Related-Party Sales and Unsupported Deductions
Crestview Manufacturing, a domestic corporation, reports gross revenue of ₱80,000,000 for Year 2. Of this, ₱15,000,000 arises from sales to a sister company owned by the same individual, priced at 20% above prices charged to unrelated customers. Crestview claims deductions of ₱9,000,000 for 'management fees' paid to the same individual with no written contract, no invoices, and no evidence of services. It also deducted ₱2,500,000 of interest on a loan from a shareholder, at 18% when the bank rate is 10%. The revenue officer proposes to disallow the management fees and adjust the related-party sales.
1. Analyze which deductions are vulnerable and explain the reasoning for the management fees and the shareholder interest.
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A deduction requires substantiation. The ₱9,000,000 management fees lack a written contract, invoices, and evidence of services received, so they fail the substantiation requirement and are vulnerable to disallowance. Payments to an individual owner also raise withholding and related-party issues.
The ₱2,500,000 shareholder interest is partly vulnerable. Interest on shareholder loans is deductible only to the extent of an arm's-length rate on the principal, and only if the loan is documented and the interest is actually paid or accrued under a valid obligation. At an 18% rate against a 10% bank rate, the excess is an unreasonable payment. Applying a 10% benchmark, imputed allowable interest is ₱2,500,000 × (10/18) ≈ ₱1,388,889, so roughly ₱1,111,111 is disallowed. Related-party pricing on the ₱15,000,000 sales at 20% above unrelated prices should be tested against arm's-length principles and may trigger an adjustment, though the direction of the adjustment depends on whether income was shifted into or out of the jurisdiction.
2. The owner argues that because the sister company is taxed, the related-party pricing is harmless. Evaluate that argument and describe the documentation the auditor or examiner should request.
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The argument is unsound. Related-party pricing is tested on arm's-length terms regardless of whether the counterparty is taxed. A 20% premium over unrelated prices suggests income shifting and can be adjusted to reflect what independent parties would agree. Even where both parties are taxed, the pricing affects each party's taxable base and may be challenged.
The examiner should request the transfer pricing documentation, comparability analysis, contracts, invoices, proof of services, bank statements, and the shareholder loan agreement. The examiner should compare prices charged to unrelated customers, confirm the services underlying the management fees, and verify the interest rate and payment. If documentation is absent, the burden of proving the deduction falls on the taxpayer, and the disallowances plus related penalties and interest should be assessed. The examiner should document each adjustment and give the taxpayer an opportunity to present evidence.