The regulatory framework for transfer pricing (TP) in the context of restructuring is primarily governed by Revenue Audit Memorandum Order (RAMO) No. 1-2019. This issuance provides the principles for evaluating whether related-party transactions, including those arising from restructuring, adhere to the arm’s length principle.
A key concept emphasized in this regulation is that any restructuring within a multinational group that results in a change in the business characterization of a local entity must be accompanied by a corresponding shift in the functions performed, assets employed, and risks assumed (collectively referred to as FAR). This principle ensures that the economic substance of the restructuring is consistent with its financial outcomes.
In practice, business restructuring often leads to a reduction in the profitability of the local entity. Such a reduction is acceptable under Philippine transfer pricing rules only if it is supported by a genuine decrease in FAR. If, however, the local entity continues to perform the same functions and bear the same risks after the restructuring, the Bureau of Internal Revenue (BIR) may view the arrangement as lacking substance and may impose transfer pricing adjustments to correct the perceived misalignment.
The BIR, in line with the OECD Transfer Pricing Guidelines and the United Nations Practical Manual on Transfer Pricing, underscores that in an arm’s length scenario, an independent enterprise would not agree to a restructuring that results in a negative financial impact unless it had no better alternatives. This concept of “options realistically available” is central to evaluating whether a restructuring is commercially rational. The burden of proof lies with the taxpayer to demonstrate that the restructuring reflects genuine economic changes and that any reduction in profitability is justified by a corresponding reduction in FAR.
To better understand how these principles apply in practice, consider a common scenario in the trading and distribution sectors. A group of companies operates through three separate entities: one responsible for importing merchandise, another for distributing the merchandise, and a third for retail operations. Prior to restructuring, the importing and distribution entities are characterized as moderate-risk distributors, while the retail entity functions as a full-fledged retailer.
In the pre-restructuring setup, the importing entity sells merchandise to the distribution entity at an X% mark-up. The distribution entity, in turn, sells the goods to the retail entity at a Y% mark-up (higher than the X% mark-up). These mark-ups are supported by transfer pricing documentation and benchmarking studies, reflecting the functional profiles and risk exposures of each entity.
The group then decides to restructure by consolidating operations into the retail entity. This involves transferring personnel, assets including merchandise inventory, and contractual obligations from the importing and distribution entities to the retail entity. During the transition period, both the importing and distribution entities begin to reduce their operational roles and gradually transfer their FAR to the retail entity.
As a result of this restructuring, the importing and distribution entities are recharacterized as limited-risk distributors. Their reduced involvement in procurement, logistics, and inventory management justifies a lower return under the arm’s length principle. Accordingly, merchandise inventory held by these entities prior to the date of transfer, when they still possessed full FAR, are transferred to the retail entity at pre-restructuring prices. This pricing reflects the full value of the merchandise, supported by the functions and risks previously assumed by the transferring entities.
However, during the transition period, as both entities continue to reduce their FAR, merchandise transferred during this time is priced at a discount relative to the pre-restructuring rates. This adjustment is justified by the diminished functional contributions and risk exposures of the importing and distribution entities. The pricing reflects the economic reality that the merchandise no longer carries the same value-added functions and risks as before.
To ensure that the restructuring complies with transfer pricing regulations and accurately reflects the economic substance of the changes, the group must undertake a series of deliberate and strategic actions.
First, it is essential to revisit and revise intercompany pricing policies to ensure they align with the updated functional profiles of each entity involved in the restructuring. This includes recalibrating mark-ups to reflect the reduced roles and risks of the importation and distribution entities while recognizing the expanded responsibilities assumed by the retail entity.
Second, the group must prepare comprehensive transfer pricing documentation for all entities involved in the restructuring. These reports should cover both the pre-restructuring and post-restructuring periods and provide detailed analyses of the changes in functions, assets, and risks. Benchmarking studies should also be conducted to support the revised pricing arrangements and ensure that they remain within arm’s length parameters.
Third, the transfer of assets and inventory must be substantiated with clear economic rationale and supported by appropriate documentation. This is particularly important in demonstrating that the transfers are not designed to shift profits artificially but are part of a broader operational realignment. The documentation should clearly show that the pricing of merchandise transfers reflects the actual FAR at the time of transfer.
Fourth, the group should evaluate its use of intangible assets, such as proprietary brands and centralized procurement platforms developed by the parent company. The group should assess whether the contributions of local entities to these intangible assets, particularly regarding their development, enhancement, and exploitation, justified the payment of royalties or service fees. This analysis ensures that the group’s profit allocation reflected the value created by each entity.
Finally, to reinforce its position and mitigate potential audit risks, the group may consider seeking a confirmatory ruling from the BIR through an advance pricing agreement as approved by the BIR. Such a ruling would provide regulatory clarity on the tax treatment of the restructuring and demonstrate the group’s proactive approach to compliance.
Restructuring is a powerful strategic tool for multinational enterprises seeking to optimize operations, reduce costs, and adapt to changing market conditions. However, executing such transformations requires diligence and a clear understanding of transfer pricing principles. Tax authorities expect that restructurings will reflect genuine shifts in economic activity rather than mere reductions in taxable income.
Ultimately, the success of a restructuring lies not only in its operational execution but also in its regulatory defensibility. When substance matches form and documentation supports intent, businesses can achieve both strategic and compliance objectives with confidence. By aligning restructuring plans with transfer pricing principles and regulatory expectations, companies can safeguard against scrutiny, enhance transparency, and support long-term value creation.
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.
Nikkolai F. Canceran is a partner from the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.