“Something has changed within me. Something is not the same.” is the iconic opening line of Defying Gravity, the showstopping climax of the musical “Wicked,” which opened in cinemas last week. Like how Elphaba realized that undergoing a spiritual transformation through a shift in her perspective is essential for her to achieve greater heights, the Philippine tax landscape faces a similar turning point, where significant tax amendments are being introduced to allow our tax system to flourish.
One of these changes is the Corporate Recovery and Tax Incentives for Enterprises to Maximize Opportunities for Reinvigorating the Economy (CREATE MORE) Act. Perhaps the industry most impacted by CREATE MORE is the Information Technology Business Process Outsourcing (IT-BPO) sector. IT-BPO entities will greatly benefit from the introduction of the lower corporate income tax rate applicable to those under the Enhanced Deductions Regime (EDR) and the more flexible work-from-home arrangements required to avail fiscal incentives.
With the implementation of such law, foreign investors are incentivized to indeed “create more” new BPO projects in the Philippines. Current industry players are also expected to expand their operations to fully capitalize on the various incentives introduced. However, along with these benefits comes a heightened responsibility to comply with the transfer pricing (TP) requirements in the country. The Bureau of Internal Revenue (BIR) is expected to increase its scrutiny on the related party transactions of multinational companies to ensure that they are being priced fairly. Hence, it is prudent for BPO companies to reassess whether their operations are still aligned with the TP rules in the Philippines and if they have adequate TP documentation (TPD) in place.
Arm’s Length Principle
The most fundamental concept governing TP is the “arm’s length principle,” which raises the question of whether transactions between related entities are conducted as if they were between independent entities under similar conditions. Such principle dictates that the prices, terms, and conditions of intercompany transactions should reflect what unrelated parties would agree upon in a comparable transaction in the current market. This can be demonstrated by establishing an entity’s characterization through a thorough functions, assets, and risks (FAR) analysis, as well as applying benchmarking procedures aligned with an appropriate TP methodology.
Entity characterization
Service providers like BPO entities are generally categorized as either full-fledged service providers or routine service providers.
A full-fledged or entrepreneurial service provider is typically involved in most, if not all, aspects of a group’s service function. Its FAR profile usually reflects its capabilities to generate profit on its own. Functionally, such entities partake in high-impact activities and the management of end-to-end service delivery, from research and development, strategic decision-making, marketing and promotion, to the provision of service warranties. In terms of assets, they often invest in proprietary technologies, advanced infrastructure, and skilled personnel. They also bear the risks associated with each activity throughout the value chain, including credit risks, performance guarantees, and exposure to market fluctuations, among others.
On the other hand, a routine or risk-mitigated service provider generally performs standardized services or support functions typically under the supervision of a parent or related entity. Its FAR profile shows that its operational scope is relatively narrow, leaning towards the execution of predefined processes instead of strategic management and innovation. The functions of these entities focus on repetitive, support-oriented tasks such as data entry, customer service, or routine IT support. Their asset base is typically limited to resources and technology that are essential to execute their assigned functions, such as computer-related equipment, office space, and employees performing actual BPO services. They bear limited risks, mostly pertaining to operational risks related to its day-to-day activities, as well as foreign currency exchange risks from dealing with foreign related parties.
Determining an entity’s characterization and its involvement in the functions, assets, and risks associated with a particular related party transaction is a crucial step in forming a comprehensive TPD since it helps establish the expected price or profitability of an entity and guides the selection of reliable comparable companies.
To illustrate, a BPO entity engaged in entrepreneurial activities such as business development, marketing, and generating and maintaining its own clientele is expected to generate a higher return compared to another BPO entity who merely provides routine support to its related parties or is being subcontracted by its parent to perform client servicing. Meanwhile, a routine or risk-mitigated service provider is expected to report a consistent level of profitability as compared to a full-fledged service provider, whose profitability tends to be more volatile and reliant on market trends.
Selection of TP methodology
There are generally five (5) methodologies to calculate the arm’s length TP, namely: Comparative Uncontrolled Price (CUP) Method, Cost Plus Method (CPM), Resale Price Method (RPM), Profit Split Method (PSM), and Transactional Net Margin Method (TNMM). For BPO entities, the three methods below are the generally adopted approaches.
