Copyright 2013 CD Technologies Asia, Inc. and Accesslaw, Inc.

Philippine Taxation Encyclopedia First Release 2013 1

July 7, 1998
REVENUE AUDIT MEMORANDUM ORDER NO. 01-98
SUBJECT : Audit Guidelines and Procedures in the Examination of
Interrelated Group of Companies
TO : All Revenue Officers Concerned
This RAMO is issued as a basic guideline for the joint and coordinated
examination of interrelated group of companies under Revenue Memorandum Order
No. 61-98. prLL
1. BACKGROUND
1.1 The remarkable decrease in collection from interrelated group of
companies has seriously affected the collection efforts of the
Bureau. Statistics showed that while 'inter-related transaction'
accounts for a big percentage of the transfer of goods and services
in the country, the revenue collection from related-party groups
continue to go on a downtrend.
1.2 The magnitude of revenue lost has become so alarming that there is
a need to immediately address this problem. It is a fact that,
because these companies are more interested in their net income as
a whole (rather than as individual corporations) there is a desire to
minimize tax payments by taking advantage of the loopholes in our
tax system and by making use of schemes that allow them to move
around the law in order to reduce their tax obligations.
1.3 It is therefore necessary to conduct a joint and coordinated
examination of interrelated group of companies in order to identify
the tax avoidance schemes and be able to prescribe the necessary
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measures in order to avoid the erosion of revenues.
2. GENERAL GUIDELINES
2.1 General Procedures. The provisions laid down in Volume 1 of the
Handbook on Audit Procedures and Techniques must be followed
with respect to:
a. Basic reportorial requirements; and
b. general audit procedures and techniques.
2.2 Special Audit Procedures. In addition, focus must be made on the
following audit issues (detailed audit procedures are laid down in
Section 3 of this RAMO ):
2.2.1 Use of tax shelters (such as a foundation or a tax-exempt
company) in order to avail of tax exemptions or of lower tax
rates; dctai
2.2.2 Shifting income and/or expenses in favor of a related
company with special tax privileges (e.g. BOI Incentives,
Tax Holidays, and etc.);
2.2.3 Transfer pricing in inter-company supply of goods (tangible
and intangible) and services;
2.2.4 Inter-company loans and advances, and financing
arrangements where the interest charged for the use of
money is not at arm's length;
2.2.5 Arbitrary cost-sharing arrangements for common expenses;
2.2.6 Tax avoidance through resale and agency arrangements; and
2.2.7 Thin capitalization and earning stripping.
2.3 Use of Section 50 of the NIRC, as amended
2.3.1 The authority for allocating income and expenses between
or among related parties is laid down in Section 50 of the
NIRC, as amended. This Section gives the Commissioner of
Internal Revenue the authority to make allocation of income
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and expenses between or among controlled group of
companies, if a related taxpayer has not reported its true
taxable income.
2.3.2 The purpose of Section 50 is to ensure that taxpayers clearly
reflect income attributable to controlled transactions and to
prevent the avoidance of taxes with respect to such
transactions. It places a controlled taxpayer in tax parity
with an uncontrolled taxpayer by determining the
arm's-length price of inter-company transactions. LLphil
2.4 Determination of Arm's Length Price
a. The method to be used in determining the arm's-length price
depends on the type of transaction whether the
transaction involves a transfer of property, services, loans,
advances, rentals or other arrangements. Accordingly,
proper judgment must be used taking into consideration the
peculiarity of the transaction and the presence of available
information that would reliably determine the correct
income of a controlled taxpayer.
b. The different methods of determining the arm's length price
of a controlled transaction under the OECD Rules on
transfer pricing may be used as a reference. This includes
the use of Comparable Uncontrolled Price Method, Resale
Method, Cost-plus Method and Gross Profit Margin Method
(these are discussed in detail in the next Section).
c. In addition, the following must be considered:
Data and Assumptions consider the completeness and
accuracy of available data and information and the
reliability of assumptions that are to be made.
Comparability consider similar transactions between
unrelated parties. Factors of comparability to be considered
in the examination include:
a. Functional analysis factors such as product design
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and engineering, manufacturing, production and
process, marketing and distribution, advertising and
etc.
b. Contractual terms this include sales and purchase
agreements, volume, nature of warranties, credit and
payment terms and other commercial arrangements.
c. Risks market risks including fluctuations in
demand, financial risks, collection risk and
commercial risks.
d. Economic conditions refers to the prevailing
conditions in the market.
2.5 Definition of Terms
2.5.2 The term 'controlled' for purposes of this RAMO shall mean
any kind of control, direct or indirect, whether legally
enforceable and however exercisable or exercised. It is the
reality of the control which is decisive, not its form or the
mode of its exercise or ownership. A presumption of control
arises if income and expenses have been arbitrarily shifted.
2.5.3 The term 'controlled taxpayer' means any one or two or
more organizations or trade, or businesses owned or
controlled directly or indirectly by the same interests;
2.5.4 The term 'true taxable income' means, the taxable income
which would have been reported by the controlled taxpayer,
had it in the conduct of its affairs dealt with the other
member or members of the group at arm's-length. cdasia
3. AUDIT PROCEDURES
3.1 Transfer Pricing in interrelated supply of goods or services. This is
relevant if one of the related-party enjoys certain privileges such
as tax exemption, lower tax rates, incentives, or is a losing
company.
