Legal basis and relationship to Tax Code
- Section 244 in relation to Section 50 of the National Internal Revenue Code of 1997, as amended (Tax Code) is the basis for promulgating the Regulations (Section 1).
- Section 50 of the Tax Code authorizes the Commissioner to distribute, apportion, or allocate gross income or deductions among related organizations, trades, or businesses (whether or not incorporated and whether or not organized in the Philippines) owned or controlled directly or indirectly by the same interests if needed to clearly reflect income (Section 3).
- The Commissioner is authorized to make transfer pricing adjustments to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent avoidance of taxes with respect to such transactions (Section 3).
- The transfer pricing framework adopted uses the arm’s length principle, reflecting international treaty concepts and methods reflected in the OECD Transfer Pricing Guidelines (Sections 1, 2, 5, 10, 11).
Policy, objective, and declared purpose
- The objective is to implement the Commissioner’s authority to review controlled transactions among associated enterprises and to allocate or distribute income and deductions to determine the appropriate revenues and taxable income of the associated enterprises involved (Section 1(a)).
- The Regulations prescribe guidelines for determining the appropriate revenues and taxable income by providing methods to establish an arm’s length price (Section 1(b)).
- The Regulations require maintenance and safekeeping of documents necessary for the taxpayer to prove efforts to determine the arm’s length price or standard (Section 1(c)).
- The purpose is to provide guidelines for applying the arm’s length principle for cross-border and domestic transactions between associated enterprises (Section 2).
- The guidelines are largely based on OECD arm’s length methodologies (Section 2).
Core definitions and key terms
- A Comparable transaction is one comparable to the controlled transaction under examination, considering the nature of the property or services, functional analysis, contractual terms, and economic conditions (Section 4).
- A Comparable uncontrolled transaction is a transaction between two independent parties comparable to the controlled transaction; it can be an internal comparable (one party to the controlled transaction compared with an independent party) or an external comparable (two independent parties neither in the controlled transaction) (Section 4).
- Associated enterprises exist when one participates directly or indirectly in the management, control, or capital of the other, or when the same persons participate directly or indirectly in the management, control, or capital of the enterprises; these are also related parties (Section 4).
- Control covers any kind of direct or indirect control, whether or not legally enforceable, and whether exercisable or exercised; control is deemed present if income or deductions have been arbitrarily shifted between enterprises (Section 4).
- A Controlled transaction is any transaction between two or more associated enterprises (Section 4).
- Independent enterprises or parties are enterprises not associated with each other with respect to each other (Section 4).
- An Advance Pricing Arrangement (APA) determines in advance an appropriate set of criteria (including method, comparables, adjustments, and critical assumptions as to future events) for determining transfer pricing for controlled transactions over a fixed period (Section 4).
- A Mutual Agreement Procedure (MAP) is a consultation mechanism among tax administrations to resolve disputes on the application of double tax conventions, described in Article 25 of the OECD Model Tax Convention (Section 4).
Coverage and arm’s length standard
- The Regulations apply to cross-border transactions between associated enterprises (Section 1(1)).
- The Regulations also apply to domestic transactions between associated enterprises (Section 1(2)).
- The Bureau of Internal Revenue adopts and uses the arm’s length principle as the standard to determine transfer prices of related parties (Section 5(a)).
- The arm’s length principle requires related-party transactions to be conducted under comparable conditions as transactions with independent parties (Section 5(a)).
- If associated enterprises earn profits above or below the comparable market level solely by reason of the special relationship, the profits are treated as non-arm’s length, allowing tax authorities to adjust taxable profits to reflect the arm’s length value (Section 5(a)).
- Application involves: (1) comparability analysis, (2) identification of the tested party and the appropriate method, and (3) determination of arm’s length results (Section 5(b)).
Comparability analysis requirements
- Meaningful comparisons under the arm’s length principle require that economically relevant characteristics be sufficiently similar so that either (1) differences cannot materially affect the price/margin, or (2) reasonably accurate adjustments can eliminate the effect of differences (Section 6(a)).
