Tax Articles

CITIRA and Transfer Pricing

By Atty. Benedicta “Dick” Du-Baladad

The current Section 50 of the Tax Code (copied from the US Tax Code) is the source of the Bureau of Internal Revenue’s (BIR) authority to reallocate income and expenses between related parties, effectively disregarding contracts and agreements in what is called “sweetheart deals” or “transfer pricing schemes.” Section 50 meant to give full powers to the Commissioner of Internal Revenue to prevent erosion of revenues.

But Section 50 seems weak, from a legal standpoint, as it is too much of a motherhood statement not strong enough to call a spade a spade. Not a single case of transfer pricing has been won in Court by the BIR, perhaps due to the difficulty in proving that prices are not at arm’s-length, or that legally, there is no sufficient legal basis to impugn valid agreements between related parties, even in agreements involving sweetheart deals.

In the case of Filinvest v. Commissioner of Internal Revenue (GR 163653 and 167689, July 19, 2011), a transfer pricing test case, the BIR imputed interest income to a holding company which re-lent the proceeds of a loan taken from a bank to its operating subsidiary. The BIR won in the tax court but upon appeal, the Supreme Court canceled the assessment stating that the BIR has no power to impugn valid contracts and arrangements unless it is against public order or policy. According to the Court, the BIR’s broad powers of distribution, apportionment, allocation of gross income and deductions, does not include the power to impute “theoretical interests” to the controlled taxpayer’s transactions. In other words, the BIR has no power to impute income where no income was agreed upon by the related parties. In this case, between a holding company and a subsidiary. Such power is not covered under Section 50.

Now, here comes Corporate Income Tax and Incentives Rationalization Act (Citira) wanting to strengthen that power. The government fears that our country has become a target of transfer pricing schemes by multinational enterprises and there is a need to arrest this situation. This fear is well-founded and could be true. The Philippines is a high-tax jurisdiction, our tax laws against transfer pricing and profit shifting is not rock-solid, audit enforcement to capture transfer pricing schemes is weak. All the ingredients for a likely target of profit shifting are present. In short, the country is exposed to transfer pricing practices without adequate cover.

Domestic transfer pricing practices by conglomerates and related-parties are also being eyed by the government to be tightened. The wide array of tax incentives gave a wider opportunity to save on taxes through shifting of income and deductions between one subject to regular taxes vis-à-vis one with incentives. Such shifting is done with the overall objective of having a bigger income for the group net of tax.

Under Citira, Section 50 was amended to give clear, specific powers to the Commissioner of Internal Revenue that includes not only the power to allocate, apportion or distribute income and deductions between related parties, but also the power to impute income. The inclusion of “authority to impute” now corrects the loophole in the Filinvest case where the Supreme Court said that Section 50 did not include the power to impute income.

Likewise, Citira clarified that the same power can be exercised by the Commissioner where a transaction or arrangement is motivated by obtaining a tax benefit or advantage with no commercial reality or economic effect. Examples of obtaining benefit are: altering the incidence of a tax, relieving a person from a tax liability, avoiding or postponing a tax liability.

The phrase “no commercial reality or economic effect” is a question of fact which the taxpayer being assessed has the burden to dispute. Another difficult hurdle with the BIR.

The old school of thought that tax avoidance is legal and allowed, in contrast to tax evasion which is illegal, will eventually be discarded by Section 50 once amended. Any transaction where the motive is to obtain a tax benefit, regardless if through tax avoidance or tax evasion, can be voided by the Commissioner under the proposed amendment of Section 50. The only difference, perhaps, is the criminal liability that is attached to tax evasion, but not on avoidance. The dividing line between evasion and avoidance has become thinner with Citira’s proposed amendment to Section 50. Thus, a more careful and prudent tax planning is necessary.

The intent of the government to plug loopholes that lead to erosion of revenues through transfer pricing schemes is very clear. Aside from amendments introduced in Citira, the BIR also issued Revenue Audit Memorandum Order (Ramo) 1-19 on August 20, 2019. This BIR issuance was meant to complement Citira through stricter enforcement of transfer pricing audits and requirement for transfer pricing documentation.

I heard that the BIR is continuously undertaking training of its examiners on transfer pricing audits. But I have yet to hear if the necessary databases for the benchmarking have already been secured. Upon Citira becoming a law, we expect a vigorous enforcement of Section 50.

Ramo 1-19 basically follows the internationally accepted OECD transfer pricing rules and principles. My take is that, as long as the BIR sticks with these principles, there is no cause to worry. On the part of businesses with related-party transactions, preparedness is the key.