BIR's power to allocate income among related taxpayers

A major consideration of multinational companies in planning to expand business in the Philippines is the presence of transfer pricing rules in the country. Recently, the BIR has become more aggressive in its tax audit by issuing assessment notices to taxpayers challenging the propriety of their transfer pricing with regard to their related party transactions.
 

The BIR used its power under Section 50 of the Tax Code as legal basis in issuing the said assessments. This grants the Commissioner of Internal Revenue (“CIR”) the authority to distribute, apportion or allocate gross income or deductions between or among 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 such distribution, apportionment or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such organization, trade or business.

The said authority was not formally implemented until January 2013 when the BIR finally issued Revenue Regulations (RR) No. 2-2013, otherwise known as the Transfer Pricing Regulations. The regulations prescribe the guidelines in determining the appropriate revenues and taxable income of the parties in a controlled transaction. The guidelines are largely based on the Organization for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines, which have served as the framework for Transfer Pricing regulations around the world.

RR 2-2013 expressly adopts the “arm’s length principle,” which is the internationally accepted standard for determining the appropriate transfer prices of controlled transactions of associated enterprises. The principle requires that a transaction with a related party should be made under comparable conditions and circumstances as a transaction with an independent party. Essentially, a taxpayer’s income from a related party transaction must be equivalent to what would be earned by a similarly situated taxpayer from a transaction with a third party.

Notably, prior to the issuance of the Transfer Pricing Regulations in 2013, the Supreme Court made a landmark decision in the case of CIR v Filinvest dated July 19, 2011. The Court held that the BIR’s power to allocate gross income does not include the power to impute “theoretical interest” because there must be actual or, at the very least, probable receipt or realization of the income that is being allocated.  It also recognized that under the Civil Code, interest cannot be imposed unless expressed in writing.

The Supreme Court decision on non-imputation of theoretical interest on non-interest bearing intercompany loans somehow creates a limit on the BIR’s power to allocate gross income among related taxpayers. A lot of companies with outstanding intercompany loans found an umbrella under the said Supreme Court decision to protect their practice of not charging interest to their related parties with respect to such loans.

Nevertheless, the above Supreme Court decision needs to be scrutinized as it appears to contradict the BIR’s power to allocate gross income and deductions among controlled taxpayers pursuant to Section 50 of the Tax Code. In the same manner, with the recent issuance of the Transfer Pricing Regulations, it appears that the BIR is seriously fighting for its limitless power to allocate income among controlled taxpayers.