Tax Articles

Transfer Pricing of the Digital Economy

By Atty. Irwin C. Nidea Jr.

While the world is already talking about obsolescence of the arm’s length principle in transfer pricing, the Philippines is only beginning to grasp the concept and apply the same in its audit procedures. The Philippines’s transfer pricing regulations have been issued as early as 2013. But it was only on August 20, 2019, that the Bureau of Internal Revenue (BIR) issued RAMO 1-2019, which prescribes the guidelines that must be followed by revenue examiners in transfer pricing audit.

These BIR issuances mandate that transfer price in a related party transaction must conform with the arm’s length principle. This principle stipulates that “if the conditions in the transaction between related parties are the same as, or similar to, the conditions in transactions between independent parties that are used as comparable, the price or profit in the related transactions must be the same as, or similar to, the range of prices or profit in the transactions between the comparable independent parties” (RR 2-2013). In other words, if a parent company buys goods from its subsidiary at P100,000, the subsidiary must sell the same goods to an unrelated party, also at P100,000.

Digital economy challenges the aptness of the arm’s length principle. People do not transact through brick and mortar anymore. The value that is added by an affiliate in a multinational enterprise is not just measured by how big its physical presence is in a jurisdiction. Digital platforms can create a significant amount of business in a country without any physical presence. This supports the emerging idea that users create value for the digital platforms that they use. Thus, it is just proper that the country where these users are located is allowed to have a share in the tax in proportion to the value that its users create. Filipinos, for example, are among the top Facebook users, but Facebook has a limited physical presence in the Philippines. How should Facebook be taxed in the Philippines and what is the Philippines’s share in Facebook’s allocation from its global profit?

The Organization for Economic Cooperation and Development has proposed a new paradigm that will address the perceived leaks of the arm’s length principle when applied to digital economy: 1. User Participation Proposal; 2. Marketing Intangible Proposal; and 3. Significant Economic Presence Proposal.

The User Participation proposal gives emphasis on digital presence in a country and income allocation based on the participation of digital users. It is based on the principle that value of the digital business is derived from the volume of digital users. When an entity engaged in digital transaction creates an impact in a country, then it will be treated as having a taxable presence in the said country. When a multinational enterprise that develops and maintains a digital platform, e.g., Internet search engine like Google, will not have a traditional Permanent Establishment in many countries where the digital platform is being used. But it may still be considered as creating a significant income that is derived from these countries when their citizens use it.

A typical digital transaction is “pop-up” advertisements. Pop-up is a window that appears suddenly on a computer screen, which is often used to advertise a product. We usually see this appear while we are browsing the Internet. Like any other advertisement, there is revenue derived from it. It is proposed that the country where the pop-up appears must be able share in the income. The calculation of share in income would be based on residual profit, determined by the number of users and the revenue generated through advertising. This proposal admits that there are many variables that remain open if the residual profit method is applied alone and suggests that a preagreed formula is also adopted to simplify what is the tax due to each country.

The second proposal is called Marketing Intangibles. These intangibles include buyer preference or bias because of experience in a product or buyer loyalty. They are difficult to measure. In this proposal, the market jurisdiction (where digital users are located) would be entitled to tax some or all of the “non-routine” income, while “routine” income will still be apportioned between affiliates based on existing transfer pricing principles. Routine income of marketing intangibles includes revenue derived from intellectual property; e.g., brand name, trade name. This proposal contemplates that marketing intangibles like customer loyalty are created in a market jurisdiction through the efforts of the business, regardless of size. The problem, however, is how to determine the value of the marketing intangibles and the corresponding allocation that must be made per market jurisdiction.

The Significant Economic Presence proposal, on the other hand, contemplates that if the revenue generated from sales to residents of a country reach a certain threshold, or the number of users per year or the volume of digital transactions exceed a certain number, a formulary apportionment of income must be effected. Instead of the usual transfer pricing methods, this proposal suggests an agreed upon formula in the apportionment of income.

Digital economy is the new economy. It is the new oil. We should be able to get our true share in the income tax allocation of the likes of Google, Facebook and Amazon. This cannot be realized if we are not even serious in implementing our transfer pricing rules.