Transfer pricing and cost contribution arrangement

Transfer pricing issues in cost contribution arrangements

by Lina Figueroa

Cost sharing, also known as cost contribution arrangement (CCA), has long been accepted, both in theory and in practice, as a tool for achieving certain efficiencies when undertaking a wide range of activities — from something as simple as centralized procurement to the more complex shared business services or the development of intangible properties.

Pooling of resource and skills can minimize potential individual losses from high-risk activities that require huge capital outlay such as research and development (R&D). Economies of scale may be realized when individual companies jointly undertake similar activities such as the development of common advertising materials or the setting up of a centralized management services. Efficiency and productivity may be achieved when individual companies combine their different individual strengths and expertise in embarking on product development.  

In addition to the efficiency gains, a cost sharing arrangement can also yield tax efficiencies and tax saving opportunities. 

This, therefore, can become a transfer pricing concern when the arrangement involves affiliated companies, especially when they are located in different jurisdictions. The amount of costs borne by each participant can become an issue as any misallocation may result in a redistribution of income or expenses across borders to the other participants in the arrangement. 

Hence, rules on the proper treatment of cost sharing arrangements are usually embodied in the transfer pricing regulations of different countries. 

A CCA is generally defined as a framework agreed upon among enterprises to share the costs and risks of developing, producing, or obtaining assets, services, or rights, and to determine the nature and extent of the interests of each participant in the results of the activity of developing, producing, or obtaining those assets, services, or rights.

The BIR has, on several occasions, ruled on the taxability of charges made to a local company by a foreign affiliate for shared expenses. If the payment is to be made to a nonresident for a CCA undertaken in another country, it will not be subject to Philippine income tax and withholding tax. Exemption from withholding tax may also be granted where the payments were deemed reimbursements of expenses, not income payments.

In cases where the costs are for the development of an intangible property, the draft transfer pricing regulations rule that the payment is not deemed a royalty payment because the participant, under a CCA, is a co-owner of the property. Not being a royalty, it is not subject to withholding VAT.

In some of the rulings issued on CCAs, the BIR went further by stipulating a condition that the contribution being charged to the local company has been accurately determined. It assumed that the company has exerted reasonable efforts to ensure that the method of allocation and charges is consistent with the arm’s length principle as may be determined through adequate documentation.

However, the BIR has acknowledged that it cannot generally rule on the accuracy of the allocation as it is a question of fact which may only be confirmed through audit or investigation. Compliance with the requirements under the transfer pricing regulations, when issued, will be required in such cases.

In the draft transfer pricing regulations, the contribution is generally allowed as a deductible expense. If the benefit can only be realized in the future, the contribution may be treated first as an asset, and then amortized in proportion to the achievement of the expected benefits.

As is the general rule on related party transactions, it is required th at the conditions of a CCA should satisfy the arm’s length principle. That is, a participant’s contribution must be of an amount or value which an independent enterprise would have agreed to contribute under comparable circumstances given the benefits it expects to derive from the arrangement. In other words, each participant’s contribution should be proportionate to the benefits that it expects to derive from taking part in the activity. 

In the evaluation of the allocation, the draft regulation requires that all contributions made by participants and the benefits it expects to derive should be considered. The amount of the contributions need not be limited to funds actually paid out. It can include property or services that a participant uses in its own business but which he allows to be partly used in the CCA project. It may also be in the form of a guaranty or a risk that the participant agrees to shoulder. 

It is equally difficult to put a value on the expected benefits. The draft regulation suggests an allocation based on the anticipated additional income generated or costs saved. Prices charged in sales of comparable assets and services may also be applied.

The approach most frequently used in practice is the use of an allocation key. The draft regulation mentions: sales; units used, produced, or sold; gross or operating profit; the number of employees; capital invested; and others, depending on the nature of the activity and conditions provided under the CCA. The same indicators have been upheld in some BIR rulings and court decisions, and even in the 1986 regulations on documentation and allocation of head office expenses to their Philippine branches. 

Hence, though the ruling from the BIR can confirm the exempt status of the payments pursuant to the CCA, it may be necessary for the company to maintain sufficient documentation to evidence the application of the arm’s length principle in the allocation of costs under the CCA. 

Otherwise, the efficiencies achieved in the CCA may be lost when the expense is disallowed or an adjustment is imposed in a subsequent examination by the tax authorities.