“It is not the strongest or the most intelligent who will survive but those who can best manage change.” This warning by Charles Darwin sends a clear message. With the world evolving so rapidly, we have to be quick to adapt. In business, it has become a necessity for multinational enterprises (MNEs) to adjust to the changing environment to remain competitive and relevant. As such, most MNEs make adjustments by restructuring their commercial and financial relations to adapt to these changes.
Cross-border reorganization in the commercial and financial relations between associated enterprises is called business restructuring. It may often involve centralization of intangibles, risks or functions, along with the profit potential attached to them. MNEs implement business restructurings for a number of reasons, typically to maximize synergies and economies of scale, to streamline the management of business lines, to improve the efficiency of the supply chain, or to preserve profitability or limit losses.
While business restructurings are not usually done for tax reasons, the changes that occur during restructuring may, however, warrant transfer pricing considerations for all the parties involved. As such, business restructurings pique the interest of tax authorities especially during transfer pricing audits. In fact, in the Philippines, the Bureau of Internal Revenue (BIR) included business restructuring as one of the factors to be considered in analyzing the transfer pricing risks and compliance of a taxpayer during an audit. In Revenue Audit Memorandum Order (RAMO) no. 1-2019, the BIR briefly discussed its key considerations in reviewing the transfer pricing implications of business restructurings entered into by associated enterprises.
According to the RAMO, the reduction in profit of an entity as a result of business restructuring may only be acceptable if the functions performed, assets employed, and risks assumed have actually been reduced. Otherwise, the revenue officer may make necessary adjustments to reflect an arm’s length arrangement. The rationale behind this is simple. In an arm’s length situation, an independent party will not restructure its business if it affects its results negatively, and where it has the option realistically available not to do so.
The RAMO did not provide further details on how to apply the arm’s length principle to business restructurings. Nonetheless, Chapter IX of the OECD Transfer Pricing Guidelines provide a thorough discussion on the application of the arm’s length principle to business restructurings.
Ultimately, there are three main points to consider in determining the arm’s length conditions of business restructurings. First, we must analyze the accurate delineation of the transactions comprising the business restructuring. We will ask questions like, “What are the functions performed, assets employed, and risks assumed before and after the restructuring?”, “Does the transferred function or risk carry with it a profit potential?”, “If so, does the transfer itself call for an arm’s length consideration?”.
For instance, let’s take the case of a full-fledged manufacturer that is converted into a toll manufacturer resulting in the elimination of inventory risk. In order to migrate from the pre-existing arrangement to the restructured one, the inventories that are on the balance sheet of the taxpayer at the time of restructuring are transferred to another associated enterprise. The question here is how to determine the arm’s length transfer price for the inventories upon the conversion.
Second, we must understand the business reasons for and the expected benefits from the restructuring. One of the most common reasons for restructuring is to have more centralized control and management of business functions. For instance, a business restructuring may involve centralizing the group’s procurement activities into a single entity to take advantage of volume discounts and potential savings from administrative costs. Thus, to determine the arm’s length nature of the transactions involved in the restructuring, it is equally important to determine the benefits derived from such reorganization. The question of who will benefit from the savings or profit derived from such reorganization should be raised. In the example, the central procurement company may be entitled to a profit for its performance of certain functions, and its assumption of the risks associated with buying, holding and reselling goods. However, it is not entitled to retain profits arising from the group’s purchasing power (e.g., savings from volume discounts) because it does not contribute to the creation of synergies.
Last, in analyzing whether the business restructuring itself is conducted at arm’s length, it is important to understand whether the entity involved in the reorganization has a more attractive alternative rather than to enter into a restructuring. Simply put, in applying the arm’s length principle, it would be important to know whether independent entities would be willing to enter into the same transaction. Otherwise, if the restructuring would make the independent entities worse off than their current situation, they would not restructure their business.
In view of the above, it is not surprising why business restructuring is one of the focus areas of tax authorities during transfer pricing audits. Aside from the potential sudden changes in the profitability of a restructured entity post-restructuring, the tax authorities would also be concerned about the transactions involved in carrying out the restructuring itself.
From the perspective of the taxpayers, robust documentation of the business restructuring would be helpful in supporting the arm’s length conditions of the reorganization. One of the major hurdles that taxpayers may face is the difficulty of finding comparable transactions. Nonetheless, every effort should be made to determine the pricing for the restructured transactions. In light of this, aside from transfer pricing documentation, an advance pricing agreement approved by the BIR (once this becomes available) should be helpful to minimize uncertainty and give taxpayers comfort on the tax treatment and transfer prices of the transactions involved in the restructuring.
The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The content is for general information purposes only, and should not be used as a substitute for specific advice.
Leizelyn De Villa is a Manager at the Tax Services Department of Isla Lipana & Co., the Philippine member firm of the PwC network.
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leizelyn.e.de.villa@pwc.com