CUP Method: The CUP method compares the prices charged by an entity for its transactions with related parties (controlled transactions) with those with unrelated parties (uncontrolled transactions). This method is the most direct way of ascertaining an arm’s length price but also demands the highest degree of similarity between the services being compared.
In the context of BPO companies, the CUP method can be applied in situations where the services provided by an entity (i.e., IT support, customer service, finance and accounting, etc.) are also being rendered by the same entity to independent third parties under comparable conditions and circumstances, such as the scope, quality, and complexity of work, terms and conditions of the contract, market conditions, functional profile, and other specific features.
Caution is advised when using the CUP method by ensuring that internal comparables are not transactions that are performed solely to justify that the related party transactions are at arm's length (intentional comparables) and are independent transactions performed in the normal course of business.
External CUP may also be used by comparing the prices charged to related parties with those charged between two independent service providers and service recipients engaged in similar services.
However, considering the BPO industry is highly specialized and services are commonly customized and tailor-made to meet specific client demands, it must be noted that if the CUP method will be used, pricing adjustments must be considered to eliminate the differences between the controlled and uncontrolled transactions being benchmarked.
CPM: It compares the gross profit markup on the costs incurred by a service provider with the gross profits realized by the same service provider (internal CPM) or comparable independent service providers (external CPM) in uncontrolled transactions.
For example, in determining the arm’s length markup rate on costs of a BPO company performing administrative support services to its parent, the markup rate used for similar comparable services with third parties may be used, provided the costs incurred are substantially the same for both services provided.
In using CPM, companies should be aware that there may be substantial variance as to how BPO companies account for and classify costs as either direct or operating expenses in their books. Due to different cost structures, certain expenses, such as labor, overhead, and technological costs, may be reported as cost of sales for some entities but are categorized as operating expenses for others. These variations must be considered in identifying possible comparable companies.
TNMM: As opposed to CUP and CPM, which focus on the transfer price itself, TNMM compares the profit level indicator (PLI) realized by an entity from controlled transactions with the same PLI realized by independent comparable companies. Such PLI is the ratio of the net operating profit of an entity relative to an appropriate base (i.e., total costs, sales, assets, etc.). In the case of BPO entities, the net markup (NMU) ratio, which uses the total costs as reference, is the most used PLI since costs are the usual profit drivers of their operations.
To illustrate, a BPO entity that imposes a 5% markup on total costs and expenses incurred (direct costs plus operating expenses) is expected to report the same level of profitability with that of comparable independent BPO entities who do not have any material related party transactions.
The TNMM is based on the economic concept that similar service providers operating in the same industry would tend to yield similar rates of return over time. It is also the most broadly applicable TP methodology due to its relatively easy implementation, which only requires financial information of candidate comparable companies.
Furthermore, compared to other TP methods, TNMM permits a level of tolerance for minor differences between the services provided and functional profile of the tested party and identified comparable companies. This allows for a more flexible benchmarking study since companies with slight variations in the nature of services offered compared to the tested party can still be considered as valid comparable companies.
TP supporting files
To ensure compliance with regulations and avoid potential disputes with the tax authorities, BPO companies must maintain comprehensive TP supporting files, such as but not limited to TP policy, TPD, contracts and agreements, and/or proof of transactions; the Annual Information Return on Related Party Transactions (BIR Form No. 1709), if required; the Annual Income Tax Return; Audited Financial Statements; and the Advance Pricing Agreement, if any.
These supporting files help demonstrate that the TPs are consistent with what would have been agreed upon by unrelated parties under similar circumstances, thereby ensuring compliance with the regulations and minimizing the risk of adjustments or penalties by tax authorities.
Takeaway
TP has become an increasingly “popular” topic in the realm of taxation. Much like how Glinda and Elphaba are “dancing through life” in their journey through Oz, businesses must be equipped with well-planned TP documentation and follow the yellow brick road to successful tax compliance. Dealing with the intricacies of related party transactions can be a challenging endeavour and cannot be accomplished in “one short day.” Hence, to avoid “something bad,” entities under the same corporate umbrella should proactively prepare and adapt their pricing strategies to remain in sync with our progressing TP regulations and ever-shifting tax environment, which hopefully have been changed “for good.”
As published in BusinessWorld, dated 26 November 2024