- Comparability analysis examines three aspects: (1) characteristics of goods/services/intangibles, (2) functions/risks/assets, and (3) commercial and economic circumstances (Section 6(b)).
- Goods/services/intangibles must be examined by their economically relevant features, including:
- For goods: physical features, quality and reliability, availability and volume of supply (Section 6(b)(1)(ii)).
- For services: nature and extent of services (Section 6(b)(1)(ii)).
- For intangibles: form of transaction, type of intangible, duration and degree of protection, anticipated benefits (Section 6(b)(1)(ii)).
- The analysis requires functional analysis of economically significant functions performed, risks assumed, and assets employed, including examples such as design, research and development, manufacturing, distribution, sales, marketing, logistics, advertising, financing (Section 6(b)(2)(iii)).
- Risks considered in functional analysis include market risks, cost/price/stock change risks, R&D success/failure risks, financial risks (FX and interest rates), credit risks, and other relevant risks; only economically significant risks/functions/assets must be compared (Section 6(b)(2)(v)–(vi)).
- Commercial and economic circumstances require comparability of: substitute goods/services, geographic location, market size, competition level, consumer purchasing power, market level (wholesale/retail), and effects of government policies and regulations (Section 6(b)(3)(i)–(ii)).
- Business strategies must be considered, including market penetration/defense strategies that temporarily reduce profits, and the taxpayer must demonstrate that independent parties would have been prepared to sacrifice profitability under similar conditions for higher long-term profits (Section 6(b)(3)(iv)).
Tested party and transfer method selection
- The tested party is the entity to which a transfer pricing method can be applied most reliably and from which the most reliable comparables can be found (Section 7(a)).
- The Bureau requires sufficient and verifiable information on the entity for it to be treated as the tested party (Section 7(a)).
- Method selection aims to use the transfer pricing method that produces the most reliable arm’s length result (Section 7(b)(2)).
- The method that provides the most reliable result is selected considering: (i) strengths and weaknesses of methods, (ii) appropriateness given the nature of the controlled transaction (through functional analysis), (iii) availability of reliable information on uncontrolled comparables, and (iv) degree of comparability and reliability of adjustments (Section 7(b)(2)(i)–(iv)).
- No method is preferred; the method producing the most reliable results based on data quality and adjustment accuracy must be used (Section 7(b)(3)).
- In exceptional circumstances lacking comparable transactions or sufficient data, the Bureau may verify compliance using: (i) extension of transfer pricing methods (comparables in another industry segment/group), and (ii) combination or mixture of methods (Section 7(b)(4)).
- Taxpayers must be able to explain why a specific transfer pricing method is selected or used through proper documentation (Section 7(b)(5)).
- The Profit Level Indicator (PLI) must be given due consideration because it measures the relationship between profits and sales, costs incurred, or assets employed; an appropriate PLI improves accuracy (Section 7(c)(1)).
- Common PLIs include:
- Return on costs: cost plus margin and net cost plus margin;
- Return on sales: gross margin and operating margin;
- Return on capital employed: return on operating assets (Section 7(c)(2)).
Determining arm’s length results
- After identifying the appropriate method, it must be applied using independent party data to arrive at the arm’s length result (Section 8).
- In cases where a single most reliable figure/ratio can be determined, it may be used; however, outcomes are generally established as a range of ratios and the use of ranges is applied when comparables are reliable (Section 8).
- If the controlled transaction’s price/margin condition is within the arm’s length range, no adjustment is made (Section 8(a)).
- If the controlled condition falls outside the arm’s length range asserted by the Bureau, the taxpayer must present proof and substantiation that the controlled transaction satisfies the arm’s length principle and that the result falls within an arm’s length range different from the Bureau’s asserted range (Section 8(a)).
- If the taxpayer cannot establish this, the Bureau must determine the point within the arm’s length range to which it will adjust the controlled transaction condition (Section 8(b)).
- When range results have relatively equal and high reliability, any point in the range may be treated as satisfying the arm’s length principle; where comparability defects remain, central tendency measures such as median, mean, or weighted averages may be used to reduce error (Section 8(b)).