3.1.1 In General. The method to be used in determining the
Copyright 2013 CD Technologies Asia, Inc. and Accesslaw, Inc. Philippine Taxation Encyclopedia First Release 2013 5
arm's-length price of a controlled transaction shall rely
primarily on the best judgment of the examiner after taking
into consideration the prevailing circumstances as well as
the availability of information at the time of transaction.
3.1.2 As a guide, the methods under the OECD Guidelines on
transfer Pricing may be used, as follows:
a. The comparable uncontrolled price method (CUP)
this evaluates the arm's length by reference to the
amount charged in a comparable uncontrolled
transaction. In evaluating comparability, consider the
following:
trademark
product differences
geographical differences, and
extraordinary market conditions;
b. The Resale Price Method (RPM) it evaluates arm's
length by reference to the gross profit margin
realized in comparable transactions.
c. The Cost Plus Method (CPM) it evaluates the
arm's-length by adding the appropriate gross profit to
the controlled taxpayer's cost of producing the
property involved in the controlled transaction and
then impose the applicable profit rate.
d. The Profit Split Method this is done simply by
dividing the profit between the members involved in
the transaction taking into consideration the extent of
their participation in the realization of the
transaction.
3.2 Loans and Advances, and financing arrangements between or
among related parties
3.2.1. In General. When one member of a group makes a loan or
advance directly or indirectly to, or otherwise becomes a
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creditor of another member and either party charges an
interest which is not at arm's length, there may be a tax
advantage to either the lender or borrower.
3.2.2 Loans and Advances may be in the form of :
a. Bona fide indebtedness such as loans or advances of
money or other considerations;
b. Indebtedness arising in the ordinary course of
business from sales, leases, or the rendition of
services by and between members of the group, or
any other similar extension of credit;
c. Alleged indebtedness
For purposes of this Section, an "arm's length rate of
interest" is the rate of interest which would have been
charged in independent transactions between unrelated
parties under similar circumstances. cda
3.2.3 Financing Arrangements.
3.2.3.1 A common element in related-party groups is the
presence of a finance company (usually a holding
company) to provide financial services for the
members of the group.
3.2.3.2 Financial services by a holding company may range
from serving as a central lender for the group, in
which capacity, it may borrow funds from unrelated
financial institutions and on-loan such amounts to
its subsidiaries. It may also perform financial
intermediary services for the group including
factoring and hedging.
3.2.3.3 Where one member of a group of controlled entities
makes a loan or advance directly or indirectly, or
otherwise becomes the creditor of another member
of such group, an arm's length price for the use of
money should be charged. The same is true in the
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case of indebtedness arising in the ordinary course
of business such as sales, leases, provision of
services and other similar extension of credits.
3.3 Performance of Services for Another
3.3.1 In general under this scheme, one member of the group
performs marketing, managerial, administrative, technical or
other services for the benefit of, or on behalf of another
member of the group without charge or at a charge which is
not arm's-length.
3.3.2 To determine the arm's length price for the service, the
"Benefit Test" may be considered. Under this test, the direct
benefit to the member which received the service must be
considered. It is necessary to take into account on some
reasonable basis all the costs or deductions which are
directly or indirectly related to the service performed. cdrep
3.3.3 Where tangible or intangible property is transferred, sold,
assigned, loaned, leased or otherwise made available in any
manner by one member of a group to another member of the
group and services are rendered by the transferor in
connection with such transfer, the services rendered in such
transaction, provided it is not ancillary, must be valued.
3.4 Sharing of Costs
3.4.1 In general. A cost sharing arrangement is an agreement
under which the parties agree to share the costs in
proportion to their respective share of anticipated benefits.
This is very common in joint undertaking and in expenses
such as research and development, office and factory
spaces, legal and consultancy services and etc.
3.4.2 In determining the appropriateness of the sharing
arrangement, factors such as benefits-received, size of the
company, participation in the venture, and etc. should be
considered.
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3.5 Thin Capitalization and Earning Stripping
3.5.1 In General The most common form of tax avoidance
scheme using corporate structure is high-debt financing of
thinly capitalized controlled company. This scheme favors
debt over equity as a form of financing mainly because of
tax favored treatment of interest payments compared to
dividends.
3.5.2 Under present laws, interest payments are fully deductible
against taxable income while dividends are not. The tax
advantages of interest payments in contrast to dividend is an
outright savings of 35% (34%-32% under CTRP) in the
form of a deductible expense against the taxable base. If
interest payments are subjected to 20% Final Tax (while
intercorporate dividends are at 0% tax), financing through
debt rather than equity would still have an advantage
equivalent to 15%.
3.5.3 In the absence of rules prescribing guidelines and
presumptions as to what constitute thin capitalization
(unlike other countries), there is a necessity to determine the
reasonable ratio of debt over equity considering all factors
surrounding the case.
4. EFFECTIVITY
This RAMO shall take effect immediately. cdasia
BEETHOVEN L. RUALO
Commissioner of Internal Revenue