RAMO 1-98

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.

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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

CD Technologies Asia, Inc. and Accesslaw, Inc.

Philippine Taxation Encyclopedia First Release 2013

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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. b.

2.2

Basic reportorial requirements; and general audit procedures and techniques.

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 Copyright 2013



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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.

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Functional analysis — factors such as product design



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and engineering, manufacturing, production and process, marketing and distribution, advertising and etc.

2.5

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.

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

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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: • • • •

3.2

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.

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 Copyright 2013



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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

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RAMO 1-98

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