Comparability adjustments rules
- Differences between comparables and the tested party must be identified and adjusted so comparables can reliably support the determination of arm’s length price (Section 9).
- Comparability adjustments include accounting adjustments and function/risk adjustments (Section 9).
- Adjustments are intended to eliminate effects of differences that may materially affect the condition examined (price/margin) and must demonstrate improved accuracy; adjustments are not made to correct differences that have no material effect (Section 9(a)).
- The following comparability adjustments are avoided because they do not improve comparability (Section 9(b)):
- adjustments where the basis for comparability criteria is only broadly satisfied;
- excessive adjustments or adjustments that too greatly affect the comparable, indicating insufficient comparability;
- adjustments on differences that do not materially affect comparability;
- highly subjective adjustments, including those based on product quality differences.
Arm’s length pricing methodologies
- The arm’s length result is determined using the most appropriate method among the following (Section 10(a)).
- Comparable Uncontrolled Price (CUP) Method evaluates whether the amount charged in the controlled transaction is arm’s length by reference to a comparable uncontrolled transaction in comparable circumstances (Section 10(a) under CUP).
- Under the CUP method, differences in commercial/financial relations indicating non-arm’s length pricing require substituting the uncontrolled price; the CUP comparability analysis must account for: product characteristics (physical features and quality), service nature and extent, same supply/production chain point, product differentiation (e.g., patented features), sales volume, timing, inclusion of transport/packaging/marketing/advertising/warranty, same economic conditions in sale places, and whether a business strategy causes material price differences (Section 10(a) under CUP).
- Resale Price Method (RPM) applies when a product purchased from a related party is resold to an independent party and evaluates arm’s length pricing by reference to gross profit margin in comparable uncontrolled transactions (Section 10(b)).
- RPM is generally appropriate when the final transaction is with an independent party and depends on the extent of added value/alteration by the reseller and time lapse between purchase and onward sale (Section 10(b)).
- RPM is most difficult when the reseller contributes substantially to creation or maintenance of an intangible attached to the product (e.g., trademarks/tradenames), through complicated processing/assembly, or with a long time lapse affecting market conditions (Section 10(b)).
- Under RPM, the arm’s length price for the original transfer is computed by: resale price minus appropriate gross margin, then adjusting for other costs associated with the purchase (including customs duties) (Section 10(b)).
- RPM comparability analysis considers reseller functions/risks, similar assets, broader product differences (still considering significant product similarities, especially for high-value intangibles), differences in business management, time lapse effects, exclusivity rights, accounting practice differences, inclusion of transport/packaging/marketing/advertising/warranty, same sale-place economic conditions, and business strategies producing material differences in resale gross margin (Section 10(b)).
- Cost Plus Method (CPM) values functions of the supplier by assessing whether the supplier’s mark-up on costs meets the arm’s length standard; it is most useful for semi-finished goods or service provision between associated enterprises (Section 10(c)).
- CPM begins with the supplier’s cost in the controlled transaction and adds an appropriate mark-up to find the price the supplier should charge the buyer (Section 10(c)).
- CPM requires consistency and comparability of the cost base and accounting policies between controlled and uncontrolled transactions and over time; costs are direct and indirect production costs (Section 10(c)).
- CPM comparability analysis accounts for functions/risks, similar assets, product similarities, management differences impacting profitability, cost accounting differences, inclusion of transport/packaging/marketing/advertising/warranty, same economic conditions of sale places, and strategies affecting cost plus mark-up (Section 10(c)).
- Profit Split Method (PSM) allocates operating profit (or gross profit then deduct attributable expenses) by determining the profit division independent enterprises would have expected from the transactions (Section 10(d)).
- PSM serves as an alternative when no comparable independent transactions can be identified, such as where transactions are very interrelated or when a unique intangible is involved (Section 10(d)).
- PSM generally seeks an economically valid allocation approximating what independent parties would reflect in an arm’s length agreement (Section 10(d)).
