this development was expected to come sooner or later, many did not expect it to come during a pandemic.
LOSSES AND REVENUE REDUCTION
Due to the adverse economic effects of the COVID pandemic, many companies — not only micro, small and medium enterprises (MSMEs), but also multinational enterprises — have suffered losses and revenue declines. In response, companies affected have activated their Business Continuity Plans and adopted various measures to keep their businesses afloat.
The adverse effects of the pandemic may put the existing transfer pricing policies to test as companies will have to explain the losses and reduced revenue to tax authorities. Companies should be able to demonstrate the commercial nature of low profits or losses and show that these were results of non-transfer pricing factors. Moreover, any transfer pricing-related decisions made during this pandemic could backfire in the future as tax authorities may scrutinize such decisions and look for opportunities to boost tax collection.
LOSS SHOULD BE COMMERCIAL IN NATURE
From a transfer pricing perspective, Revenue Audit Memorandum Order (RAMO) No. 1-2019 acknowledges that companies incur losses for a variety of economic and business reasons, such as startup losses, market penetration costs, and research and development failures. The COVID-19 pandemic is no exception.
However, losses are acceptable if related-party transactions are commercially realistic and make economic sense. The taxpayer needs to establish that these losses are commercial in nature and are not the result of transactions with related parties.
CONTEMPORANEOUS DOCUMENTATION
Companies incurring losses in 2020 due to the pandemic are expected to maintain contemporaneous documentation which outlines the economic rationale and non-transfer pricing factors that have contributed to the losses. Efforts to compile relevant evidence, such as minutes of board meetings, correspondence, intercompany memoranda, and agreements demonstrating that the situation is not the direct result of intercompany transactions, must be maintained.
In Singapore and Australia, the tax authorities have provided guidance and listed the information and analyses to be included in the TPD of companies severely affected by COVID-19.
These include:
• A broad analysis of how the company has been affected by COVID-19 and the direct impact of COVID-19 on the company;
• Documentation of who and which entity within the group made decisions relating to management of risks relating to COVID-19. This information will help to indicate which entities are in control of the decisions and thus should bear the related risks;
• The functional analysis of the company and the related parties before and after COVID-19 (i.e. any re-allocation of functions, assets and risks, as well as any recharacterization);
• The contractual arrangements between the company and its related parties, and highlight whether any obligations or material terms and conditions have been varied, amended or terminated in light of COVID-19;
• A detailed profit and loss analysis showing changes in revenue and expenses, with an explanation for variances resulting from COVID-19 — this may include a variance analysis of budgeted (pre-COVID) versus actual results;
• Details of profitability adjusted to what the outcome would have been if COVID-19 had not occurred — these should consider all factors that have a positive or negative impact on your profits and should be supported by evidence;
• Details relating to COVID-19-specific government assistance that the company has received, or government regulations imposed on the company which has an impact on its operations; and
• The rationale and evidence for any increased allocation of costs or a reduction in sales (and subsequent changes in operating margins) to the entity, taking into consideration its function, asset and risk profile.
REASSESSING BENCHMARKS AND CHALLENGES
It is also advisable to assess whether benchmarks conducted in the past TPD remain applicable or whether new benchmarks should be undertaken for the period during and after COVID-19.
In setting new benchmarks, challenges, such as the absence of reliable financial data on comparables and the varied impact of COVID-19 across industries and markets, could hamper the analysis. For example, in preparing the 2020 benchmarking analysis, the available financial information of comparable companies is most likely the pre-COVID-19 (i.e. 2019 and prior years) because the 2020 financial statements are due for submission next year. Hence, comparing the pre-COVID-19 financial data with the post-COVID-19 financial data does not make sense. The benchmarking results will not be comparable to that of the controlled transaction.
On the other hand, for selected comparable companies outside the Philippines, the analysis will require more in-depth research because the pandemic impacts industries to various degrees in different markets. Even if 2020 financial data of comparable companies are found in other countries, depending on the product and the market where the product is being sold, the effect may still be different because the market and economic conditions in other countries may be different from conditions in the Philippines. For example, businesses in the Philippines may have experienced worse adverse effects due to the prolonged lockdown than the businesses in other countries with shorter lockdown.
ADDRESSING THE CHALLENGES
It would help in the benchmarking analysis if loss-making entities can be accepted as comparables. RAMO 1-2019 rejects companies that are not comparable due to volatility of their profitability as evidenced or shown by consecutive years of losses incurred. However, given the present situation, this criterion may be relaxed since the general market conditions during these times are extraordinary.
With respect to the timing, information and financial gaps between the tested party and comparable companies, RAMO No. 1-2019 allows for a comparability adjustment. This may either be in the form of adjustment of difference of contractual terms or use of other transfer pricing method that is most appropriate with the facts and conditions. The Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines, from which the Philippine transfer pricing regulations also rely, recommends that where independent transactions are scarce in certain markets and industries, a practical solution needs to be found on a case-by-case basis. This means that when the data are insufficient, stakeholders can still use imperfect comparables, after necessary adjustments are made, to assess the arm’s-length price. The validity of such procedures depends heavily on the accuracy of the comparability analysis as a whole.
Let it be known that transfer pricing is not an exact science. In extraordinary situations, business strategies are subject to reassessment and even to change. Revisions to transfer pricing policies should be documented and substantiated properly. In these periods of distress, guidance is very crucial to taxpayers. Hopefully, the BIR can provide its own guidance soon on how taxpayers may approach the impact of the pandemic from a transfer pricing perspective.
Let’s Talk Tax is a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
Juvy H. De Jesus is a manager of the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.
As published in BusinessWorld, dated 27 October 2020