As businesses engage in cross-border transactions with related parties, transfer pricing adjustments become essential to ensure compliance with the arm’s length principle. These adjustments help align intercompany pricing with market standards, reducing the risk of tax disputes, penalties, and double taxation.
Transfer pricing adjustments are revisions or corrections made to the pricing of transactions between related parties to ensure that such prices reflect the arm’s length principle, reflecting what unrelated entities would have agreed upon under similar conditions.
Adjustments can be initiated voluntarily by the taxpayer or imposed by the tax authority during an audit.
TRANSFER PRICING ADJUSTMENT KEY POINTS
1. Arms-length principle: Taxpayers must price their related-party transactions as if they are between independent entities under similar conditions. Philippine regulations, particularly Section 5 of Revenue Regulations No. 2-2013, reinforce this standard by mandating that transfer prices reflect economic reality.
2. Adjustments
• Comparability adjustments: To proactively align actual intercompany results with arm’s length benchmarks and to eliminate material differences between controlled and comparable transactions that could affect the reliability of the transfer pricing analysis.
Although comparability adjustments themselves are not accounting entries, they play a critical role in establishing an arm’s length range. Once this range is determined, a taxpayer may perform internal true-ups or year-end corrections to ensure that its actual intercompany results fall within the adjusted range. These true-ups are acceptable when they reflect genuine economic conditions and are applied consistently with the taxpayer’s documented transfer pricing policy. However, adjustments that are excessive, immaterial, or highly subjective should be avoided, as they may undermine the reliability of the analysis.
For example, a multinational company may notice that due to fluctuating market conditions, its intercompany prices differ from benchmark prices. Before tax filing, it makes year-end true-up adjustments to align the transfer prices with arm’s length benchmarks.
• Compensating adjustments: To reflect changes made by one party to a controlled transaction and ensure a corresponding adjustment is made by the counterparty, preserving symmetry in the tax treatment. This is usually done through reciprocal entries in both parties’ accounting records. Some jurisdictions allow compensation adjustments to be applied simultaneously with comparability adjustments or, alternatively, when comparability adjustments alone are insufficient to achieve arm’s length results. However, in the Philippines, compensating adjustments are not explicitly allowed under current regulations, which discourage retroactive changes.
• Tax authority adjustments: To correct transfer prices that deviate from arm’s length, typically discovered during audit, these may lead to primary and secondary adjustments. Secondary adjustments address the resulting impact of a primary adjustment.
An example is when, during an audit, a tax authority increases a subsidiary’s taxable income after finding that transfer prices were set below market rates (primary adjustment). To address the financial impact, the authority applies a secondary adjustment, treating the difference as a deemed dividend, which may be subject to withholding tax.
3. Supporting documentation: To justify the basis and calculation of any adjustment made, demonstrating compliance with the arm’s length principle. It should provide a clear and transparent explanation of why the adjustment is necessary, how it was determined, and its impact on the transfer pricing analysis.
ADVANCE PRICING ARRANGEMENT (APA) PERSPECTIVE
The draft Revenue Regulations on Advance Pricing Arrangements (APA) issued by the BIR provide a proactive mechanism for managing transfer pricing risks. Under Section 50 of the Tax Code, the Commissioner is empowered to allocate income and deductions among related parties to ensure arm’s length results. The APA framework allows taxpayers to agree in advance with the BIR on acceptable transfer pricing methodologies, thereby reducing the likelihood of future adjustments or disputes. This is particularly relevant for taxpayers engaged in complex or high-value cross-border transactions, where certainty and consistency are critical.
The draft RR also introduces a revision mechanism for APAs, which may result in transfer pricing adjustments when critical assumptions change — such as business restructuring, economic shifts, or updates in domestic or treaty laws. These revisions ensure that the agreed methodology remains aligned with arm’s length principles. In bilateral or multilateral APA cases, coordination with foreign tax authorities is emphasized to prevent double taxation and maintain symmetry in tax treatment. This structured approach enhances transparency and provides a safeguard against audit-related surprises.
We appreciate the BIR’s initiative in issuing the draft Revenue Regulations on Advance Pricing Arrangements, which provide a clear framework for achieving tax certainty. As stated in the draft, “As long as the terms and conditions of the APA are satisfied, the covered transactions will not be subjected to audit, and no transfer pricing adjustments shall be made by the tax authorities that concluded the APA.” This not only prevents resource-intensive transfer pricing examinations and litigation but also mitigates the risk of economic double taxation or taxation not in accordance with relevant tax treaties. By allowing taxpayers to file a request for APA, the BIR fosters a non-adversarial environment that builds trust and confidence between taxpayers and the tax administration.
Transfer pricing adjustments play a critical role in aligning related party transactions with the arm’s length principle. These adjustments are essential because they address differences in functions, risks, and financial outcomes that, if left uncorrected, could distort the accuracy of transfer pricing analyses.
Such adjustments are crucial not only for achieving accurate tax reporting but also to reduce the risk of tax disputes, penalties, and double taxation. To be effective, all adjustments must be well-documented and clearly disclosed.
An APA, on the other hand, is a tool giving taxpayers the opportunity to prevent transfer pricing disputes with the BIR, as the BIR and taxpayer agree in advance on a mutually beneficial and pragmatic solution that applies the arm’s length principle to the covered transactions.
Let’s Talk Tax is 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 professionals.
Donna Kasandra A. Dela Torre is a senior in charge from the Tax Advisory & Compliance practice area of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.