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The taxability of reimbursable or allocable expenses for cross-border services

Is there a flow of wealth when there is a reimbursement at cost? Is there an income to speak of when repaying a cost allocated by a related party? Are these kinds of transactions included in the definition of taxable income or VATable transactions in Philippine law? These are the common questions that taxpayers may ponder when they read the new Revenue Memorandum Circular (RMC) 05-2024 pertaining to reimbursable and allocable expenses.

In the recent RMC 5-2024, the Bureau of Internal Revenue (BIR) clarified the tax treatment of cross-border services in light of the Supreme Court’s (SC) decision G.R. No. 226680 dated Aug. 30, 2022. The RMC provided a new framework for assessing the final withholding taxes and final withholding Value-Added Tax (VAT) on services rendered by non-resident foreign corporations (NRFC).

Specifically, the RMC states that cross-border reimbursements and allocated expenses are now taxable because of possible tax savings or benefits received from the transaction. The circular explained that these charges by a foreign corporation contribute to the value or benefit received by a local company. The reduction of expenses by the foreign company increases the foreign company’s net income or profit because the foreign company spends less on its operations, resulting in additional funds that can be used for other purposes or retained as profit.

Therefore, the reduction in expenses is viewed as a form of income of the foreign company, and this increases the tax base that is subjected to Final Withholding Taxes (FWT) as well as the Final Withholding VAT. It is then of the greatest importance to understand the nature of reimbursable and allocable expenses to afford the proper tax treatment.

Reimbursement transactions happen when a related party procures goods or services from a third party on behalf of the taxpayer and is subsequently repaid by the taxpayer at cost. In some sense, it may be referred to as a pass-through cost because the related party was only an agent between the taxpayer and the third-party service provider and did not enhance the value of the acquired goods or services.

On the other hand, expenses may be allocated to the member companies of a group of companies through a cost-sharing or cost-pooling arrangement. In both cases, multinational companies merely reimburse or allocate business expenses among the affiliated companies at the same cost as those incurred. In this case, the foreign company is not spending less on its operations because these costs are liabilities of the local entity, even though the foreign company is legally or contractually liable to pay for the acquired goods or services that it seeks to reimburse or allocate to the local company.

Prior to the release of RMC 5-2024, reimbursements and allocation of expenses from foreign companies were not subject to any taxes because the nature of the transaction does not constitute any income that is subjected to income tax and, consequently, to final withholding tax.

Revenue Regulations No. 2 defines income as the wealth that flows into the taxpayer other than as a mere return of capital. It includes the forms of income specifically described as gains and profit, including gains derived from the sale of other dispositions of capital assets. Income cannot be determined merely by reckoning cash receipts.

In a SC decision, the SC held that receipts entrusted to a taxpayer that do not belong to it/him and do not redound to the taxpayer’s benefit are not included in the term “gross receipts,” and it is not necessary that there must be a law or regulation that would exempt such receipts. In this case, reimbursements are entrusted only to the foreign affiliate for the payment of expenses and do not constitute an increase in benefit that should be taxable.

Further, the Court of Appeals (CTA) in a decision states that “In order for the expenses not to be subject to withholding tax, it must first be established that they are reimbursements of actual expenses. In a reimbursement-at-cost transaction, it is inferred that the expenses are incurred by the advancing party for the benefit and account of the party accommodated.”

The BIR, in a ruling, even agreed that reimbursement costs pursuant to a cost-sharing agreement are not subject to income tax as these are not income, stating that “well settled is the rule that reimbursement of costs shall not be regarded as income but as a return of capital.”

Last, with respect to VAT in various BIR rulings, the BIR explains that in reimbursement-at-cost transactions, expenses that are incurred by the advancing party for the benefit and for the account of the party accommodated can be considered reimbursable expenses not forming part of the gross receipts of the advancing party subject to tax. Since the party seeking reimbursement does not sell, barter, exchange, or lease any food or property, nor does it render any service to the party accommodated, the reimbursement transactions are not subject to VAT.

With the issuance of RMC 5-2024, multinational companies may find it difficult to have reimbursement or allocation of expenses transactions with Philippine companies because of the imposition of tax on these transactions. For better clarification, the BIR could provide guidance to the taxpayer regarding the transfer pricing aspect. For instance, depending on the specific facts and circumstances of each case, the group service provider should charge an appropriate arm’s length markup for its function in arranging and paying for the acquired services on behalf of its related parties, especially when the group service provider adds significant function or provides value-added services.

Considering the risks and costs in the case of tax audit, it would be wise on the part of the local companies reimbursing or repaying the allocated costs from their foreign affiliates located in countries that have a tax treaty with the Philippines to confirm the tax consequences of the arrangements through a Request for Confirmation.

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 professional advice.

 

Juanito Rafael Clemence O. Uy is a semi-senior from the Tax Advisory & Compliance division of P&A Grant Thornton. P&A Grant Thornton is one of the leading audits, tax, advisory, and outsourcing firms in the Philippines, with 29 Partners and more than 1000 staff members. We’d like to hear from you! Tweet us: GrantThorntonPH, like us on Facebook: P&A Grant Thornton,

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