In our previous articles and public seminars on transfer pricing (TP), we’ve consistently emphasized that it was only a matter of time before the Bureau of Internal Revenue (BIR) actively incorporated transfer pricing into its regular tax audits. That time has now come. In this article, we’ll explore the key issues flagged by the BIR in an actual transfer pricing audit, how the taxpayer was able to address these findings, and what steps can be taken to prevent similar issues in the future.
FACTS OF THE CASE
The taxpayer is a domestic corporation established in 2022. It is engaged in call center services providing support, consulting and maintenance exclusively for the parent company. Despite being newly incorporated, the taxpayer received a Letter of Authority (LoA) from the BIR to examine its compliance for 2023 — barely a year into its operations.
After the audit was conducted, the BIR alleged that the taxpayer had underdeclared its revenue. This finding was based on a discrepancy observed in the taxpayer’s 2023 Audited Financial Statements (AFS), where the total reported cost of services, administrative, and other expenses (herein referred to as “fully loaded costs”) amounted to approximately P100 million, while the declared revenue was only P90 million. The BIR questioned how the company could incur higher expenses than its reported income, raising concerns about potential unreported revenue.
Then, the BIR applied a standard industry markup of 10% on fully loaded costs, which, according to the BIR, is consistent with industry norms for business process outsourcing (BPO) companies. Applying the 10% industry markup on the P100 million fully loaded cost resulted in an adjusted revenue of around P110 million. Hence, the difference between the adjusted revenue and declared revenue amounting to P20 million constituted undeclared income subject to regular corporate income tax.
WHAT COULD TRIGGER THE BIR AUDIT?
While it may seem surprising for a newly established company to undergo a tax audit, it’s not entirely uncommon. One possible trigger for the BIR’s scrutiny could be the taxpayer’s reported net loss in 2023. In fact, this is one of the audit triggers specifically identified in Revenue Audit Memorandum Order (RAMO) No. 1-2019.
Loss declarations, particularly during a company’s early years, often attract closer scrutiny from the BIR. This is especially true for BPO companies, which are generally expected to report positive earnings, as their service fees are typically structured based on fully loaded costs plus a markup. A reported net loss in such cases may prompt the BIR to question the accuracy and appropriateness of the transfer pricing policies applied.
TRANSFER PRICING RULES AND LOSSES
RAMO No. 1-2019 explains that companies incur losses for a variety of economic and business reasons, such as startup losses, market penetration costs, and research and development failures. However, an independent company typically would not endure continuous losses without taking appropriate measures to correct the situation within a reasonable time. The fact that a related or associated company continuously suffers losses may be an indication that it is not being compensated fairly.
In determining whether the losses are acceptable, it is important to ensure that the controlled transaction entered into is commercially realistic and makes economic sense. A taxpayer needs to establish that the losses are commercial in nature within the context of its characterization. In this regard, a taxpayer is expected to maintain contemporaneous documentation which outlines the non-transfer pricing factors contributing to the losses incurred.
RESOLVING THE TP AUDIT
a. On the fully loaded costs
In the case at hand, the taxpayer’s transfer price to its parent company was based on fully loaded costs, excluding non-recurring startup expenses, plus a markup. However, the BIR, in its audit, failed to exclude these non-recurring startup costs from the P100 million fully loaded costs reported in the AFS before applying the industry-standard BPO markup.
Fortunately, the taxpayer had prepared a comprehensive transfer pricing policy and intercompany agreement that clearly outlined its fee structure. The taxpayer said that startup costs are not subject to arm’s length markup, citing the Organisation for Economic Co-operation and Development’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2022), which provide that a taxpayer seeking to enter a new market or expand (or defend) its market share might temporarily incur higher costs (e.g., due to startup costs or increased marketing efforts) and hence achieve lower profit levels than other taxpayers operating in the same market. Additionally, it is typical that startup costs may result in temporary losses within that period. As stated in OECD Guidelines: “…associated enterprises, like independent enterprises, can sustain genuine losses, whether due to heavy startup costs, unfavorable economic conditions, inefficiencies, or other legitimate business reasons.”
Moreover, the application of the arm’s length principle ensures similar tax treatment between members of multinational groups and independent enterprises. In practice, an independent enterprise would not be expected to bear the startup costs of a contracted, unrelated service provider.
The taxpayer’s TP documentation (TPD) played a crucial role in explaining the pricing methodology to the BIR. That said, it is essential for taxpayers to ensure that the terms of their agreements — particularly pricing provisions — are consistent with the actual conduct of the parties. To mitigate future risks, taxpayers are strongly advised to conduct an annual review of their operations to confirm that the actual financial results reported in the AFS align with the terms of their transfer pricing agreements.
b. On the markup rate
Regarding the appropriateness of the 10% standard BPO markup rate imposed by the BIR, the taxpayer was able to present robust TPD demonstrating that the actual markup it applied to its fully loaded costs fell within the arm’s length range observed among independent comparable companies.
The 10% rate cited by the BIR was at the higher end of that range and, therefore, not reasonable to impose on the taxpayer. This is particularly true given the taxpayer’s business profile as a captive or limited-risk service provider, which typically warrants a lower markup. Additionally, the taxpayer was newly established, in contrast to the mature, independent companies used as comparables. These factors supported the propriety of the taxpayer’s actual markup and helped justify its pricing position during the audit.
KEY TAKEAWAYS
Many taxpayers still fail to maintain proper TPD, such as benchmarking analyses, often due to the perceived complexity, lack of awareness, or the belief that non-compliance penalties are minimal. However, maintaining robust documentation is essential. It not only supports the arm’s length nature of related party transactions but also provides a clear audit trail and strengthens a taxpayer’s position during BIR audits.
Taxpayers should avoid complacency in dealing with related parties. Cost and pricing arrangements must be backed by written agreements and aligned with actual business operations. While we commend BIR’s efforts to look at the dealings among related parties, it’s equally important that assessments are grounded in a thorough understanding of taxpayer data.
Ultimately, tax audits should be seen as opportunities by taxpayers to enhance compliance and by the BIR to foster greater awareness and promote responsible tax practices among businesses.
Let’s Talk TP is an offshoot of Let’s Talk Tax, a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
Lorenzo Miguel A. Soriano is a manager from the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.