- PSM allocation follows two approaches:
- Residual Profit Split Approach:
- stage 1 allocates basic return to each participant based on comparable market returns, reflecting functions and not unique asset returns;
- stage 2 allocates residual profit (or loss) considering facts indicating how independent parties would divide residuals, allocating returns attributable to unique assets based on relative contributions to their creation (Section 10(d)(1)).
- Contribution Profit Split Approach: divides combined profits in a single stage based on parties’ relative contributions to profit or relative value of functions, supported as much as possible by external market data (Section 10(d)(2)).
- Residual Profit Split Approach:
- Transactional Net Margin Method (TNMM) evaluates arm’s length pricing by comparing net profit margin relative to a base such as costs, sales, or assets, comparing controlled transactions with the same entity’s uncontrolled transactions or comparable independent entities (Section 10(e)).
- TNMM’s primary difference from RPM/CPM is its focus on net margin rather than gross margin, and net margins may be influenced by factors less directly tied to price/gross margin; reliable and accurate adjustments are required (Section 10(e)).
- TNMM is usually appropriate when gross profit is difficult to determine such that CPM or RPM cannot be used, using net margin with the same conceptual approach as CPM (for manufacturers/service providers) or RPM (for distributors) but substituting net margin (Section 10(e)).
Advance pricing arrangements and MAP process
- An APA is an agreement between the taxpayer and the Bureau determining in advance criteria (including method and comparables with adjustments) to ascertain transfer prices of controlled transactions over a fixed period (Section 11(a)).
- The purpose of an APA is to reduce the risk of transfer pricing examination and double taxation (Section 11(a)).
- APAs come in two types: (i) Unilateral APA (taxpayer and BIR only) and (ii) Bilateral or Multilateral APA (Philippines and one or more treaty partners) (Section 11(a)).
- A Bilateral or Multilateral APA is authorized under MAP in Article 25 of Philippine tax treaties (Section 11(a)).
- Availing an APA is not mandatory for taxpayers engaged in controlled transactions (Section 11(a)).
- If a taxpayer avails of an APA, the taxpayer may choose freely between unilateral and bilateral/multilateral APAs (Section 11(a)).
- If a taxpayer does not enter into an APA and later faces transfer pricing adjustments, the taxpayer may invoke the MAP article to resolve double taxation issues (Section 11(a)).
- The Bureau must issue separate guidelines on the application of APA and MAP processes (Section 11(a)).
Documentation duties and retention
- Taxpayers must demonstrate that their transfer prices are consistent with the arm’s length principle (Section 12(a)).
- Adequate documentation is meant to:
- defend the transfer pricing analysis;
- prevent transfer pricing adjustments arising from tax examinations; and
- support applications for MAP (Section 12(a)).
- Taxpayers who do not prepare adequate documentation face rejection of MAP applications or make transfer pricing issues more difficult to resolve (Section 12(a)).
- Taxpayers are not required to submit transfer pricing documents when filing tax returns, but the documents must be retained and submitted to BIR when required or requested (Section 12(a) under “Retention Requirement”).
- Transfer pricing documents must be retained for the period provided in the Tax Code as the retention period, unless another legally provided different period applies (Section 12(b)).
- Transfer pricing documents must be contemporaneous, meaning they exist or are brought into existence at the time associated enterprises develop or implement arrangements that might raise transfer pricing issues or are reviewed when preparing tax returns (Section 12(c)).
- Documentation must include details such as:
- organizational structure;
- nature of business/industry and market conditions;
- controlled transactions;
- assumptions, strategies, policies;
- cost contribution arrangements (CCA);
- comparability and functional and risk analysis;
- selection of transfer pricing method;
- application of transfer pricing method;
- background documents; and
- index to documents (Section 12(d)).
Penalties, separability, and repeal
- Penalties and other appropriate sanctions for failure to comply with or violate these Regulations are imposed through the Tax Code and other applicable laws (Section 13).
- The Regulations include a separability clause: invalid or unconstitutional parts do not affect other provisions that remain in force (Section 15).
- The Regulations include a repealing/modifying clause: all existing inconsistent rules, regulations, and issuances are modified, repealed, or revoked accordingly (Section 16).